With war in Iraq looming, Dermott White takes a look at how conflict in the Middle East might affect the global economy, as well as the aviation and marine re/insurance sectors.
War with Iraq now looks very likely indeed. Apart from the US's own manoeuvres, such as the decision to send 62,000 troops to the Gulf in early January, several signs point in that direction: Britain has sent 30,000 troops and 120 Challenger tanks to the Gulf; French President Jacques Chirac has rallied his troops, ordering them to be "ready for every eventuality"; the price of gold - considered a safe-haven in times of great uncertainty - has surged to over $350 per ounce; and, at the time of going to press, the oil price was still above $30 per barrel, despite an Opec decision to increase its output quota by 1.5 million barrels to 24.5 million barrels per day.
In addition, although there are several factors behind the ongoing bear market, the possibility of conflict in the Middle East is weighing on share prices and suggests that investors are pricing in a short, successful campaign to remove Saddam Hussein from the Iraqi leadership.
War with Iraq does not necessarily spell doom and gloom for the global re/insurance industry but it will have consequences for participants in sectors like aviation and marine - for these lines of business, war is a double-edged sword. Also, subdued stock markets will continue to pressure re/insurers' investments and asset values no matter which line of business they write.
For Swiss Re, there are three scenarios which could play out over the course of 2003. The first, most desirable possibility is that war in Iraq is avoided altogether. Swiss Re chief economist Thomas Hess says if this happens, it is likely that the economies of Europe and the US will recover, and there is the possibility of substantial economic growth in the second half of this year. Swiss Re forecasts GDP growth in the US of 3% in 2003 and 1.5% in Europe.
"On the stock market, if everything settles quickly, this would mean a lot of uncertainty is removed and it should give the stock market some relief. Oil prices should go down to the $20 [per barrel] level and this would give relief to inflation, so the interest rate environment would be quite favourable. Of course, interest rates would rise when the economy starts growing faster," says Mr Hess.
The second scenario, the one that Swiss Re thinks is most likely to occur - it has attached an 80% probability to it happening - is the quick, victorious invasion of Iraq which most people expect.
Mr Hess says the difference between these two outcomes would not be substantial.
"The upside of a no-war scenario against a short-war scenario is limited. If we have a short war and everything goes smoothly, like in the first Iraq war, then we'll see oil prices not rising substantially - perhaps another $10-$15. That's if the war does not last longer than 30 to 60 days," says Mr Hess. "There would be a little bit of a hit to economic growth but it would not be very substantial. So, we could still expect US growth of about 2% or even more this year. Inflation will perhaps pick up by one percentage point or so. Long-term interest rates may rise a little bit but in the short-term perhaps the Fed (the US Federal Reserve) will reduce interest rates to support the economy." He adds there would probably be some negative impact on the stock market at the beginning of a war and this would affect the value of re/insurers' investment portfolios. However, there is likely to be quick relief for share prices if the war is short-lived.
"On the insurance side, with the increase in terrorist activities, although they are very hard to predict, I think the insurance industry is today much better prepared than in the past for dealing with them.... So the risk there is also limited. If oil prices pick up, inflation picks up a little bit. Of course, this spills over to higher claims costs, but if the war is short, the inflation effect to insurance is not substantial."
However, the third scenario, and the most damaging for the world economy, would be a drawn out conflict with Iraq that spilled over into neighbouring countries.
"Although our opinion still is for a short and successful war, the risks are high that something goes wrong.... And this would mean quite a severe scenario which would include a few quarters of negative growth in the US, rising prices, because the oil price goes up to $75 or above, long-term interest rates may go up and the real economy would be severely affected," he says.
Setting aside that possibility and assuming a war with Iraq is short, sharp and successful, the flipside of periods of great uncertainty is higher demand for insurance. Where there is concern about asset values, financial analysts and ratings agencies study companies even more carefully to prove that they are safe. And one way to protect a company is to buy insurance.
"When you only have the opportunity to raise capital at very expensive prices on the capital market - either through debt or through stock issues - you have to manage your risks better, and managing your risks basically means also insuring. And that is favourable for insurance demand and also the price for cover which can be achieved," explains Mr Hess.
However, the closer scrutiny to which companies are subjected also applies to re/insurers, and their capital costs also rise during periods of uncertainty.
"On balance, it might be favourable for the insurance industry but I think the industry would be happier if the uncertainty was removed and stock prices rose a little and the general economic situation improved. So I think the uncertainty is good for prices in the insurance sector but it's not good for the stock market valuation of the insurance company," says Mr Hess.
The aviation sector would also face mixed fortunes. The charging of additional premiums (APs) for airlines flying to danger areas, close to the conflict zone, could provide some upside for aviation underwriters in the short-term. Simon Clapham, the active underwriter of Brit syndicate 2987 at Lloyd's, which underwrites aviation business among other lines, says some underwriters made quite a lot of money during the Gulf War of 1991 from APs - despite the market suffering a large war-related loss after it paid out for aircraft that were caught up during the Iraqi invasion - but adds that any short-term gain would be quickly outweighed by the long-term losses.
"It wouldn't do us any good whatsoever because we need the airlines to start making some money, and war ... would make them even weaker than they are now, which won't do us any good in the long-run at all," says Mr Clapham. "War will hit them (the airlines) in three areas. One will be their revenue stream because there are less passengers flying. Two, the price of oil will go up, so it'll have an effect on the fuel they buy. And three, if we charge them more money for the war, which inevitably we would do if they flew into any particular area, then that would be another major hit on them."
The situation is not dissimilar in the marine market, where hull and cargo underwriters also charge APs for vessels that sail into excluded zones (see figure 1).
"When war breaks out in some part of the world, if you think about the post-war (World War II) period, it doesn't tend to be anything greater than regional - there's never been anything continental wide," says Sam Ignarski, a London-based transport specialist with Charles Taylor Consulting. "Would it raise prices universally? That's not what history tells us. There have been hot wars all over the planet in the last 30 years but they don't particularly impinge on the global rating of things. But they certainly would on the local rating."
This offers profitable opportunities for those underwriters willing to take on the additional risks. For example, during the Vietnam War, most ships that went close to that area were still insured at Lloyd's. However, as Mr Ignarski says: "At the end of the whole system, when lead starts flying, the insurers tend to withdraw."
He adds: "War is not really that good for business. Places where wars are being fought are not that lively economically and the basic proposition in war and war insurance is that there comes a point where it's economically no longer tenable to insure. So, therefore, if anybody is going to insure it, it's governments."
Any business advantage in re/insurance from war is likely to be only very short-term. But there are some things that insurers can do to minimise the impact of the uncertainty that war could bring.
Swiss Re's Mr Hess advises them to think of different scenarios and the different ways in which war could affect their companies.
"If war starts, for example, inflation might be affected, then interest rates might be affected, stock markets might be affected. So in such a situation, it's always good to have a proper asset-liability match in place," he says. "In a situation of uncertainty, you should think through the scenarios, look where exposure is, where your risks are and try to do an asset-liability match so that you can even cope with the real scenario."
He adds this is not only vital for survival but also for a chance to turn the turmoil into an opportunity: "You can gain a competitive advantage when you are well prepared to deal with different adverse scenarios. A defensive strategy I think is preferable to making big bets on what the outcome of this war could be."
Figure 1: current exclusions for vessels engaged in world-wide trade.
A) Persian or Arabian Gulf and adjacent waters including the Gulf of Oman North of 24°N.
B) Angola (including Cabinda)
E) Libya (including Gulf of Sidre/Sirte)
H) Congo, Democratic Republic of (formerly Zaire)
J) Sri Lanka
K) Sierra Leone
L) Gulf of Aqaba and the Red Sea
M) Republic of Yemen
S) Indian ports north of 18N
By Dermott White
Dermott White is assistant editor on