Germany’s strong economy and heavyweight reinsurance players can do little to hold back the credit crisis. Many recognise the impact of subprime will go much deeper than first thought, as Herbert Fromme reports.

The seasoned insurance manager was visibly angry. “If the government covers the banks’ subprime losses, I will convert to communism,” he said loudly at a Berlin function of the German insurance federation Gesamtverband der Deutschen Versicherungswirtschaft (GDV). Although it is unlikely that he will radically change his political views, the outburst in a hotel in former East Germany of all places, illustrates the uneasiness among the country’s insurers about the current overall climate for financial markets.

Most managers realise that the effects of the crisis will be far deeper and last much longer than they thought last year. Back then, some of them made jokes about the banks’ incompetence and added the hope that the true price of risk – and thus insurers’ services – would be valued by the markets again.

The subprime crisis is felt by insurers in a number of ways. On the one hand, there are a few companies which have invested directly in that segment. Of the ?690bn book value of German life insurers’ investments, just 1.7% was held in asset-backed securities or credit-linked notes, GDV found. “German insurers are so far not directly affected by the US mortgage crisis,” says GDV president Bernhard Schareck. “But we will closely monitor its effects on the economy and the finance industries, and will take it into consideration in our strategic thinking.”

The tone of the statement is guarded for a reason. The industry is far more affected by subprime than many managers believe. Some insurers (and reinsurers) active in the German market have higher exposures, as some of them have already shown. This is true for Swiss Re, for example, one of the largest operators in Germany. In November, it revealed a CHF 1.2bn hit, only days after announcing that the burden would be much smaller. Further hits at other companies have not been ruled out.

The industry as a whole is suffering from the sharp volatility of the stock markets in its investment results – and this volatility is likely to last, given the unstable situation. Life customers in particular are being very careful at the moment, preferring not to sign long-term contracts. There will be losses from D&O and E&O policies, although only on a limited level in Germany.

“Most managers realise that the effects of the crisis will be far deeper and last much longer than they thought last year

Insurance groups with close ties to banks are feeling a much bigger impact, such as Allianz, which has owned Dresdner Bank since 2001. For seven years, Allianz’ management has defended the fact that it owns a bank, although many investors and analysts criticised it for the extremely patchy performance of the bank. Allianz’ high profits – it earned ?8bn after tax in 2007 – and the fact that the share price had been rising continuously since chief executive Michael Diekmann took office in 2003 allowed him to shrug off the criticism.

But after the share price plunged since mid-2007, Allianz announced in mid-March 2008 that it would split the bank into two – one investment bank and one high-street institution. This is widely seen as the first step to selling or merging the investment bank. At the same time, Allianz did not deny rumours that it might want to buy Postbank, the giant postal bank up for sale. A merger of Postbank and the Rest Dresdner (Dresdner’s high street unit) could solve many of the problems that the more rural and down-to-earth Allianz has with the posh Dresdner. Whatever the outcome is – the subprime crisis has forced Allianz to change its direction, which will have a far-reaching effect on its overall business model.

The second group significantly affected are the public-law insurers, which are part of the savings banks financial group. The German Landesbanks, politically- controlled banks, are heavily involved in the spiralling lending crisis. WestLB in Düsseldorf suffered a ?1.6bn loss in 2007, despite moving most of the problematic assets to an off-balance sheet operation. BayernLB suffered hits amounting to ?4.3bn by the end of March. SachsenLB has already been taken over by LBBW, the Stuttgart Landesbank. So far, the savings banks, together with the state governments, have had to shoulder the burden that cannot be carried by the banks themselves.

The subprime crisis highlights the complicated situation the German market is in. The big corporations such as Allianz and Munich Re no longer have cross-shareholdings or other stabilising large investors; they are driven by the need to please the stock market. The market as a whole is suffering from a political trend towards more regulation. The new German insurance contract law Versicherungsvertragsgesetz (VVG) came into force on 1 January and burdens companies with a host of new rules on transparency, customers’ participation in hidden reserves and disclosure of sales costs. The VVG is only one of several reforms already passed or soon to come, including a major overhaul of the health system (hitting private health insurers) and the dreaded introduction of Solvency II.

While the German economy as a whole grew by a strong 2.6%, insurers saw premium income go up by just 0.8%. In property casualty, there was even a decline of 0.4%. This is partly due to the fact that the price war is continuing, not only in motor, but also in industrial insurance – where the market saw another drop, this time of 2.9%. It is also a result of the fact that the German property casualty sector is saturated, which drives companies such as Allianz and Munich Re to seek growth primarily abroad. Motor saw a combined ratio – after settlement results of earlier years – of 101% in 2007, compared with 95% in 2006. For 2008, the industry expects 105%.

“The subprime crisis has forced Allianz to change its direction, which will have a far-reaching effect on its overall business model

The cycle has clearly turned. Even Munich Re, which is well-known for its ability to talk up the market as long as possible, had to concede that. In the January renewals, prices in renewed contracts went down by on average 2.8%, said chief executive Nikolaus von Bomhard. “We can live with the renewal; in most cases, we were able to maintain our profitability standard,” he added. Such comments, incidentally, prompt reinsurance buyers to wonder what happened when the prices were higher. Were profitability standards over-fulfilled?

The fact that the heavyweights of the industry came up with record profits in 2007 – Allianz ?8bn net, Munich Re ?3.9bn net – does not really contrast with the stagnant development. On the contrary: both companies are acutely aware that investors question their business model and their ability to grow. High profits, increased dividends and massive share repurchasing programmes are their way of trying to convince investors that they have a valid business model.

Welcoming the Oracle

So far, the measures failed to ignite the companies’ share prices. Over the last seven years, the German blue-chip index Dax lost 7% and Munich Re’s shares lost 70%, angry shareholders told the management at the AGM on 17 April. It was welcome news in that situation that Berkshire Hathaway boss Warren Buffett has built up a 0.5% stake in Munich Re in recent months, along with his 3% in Swiss Re.

While Munich Re welcomes Buffett, it is uneasy about the emergence of hedge funds as investors which together hold some 15% of the company’s stock. Cevian of Sweden in 2007 demanded “major changes” in the reinsurer, without being more specific. The fund, supported by US investor Carl Icahn, has a history of aggressively pushing through its strategies, but has so far not made a move. Cevian’s managing partner Lars Förberg was at Munich Re’s AGM, but shied away from an open confrontation.

“The cycle has clearly turned. Even Munich Re, which is well-known for its ability to talk up the market as long as possible, had to concede that

Munich Re clearly hopes that Cevian has run out of steam, which might be a bit premature. CEO von Bomhard and Torsten Jeworrek, the head of reinsurance, are convinced it would be foolish to buy reinsurance capacity at the moment – but in order to present shareholders with a growth story, they embarked on a series of small expansion moves, mainly in primary insurance and in healthcare. The company rules out selling its large primary unit Ergo and insists that the offsetting factors of being both a large primary insurer and a reinsurer help it to remain profitable.

Others are busy with their restructuring, too – namely Hanover-based mutual Talanx, which took over Gerling and is currently in the digesting phase, merging it with its own industrial insurer HDI. After a very bad start, the merger is now going somewhat better. However, given the current stock market climate, Talanx is unlikely to go ahead with the initial public offering it has long planned and which was scheduled for 2008. While this is no immediate problem, it could pose difficulties for successful reinsurer Hannover Re. Hannover Re controls Talanx with a 51% stake. The parent made it clear that it will not give up control. At the same time, it does not have the money to prop up Hannover Re’s capital for the latter’s continued expansion. Hannover Re CEO Wilhelm Zeller and finance chief Elke König will need all their ingenuity to overcome the problem with even more hybrid capital.

So where is the German insurance and reinsurance market in a nutshell? A stagnating, but so far highly profitable market that is just about to turn, where there are political moves to re-regulate the market, share prices of insurers that are a third of what they used to be, and where above all a financial crisis looms that will be felt by insurers in many ways. The market certainly needs a lot of courage and high management talent in the immediate future.

Herbert Fromme is a freelance journalist.