Will the subprime crisis and resulting global credit crunch impact reinsurers? In the first of a new series, we ask Andrew Barile and Seymour Matthews to present two differing views.

The debate

A relatively benign hurricane season would usually be cause for celebration in the reinsurance industry. However this year’s champagne has been put on ice and the tasty canapés cancelled as a new and unexpected threat has arisen. The subprime crisis in the US has triggered a global credit crunch and the ripples are starting to be felt in many industries.

At this year’s Monte Carlo Rendez-Vous, reinsurance executives were bombarded with questions from the media about the affects of the subprime crisis on the reinsurance industry. Responses varied from cautiously optimistic to glumly pessimistic, but all agreed that insurers would not emerge totally unscathed.

Inspired by this spectrum of opinion, Global Reinsurance decided to launch a new monthly feature, allowing industry professionals to voice their thoughts on a hot topic. There is no room for fence-sitters on these pages – it’s yes or no, for or against.

To mark its debut, this month we asked Andy Barile and Seymour Matthews if they thought the subprime crisis and credit crunch would have much, if any, affect on the reinsurance industry.

YES it will!

Andy Barile is principal of Andrew Barile Consulting.

Whenever the credit markets become restricted it has an impact on both the insurance and reinsurance industry. Credit becomes scarcer, as foreign and domestic investors lose confidence. This has a direct impact on the hedge fund who is about to invest in the new start-up Bermuda reinsurer.

Some $4.5bn has been raised through sidecars, all during the time when credit markets were riding high. Market conditions are now at a credit crunch. Will there be the investors to continue the renewal of the sidecars?

The downgrading by rating agencies of subprime bonds has an impact. When the retrocession market dried up, smart reinsurers turned to alternative sources of capital. Catastrophe bonds and sidecars became popular choices rather than giving up equity. Many of these investors had turned to unrestricted credit markets to leverage their investment. Of some 15 Bermuda sidecars, the capital raised ranged from $70m to $1bn. The credit crunch will reduce this amount.

“The harsh realities of the subprime crisis will cause the capital markets to carefully analyse their decisions to be involved with the insurance and reinsurance industry

Andy Barile

The catastrophe reinsurance market has now gone through a soft market, which reduces the need for reinsurance capital. Even with the cat modellers taking a more conservative approach in determining insured values, and rating agencies demanding more capital, reinsurers will need to adapt to the new credit crunch.

Reinsurers can protect themselves for the future if they do not build their future earnings on leveraged capital, and what can be referred to as “temporary capital”, all searching for great returns brought upon historical triple digit reinsurance pricing. Observing catastrophes since Hurricane Betsy in 1965 to Hurricane Katrina in 2005 has taught me to be more conservative.

The baton has been passed from captive insurers, owned by corporations who provided retrocession capacity, to sidecars and cat bonds capitalised by hedge funds and private equity firms. Hedge funds have a recent attraction to reinsurance investments as the offshore vehicle provides ease of entry and exit, and a short-term commitment, ie one year or possibly two. So if there are no catastrophes, its high returns all round.

Finally, as credit markets become more restrictive, banks providing Letters of Credit for captive insurers and other non-admitted reinsurers will have to increase their transaction costs. Be prepared to pay more. The overall impact will be that investors will become more cautious, and rethink their exposures. Investments in catastrophe exposures will come under a watchful eye, as the harsh realities of the subprime crisis will cause the capital markets to carefully analyse their decisions to be involved with the insurance and reinsurance industry.

NO it won’t!

Seymour Matthews is managing director of reinsurance at Heath Lambert.

As I see it, “prime” as in “prime rate” is the lowest rate at which money can be borrowed commercially – so “subprime” is automatically accepted as “sub standard” or below economical cost.

With this in mind, anybody “gambling” on such quality business is doing so either with their eyes open or they are blind to the market that they are trading in. Incompetence or innocence are not exposures to a typical financial institutions or professional indemnity policy.

As a result of the subprime crisis, there will probably be many cases for insurers and reinsurers to defend, and as is typical in the US, all advisors will be cited in the same action. This will incur substantial defence costs for insurers under professional indemnity and directors’ and officers’ (D&O) policies, but actual claims and cases won should not seriously affect the insurance industry, particularly in London as the majority of this area of D&O is written in the US.

It is interesting to note that since the subprime story broke, a number of new D&O offers are appearing from the US, which certainly would not have come for the last two years. So somebody is hurting!

“I do not believe that London reinsurers are heavily exposed in this area and it will not be an Enron or Worldcom-type situation

Seymour Matthews

The exposure here for reinsurers will come via the insurance market. It is involved with collateralised debt obligation (CDO), which are packages of investments much of which is “AAA”, “AA” and “A” and around 10% below investment rate. However, amazingly, the rating agencies sometimes rated these particular packages as “AAA” or “AA”, hence upgrading the minority of low grade or ungraded business to “AAA”. This has allowed hedge funds and other investors access to packages many of them might normally avoid.

The exposed areas for London reinsurers could come from:

• D&O from actions against publicly-listed mortgage banks – only relevant if the share price is down at the time of the action;

• Hedge funds will have D&O exposure from shareholders claiming that CDOs are an over risky investment;

• Professional indemnity against mortgage brokers for steering buyers towards subprime markets for higher commissions, therefore misselling;

• Rating agencies for misleading investors as to the quality of some of the CDOs; and

• Lawsuits will be brought against all the professional advisors.

But the fact of the matter is the primary markets are exposed to costs of defence and there will be some out-of-court settlements, all of which will be quite substantial. I do not see London market reinsurers being heavily exposed to this, though as always there will be one or two exceptions to this rule. The majority of these exposures and therefore settlements will remain in the primary market in the US, and possibly some US reinsurers of US primary writers.

The other point worth considering and noting is that this debt was passed around in a variety of “packages”, very similar to the LMX [London Market excess] spiral in the 1980s. It is very well spread around the world and in some cases very well hidden as well. Should there not be defaults on this mortgage business, then there is no exposure.

So it is only investors who need to liquidate in the short term that are seriously exposed, and the remainder probably have little to no exposure. A number of the providers of this CDO business are buying back some of the packages from the more desperate investors as in the long term this subprime exposure may not cause losses to anybody.

I do not believe that London reinsurers are heavily exposed in this area and it will not be an Enron or Worldcom-type situation, as London underwriters are typically excess-of-loss writers at a non-frequency level. It is worth noting, however, that this opinion is based only on the information that is available at the time of writing in late-October 2007.