As the credit crunch widens its grip on the global debt markets, Lindsey Rogerson asks if the insurance and reinsurance industry should be concerned

Global debt markets remain in turmoil as we go to press. The full extent of the chaos wrought by the collapse of the US subprime mortgage market is still unknown. Indeed, some market experts believe it could take months for a full list of those caught out to appear. In the meantime investors could be forgiven for not knowing which way to turn, with some analysts spying opportunity in the current uncertainty, while others urge caution.

For the purposes of this article, we will take a deep breadth, and completely overlook the irony that the past month has seen the world’s loudest exponent of free markets – namely the US – demonstrate a level of market interference worthy of Soviet-era Russia. Only time will tell if the meddling of the US Federal Reserve, which has pumped billions into the money system, will prove to have been a helpful step, or one which merely delayed the pain.

Instead we will look to see if history has any lessons to teach us about the eventual winners from such crisis, and run through what fund managers and analysts will be looking for in the months to come. First, it is important to recap on the reasons why the problems in a sector of the US mortgage market are of any concern to reinsurers.

It’s all about yield

Some reinsurers, looking for a constant income flow for their investment portfolio, bought securities which derived their income from US homeowners in the so-called subprime sector. In short, as long as these homeowners paid their mortgages every month, the reinsurers got their steady income. Unfortunately, as we now know, some overzealous lending practices meant that loans were granted to those who could not afford repayments. So the income streams expected from these subprime-backed securities can no longer be guaranteed.

Further uncertainty has been added to the mix. Firstly, because of the way these securities were packaged it remains unclear whether an investor has any call on the underlying asset (the homes which are being repossessed). Ultimately it could well end up being decided by the courts. The investment products in question are relatively new and have yet to be tested by a financial downturn. Because the construction of many of these products is so complex, who exactly will end up getting paid remains uncertain.

“Many of the new entrants to reinsurance in recent years have relied on the ready availability of credit to fund their ventures. With such capital gone, investors will be considering the impact

Uncertainty also arises from the ensuing panic, which has seen a drying up of global credit. Many of the new entrants to reinsurance in recent years have relied on the ready availability of credit to fund their ventures. With such capital gone, for the time being, investors will be considering the impact this will have on the reinsurance landscape.

The unravelling mess

Investors will be looking, not just at the quality of a reinsurer’s book, but also at its investment sheet. If a reinsurer has taken a hit in US subprime-originated paper, or looks likely to take one on investing, then it might not have the reserves to meet claims. Bill Bergman, a reinsurance analyst at Morningstar, says investors will need to be asking the companies they have invested in, or are thinking of investing in, what exposure they have to subprime mess.

In particular he believes they should be watching for any downturn in investment performance at reinsurance companies. “We have raised our sensitivity to reinsurer management communication about investment results,” he explains. “We encourage investors to listen carefully to the upcoming earnings conference calls for discussion about this topic.”

In theory, investors should be able to rely on the rating agencies for guidance. Fitch says it does not think the subprime crisis will adversely impact the industry; however it has already downgraded Scottish Re sidecar, Ballantyne Re, on the basis of its exposure to subprime paper.

Bergman has identified five reinsurers which had more than one third of their fixed-interest investments in the subprime area at the end of 2006: Endurance Specialty Holdings, Allied World Assurance Company Holdings, Axis Capital Holdings, Platinum Underwriters and XL Capital.

“Pension funds and fund managers may be tempted by the current high yields available on cat bonds

Spying opportunity

Robert Buckland an equity analyst at Citigroup believes that while the blame for triggering the current crisis rests with some financial companies, now that central banks have stepped in, the financial sector as a whole could be the biggest beneficiary of that intervention. With central banks around the globe now likely to either hold or cut interest rates in the coming months, Buckland looked at what happened to global sectors after previous cuts.

He found that since 1974, every time the Federal Reserve had cut rates, the average rise in financials was 23.8%, after 12 months. More than any other sector. Of course averages can mask a lot of dogs and how to spot the best in breed from the mutts can be tricky.

Buckland has picked Swiss Re and Korean Re as two reinsurers likely to do well. Although he cautions that their share prices could dip further before they begin to rise. He said: “We would prefer to buy them into further weakness over the next couple of months. But they should be well-placed to benefit once the global equity market has taken a more decisive stance on the impact of lower US rates.”

Other market watchers are spying opportunity in cat bonds. With half this year’s hurricane season passed without incident on the US mainland, cat bonds have been trading high. Cat bonds typically offer high yields to tempt in investors, who of course run the risk of losing some, or all, of their capital if catastrophe strikes. Cat bonds tracked by Swiss Re have returned an average 11% a year since the start of 2005.

Michael Millette, a managing director at Goldman Sachs (which helped create the first cat bond a decade ago), believes that pension funds and fund managers may be tempted by the current high yields available on cat bonds. These may look particularly attractive if they are trying to rebuild returns on the back of the subprime losses.

Finally, if the second half of the hurricane season does prove to be above average, it is worth remembering that the contraction in the capital markets will play well for the fortunes of established reinsurers. Those with healthy balance sheets, who will be able to hike rates in the face of the credit crunch, could see higher-than-expected written premium returns come 1 January 2008.

Investment: IMF credit crisis warning

The International Monetary Fund (IMF) has said that markets are likely to go through a protracted adjustment period following recent financial turbulence triggered by the collapse of the US subprime mortgage market.

The report, the Global Financial Stability Report, said the turbulence represents the first significant test of innovative financial instruments and markets used to distribute credit risks through the global financial system, with markets recognising the extent that credit discipline has deteriorated in recent years.

This has caused a repricing of credit risk and a retrenchment from risky assets that, combined with increased complexity and illiquidity, has led to disruptions in core funding markets and increased market turbulence in August.

The report said the turbulence could impact global economic growth. “Although the dislocations, especially to short-term funding markets, have been large, and in some cases unexpected, the event hit during a period of above-average global growth. Our assessment is that credit losses and the liquidity constriction experienced to date will [nevertheless] likely slow the global expansion,” it stated.

The report also said that tighter monetary and credit conditions could reduce economic activity through a number of channels. A tightening of the supply of credit to weaker household borrowers could exacerbate the downturn in the US housing market, while falling equity prices could reduce spending through the wealth effect and a weakening of consumer sentiment. Capital spending could also be curtailed owing to a higher cost of capital for the corporate sector. In addition, the dislocations in credit and funding markets could slow the overall provision and channeling of credit.

Jaime Caruana, the IMF’s counsellor and director of the monetary and capital markets department, said that the task for policymakers and market participants now was to learn lessons from the turbulence and use them to help make the global financial system stronger. He suggested various elements of the existing framework which need to be re-examined:

• Greater transparency – Greater transparency is needed on links between systemically important financial institutions and some of their off-balance sheet vehicles.

• Improvements by rating agencies – Ratings and rating agencies will continue to be a fundamental component in the functioning of financial markets. Differentiated ratings scales for structured products could alert investors to the scope for more rapid ratings deterioration in such instruments, compared to, for instance, traditional corporate or sovereign bonds.

• Better valuation – The valuation of complex products in a market where liquidity is insufficient to provide reliable market prices requires more consideration, in particular when assessing the appropriate allowance for liquidity risk premiums and financial institutions holding such securities as collateral. More work on best practices in liquidity management is necessary.