In the absence of major hurricanes, talk at this year’s Monte Carlo Rendez-Vous focused on the “credit crunch”. Mairi Mallon considers what fallout the industry should expect from the collapse of the US subprime market.

Predictions go from one extreme to another. Some say there will be a run on hedge fund cash invested in the Class of 2005 start-ups. Others say it is no more than a minor blip on the investment sheet of companies. Then there are those who say there will be up to $3bn in possible director’s and officer’s (D&O) claims from executives and further errors and omissions (E&O) claims on rating agencies and advisors.

The truth is no one knows exactly what the effect of the subprime mortgage market crash will have on the insurance and reinsurance industry. In the same way, no one knows what long-term impact it will have on the global economy.

Rating agencies have been issuing fairly upbeat commentary – but still have worst-case scenario warnings if the subprime crisis sparks a stock market crash like the one seen in 2000 after technology stocks imploded. Their upbeat notes also belie their own problems, having been blamed for not picking up on the vulnerability of certain mortgage and asset-backed investments.

Non-correlated class

Standard & Poor’s has surveyed all the insurance and reinsurance companies it rates globally to determine their exposure to US subprime mortgage-related instruments. “We expect that these sectors will navigate the recent deterioration in subprime mortgage-related assets with sufficient liquidity to meet their financial obligations,” it concluded in a recent report.

There is a caveat to that. “Given the recent market volatility, we continue to be alert that more traditional bond and stock portfolios don’t deteriorate and that underwriting results remain strong.” S&P said the vast majority of rated insurance entities have negligible subprime exposure and the small number with exposures that aren’t negligible are considered to be “manageable” because these companies targeted asset classes rated “AA” and higher. It said of the $91bn in estimated total exposure, 93% is in “AA” or “AAA” tranches.

S&P said global players usually acquired subprime exposure through their US subsidiaries and the life sector generally had a greater percentage of subprime exposure. “This isn’t surprising given life insurers’ longer-tailed product liabilities, need for longer-dated asset instruments, and pursuit of higher yields,” it added.

Economic fallout

“Hank Greenberg says insurers will suffer greatly from the crisis through investment exposure

There have been reports in the financial press that hedge fund portfolios have suffered more than most as a result of the subprime collapse. At the same time, some hedge funds have been recording some big wins after taking a bet on falling share prices. When UK mortgage lender Northern Rock’s share price plummeted, for example, a number of hedge funds apparently made a lot of money from “shorting stock”. This is a typical hedge fund strategy where shares are sold as prices begin to slide and bought back later at a cheaper price.

It might seem contradictory that hedge funds should both suffer and prosper under the subprime fallout but this scenario is likely for insurers too. There is the opportunity for firms to exploit the volatile market conditions to make money, believes Grahame Chilton, CEO of Benfield, but the crisis could also hit some underwriters badly. Particularly those backed by a lot of debt like the hedge fund-sponsored Bermuda start-ups. “If you’re running an absolute return underwriting model, based on leverage and debt, then your spreads have just gone up at a time when you are getting less money in the front door,” explained Chilton, referring to the softening market.

John Andre, vice president, AM Best also predicted that some of the Class of 2005 might be impacted in the future because of the large investments hedge funds made into this group. This would not affect the likes of Validus Re or Flagstone Re, which have gone public, but it may be an issue for those that have remained private.

Access to liquidity is likely to be an issue across all asset classes. Those insurers and reinsurers backed by capital market investors “might have trouble accessing additional funds,” said Andre. “I stress that we have not seen this happening in companies, but is a potential danger only.” He explained: “The owner might have cash-flow problems and might not have money to put into a company. It might, long term, affect their financial flexibility. We don’t see it at all (at the moment), but it is a potential.”

Sean Mooney, chief economist at Guy Carpenter & Company, said if you looked at a more extreme scenario and a collapse of faith in financial markets in general, then you could see some of that affect the insurance industry. “Our biggest concern on the investment side would be if the subprime market and the related credit crunch resulted in a major fall in the stock markets around the world. Then you can see a decline in the value of the assets held by an insurer and that would be through the mechanism of their equities.”

Flood of claims?

Mooney said there was a separate concern with professional liability lines. “On the D&O side there have been reports that the claims in the worst-case scenario could be as high as $3bn. We think that number is fairly high, as there is a certain standard you have to reach to be successful in a D&O case. You just can’t allege some issues or some problems, you have to show gross negligence on the part of the directors. In the E&O, somewhat similar. You could see rating agencies being sued and probably investment advisors, but again you would have to show that their standard of performance was negligent.” Many in the industry are predicting that rates will harden across professional liability lines if there is a flood of claims. They have been softening since 2002.

In terms of the cat bond market, Guy Carpenter believes the credit crunch could even be favourable for that market. Mooney said: “The basic argument for a cat bond as an attractive asset is they are not correlated with the rest of the market. So we think that argument would be reinforced by what happened in the subprime market.

“The basic argument for a cat bond as an attractive asset is they are not correlated with the rest of the market

Standard & Poor’s agrees. Credit analyst Maren Josefs put part of the recent inactivity in the insurance-linked security market down to the “seasonality of insurance”. She concludes that the credit market events were “unlikely to dampen ILS investor appetite and that total issuance in 2007 will be greater than in 2006”.

Former AIG boss, Maurice “Hank” Greenberg, thinks the problem has been underestimated. He told delegates at a recent marine insurance meeting in Denmark that insurers will “suffer greatly” from the crisis through investment exposure. Greenberg, who now heads up CV Starr, said he could not believe the extent to which financial institutions had packaged and traded risk through instruments such as collateralised debt obligations with little understanding of what they were buying.

“It was an example of when everybody took their eye off the ball on credit,” he told underwriters at the International Union of Marine Insurance. “In the insurance industry, many companies will suffer from the subprime debacle. A lot of it will end up in the insurance market.” Greenberg was also critical of the role of credit rating agencies in the problems of the subprime market, saying that they “did a bad job. Some of the best minds were caught up in that.”

The re/insurance industry could face D&O claims of up to “a billion dollars” and the industry could find itself with a major problem on its hands, warned Benfield boss Chilton, speaking in Monte Carlo. On those who said the impact of the subprime crisis would be negligible, he said: “I think they’re wrong. I think the D&O claims may be sizeable. You have the potential for a billion dollars of D&O claims to come through.”

Ups and downs ahead

David Siesko, founder of New York-based consultancy Siesko Partners, said he was amazed that financial institutions had got into this situation. “They are highly compensated, well-trained, the best and brightest financial people. I’m absolutely gobsmacked that in highly regulated institutions there is such a lack of focus on a market that deteriorated so quickly. That there were no controls is food for lawsuits.”

Peter Middleton, managing director of the specialty division at Markel International said: “It will be interesting to see what affect that will have on Bermuda and whether there will be any consolidation.” He added: “It might generally help to harden things up but at the moment it’s difficult to tell.” He agreed there would be some impact on professional liability lines such as D&O and E&O. “It’s normal in the US that if investments are affected somebody ends up being sued.”

Consultant Andrew Barile said the subprime issue could lead to a “run” on hedge funds wanting their money back. Those reinsurers they invested in may come under pressure as the hedge funds themselves come under pressure from their own investors.

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