The insurance and reinsurance industry cannot stay immune from the financial crisis. So what will be the reaction of the industry’s supervisors?

To say that the past two months have been tumultuous is probably an understatement. At the Rendez-Vous de Septembre in Monte Carlo this year, who could have predicted that just one week later the bottom would fall out of the global economy?

That Lehman Brothers would become the world’s biggest bankruptcy and American International Group (AIG) would be nationalised in an $80bn bailout?

“Monte Carlo was lots of money ago,” says Jim Bryce, IPC Re CEO. “First there was Lehman and then AIG – the whole thing just goes on and on.”

Keeping up with the financial meltdown has been one of the biggest challenges. The situation changes day to day, making it difficult to predict how it will pan out: dramatic failures, government bailouts worth hundreds of billions of dollars and volatile stock markets dominate headlines. The situation changes from day to day.

There’s a lot of finger pointing. First at “irresponsible” fat cat banking bosses and subprime mortgage lenders, then at the regulators, rating agencies and politicians. The concern now is that regulators will come down hard on the banking sector, and that with taxpayers’ money at stake and scrutiny from all corners, they will discipline those considered responsible. And if they do, it is likely that their efforts will have a knock-on effect on the insurance and reinsurance industry.

“It’s all going to change by the middle of next year,” predicts Bryce. “The accountancy firms, rating agencies and regulators will all come up with new rules. It’s almost becoming an overly-complicated business plan to be a public company – and the only one that can deal with it is Warren Buffet. He’s so big no one really worries about him.”

OVERCOOKING THE GOOSE

Market failures are invariably followed by heightened supervision. Just look at Hurricane Katrina and the impact it had on the rating agency’s capital requirements, or the introduction of Sarbanes Oxley following the accounting scandals of the late 1990s. “Of course everything is going to be an overreaction,” says Bryce. “The rating agencies are going to come up with a whole new set of rules – they’re probably going to want to increase the capital requirements because there’s more risk there than they ever envisaged.”

Charl Cronje, general insurance partner at actuaries Lane Clark & Peacock LLP, believes the current crisis gives regulators a stick to beat the industry with. “We would expect the recent events to harden the resolve of governments and regulators to prevent certain types of problems recurring. If and when the dust settles, I wouldn’t rule out the prospect of new legislation in the US, Europe and elsewhere to address what many see as serious regulatory failing sover the past year.”

There is already plenty of fighting talk. The EU has backed a major overhaul of the World Bank and International Monetary Fund while Gordon Brown warns of “very large and very radical changes” in the

UK. A joint statement from the G8 leaders says that they are committed to change the regulation of the world’s financial sector. Germany’s chancellor Angela Merkel has also warned of a clampdown. Her cabinet has drafted a new set of rules governing the financial industry which she calls the “new financial market constitution”. In the US, there is pressure for a major regulatory overhaul. AIG’s insolvency is reviving talk in Congress of federal regulation of the insurance industry. While a federal insurance regulator may be welcome, over-regulation is not something anybody wants to see.

Bryce warns of “overcooking the goose. It’s like all the financial scandals – Enron and WorldCom – that really ended up with Sarbanes Oxley. And frankly, the guy that wants to be a crook, Sarbanes Oxley is not going to stop him.”

But should (re)insurers fear excessive regulation when they have shown sound risk management and solid balance sheets? “You would expect to see greater regulation as a result of the financial crisis,” says Bryan Joseph, head of actuarial insurance at PricewaterhouseCoopers. “Clearly insurance companies

are financial services institutions, and some of them own banks while others are owned by banks. You also will find regulators and directors are now taking a more comprehensive look at risk, capital and solvency.”

The collapse of AIG is another major factor.

Although this insurer was unique in its size and leverage, the wider industry could be tarred with the same brush. In a testimony to the US House of Representatives Committee on Oversight and Government, Eric Dinallo, the Reform New York insurance superintendent, was adamant that AIG’s problems had nothing to do with its insurance business.

In a hearing on “the causes and effects of the AIG bailout” he said: “AIG’s problems came from its parent company and from its non-insurance operations, which are not regulated by New York or any other state.” His testimony was welcomed by the International Association of Insurance Supervisors.

Michel Flamée, IAIS chairman, noted: “Since the financial community is so inter-linked, financial supervisors must continue to cooperate closely in order to protect policyholders around the world.”

BLAMING THE MODELS

Cronje predicts that there will be some criticism of Basel II in the wake of the crisis – and that criticism of over-reliance on mathematical models might be valid. Banks and insurers alike increasingly use actuarial modelling, he says, something that under Solvency II will become a way of life for insurers. Just as the value of the vendor catastrophe models were called into question after Hurricane Katrina, so the value of actuarial models is now likely to be questioned.

During a debate at the AM Best Review & Preview Europe conference in London in October, speakers were asked if the industry should rethink their models in light of the financial crisis. “In the banking system, the misalignment of incentives with risk to the firm is a very hot topic,” said Tony Brooke-Taylor, head of wholesale insurance firms at the FSA. “In the insurance industry you don’t have the same problem – but we shouldn’t forget that.”

He added that the models shouldn’t be thrown away just because they could not predict each event. “We’ve hopefully learnt a lot over the last year and we must be careful not to throw out the baby with the bathwater.”

With Solvency II creeping closer, any failures found in current capital and risk modelling techniques undoubtedly will be corrected and fed into the new regime. For companies with internal capital models this could mean yet more paperwork and box-ticking to ensure that they get the regulator’s seal of approval. Janet Nelson, chief risk officer at Catlin, says that she is trying to find the value-add in providing 1,000 pages of documentation - the rumoured level under Solvency II.

MONOLINE MONSTROSITIES

The woes faced by the bond insurance sector are a cautionary tale in relying too heavily on the models and credit ratings. The highly-capitalised “AAA” rated monoline bond insurers were considered adequate guarantees for subprime securities, including collateralised debt obligations. Using a financial guarantor meant high-risk subprime securities could be repackaged with investment-grade ratings. It worked well, until the housing market collapsed. So why didn’t the bond insurers see it coming? “You could argue that they didn’t fully understand their aggregate risk,” says Joseph. He thinks they relied too much on model outputs without considering results from appropriate stress and scenario testing.

“Underwriting standards loosened for Freddie and Fannie – in pursuit of the American dream of homeownership,” says Ed Easop, vice president at AM Best. He thinks the mortgage crisis is a good example of why the industry should focus more on enterprise risk management. “We’ve learnt that tail events do happen.”

The recent crisis just brings the importance of an ERM approach to the forefront of managing a company’s risks, says Joseph. “It is fundamental to the running of any company but for complex financial organisations like banks and insurers it becomes an essential management tool as the bigger and more complicated the organisation, the more difficult it is to understand its risks.”

Many now ask whether the world’s largest insurance company had a handle on its risk exposures. “The key lesson from AIG is that no insurer is too big or too diversified to fail,” says Cronje.

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