It could be years before the full force of the credit crunch is felt by the insurance markets, as Michael Cook explains. So are initial reports of unscathed insurers premature?

The impacts on the insurance industry from both the subprime crisis and the ensuing credit crunch, can already be counted. Whether it be the many writedowns insurers and reinsurers are announcing or the first quarter losses caused by the overall fall in the worldwide stock markets, combined with softening rates. The writedowns have resulted from losses suffered as a consequence of the subprime investments.

The effects of the various writedowns are not only purely financial. The rating agencies are starting to flex their muscles and make downgrades on the back of the announced subprime or related losses. Subprime is clearly already impacting insurers and reinsurers, but not on the same level as it has impacted the banking industry. Has the industry as a whole survived subprime, as some are suggesting? What about the many claims that are anticipated?

Fuelling the fire

As the deterioration in the credit markets gained speed during the second half of 2007, so did the related litigation. Based on a study published by Navigant Consulting, which analysed the subprime mortgage and related civil litigation filed in federal court, 278 such cases were filed during 2007. Of these, 65% were filed during the last six months of the year. While this list may not be exhaustive, it clearly presents an accurate picture of the nature and volume of this rapidly emerging area of litigation. Based on the study of 278 cases, it was noted that the cases were grouped into the following six major categories:

• Borrower class actions

• Securities cases

• Commercial contract disputes

• Employment class actions

• Bankruptcy-related

• All other

At the end of 2007, 90% of these cases continued to be active. Whilst there was a meaningful number of filings in each category, borrower class actions dominated, making up 43% of the total. Each of the top ten subprime mortgage lenders for 2006 was named in at least one borrower class action suit during 2007. Securities cases accounted for 22% of total filings. Of those, 54% were securities fraud class actions alleging temporary inflation in a company’s stock price due to inaccurate or incomplete disclosures to shareholders.

Directors and officers of the target company were individually named as defendants in 97% of the class actions. The remaining securities cases targeted either underwriting firms for allegedly making material misrepresentations in connection with the issuance of mortgage-related securities or investment managers who are alleged to have taken imprudent risks and/or to have misled investors in managing client portfolios.

This clearly shows that there is not only a substantial number of lawsuits in relation to subprime but also that many different organisations and groups of individuals are being targeted. Furthermore, the range is from some of the world’s largest financial institutions through to individual director and officers. These claims will in time impact a number of different lines of insurance. It is already estimated that in quantum terms, subprime far exceeds the magnitude of the savings and loan crisis of the 1980s.

Once these many lawsuits have concluded and the claims against various financial institutions and individuals have been crystallised, the majority of those institutions will be making claims against their errors and omissions (E&O), directors’ and officers’ (D&O) or professional liability (PL) insurance.

In turn, each of the insurance companies who underwrote D&O, E&O and PL in the relevant years, which is anticipated to be mainly 2006, 2007 and 2008, will be making subsequent claims against their own insurers and so the reinsurance claims will begin. It is therefore relatively easy to see how these D&O, E&O and PL claims will impact the live insurers, and in time reinsurers. It is not immediately clear, however, how any of the effects of subprime will impact the run-off industry.

Lower investor interest

Based on events to date, there are likely to be two major subprime-related impacts felt in the world of run-off. Although, the possibility that an existing run-off company or portfolio could be directly impacted by subprime-related claims should not be discounted. If the company in question underwrote D&O, E&O or PL business and only recently went into run-off, it is possible that based on the wording of the insurance or reinsurance and the underwriting year that the company may receive subprime-related claims against the D&O, E&O or PL coverage they issued. However, this is the least likely, or perhaps the least significant, of the impacts to the run-off industry.

The more substantial impacts will be felt in the availability of capital and the increase in both the number of companies going into run-off and/or the number of companies exiting the D&O, E&O and PL markets. There is no doubt that many of the major deals in the run-off market over the last few years have been backed by capital. The level of both merger and acquisition and transfers of books of business has been very high. Many of these transactions have been made possible by external capital.

Now that is not to say that external capital has been the only source of such deals, far from it. Some of the largest transactions have come from funds within the insurance industry. We only have to look to Berkshire Hathaway and Enstar for examples of that. However, with a number of the run-off industry giants taking such large losses from their active underwriting companies and/or their investment portfolios, the question remains as to whether these companies are going to be as active in the transaction market over the next year.

It is also hard to believe that external capital will be quite as keen to enter the run-off market, purely based on the fact that there is going to be far less capital available generally and therefore by default, less to be utilised by the run-off market. Add to this the fact that many of the transactions completed over the last few years in the run-off arena have not made the returns originally anticipated.

The external capital that is available is most likely to be deployed in more traditional areas where those responsible for it are more familiar and feel that better returns can be made. Indeed some capital market commentators are already saying this very thing is happening and that in general, far less capital is looking to enter the insurance market, whether that be via start-ups, sidecars or run-off purchases.

Next generation of run-off

The other likely impact of subprime will be an increase in companies going into run-off or most likely exiting certain classes of business such as D&O, E&O and PL effectively discontinuing to underwrite that business. This result should not be thought of in isolation to the reduction of available capital. One of the ways capital is frequently deployed within the industry is to recapitalise a company. If this option is not available, companies may be forced into run-off. Particularly if the option to raise funds from shareholders is also not available. This may happen as a result of lack of capital or even the impact of rating agency downgrades, as we have seen historically.

One other critical factor that should be addressed here is timing. There is no doubt that the timing of subprime is already proving to be a major factor in the determination of the ultimate effect. The reason timing is so important is if subprime occurred at a time of high premium rates across the board and the insurance industry was awash with capital, the impact would be less pronounced.

This is also true of the capital markets themselves. If the only thing capital market investors had to deal with was the mortgage-related subprime issue, it would be a far smaller problem. However, through 2007 and into 2008 neither the capital markets nor the insurance industry are facing the credit crunch in isolation.

No escape

Many reports tell us that the insurance industry has escaped relatively unscathed from subprime. These are likely to be premature. While it is true that insurance companies have survived the initial effects, it will take many years for the impact of the claims from subprime and related exposures to materialise and to make their way through the many insurance and reinsurance programmes.

While some of the impacts of writedowns and downgrades are being felt today, the ultimate effect of these is not yet known. So much of the eventual impact will also be determined not only by the writedowns, the claims, the investment losses and the reduction in the availability of capital, but by other events in the industry. Premium rates and other significant claims such as the estimated $20bn economic loss from an earthquake in China will all play their part.

The hurricane season is yet to come. While the industry could have weathered the long-term effects of subprime alone, can it weather the combined effects of the restriction of available capital, a soft market and a number of major claims? While many of the points mentioned are clearly issues for the current market, there is no doubt that the run-off market will see some of the ripples entering its otherwise calm and tranquil waters.

Michael Cook is a director of Navigant Consulting UK.