Originally published in the Captive Review, Guernsey Report, October 2008
David Sheil of Alternative Risk Management contemplates the future effects of the current economic climate on the captive industry
In the middle of September, what was a rolling but intensifying financial problem for a number of Wall Street investment banks and a range of other large American financial institutions rapidly turned into an overnight crisis. The warning signs had already been sent out in July with Bear Stearns. That was followed by a period of accelerating loss of confidence over the summer that led into the Fannie Mae and Freddie Mac rescue; followed closely in September by the collapse of Lehman Brothers.
The demise of Lehman Brothers and the adjacent 'fire sale' of Merrill Lynch to Bank of America were major shocks to the system but the government rescue of AIG through an US$85bn revolving credit facility marked a new low and a serious deepening of the crisis.
The problem for AIG specifically was contained within AIG Financial Products; a business unit that was allowed to act much like an investment bank. It offered Credit Default Swaps (CDS) instruments on fixed income securities and mortgagebacked derivatives held by banks, many of them European, that basically allowed them to hold less cash in reserve. Auditors and regulators of banks, it was assumed, would be naturally assured that the risk of the underlying asset going bad was protected and with a AAA-rated counterparty; none other than the mighty AIG. This level of counterparty risk however accumulated to a staggering notional exposure of US$441bn; US$58bn directly exposed to sub-prime securities.
Allowing banks to collapse or to be taken over were obviously considered shocking but containable events by the US Treasury, but clearly an AIG collapse was too great a systemic risk both at home and abroad. AIG, with its significant involvement in bank guarantees and its virtually unmatched global reach into both the heart of corporate insurance programmes and private individuals around the globe, could not be allowed to fail. An AIG collapse could have panicked small investors, forced banks to take steep write downs and introduced a new, very panicked, phase in the crisis.
What were the origins of this series of events? There are always many aspects to a financial crisis but a few come to mind;
- Some would argue that the repeal of The Glass Steagall Act of 1933 under the Clinton administration precipitated the crisis; basically the repeal of this legislation created a whole new era in US investment banking with huge emphasis placed on leveraged instruments as one of its cornerstones.
- Sub-prime mortgages & CDS; very much the same issue; these highly leveraged instruments based on illiquid and difficult to value assets began to unwind.
- Short selling; the new 'bête noir' of the markets or more specifically 'naked' short selling incorporating tactics of market abuse concerning a stock or a group of stocks in which the seller may not even borrow the stock and fails to deliver to the buyer. In recent months, short sellers had shifted their focus to big financial services firms in the belief that they were overvalued and undercapitalised.
- Fair Value accounting; obviously a worthy idea with good intentions but the accounting system has, in some ways, come to amplify the extremes of the cycle. Fair Value accounting, which pegs assets to current market prices rather than historic costs, leads to upwards and downward spirals in prices and hence a requirement for significant leverage to cover positions. Capital and liquidity requirements needed to run counterpoint simply could not keep pace.
So what does the post-financial crisis present to captive owners and what opportunities might arise?
- Are we likely to see a hardening (in some classes) of the insurance cycle? It is possible and was probable anyway even before the crisis. However, a lot will depend on what capital and liquidity flows are after the hurricane season and what happens in terms of capacity and the positioning of AIG in the market.
- A greater focus on the part of regulators and rating agencies of insurance companies on liquidity as opposed to solvency.
- Perhaps greater and more varied use of captives owned by financial institutions to assume risks with appropriate collateral. Unless markets harden considerably, the effect on captive owners in the manufacturing, transport, and technology industries could be largely unaffected. However, financial institution captive owners and also perhaps those involved in retail and consumer products (writing third-party warranties and creditor insurance) industries may be required to reconsider any unaggregated positions in their captives. The real problem will not be so much insurance markets; interbank liquidity will dominate and may cause unusual distortions in the insurance market as a secondary effect.
- If it is not already the case, LOC requirement for captive fronting may become more focused on cash/very liquid instruments.
- Solvency II impact on new capitalisation requirements; most captives in the EU are already well-capitalised but regulators may become more attuned to insurance and investment counterparties credit ratings.
- Are we likely to see more E&O and D&O claims?
- Impact in investment income leads insurers to recalibrate IBNR and reserving techniques.
- The main themes of the UK insurance market over the next few years are likely to be focused on insurers enhancing and improving distribution networks and at the same time more emphasis on customer centricity and service as interaction within the market becomes more sophisticated and mobile. It is also likely that there will be a stronger bias towards underwriting discipline.
The future – short- or long-term?
Again, the most significant effect of September's financial crisis will be felt first in banks (rather than insurance companies) or any financial institution that depends on liquidity; many of whom refinance at short maturities in capital markets. Some US financial institutions rely heavily on the immediate support of their investors and counterparties and a federal guarantee for their credit enables the market to continue working; but if no guarantee is there as was the eventual turnout at Lehmans, then we are dealing with a whole new paradigm in which banks wont trust each other nor lend to each other.
The main objective of the Federal Reserve in any of its strategies is to free up interbank markets. They will also aim to increase liquidity injections into that market to offset deleveraging of bank balance sheets. The additional objective will be to take on toxic assets and free up capital.
It all has a sense of déjà vu because, of course, America has been here before in the 1980s with the Savings & Loan crisis when the Resolution Trust Corporation was brought into being to absorb bad loans.
The difference here is that we are now dealing with a hyper sensitivity to systemic risk. To put a stop to further contagion, one possible additional short-term development is likely to be a government-backed insurance scheme for the US$3.5trn money market funds industry.
The economic impact on insurance markets could be far-reaching; we may see a return to lower inflation if liquidity remains tight. That in turn may strengthen resistance to any attempt at increasing insurance premiums across the board while consumer spending also slows down. There could be a knock on effect to slower purchases of products that have tie-ins to complementary insurance such as vehicle warranties, travel cover and electrical goods.
Obviously it is difficult at the time of writing to predict what the eventual outcome will be as we are dealing with a shifting sand; the federal reserve has sought to address the systemic risks and hiked up liquidity and at the same time set out to prepare to absorb toxic assets. In Europe, where larger banks are, after all, located in smaller countries like Switzerland, the Netherlands and Belgium, regulators and the ECB (for EU countries) will need to maintain a high level of confidence and immediate support in the form of liquidity if needed (Fortis, for example).
Whatever happens, there will likely be a move to a much pared down and cautious financial system; we have entered a new phase in financial markets where the assured availability of credit and liquidity is fast disappearing. Until the ability to assess asset valuations becomes clearer and until regulators have managed to guide the system through the narrow straits, we will simply have to wait and see.
For more information about Guernsey's finance industry please visit www.guernseyfinance.com
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.