Claims relating to the US sub-prime crisis have started to arrive and could cost a considerable amount of money. Ben Cook reports
The sub-prime mortgage debacle in the US could end up costing insurers a considerable amount of money. Estimates of the sector’s potential exposure to sub-prime related claims range from $3bn to a whopping $9bn. But is the outlook for insurers as bleak as it seems? No, say a number of insurers which argue that the industry will be able to comfortably sustain any potential losses.
Greg Carter, insurance group managing director at ratings agency Fitch, says the sub-prime crisis could cause a problem for directors’ and officers’ (D&O) underwriters.
“There could be legal action against investment banks and companies that have structured sub-prime packaged investments – there could be claims that they have been negligent in some way.”
Carter adds that claims on errors and omissions (E&O) policies could soon follow. “It tends to be D&O claims initially, but E&O claims may be triggered – E&O claims take longer to emerge.”
So, which insurers will have the biggest exposure? Carter expects Lloyd’s – with ‘ ‘ its reputation for providing sophisticated products – will have a higher than average exposure. He also highlights AIG and Ace as insurers which could face sizeable claims, with AIG looking particularly vulnerable considering it underwrites around 20% of the global D&O market.
However, Carter doubts whether AIG’s loss would be a major blow to the insurer. “If there’s a £3bn market loss, it [AIG’s exposure] will amount to 1% of AIG’s market capitalisation.”
Carter says the extent of insurers’ exposure to sub-prime related claims will become clearer after the year-end reporting season, but adds that the early signs are encouraging.
“It’s difficult to say when all the losses will emerge, but it’s reassuring for the insurance industry that no insurance company has said it has significant exposure on the asset or liability side.” Carter commends the insurance sector for its risk management, and says the risk has been well syndicated across the market.
Limited exposure
A spokesman for Lloyd’s says it is too early to draw any firm conclusions with regard to the size of potential losses. “From an investment perspective, Lloyd’s businesses appear to have limited credit exposure – however, some indirect investment returns are likely to be impacted,” he says.
“As far as underwriting activities are concerned, we believe that the market’s exposure is restricted to D&O, E&O and professional indemnity and with that, based on preliminary investigations, Lloyd’s exposure will be manageable.”
An AIG spokesman says the insurer has received claim notices related to sub-prime events. However, he adds: “At this point, it is not a significant claim issue. Claim activity may increase as the issue evolves but, due to our experience in the financial institutions sector, we have been prudent in risk selection, maintaining underwriting discipline and actively managing limits.”
Ace was unavailable for comment.
“It’s reassuring for the insurance industry that no insurer has said it has significant exposure on the asset or liability side
Greg Carter, Fitch
Other insurers highlighted as potentially vulnerable to sub-prime related losses include Beazley, Brit and Novae Group. A Beazley spokesman says its exposure will be limited because it does not focus on D&O and E&O for financial institutions, while a Brit spokeswoman acknowledges that it has received sub-prime related claims, though its investment portfolio has minimal exposure to sub-prime debt. Novae Group was unavailable for comment.
XL Capital is already reeling from the impact of the sub-prime mortgage crisis. The insurer recently had its financial strength rating downgraded by AM Best and Fitch due to the fact that it had incurred £1.7bn in charges relating to sub-prime related investments, and was also potentially exposed to sub-prime related D&O and E&O claims.
Miles Trotter, assistant general manager at AM Best, says it is too early to quantify what the insurance industry’s exposure to sub-prime related claims could be, but he acknowledges that, with talk of claims totalling between £3bn and $9bn, it has the potential to run to that sort of figure.
He says the insurers at risk are those writing financial institution D&O with significant exposure in the US. So, which insurers could fit that description?
“Traditionally, Lloyd’s has been significantly involved in the financial institutions market,” Trotter says.
Past experience
That said, Trotter argues that the Lloyd’s market will have learned from its past experience of laddering claims – which concerned underpricing and undisclosed commissions relating to IPOs in the late 1990s – and ensured that its vulnerability to claims involving financial institutions was limited.
“After the claims related to laddering, exposure was reduced”, he says. “I would expect Lloyd’s and the London market to have some exposure, but not as significant as laddering.” Trotter adds that laddering claims totalled “many millions” with some still not yet fully paid.
“Companies started receiving laddering claims in late 2000, but they did not have a clear idea of quantum until the last year to 18 months”, he says. “We’ll have a clearer idea [of insurers’ sub-prime exposure] within two to three years.”
Trotter believes the sub-prime crisis will serve as a reminder to insurers of how volatile financial institution business can be, as well as emphasising the need to have a better understanding of financial products.
William Sturge, insurance partner at law firm LG, says very few sub-prime related insurance claims have been made so far, but expects there will be “big numbers” of professional indemnity claims.
He highlights the example of investment banks which may have advised clients to invest in mortgage-backed securities where there is a “sub-prime toxic element”. Sturge adds that sub-prime mortgage claims could be quite a big event for insurers, and estimates that the industry’s exposure could reach $6bn.
In addition, Sturge argues that D&O cover has been undervalued. He says: “There has been an incredibly soft market over the last few years. D&O can produce horrendous losses and premiums haven’t reflected that.
Why have US sub-prime mortgages given rise to insurance claims?
The normal way for banks to fund mortgage lending is through deposits made by customers – this effectively limits the amount of lending they can do. However, more recently, banks began selling mortgages on to bond markets, which enabled them to lend more.
Consequently, banks became less conscientious when assessing the credit-worthiness of people to whom they lent money. They offered loans to Americans who were a “credit risk†– for example, those with county court judgments for debt. People were tempted to take the loans because, in many cases, the interest on the loan was a “teaser rate†– that is, a very low rate – or even a negative rate, which means no interest is paid initially and is instead added to the total amount borrowed. But interest rates on these loans were later significantly hiked, resulting in people defaulting on their mortgages, and, consequently, having their homes repossessed. With many homes being repossessed, house prices fell dramatically.
This fiasco could lead to directors’ and officers’ insurance claims being made. For example, shareholders of financial institutions can accuse directors of acting negligently in sanctioning sub-prime mortgage lending. Similarly, pension fund managers could be subject to professional indemnity claims if they have invested huge pension funds in bonds backed by sub-prime mortgages. Similarly, professional indemnity claims could be made in cases where investment banks have advised clients to invest in securities backed by sub-prime mortgages.
William Sturge, insurance partner at LG, says insurers could be exposed to claims based on the relaxation of lending criteria or claims based on defective investment strategies.
