Effect of the crisis on insurance risk

Non-life insurance claim levels tend to rise generally in an economic downturn. Almost inevitably, there will have been some increase in fraudulent or exaggerated claims during the recent recession and more claims for relatively trivial losses that would go unclaimed in better times.

Demand for non-life insurance is relatively inelastic, because few substitutes for insurance exist and because some major lines (such as motor) are mandatory. However, a financial crisis and ensuing recession will inevitably reduce demand to some extent, forcing insurers to cut costs (e.g. by shedding staff) in order to maintain profitability.

Confirming this, Swiss Re record an overall decline of 0.8 per cent in non-life premiums in 2008 as a consequence of fall in demand and softening rates, a sharper fall of 1.9 per cent in the industrialised countries being partly offset by growth in the emerging markets, which remained strong at 7.1 per cent compared to 2007 levels.

Swiss Re note, however, that non-life insurance remained profitable, despite falling premiums. They expect non-life premiums to remain flat in 2009, as the economic downturn continues to curb demand, particularly in the commercial lines of business.

In the case of life insurance, claim payments as such do not increase in a recession, but the cashing in of policies, and the drop in demand for new ones (particularly for saving plans and mortgage-linked products), is likely to be more severe, creating a greater imperative to cut costs.

Swiss Re confirms that the global financial crisis has indeed hit life insurance premium growth in particular, with a decline of 3.5 per cent in global premiums in 2008, most of it relating to the second half of the year.

They note: “Sales of unit-linked products and products linked to equity markets were severely impacted by falling stockmarkets in 2008, causing life insurance premiums in industrialised countries to drop by 5.3 per cent (US$ 2.219 billion).

Sales of non-linked savings products, such as fixed annuities and traditional life savings, continued to increase in many countries, but failed to offset the declines seen in the unit-linked business”.4 Strong growth in emerging markets was clearly not enough to reverse these trends.

Quite apart from these general effects, there are some specific lines of non-life insurance where the impact of the banking crisis is likely to be more direct and more intense. These are liability insurance and insurance that covers credit risk. We look at these next.

Liability insurance

Of course, in addition to insuring property and various forms of financial loss, non-life insurers also write liability (or casualty) insurance, covering losses that individuals or firms incur when they are sued for negligence or other legal wrongdoing.

Banks, financial firms and their professional advisors (such as lawyers and accountants who operate in financial markets), real estate agents, mortgage brokers and the like are at risk of compensation claims by clients who believe themselves to be victims of negligence.

Stakeholders (such as shareholders) in financial businesses who suffer loss as a consequence of mismanagement by the firms’ own directors or senior management may also target the individuals concerned.

The first of these risks is insured under Errors and Omissions insurance (E&O) and the second under Directors’ and Officers’ insurance (D&O).

Leading insurers in these markets include AIG (which writes around 35 per cent of D&O insurance by premium volume), Chubb (which writes around 15 per cent), XL and Lloyd’s of London.

A major financial downturn always brings an increase in liability suits of this kind as firms and individuals look around for people to blame for their losses the “dotcom” crash of 2000 being a recent episode that triggered such a spike in claims.

Most business leaders in the United Kingdom believed, at least initially, that the current financial crisis would generate even more claims than the punctured dotcom bubble,5 and all insurers in this market anticipate a sharp rise.

One analyst suggests that claims will reach US$9.6 billion, comprising US$5.9 billion for D&O and US$3.7 billion for E&O,6 others suggest upward of US$12 billion for D&O alone.

Another commentator has identified no fewer than 205 subprime and credit crisis-related securities class action lawsuits filed in the United States alone since the beginning of the crisis.8 However, estimating the ultimate cost to the insurance industry is difficult.

Many probably the majority of these claims will fail, because proving negligence or positive wrongdoing on the part of professional firms or corporate directors is difficult: they are not liable for mere errors in judgement or losses caused by market fluctuations beyond their control.

Nevertheless, insurers are generally bound to defend their clients, even when the suits they face are unmeritorious, and such defence costs always constitute a significant portion of insurers’ outlay.

Furthermore, liability insurance of this type is “long-tail” business, with significant delays in the notification of claims and long settlement periods. This means that the final cost of the credit crunch and financial crisis will not be known to liability insurers for many years.

However, there is no sign of any shortage of supply for these lines of insurance at the time of writing. For example, while D&O premiums for financial firms rose quite sharply in 2008 they have eased steadily since and are far below the peak attained in 2003.

This may reflect the recent recovery in the equity markets, there being an inverse relationship between equity indices and D&O securities actions. In any event, there seems to be no immediate likelihood of insurance becoming unaffordable, let alone unobtainable.

The underwriting of credit risk by insurers

Several types of insurance cover credit risk, either directly or indirectly. These include Mortgage Indemnity Insurance (MII, or Mortgage Indemnity Guarantee, MIG), which covers losses that mortgage lenders incur in cases where the mortgagor defaults, leaving the lender with an asset that is worth less than the outstanding mortgage loan, and Mortgage Payment Protection Insurance (MPPI), which covers the borrower (rather than the lender) who is unable to pay the mortgage loan as a consequence, for example, of illness or loss of employment.

The latter is a specialised variant of what is commonly called Payment Protection Insurance, which covers the inability of a borrower to repay other sorts of loan.

Clearly, the practice of granting mortgage loans that are very high in relation to the value of the property, combined with a drop in house prices and a recession that leads to sharply rising employment all of which we have seen in the United Kingdom and other countries recently is likely to trigger an increase in claims on contracts of this sort.

In fact, Mortgage Indemnity (MI) insurers made massive losses on this line of business in the United Kingdom in the late 1980s and early 1990s, leading to the failure of a number of specialised MI carriers.

The widespread use of this insurance cover by lenders to hedge their position when granting mortgages with a high loan to value ratio had helped to fuel the credit boom of this time and contributed to a bubble in house prices.

The insurers concerned failed to foresee the bursting of the bubble: therefore, when house prices fell sharply at the beginning of the 1990s, disaster befell them.

However, there has been no repeat of this experience in the United Kingdom to date, largely because these lines of insurance are not used so widely as in the past. The most important ways in which insurers and reinsurers now underwrite credit risk are through credit insurance and, in recent years, through credit default swaps (CDS).

Here we consider credit insurance only. CDS, and their role in enhancing systemic risk are considered later, in the section “Systemic risk in banking and insurance”. In essence, credit insurance covers losses that insured firms suffer when their clients fail to pay for goods and services.

The main risks covered are insolvency of the client or protracted default (failure of the client to pay within a set time period). In addition to these risks of commercial default some insurers also cover short-term political risks for example, failure of a foreign buyer to pay as a consequence of war or revolution.

The world market for credit insurance is dominated by three groups— Euler Hermes, Atradius/Credito y Caucion (CyC) and Coface, which have around 37 per cent, 31 per cent and 18 per cent of the market, respectively.

Western Europe accounts for around 74 per cent of credit insurance buyers, with North America and Asia at just 6 per cent and 3 per cent, respectively. Important insured sectors include constructions (16 per cent), metals and engineering (15 per cent), agriculture and food (13 per cent), services (12 per cent) and electronics (9 per cent).

Claims against credit insurers do not arise from purely financial transactions, such as a borrower defaulting on a loan, but from the default of buyers who fail to pay for goods or services. Therefore, credit insurers are not directly affected by the financial crisis, but rather by the increase in bankruptcies in the real economy that the crisis has brought about.

Currently, credit insurers are experiencing a sharp rise in claims as the recession bites. However, credit insurers are well used to managing substantial peaks and troughs in their business that coincide with the business cycle.

Swiss Re notes that the loss ratio for German credit insurers has varied from 33 per cent (in 2004) to 106 per cent (in 2006), and that dynamic management of the credit limits (in simple terms, a process whereby the credit insurer has a right to reduce or remove the credit limits for future transactions of a specific buyer if its financial positions deteriorates) enables credit insurers to ride these cycles effectively and reduce their loss ratios well before bankruptcies start to decline.

Credit insurers can also refuse to renew their policies and decline new business. Evidence suggests that all this has happened, with credit insurance becoming increasingly difficult to obtain for some firms.12 Withdrawal of credit insurance can have serious consequences.

First, it can create a domino effect along the supply chain in which companies that cannot buy insurance cut ties with suppliers who are judged to be high risk.

Furthermore, companies in difficulty become less attractive to potential buyers if they cannot get credit insurance, making it harder for insolvency practitioners to find a buyer for the business.

Clearly, the reduction in the supply of credit insurance has had some effect in reinforcing the economic downturn that has been triggered by the financial crisis.

This has raised concern at government level, with the result that several countries have taken state action to maintain the availability of credit insurance in order to safeguard trading activity. We will return to the underwriting of credit risk by insurers in the section “Systemic risk in banking and insurance”, where we consider the role of CDS in enhancing systemic risk.

Location: Indonesia