Heads in the sand

Claims that the insurance industry can somehow sidestep the meltdown of the US financial market are wide of the mark, say Linda Dakin-Grimm and Patty Quilizapa

Heads in the sand The US credit market crisis is far from over, as the events of early July have demonstrated. California-based mortgage lender IndyMac Bank failed and the FBI has announced a fraud investigation of the company. The US Treasury Department has announced a plan to prop up the huge but deeply troubled US-sponsored mortgage securitisers Fannie Mae and Freddie Mac. The Securities and Exchange Commission announced that, as of 15 July 2008, it had more than 48 investigations underway involving subprime lenders, investment banks, credit rating agencies, insurers and others. As of the end of the second quarter, Wall Street layoffs at Morgan Stanley, Merrill Lynch, UBS and Citigroup were estimated to exceed 32,000 employees.

At the same time the US litigation engine has been revved up. Compared with all of the litigation filed during the 1990’s savings and loan crisis, more than half as many subprime-related cases were already filed in US ­federal courts by the end of the first four months of 2008. These lawsuits include borrower class actions alleging inadequate disclosures of the nature and risk of loans and discriminatory mortgage practices; securities class actions that focus on inflation/deflation of a target company’s stock price due to alleged wilful misrepresentations and inaccurate/incomplete disclosure to stockholders; shareholders’ derivative claims; and Emp­loyee Retirement Income Security Act actions by company-sponsored plans.

Financial institutions, issuers and underwriting firms that were heavily engaged in the subprime market all have been sued on theories of negligent underwriting, wilful failure to adhere to posted underwriting standards, misleading statements to investors and other related ­theories. Loan originators, ­brokers and appraisers are also being sued. Boards of directors and officers – both of companies that created structured financial products and those that invested heavily in such ­products – face negligence and breach of fiduciary duty claims.

How, then, has this ever-expanding ­financial market crisis affected the insurance industry during the first half of 2008? Not as much as might be expected. Of course, it is all the industry has been talking about.

Certain insurers have been hit hard as a result of investments in mortgage-related securities. Even before year-end 2007, Swiss Re, the biggest reinsurer in the world, had announced a writedown of $1.07bn (£537.12m) for the value of held derivatives, which it stated were mortgage-backed ­securities and subprime and asset-backed holdings in the form of collateralised debt obligations (CDOs). Swiss Re itself called the writedown “deeply embarrassing”.

AIG announced in May 2008 that it had lost $7.8bn (£3.92bn) in the first quarter of 2008 due to heavy writedowns on credit-default swaps and mortgage-related ­investments. This followed its 2007 announced writedown of $11.5bn (£5.77bn) in the value of its derivatives portfolio. ­Security Benefit Life Insurance (SBLI), which was heavily invested in subprime mortgage-backed securities, saw its Moody’s rating reduced from A3 to Baa1 and its Fitch rating reduced from A to BBB minus. Standard & Poor’s reduced SBLI’s counterparty credit and financial strength rating from A to BBB plus.

Australian general insurer IAG is reportedly poised to announce ­writedowns of the value of its investment portfolio on the back of the credit crunch. This list, too, is likely to expand.

How else has the industry been affected? Clearly by credit market-related claims and ensuing claim-related lawsuits (and ­accompanying expenses).

Insurers engaged in the financial guarantee/credit risk business are struggling mightily. It is not unrealistic to predict a wave of ratings downgrades and eventual insolvencies of monoline financial guarantee insurers. These insurers have taken, and are taking, millions of dollars of write-offs on their financial statements, including both losses to reserves for credit impairments on which the insurers expect to pay claims, and mark-to-market losses on their credit derivative portfolios.

But claims and lawsuits also are likely under directors and officers (D&O) and errors and ommissions (E&O) policies against the directors and officers who created the disastrous products and authorised investments in them. In the wake of massive layoffs in the financial sector, the possibility exists that employment practice liability covers may also be implicated. Ameliorating this, to some extent, is the fact that many large financial institutions have very large self-insured retentions and non-traditional insurance structures.

Very preliminary estimates of the impact of D&O and E&O claims on the insurance industry overall have varied from $3bn (£1.51bn) (D&O only) to $30bn (£15.15bn) (D&O and E&O), according to the National Underwriter (12 October 2007). Perhaps the first measurable indications of the effect of the financial ­crisis on the insurance industry were seen in the announcements of the first quarter of 2008’s results last month. The National Underwriter reported – based on statistics from the Insurance Services Office and the Property Casualty Insurers’ Association of America – that net income for the US property-casualty insurance sector plummeted by nearly 50 per cent in the first quarter. This result was driven by underwriting losses and high catastrophe losses, but also by deteriorating investment results.

While there have certainly been reports in the press claiming the insurance industry has or will escape relatively unscathed from the financial market’s meltdown, these reports are at best premature and at worst ostrich-like. Due to the nature of the business, it will certainly take time to determine how bad things will actually be. What is guaranteed is that speculation and estimates on the effect of the market’s meltdown on the insurance industry will continue to be plentiful.

Linda Dakin-Grimm is a partner and Patty Quilizapa an associate at Milbank Tweed Hadley & McCloy