The Intelligent Quarterly from the publishers of The Insurance Insider

Summer 2018

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On the edge?

Matthew Neill

Almost a decade on from the 2008 financial crisis, when the world's monetary system faltered then finally crashed, the (re)insurance industry could be forgiven for thinking its walk-on part in the debacle is unlikely to be repeated.

The spectacular collapse of the sector's torchbearer, American International Group (AIG), has faded into history somewhat, after the company sought to rehabilitate its image following a humiliating bailout by the US government.

However, it still stands as a parable of what happens to those who would seek to flout the relatively conservative traditions of (re)insurance business.

AIG and the industry at large have done a solid job of distancing themselves from what occurred in the carrier's Financial Products unit and, to a lesser extent, elsewhere in the company.

This is unsurprising, given that in the run-up to the financial crisis no other carrier was found to be taking on the stupendous level of risk that eventually sank AIG.

Choose your poison
AIG's issues stemmed from two concentrated pools of risk which, when combined, proved to be nearly fatal.

The first, and best-known, of these poisons was the company's exposure to the US sub-prime mortgage market.

The Financial Products unit's ill-advised decision to take on enormous levels of counterparty risk in a series of credit default swaps caused $25bn of losses within several weeks in September 2008, and AIG came within a whisker of outright failure before a reluctant US government finally offered the $85bn bailout the company needed to survive.

A second, less publicised, issue at the company was its securities lending scheme.

Securities lending is a common practice among institutional investors seeking to extract that extra little bit of yield from their portfolio, and is a mainstay of short selling.

The lender, in this case AIG, loans its shares of certain companies in which it holds a long position to other parties for whatever purpose they see fit, usually to short-sell the security in question.

Companies with the scale of AIG tend to be unconcerned about the temporary short position of firms such as hedge funds, and are happy to lend their shares out for a fee.

They can then get the shares back when the shorter has closed out their position and make a tidy profit off whatever, normally safe, investment the seller has made with the capital provided by the borrower, on what would otherwise be an immobile asset

Unfortunately for AIG, what it presumably thought would be an uninspiring, tepid, but ultimately secure investment choice turned out to be fuel for the fire ignited by its Financial Products unit.

According to a paper by Anna Paulson of the Federal Reserve Bank of Chicago and Robert McDonald, a professor of finance at the Kellogg School of Management at Northwestern University, the company chose instead to invest its temporary windfall into what it believed were the safest of all short-term plays: the US housing market.

One can't necessarily blame AIG for making what proved to be such a fatal choice. The bulk of these bonds were AAA rated and it was by no means the only company to have been caught out on this side of the transaction.

But why was AIG the only (re)insurer to suffer such heavy losses as a consequence of this investment?

Different times
Back in the early 2000s there were few carriers in the global specialty market with an appetite for the more exotic risks offered by the financial markets.

Given that interest rates were much more favourable than they are now, there was simply no need to take on the risk of products such as mortgages and other loans.

A review of (re)insurers' earnings calls from the third quarter of 2008 is revelatory on this topic, as their results demonstrate the degree to which the industry was, to a great extent, insulated from the convulsions that rippled throughout the wider financial world.

Given the prominence of AIG's near-death experience, virtually every executive in the industry was questioned to a greater or lesser extent by analysts on this topic at the time.

But what is really remarkable is the sanguine nature of responses given by carriers. Consider this example from then Chubb chairman and chief executive John Finnegan:

"Our capital base, overall financial strength in ratings, underwriting excellence and reputation for premier claims service uniquely position us in the current market environment.

"Having worked so hard to position our company as a market leader, we intend to take advantage of those opportunities which are within our underwriting appetite and meet our pricing parameters."

This is not exactly sounding the alarm to abandon ship, aboard a Tarp-shaped lifeboat!

Tarp - the US government's Troubled Asset Relief Program - was perhaps anathema to the (re)insurance industry, as was suggested by WR Berkley founder William Berkley at the time:

"I think that Berkley as well as a number of other well-capitalised insurers are opposed to property casualty companies participating in the Tarp programme.

"We don't think we need it and we don't think that for the most part the insurance industry needs the participation of the Tarp plan, and those companies that are seeking participation are seeking it primarily because of liquidity issues that could be dealt with the falling in securities as opposed to capital infusions.

"So we're not in favour of Tarp at all, for the insurance industry at least." Even the vast bond portfolios of (re)insurers were considered immune from the shocks rippling through global financial centres, and the collapses happening elsewhere were not something to be worried about, according to AmTrust's Barry Zyskind:

"As we mentioned, half the portfolio is in the AAA MBSs [mortgage-backed securities], which are government-backed, and then in the corporate portfolio the names that we are left with are names that we feel very, very comfortable with, and we don't see this situation again which happened with Lehman and Washington Mutual."

Contrast this with the curt introduction of AIG's firefighting chief executive at the time Ed Liddy, who in all fairness just probably wanted to get on with the whole thing:

"We have a really an awful lot to cover this morning, so bear with us."

Seemingly, at the height of the financial crisis, when the largest carrier in the industry appeared to be on the verge of collapse, others in the industry were entirely unworried.

But given the shocks that have affected these and other companies in the decade since AIG's fall from grace, is it possible that the impact of the next collapse will be more widely felt across the sector?

Mortgage (re)insurance
The (re)insurance world is a markedly different place these days to the one carriers and brokers inhabited back in the early 2000s.

Years of steadily falling rates and overcapacity have not only forced the industry to change its assumptions about the fundamentals of hard and soft market cycles, but have also prompted participants to look elsewhere for growth and profitability.

This need to diversify away from the traditional, comfortable markets in which the (re)insurance sector has always operated has manifested itself in a number of ways.

While InsurTech gains a lot of attention as the greatest potential force for disruption in the industry, a more subtle but no less important harbinger of change has increasingly been targeted by carriers over the last decade: mortgage (re)insurance.

This market has proved to be a fairly lucrative area in recent years, and ever more carriers are keen to get into it. The most spectacular example of this trend was Arch's blockbuster $3.4bn bid for AIG's mortgage unit, United Guaranty Corp (UGC).

Standard & Poor's (S&P) credit analyst Hardeep Manku described the bid as evidence of the Bermudian giant "doubling down" on the mortgage market - a clear bellwether for industry sentiment and the belief that mortgages once again represent an opportunity rather than an existential threat for carriers.

Given this widening of the industry's direct exposure to the whims of the global credit markets, should (re)insurers be worried about becoming the next AIG?

At the epicentre
When we talk about the global credit markets and their propensity to wreak havoc, we really are referring to one country above all others: the US.

US sub-prime housing loans were at the epicentre of the global financial crisis - the trigger for a quake that impacted the world's financial markets in much the same way as a real earthquake can affect the (re)insurance industry.

However, much has changed in the US credit space in the past decade. The gargantuan government-supported enterprises (GSEs), Fannie Mae and Freddie Mac, have embarked on a mass transfer of mortgage risk from the state into the private markets, and this has created a lucrative opening for the (re)insurance industry.

Joe Monaghan, executive managing director at Aon Benfield, reckons around 200 carriers have got in on the action, with around 75 percent of the risk transfer being conducted through bonds.

He says the reinsurance broker has helped place over $12bn of limit for GSEs into the private market over the last three years alone, spread across some 50 individual transactions. The total premium for these placements comes in at about $2.5bn, Monaghan estimates.

And this mass transfer of risk to the private sector, with all the attendant discipline that companies in this area typically bring to bear on their exposures, has changed the scope of underwriting quality for mortgages in the US. "Obviously, post-crisis, the quality of the underwriting has been absolutely pristine, and you have multiple people buying mortgage credit risk transfer today that were not doing it before," says Monaghan.

He blames the GSEs' core mission of expanding homeownership rates in the US as a key factor in the deterioration in mortgage risk quality in the 2000s.

Monaghan argues this created an incentive to allow poor-quality risk to balloon. In addition, the knowledge that the state would backstop any losses meant that the originators and underwriters in the market had little incentive to ensure their products were of high (or indeed, any) quality.

"[The GSEs] strayed from those core underwriting principles. The GSEs also serve a mission to expand home ownership. How do you balance this with prudent underwriting?" he asks. "I think having a number of private investors, including mortgage insurers, taking this risk acts in many ways as a second set of eyes and [a] governor on underwriting standards."

Underwriting quality
Taoufik Gharib, senior director at S&P Global Ratings, echoes this sentiment. But he also cites the raft of regulatory change spurred by the financial crisis as a significant factor in ensuring that carriers are careful in maintaining the quality of their mortgage risk.

"The advent of Dodd-Frank and the regulation around qualified mortgages and QRM mortgages are two guidelines that have been out there since the crisis, which basically determines the amount and type of due diligence that lenders have to do," he explains.

"So there is a lot of focus on the ability to pay from the lenders' perspective, and they have been under the lens in terms of the kind of collateral that is coming through."

But is this short-term shift in attitudes and discipline that has enticed carriers back into the mortgage (re)insurance game sustainable?

Gharib highlights that underwriting quality across all lines typically deteriorates over time.

Given we are around a decade on from the last real estate bubble in the US, and just under a decade from the subprime mortgage-induced financial crisis, (re)insurers remain extremely conscious of the potential for their mortgage book to be an unexpected source of heavy and concentrated losses.

The memories of AIG's spectacular decline are still fresh in the memory. "In any economic cycle, once the crisis hits you see a tightening of the mortgage underwriting quality, but over a period of time you see a sort of loosening because the risk appetite returns and there is an increase in how much a bank or lender wants to give out," says Gharib.

However, he adds, carriers are continuing to display a high degree of discipline: "[Loosening of underwriting standards] really has not happened yet. There has been some, but not to the extent that we would have expected."

His colleague Manku agrees, arguing that mortgage carriers have "learnt the lessons of 2008".

History repeating itself?
However fresh the scars of the 2008 financial crisis remain for the (re)insurance industry, mortgage business is increasingly becoming a source of growth and profits that is difficult to ignore at a time when the sector will jump at new opportunities for either. While (re)insurance rates continue their seemingly perpetual track downwards and the influx of excess underwriting capacity persists, carriers are bound to be attracted into new lines of growth. But those writing mortgage business should be aware that it comes with a warning label attached.

AIG managed to be pulled back from the brink only because of its sheer size and links with the wider economy; because the US government was willing to step in to stop further bloodshed following poor decisions made by a handful of operators.

Would it do so next time? The current mood in the White House suggests any form of government intervention in financial markets is unlikely in the near future. And other companies that do not carry the systemic importance of an AIG should think twice before hoping for a government bailout to stop their losses. Mortgage (re)insurance is here to stay. So let's hope the changes wrought in the market since 2008 are enough to prevent a similar - or even larger - crisis battering the industry once again.

This article was published as part of issue Autumn 2017

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