casualty among US insurers, the travails of many of its peers leave
little doubt that the industry is in need of a review of its risk
management capabilities and regulatory structure.
Would that it were, for behind the AIG saga lies many of the
nettlesome issues that plague the financial services industry at
large – namely the murkiness of risk and the reciprocal trust that
fuels credit markets, a trust that has dissolved along with the
markets. The AIG bailout is a stark reminder that the US insurance
industry has no structure of self-regulation. A failure of one
insurer impacts confidence in the entire industry.
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Any sighs of relief from the insurance industry quickly gave way to
groans as MetLife announced on 7 October that it would sell 75
million shares to bolster its balance sheet against mounting losses
on investments. MetLife’s move follows a rout in insurer stocks
that also hit Hartford Financial Services, which on 6 October
announced a $2.5 billion investment from European insurer Allianz
SE.
The Hartford, stressed by deflated investments, also said that it
would report a net loss of $2.6 billion in the third quarter and
that it has replaced its chief investment officer. The company is
also slashing its quarterly stockholder dividend by 40 percent to
32 cents a share.
Beneath it all, there is the public furor in the US over a
regulatory blind spot so vast that an insurer – AIG – with $110
billion in annual sales and assets in excess of $1 trillion could
find itself suddenly, and without a trace of warning, standing on
the brink of bankruptcy.
The story now has a worn feel to it: AIG’s derivatives, credit
derivative swaps, a balky mortgage insurance business, United
Guaranty, that began bleeding money in 2007 and suffered the slings
and arrows of the housing markets in the US. It also had invested
in mortgage-backed securities that led to $12 billion in costs over
the past year as their values plunged – money it owed to its
insurance companies in order to maintain strictly regulated capital
requirements.
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By GlobalDataEven as earnings declined throughout the business, AIG’s ratings
remained strong. That was, at least in part, a reflection of AIG’s
size and scope, as few observers ever doubted AIG’s ability to
repay its obligations. When AIG reported a $5.36 billion loss in
August, there still was no tangible panic, no calls for a
rescue.
Then Lehman Brothers went belly up, Merrill Lynch sold itself to
Bank of America and the credit markets tightened, just as AIG
needed more cash. Ratings agencies began to hammer AIG in
mid-September, triggering terms in their derivatives contracts that
required them to come up with an additional $14.5 billion in
capital. Having already raised $20 billion in capital through stock
and debt offers in May, and $4 billion in a private investment just
weeks ago, options were limited. The government was sending clear
signs that it wouldn’t step in, only to relent in the face of the
reality of an AIG collapse.
“The [Federal Reserve] Board determined that, in current
circumstances, a disorderly failure of AIG could add to already
significant levels of financial market fragility and lead to
substantially higher borrowing costs, reduced household wealth, and
materially weaker economic performance,” the Federal Reserve Board
said in a statement. “The purpose of this liquidity facility is to
assist AIG in meeting its obligations as they come due. This loan
will facilitate a process under which AIG will sell certain of its
businesses in an orderly manner, with the least possible disruption
to the overall economy.”
Now AIG must divest of significant life operations in Japan and
perhaps elsewhere to staunch the bleeding, and its aftershocks are
being felt among other US insurers, including The Hartford and
Prudential, which have spent much of the post-bailout period
fighting off speculation as to their capitalisation.
While near-term capital quality will remain at adequate levels in
the insurance sector, as rating agency Fitch said with remarkable
understatement: “conditions in the financial markets could
experience further deterioration and thus provide additional
challenges.”
Thomas Gallagher and Michael Zaremski , insurance analysts with
Credit Suisse in New York, described the AIG rescue as a
“staggering development,” noting that the Federal Reserve Board
statement that AIG will pay off its loan from the sale of
businesses suggests that the majority of the company may be sold
off in pieces. It is also worth noting that AIG’s insurance
businesses are separate units or subsidiaries that are restricted
from transferring assets to related entities without regulatory
approval to facilitate their ability to pay claims.
AIG’s problems means that there will be plenty of “high quality
businesses for sale, notably international life insurance, foreign
general, and the domestic retirement business sold through the
Variable Annuity Life Insurance Company (VALIC), a unit of the
American General unit of AIG,” Gallagher and Zaremski wrote in an
investment note to clients.
“We suspect that some of the big foreign players (Chinese,
Canadian, European, and Australian insurers) may be interested
buyers along with the usual large cap suspects domestically on both
the life and P&C sides,” they added.
Citing the severe dislocation in the capital markets fuelled by the
Lehman Brothers bankruptcy liquidity concerns at high-profile
financial institutions, rating agency AM Best revised its rating
outlook for the US life insurance industry to “negative” from
“stable.”
Although AM Best said that “fundamentals for the vast majority of
life/health companies are currently sound,” the ratings agency also
found that “uncertainty continues to be widespread in terms of the
future direction of the economy, real estate values, interest
rates, equity markets – both domestically and globally – and
liquidity.”
For life insurers, the short-term could see major changes in
investment patterns, as access to additional capital is limited as
stock prices are depressed and the liquidity crunch continues. The
re-pricing of risk has led to large-spread widening in the US
corporate fixed income market in a flight to quality, yet credit
remains painfully tight. Adding insult to injury, credit defaults
have begun to increase and many investments have experienced
significant impairments and large unrealised losses.
Life insurers with large variable-annuity operations are taking a
hit because the profitability of their products is tied to the
performance of the stock market. So far this year, the S&P 500
Index has dropped 21 percent.
AM Best believes there are additional risks emerging in the life
and annuity sector, notably the industry shift to asset
accumulation products from traditional protection products that
brings higher exposure to guarantees and greater policyholder
flexibility.
“Specific areas of emerging investment risk include a number of
previously stable investment classes: commercial mortgages (both
direct loans and securitisations), asset-backed securities (for
example credit card receivables and auto loans), alternative
investments (such as limited partnerships and hedge funds) as well
as prime residential mortgage-backed securities,” AM Best
said.
Despite the negative outlook, AM Best expects that the industry
will weather the storm. Historically, in troubled economic times,
life/health companies have generally reacted prudently by reducing
exposures when possible and enhancing liquidity. The current
capital levels for the industry – albeit down roughly 10 percent
from year-end 2007 – remain sound; however, net income for the
foreseeable future will likely be depressed.
The resultant rescue package has stemmed the tide, and the federal
government’s subsequent $700 billion package weathered the
political storm and has, perhaps, restored some semblance of order
to the larger financial services market. But the markets remain
incredibly skittish as evidenced by the recent plunge in stocks of
The Hartford, MetLife and Prudential after a comment by US Senate
Majority Leader Harry Reid – later retracted by a spokesman – that
an unnamed insurer is on the brink of bankruptcy.
There will be no domino effect in the US life sector, said industry
body Independent Insurance Agents and Brokers of America president
and CEO Robert Rusbuldt in a statement.
“Independent insurance agents and brokers across the country will
continue to focus on the consumer and know the state guaranty funds
in all 50 states serve as important protection for policyholders,”
Rusbuldt said. “Virtually all experts agree the insurance
subsidiaries of AIG are fundamentally sound.”
Perhaps. But the tremors of the AIG meltdown reach far and wide,
and promise to reshape the industry. If it wasn’t a done deal
before the meltdown, it is now a fait accompli that the insurance
industry, now regulated by individual states, eventually will be
moved under the umbrella of a federal regulator.
Given the palpable sense of panic in recent days, it’s worth
distinguishing what could happen from what has happened – and dire
as it has been, it is a long way from The Great Depression, a
much-repeated comparison of late.
America is doing relatively well with GDP growth at an annual rate
of 2.8 percent in the second quarter of 2008, although it did
suffer a 0.2 percent fall in the final quarter of 2007. In
contrast, it is worth remembering that America’s GDP fell by a
massive 30 percent during the Great Depression of the 1930s.
Painful as it may be, the current crisis is far from a global
depression.
The next date looming on the horizon: the end of October, when
insurers begin to post third-quarter earnings. It’s not likely to
be an edifying moment for an industry fighting forces beyond its
control.
