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US subprime crisis impacts on insurance

In August last year Henry Keeling, the COO of giant Bermuda-based insurer XL Capital, said he expected the industry’s exposure to the US subprime mess to be “manageable”.

XL’s exposures through a related company caused a public relations hiccup last week until it was able to demonstrate its lack of exposure, which is a fair demonstration of just how sensitive everyone is at present. But Mr Keeling’s expectation of the industry’s ability to absorb the punishment appears to be correct so far.

“When the word ‘subprime’ emerged in the middle of last year from the darker swamps of the international financial system, the insurance industry wasn’t being seen as one of the likely victims. But now US insurance companies, brokers and commentators are tipping losses of more than $US9 billion ($9.76 billion) on directors’ and officers’ (D&O) cover alone – cover for directors and managers of mortgage lenders and investment banks which have already reported billion-dollar writedowns.”

The market is starting to see massive legal actions being mounted against lenders and large banks which provided securitisation on loans. The banks are already bleeding from the losses they have taken since the middle of last year.

Much of it will flow on to the London market, where the professional liability business is centred.

US commentators say the market is already seeing evidence of hardening in the professional liability market with tighter underwriting, reduced coverage and higher premiums. Several insurers have already put their PI businesses into run-off. And no wonder; one recent US study says virtually every participant in the subprime collapse is being sued.

The number of securities fraud class actions in the US is likely to increase dramatically over the next year, and hedge fund investors are also starting to bring actions against the funds for misrepresentation or negligence.

More problems are going to come to light, with the US Securities and Exchange Commission expressing concern that large financial institutions don’t have the risk management systems they should have had in place.

Too little too late, perhaps. And that’s all before the insurers start looking at the impact on their own investments. US commentators say the subprime market collapse will lead to record losses for insurers, with claims higher than the $41.4 billion ($45.18 billion) paid out for Hurricane Katrina – the highest payout for one event on record.

The insurers’ asset writedowns and credit losses have reportedly reached around $40 billion ($43.65) so far. This doesn’t include a number of other large publicly traded companies.

AIG reported its largest quarterly loss in 89 years because of the decline in investments linked to mortgages, and it expects more losses. It reported markdowns on topped residential mortgage-backed securities of $US6.7 billion ($7.3 billion) and more than $US11 billion ($12 billion) from credit-default swaps, which is cover for fixed-income investors.

Standard & Poor’s has downgraded or placed under review more than $US350 billion ($381.9 billion) of collateralised debt obligations.

The $US1200 billion ($1309 billion) subprime mortgage market is financed by bonds, called residential mortgage-backed securities, which are packaged and sold as high-risk high-yield packages to investors around the world.

Many of these securities were placed in the asset pools that back collateralised debt obligations (CDOs). This is another type of high-yield high-risk security that has emerged in recent years. The asset pools that back CDOs contain prime and subprime housing loans, credit-card receivables, car loans and even US student loans.

It’s remarkable that this crisis stems from the willingness of US lenders – including major banks – to finance and support the lending of money to people who obviously lacked the ability to pay it back. This type of lending accounted for 15% of the US home mortgage market. Compare that with Australia, where the exposure is believed to represent about 2% of total mortgages, or $10 billion of the mortgages held by Australian institutions.

Shortly before resigning in disgrace a few weeks ago, New York Governor Eliot Spitzer said US insurance companies “may not have sufficient capital to cover the potential defaults” of the subprime-backed securities they insured.

It’s a gloomy assessment, and it will be months before the true global impact of the crisis is felt in the Australian market – if, in fact, it affects the local market at all. But one thing is for sure – it will be a significant factor in the hardening of rates on commercial insurance premiums over the next year.