pg5Editorial_v1_DG_VM
5/6/08
9:38 PM
Page 5
Back to the Basics
S
David Gambrill Editor david@canadianunderwriter.ca
5 www.canadianunderwriter.ca • May 2008
mortgages off their books. And it all came crashing down when the bad mortgages went into default. The whole financial process was far too complicated. The natural instinct is to say: “Someone must be accountable for this mess.” If these people are found, they will be drawing on insurers to help them pay the damages if they are sued. Institutions sued thus far include the large investment banks and mortgage lenders. Estimates suggest the D&O and E&O insurance claims alone will be worth a total about US$9 billion. Some U.S. commentators say the subprime market collapse will lead to record losses for insurers, with claims higher than the US$41.4 billion (Can$45.18 billion) paid out for Hurricane Katrina. It remains to be seen what the U.S. courts will do. One key question for insurers in these cases seems to be whether subprime damage awards and settlements payments will be considered “losses” (covered by insurance) or as “restitution” or “disgorgement” of profits illegally obtained (not covered by insurance). Another obvious arena in which this will play out is in the regulatory arena. Obviously, when all of the dust settles, regulators will be looking for ways to strengthen the securitization process. It remains to be seen what long-term affect this will have on the industry. But certainly slowing down the circulation of capital in order to avoid the kind of financial disasters seen in the subprime scenario most likely will have some long-term impact on insurers’ investments and further D&O and E&O coverages. Which brings us to the topic of risk management. How could something like this happen, it might be asked, if all of the proper risk management procedures and policies were in place? That’s a good question. PACICC has asked this question recently in these pages and it will be interesting to see and learn from the litigation that ensues from the subprime crisis just how weak internal process and controls at many major financial institutions still are. Clearly more work needs to be done in this area; it will probably be years before the dust settles and the courts and regulators will be able to provide the industry some kind of direction. How big and messy is this crisis? Big enough that it involves every player in this industry — as well as many other financial industries as well. Which begs the observation raised by the reinsurer noted above: Maybe it’s time for the financial services industry to get back to the basics and really analyze just what it is everyone is supposed to be doing.
EDITORIAL
ome time ago, a Canadian reinsurance company executive casually commented on the swirl of controversy around the concept of finite reinsurance. Paraphrased quite a bit, his argument essentially was: Sometimes in the effort to make and move money, the insurance industry has become too sophisticated for its own good. One has to wonder if this same argument holds true in light of the subprime mortgage crisis in the United States. This is a financial services mess of huge order — A.M. Best likens its scope to that of a huge natural catastrophe, predicting the subprime fiasco could cost the North American financial services area as a whole almost US$1 trillion over a period of two or three years. Given this type of scope for damages, it’s hard to imagine insurers will not be caught up in this in ways hitherto inconceivable. Thus far, Canadian (re)insurers have reassured markets the subprime mess doesn’t affect them. In the United States, some (re)insurers dabbling in the securities markets have proceeded to post significant writedowns. At its annual general meeting in Toronto, the Property and Casualty Insurance Compensation Corporation (PACICC) noted: “because most P&C insurers in Canada hold conservative, high-quality fixed-income investments, the industry’s exposure to subprime debt concerns is small.” This, however, speaks to only one area in which the subprime mess is likely to affect Canadian insurers (i.e. in the area of investments). But there are at least two other ways in which subprime might have some ramifications north of the border — i.e. D&O and E&O litigation costs, and calls for increased regulatory oversight over financial derivatives and securities markets. Before addressing the financial consequences of prospective D&O and E&O litigation, first a very brief summary of what happened. Characterizing the issue to quite a degree, the subprime crisis in the United States could be described as a securitization gone horribly wrong. Investment bankers re-packaged mortgage loans to people with poor credit histories as collateral for new “securities,” and proceeded to sell these securities to investors. Bond insurance made the securities more attractive to some ratings agencies; based on high credit ratings, investors bought the securities. Accounting rules allowed investment banks to create so-called “special purpose vehicles” to move the bad