By Rick Vassar CPCU ARM
Author of the #1 Insurance Liability Book on Amazon.com Hide! Here Comes the Insurance Guy
CHICAGO, Dec 17, 2008 (BUSINESS WIRE) -- Fitch Ratings downgrades XL Capital Ltd (XL) and its property/casualty (re)insurance subsidiaries, including the Issuer Default Rating (IDR) for XL to ’BBB+’ from ’A’, and the Insurer Financial Strength (IFS) rating of its core operating companies to ’A’ from ’A+’. (See the full list below.) The ratings remain on Rating Watch Negative.
The rating action follows XL’s announcement that the company anticipates the estimated mark-to-market decline in its investment portfolio through November 2008 to be largely in line with the $1.1 billion of unrealized losses, other than temporary impairments and realized losses on sales the company incurred in the third quarter of 2008 and the $200 to $220 million in net investment fund affiliate losses from its alternative investment portfolio for the fourth quarter of 2008.
Rick Vassar’s insurance/Financial Interpretation – “Sorry, man, my bad…”
NEW YORK--Dec. 17, 2008--American International Group, Inc. (AIG) has issued the following statement regarding an article published today by Bloomberg:
"AIG reports all its derivatives at fair value in accordance with US GAAP including AIGFP’s credit derivative portfolios. In accordance with US GAAP, in its determination of fair value for its credit derivatives, AIG considers all available information including but not limited to market available data, dealer provided prices, prices used for collateral posting and recent trades including early terminations initiated by counterparties. In evaluating fair value for its Regulatory Capital portfolio, AIG also considers factors relating to the individual underlying portfolios including, but not limited to, asset type and seasoning, default history, loss history and attachment point.
"AIG has clearly described its valuation approach including key assumptions used for AIGFP’s super senior credit default swap portfolio in its Form 10-Q for the quarter ended September 30, 2008."
Rick Vassar’s Insurance/Financial Interpretation:
“Face it. You [screwed] up! You trusted us.”
-Eric ‘Otter’ Stratton from the motion picture Animal House (1978)
I have been asked on numerous occasions in the past few months how this could happen to a big insurance company like AIG.
Why are they investing money in sub-prime mortgages?
How could they not see this coming?
You see, the general public believes that insurance is quite a simple process. You charge premiums, you pay claims, and you keep the money that’s left over.
It’s sort of like that, except that there’s one component left out. The insurance companies charge premium, put some of it aside to pay claims, and invest the rest. The insurance industry as a whole loses money on the spread of premium to losses, but makes it up handsomely on the investment returns. The industry has been doing this for hundreds of years.
So what’s the problem, Rick?
The problem was outlined in my book Hide! Here Comes the Insurance Guy in early 2006:
“I believe there was a watershed decision made in 1999 that should have put the debate of the hard market to rest. In that year, Congress passed the Financial Services Modernization (Gramm-Leach-Bliley) Act. This act allowed, for the first time, banks to offer insurance products and for insurers to offer banking services through holding companies. This created a synergy between the two industries which allowed both to tap into their customer bases and mine business from the other industry. Banks and insurance companies could offer their clients a one-stop alternative for both insurance and banking.
The result was an increase in competition in the marketplace, which led to consolidation of companies that were too weak to compete in the more dynamic market. The increased competition increased supply for a fairly stable demand, reducing the prices in the marketplace. The increased competition also caused some weaker insurers to lower their qualifications for coverage, which weakened their overall book of business and made them susceptible to the vagaries of the free market. At the same time, it provided a need for coverage in the secondary market that was not being fulfilled at a reasonable price.”
In other words, instead of insurers going to the bank to invest their money, they became the bank. Insurers found that by going to themselves to invest their money to be much easier and much more profitable.
I mean, who is going to ask questions of you if you are borrowing from you.
Sarbanes-Oxley only expanded the problem, because the transactions were being reported. No one understood the investments, but they were being reported. And don’t worry, it’s mostly our money.
Then, the bottom falls out, and the bank turns back into an insurance company and tells us that they don’t know what these swaps and stuff are all about, because this isn’t our core area of expertise.
Exactly.
One needs to look only at the insurance industry’s combined ratio, which is the percentage of each premium dollar a property/casualty insurer spends on claims and expenses. The industry average has been hovering around 102%, which means for every $100 collected in premium, $102 is paid out in claims and expenses.
The combined ratio is conservatively estimated to be around 104% in 2008, with some experts saying that it could be as high as 108%.
So, what has this taught us?
Insurers began to rely on investment income to offset poor premium pricing and underwriting decisions in reaction to increased competition brought about after Gramm-Leach-Bliley. Insurers lowered qualifications to bring in more income to invest. Once claims cost began to rise due to poor underwriting, there was more pressure on the investment side to make up the difference.
The pressure for increased investment income led to lower standards in the underwriting of investments. The greater the risk, the greater the return, unless the bottom falls out
If there is transparency in financial transactions that no one understands, are they really transparent? SarBox gives the impression of accountability without accountability, which is okay, unless the bottom falls out.
It makes me chuckle to hear insurers tell me that the insurers are actually in good shape. My question is: How good would they be if that $100 billion or so didn’t come to the rescue? The insurance subsidiaries are being kept alive to sell off from the banks – I mean holding companies.
Let’s go back to banks being banks and insurers selling insurance. When they’re apart, they work pretty well. When they got together, it was real good for awhile. Premiums came down, insurance was available, investments were plentiful. When the bottom fell out, the fall was swift and severe, and there was no place to go.
Too good to be true is all well and good, unless the bottom falls out.
