First published in ITIJ 93, October 2008
Hard times are upon the insurance industry, as is evidenced by the collapse of Lehman Brothers and the appeal by AIG to the US Federal Reserve for $40 billion in aid. Stewart Farr and Mandy Aitchison report the latest developments
A few weeks ago the comment was made, on the back of that old adage 'Insurance companies are run by people who can't get jobs in banks', that having escaped relatively unscathed from the effects of the credit crunch, insurers were not looking so dumb these days. That might be so where insurance companies are not part of banking conglomerates headlined for their operating losses, but businesses generally are reliant on consumers; future demand is not looking too bright as recession bites, airlines fuel costs rise and cash-strapped travellers curtail activity.
Last August, when aspects of the media were 'celebrating' the first anniversary of the credit crunch (9 August 2007 was the day when the European Central Bank injected an unprecedented €94.8 billion into the money markets in an attempt to free up lending), Royal Bank of Scotland (RBS), one of the world's biggest banks, chose that same day a year on to announce first half losses of £692 million. This was the second-largest loss in British banking history, following closely behind Lloyd’s £715 million debacle in 1989.
RBS wrote down £5.9 billion on investments hit by the credit crunch and said talks to sell its insurance subsidiaries Direct Line and Churchill were continuing with the hope of realising as much as £7 billion. The insurance businesses were put up for sale in April when RBS announced its £12 billion rights issue and had attracted initial interest from the likes of AIG, Allianz, Axa and Generali.
Not much more than a week later, RBS was on the point of abandoning the auction sale of Direct Line and Churchill because it had raised almost £6 billion through the sale of risky loans. By then there was thought to be only one serious bidder left in the auction anyway, but American insurer Allstate was believed to have tabled a bid at least £1 billion short of the original asking price. Sources indicated that US investment supremo Warren Buffett, who initially expressed an interest in the insurance businesses with the caveat of non-auction participation, might be tempted back into the frame.
There have been no developments since (at the time of writing) amid suggestions that the auction is likely to be delayed or abandoned. RBS continues to be pilloried in the press, amid calls for the resignations of both the chief executive and chairman, accused of destroying billions worth of investors' money by overpaying for ABN Amro (on the eve of the credit crunch) and by piling into the US sub-prime and leveraged loans market.
German insurer Allianz was also making the news during August with its attempts to dispose of the Dresdner Bank business
German insurer Allianz was also making the news during August with its attempts to dispose of the Dresdner Bank business, for which it had paid €24 billion (in cash) back in 2001. The hope then was to sell across-the-board financial services to Dresdner customers; instead Allianz found itself dragged into the US sub-prime crisis. The subsequent sale to Commerzbank earlier this month was for a rather embarrassing €9.8 billion and the buyer is paying a large chunk of that figure in shares. Allianz will now be Commerzbank's biggest shareholder with a stake of almost 30 per cent. An unfortunate casualty of the takeover will be the demise of subsidiary Dresdner Kleinwort which, dating back to 1786, was one of the most historic names in banking. The China Development Bank had been a possible buyer of Dresdner, which wrote down €286 million in its asset-backed securities portfolio in 2008's second quarter, but pulled out of the race because of diplomatic friction between Beijing and Berlin over Tibet.
Meanwhile, speculation was mounting over the viability of Fannie Mae and Freddie Mac, America's two biggest mortgage finance companies. Fannie and Freddie are collectively responsible for $5500 billion worth of residential mortgages, almost half of America's $12,000 billion of outstanding home loans. Expectations that the US Government would implement a bail out had been growing since Congress had granted permission for the injection of money into Fannie and Freddie if required.
Warren Buffett had already predicted that the independent existence of these two mortgage finance companies was not feasible. As the world's richest man his views have certain clout; he expects more banks to fail (“We will see failures where the bankers were dumb in what they did.”) and economies to stay in the doldrums for months ahead: “You can have a whole bunch of domino-type effects that eventually can get to people who are doing fairly sound things.” Further, albeit retrospective, wisdom from the Sage of Omaha included “You always find out who's been swimming naked when the tide goes out. We found that Wall Street has been kind of a nudist beach.”
Billionaire George Soros, while conceding that the acute phase of the credit crunch may have passed also said there would be future effects, ‘almost inevitably’ including recessions in the US and UK. Oppenheimer analyst Meredith Whitney who correctly predicted the Citigroup disaster last autumn also believed the ‘credit crisis is far from over’ and ‘what lies ahead will be worse than what is behind us’.
In the event, the US Government took control of Fannie Mae and Freddie Mac on Sunday 7 September, injecting up to $200 billion to keep them afloat. Commentators felt this move would now get the US economy and financial system back on track and also spelled good news for British and European banks. “The best deal and the most sensible deal available now,” said Buffett. Shares jumped in markets around the world; everybody was asking the question, did this mark the low point of the financial crisis?
Two days later Wall Street shares dived as investor confidence in the struggling broker Lehman Brothers collapsed; talks had fallen through with Korean Development Bank about a takeover or injection of capital. Eventually, Lehman Brothers filed for Chapter 11 bankruptcy protection, dealing a further blow to the fragile global financial system. Barclays and Bank of America had been in talks to rescue the bank, but negotiations faltered when it emerged that the US Treasury was not going to use government money to settle a deal.
“You always find out who's been swimming naked when the tide goes out. We found that Wall Street has been kind of a nudist beach.”
Meanwhile AIG, the world's biggest insurer, has recorded unrealised losses on credit default swaps of more than $20 billion over the past three quarters. Shares in AIG have now fallen by 79 per cent over the year as a whole. And, on 14 September, AIG made an unprecedented approach to the US Federal Reserve seeking short-term financing to the tune of $40 billion, which, said the company, would be used to in an effort to avoid a downgrade from credit rating agencies. In the event, the Federal Reserve Board lent nearly $85 billion to rescue the crumbling insurer; in return, the federal government will receive a 79.9-per-cent stake in the firm. Officials said they decided to act to stop the nation’s largest insurer from filing bankruptcy. However, an eventual liquidation of the firm is still likely, according to senior federal officials. But the government loan won’t spare the firm a tumultuous fire sale of assets – at an interest rate of just under twelve per cent and repayment of the loan expected as early as possible, assets must be sold, and sold quickly. Speculation has already started as to which subsidiary will be first to go, with some industry insiders suggesting AIG could dispose of some of its Japanese operations to keep afloat, which could herald a wave of consolidation in the Japanese insurance industry. However, speaking to Asia Insurance Review, Leslie Mouat, regional president of AIG Southeast Asia, said: “AIG’s business in the region is secure. As you know, most markets are professionally regulated and our AIG companies hold assets and margins of solvency well in excess of requirements. For us, it’s business as usual.” Nan Shan Life Insurance, a Taipai-based subsidiary of AIG, has also moved to reassure investors and policyholders, confirming that its obligations to both parties would be honoured, despite the problems.
Local media reports in India share a similar confidence that the troubles affecting AIG in the US will not have any major impact on the insurer’s operations there. AIG is the minority partner with the Tata Group in two ventures in India, with a 26-per-cent stake in Tata AIG Life Insurance and the same in Tata AIG General Insurance – sources close to the company say that if it becomes necessary, Tata has the ability to buy out AIG’s stake. The Indian Insurance Regulatory and Development Authority (IRDA) has said it is monitoring how AIG’s liquidity crisis will affect the two companies’ solvency ratios in India. One AIG executive said that Tata AIG General Insurance is in the black with a solvency ratio of 176 per cent, while Tata AIG Life Insurance has a solvency ratio of 305 per cent – both are higher than the 150-per-cent margin required by IRDA.
However, Indian non-life insurance firms are nervously watching to see how the troubles facing AIG will affect its reinsurance arm, as under rules stipulated by IRDA, a reinsurer must have a credit rating of at least BBB awarded by Standard & Poors, or an equivalent rating by an international rating agency. If AIG’s reinsurance arm rating falls below BBB, local insurers would be forced to seek another reinsurer. As a reinsurance group, AIG provides significant reinsurance capacity to the Indian insurance market, especially in aviation, as well as providing cover to large energy reinsurance policies.
Despite the chorus from AIG’s subsidiaries that all is well in the Asian divisions, in Hong Kong, Singapore and South Korea hundreds of people have terminated the policies they held with AIG. More than 2,000 policies were cancelled in Singapore alone, where AIG has a customer base of around two million people, while at least 1,500 policies were cancelled by anxious clients in Hong Kong. However, in mainland China and Indonesia, AIG officials said there had been no such rush to dispose of policies.
In a statement, AIG said its plans to increase short-term liquidity ‘do not include any effort to reduce the capital of any of its subsidiaries or to tap into Asian operations for liquidity’. The statement continued: “The insurance policies written by AIG companies are direct obligations of its regulated insurance companies around the world. These companies are well capitalised and meet or exceed local regulatory capital requirements.” Insurance regulators across Asia have stepped forward to offer their separate reassurances that vouch for the solvency of AIG’s Asian units in their respective jurisdictions: South Korea’s Financial Supervisory Service said there would be no problems protecting local policyholders, while in Singapore, the Monetary Authority warned policyholders not to hastily terminate their contracts. Clement Cheung, the commissioner of insurance of Hong Kong, told reporters that AIG’s local subsidiary was ‘financially sound, based on the accounting statement and the information given to us’. Other officials in Hong Kong have voiced their concern over what effect AIG’s calamity will have on the reinsurance industry, as many large property developers have purchased reinsurance from American Insurance Underwriters – AIG’s property/casualty arm.
AIG made an unprecedented approach to the US Federal Reserve seeking short-term financing to the tune of $40 billion
Back in the US, CEO of AIG Travel Guard John Noel commented: “We know that the complexities of the challenges faced by our parent company caused concern among our travel partners and our policyholders. Let me assure you, Travel Guard is strong and the AIG insurance companies that underwrite our policies are strong, with ample resources to pay claims to policyholders and commissions to our travel partners.” He claimed that the complete restructure of the parent company would not affect operations at Travel Guard, adding: “Travel Guard continues to be one of many profitable and growing enterprises within AIG’s insurance operations.” Even with such assurances, travel agents in the US have been warned they must perform due diligence and have other travel insurance options available to recommend to their clients.
The Australian arm of the company, AIG Australia, also spoke up after the Federal intervention, declaring it was never in any danger of not meeting its travel insurance claims responsibility. The firm’s assets are held in Australia, and its operations are subject to local regulations, which gives it a certain distance from the ultimate parent company. Chris Townsend, CEO of AIG Australia, said in a statement: “The trading position of the group’s general insurance arm remained strong and that as far as the Australian operation was concerned it was business as usual.”
In a statement to the press, the Federal Reserve said: “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 line of credit to AIG is available for two years, and over that time AIG has said it will sell certain parts of its business that bring ‘the least possible disruption to the overall economy’, although the government now has the power to veto asset sales and the payment of dividends to shareholders. AIG has already changed its CEO after the debacle – Robert Willumstad has been replaced by former Allstate Corp CEO Edward Liddy. As a result of AIG’s turmoil, Fitch Ratings company has downgraded the Issuer Default Rating (IDR) and outstanding debt ratings of the firm: long-term IDR has been moved to ‘A’ from ‘AA-‘, senior unsecured debt to ‘A’ from ‘AA-’, short-term IDR has been downgraded to ‘F1’ from ‘F1+’ and its commercial paper programme to ‘F1’ from ‘F1+’.
As if it needed another problem on its plate, AIG’s former chief executive and board are now being sued by a public pension fund, which is accusing the board and CEO of mismanagement and ‘grossly imprudent risk taking’, which led the company to where it currently stands. The lawsuit is being brought by the City of New Orleans Employees Retirement System, an AIG shareholder. The pension fund has said it wants the individual defendants to return to AIG all compensation they have been paid, amongst other damages.
Not everyone thought the rescue of AIG was such a good idea, with Ronald Chan, chief investment officer for Asian equities with Fortis Investments in Hong Kong saying: “What the US government is doing is basically delaying the recovery of the economy by really keeping AIG alive and by going back to the printing press to issue more US dollars, which long terms should be negative to the US dollar.”
Next to fall in the demise of the financial giants was Halifax Bank of Scotland – HBOS was purchased by British bank Lloyds TSB Group in a transaction valued at £10.5 billion on 17 September. Sir Victor Blank, chairman of Lloyds, admitted the deal, which will allow the combined bank to dominate the UK high street, was only made possible because the government decided to ignore competition rules. In return for this concession, the bank has promised to keep offering mortgages, particularly to first-time buyers. The new bank will have a total of 3,000 branches (provided none is shut as a result of the takeover), and manage one in three of all current accounts in the UK. Eric Daniels, the Lloyds chief executive who has been named has chief of the combined bank, said he could not rule out the possibility of compulsory redundancies after promising a £1-billion cost-cutting exercise for the company.
The effect on the companies’ travel insurance offerings will not be obvious for some time, as it has yet to be seen as far the two firms will operate as one. But with Halifax’s offering underwritten by Great Lakes Reinsurance, a wholly-owned subsidiary of Munich Re, and Lloyds TSB’s travel insurance underwritten by AXA, it could yet mean one provider is chosen above the other.
The inevitable spread
The seismic upheavals across financial markets these past few months, the rollercoaster of oil prices, accelerating inflation and currency fluctuations have shattered assumptions that the worst of the economic trauma would be confined to the US and UK. Europe's frailty has been exposed; both Eurozone and Japanese economies shrank in the second quarter. Spain and the UK have been designated as heading for recession by the European Economic Community (EEC), Denmark is already in recession, while Germany and France are hovering on the edge. British private shareholders alone have lost £48 billion on investments in the 12 months of the credit crunch.
The domino-type effects have now started appearing in the travel insurance industry. Rising fuel costs and a fall-off in passenger numbers are dictating a wave of consolidation in aviation both in Europe and beyond, for example British Airways and American Airlines and Ryanair's revived bid for Aer Lingus. Only BA, Air France-KLM, Lufthansa, easyJet and Ryanair are strong enough to weather the tough times ahead, said the latter airline's chief executive Michael O'Leary; everyone else would be forced into bankruptcy or be bought.
Since O'Leary's prediction at the beginning of the summer a few airlines have gone bust, including Silverjet and Zoom. The budget carrier Zoom Airlines went down at the beginning of this month with estimated debts of £20 to £25 million. However, summer is traditionally the travel industry's boom period; many airlines and tour operators would have been clinging on, hoping for the best. The recent collapse of operator XL Leisure could suggest that the pace of failure is now about to increase. City analysts are saying that further failures are inevitable. So far this year more than two dozen airlines and holiday companies have gone into bankruptcy; More will follow in the coming months as seasonal demand and revenue fall away. At the time of writing Alitalia is on the brink of insolvency.
AIG could dispose of some of its Japanese operations to keep afloat, which could herald a wave of consolidation in the Japanese insurance industry
According to company documents and financial results, XL Leisure lost £24 million on a turnover of £550 million last year. Its total debt exceeded £200 million. Chief executive Phil Wyatt blamed the collapse on soaring fuel costs, the economic downturn and inability to obtain further funding. He added that the rising dollar had wiped out the benefits of a more than 30-per-cent fall in the price of oil in the past two months. Barclays, a major XL creditor, apparently demanded more than £2 million in immediate payment from the airline amid growing concerns about its insolvency.
British Airways CEO Willie Walsh maintains that, worldwide, some 30 airlines have gone this year (either bust or been consolidated) and he wouldn't be surprised to see a similar figure in the next three or four months.