Question

Explain the Credit Crisis and Impact on Insurance Companies

Answer 1

Answer:

The current financial crisis may primarily be a banking crisis, and the solvency of the insurance sector as a whole does not appear to be threatened. Nonetheless, insurance companies have been affected, and in mostly adverse ways. For many insurers, direct exposure to the epicentre of the crisis, the US mortgage market, and to related securities appears to have been limited. But the financial crisis has nonetheless had an increasingly visible impact on the insurance industry, primarily through their investment portfolios, as the crisis spread and financial market valuations and the outlook for real activity deteriorated significantly. Also, a number of concentrated exposures to credit and market risks have been revealed, including in US mortgage and financial guarantee insurance companies, as well as in parts of certain other insurance-dominated financial groups. Thus, while insurers as a group may have cushioned rather than amplified the downward pressures during the financial crisis, some clearly have added to downward pressures. Financial instruments that were at the core of difficulties served an insurance function and, thus, it is not so surprising that some institutions from that sector have been affected by the crisis on one or the other side of their balance sheets.

Many companies have been affected by the recent economic turmoil. Notably, the severe downturn has had a marked effect on AIG, the world's largest insurer, which nearly went bankrupt as a result of credit default swaps it wrote for asset-backed securities and collateralized debt obligations. These products, while derivative in form, were essentially insurance contracts in substance and served to protect third-parties from debt defaults on pools of loans that included subprime mortgages and other risky investments. As the nation suffered from skyrocketing foreclosure rates, the value of the assets underlying the credit default swaps plummeted, and AIG was forced to write down its positions.4 While loss rates on other types of insurance, such as life and property, may be reasonably consistent and estimable, AIG failed to account for systemic risk factors, such as a broadly declining market, to which financial guaranties are exposed.

Different views exist regarding the role of the insurance sector in the context of this crisis, reflecting among other things differences in the interpretation given to some financial contracts that were at the heart of the recent financial crisis. One view, which is shared among at least several insurance industry representatives, is illustrated by the following statement:

There are no indications whatsoever that insurers have contributed to the systemic issues that many banks are facing today. Insurers have not originated and repackaged subprime mortgages. They did not act as major investors in mortgage based financial instruments. To the contrary, the insurance industry displayed resilience in the face of adverse market conditions and was in a position to absorb market volatility as an institutional investor with a long-term perspective. In this sense, the insurance sector acted as a stabilising factor at a time of considerable stress in the global financial system