That the implosion of the US subprime market would have an impact on insurance companies writing US casualty business was never in doubt. The question was how bad it would get. The answer is a lot worse than first expected.
When the subprime crisis first took hold in the late summer of 2007, Bear Stearns – itself a victim of the crisis – estimated that a worst-case possibility for directors' and officers' liability (D&O) insurance losses would be roughly $3bn, with errors and omissions (E&O) losses adding to the total.
By earlier this year, D&O and E&O losses as a result of the credit crunch gripping the world's financial markets had increased to between $3bn and $8bn.
But in light of the recent escalation of the financial crisis – which led to America's oldest bank Lehman Brothers filing for bankruptcy, Merrill Lynch, Wachovia and Washington Mutual being acquired and American International Group (AIG) and mortgage firms Freddie Mac and Fannie Mae having to be bailed out by the US government – such estimates now look woefully inadequate.
"There were a number of estimates in the early summer that put subprime and credit crunch losses at around $8bn to $9bn, of which $3bn was D&O with the E&O issue adding up to $5bn," says George Carrington, managing director at Guy Carpenter. "Since then things have just accelerated and have come so thick and fast. In recent weeks we have seen unprecedented and catastrophic events."
What began as an isolated subprime problem has ballooned into a global financial crisis, the like of which has not been witnessed since the great depression of 1929.
Governments around the world have been reacting to the crisis. The US government weighed in with a $700bn bail-out package for the US banking system, the UK government came to the aid of its banks with a $500bn rescue package and six central banks including the US Federal Reserve, the European Central Bank, the Bank of England and the central banks of Canada, Sweden and Switzerland cut interest rates by half a percentage point in a coordinated move.
However, any benefits provided by the cut in interest rates quickly dissipated amid concerns the move and government bail-outs will not be enough. Stock markets around the world continued to plunge to their lowest depths in the past five years.
On October 10 2007 Wall Street had reached a peak with the Dow Jones hitting 14,279 points but since then the index has lost 40% of its value. On October 9 this year the Dow Jones Industrial Average plummeted by 678 points, or 7%, to 8,579. The fall was the index's third worst-points fall of all time and compounded the damage caused by the previous week's record one-day fall of 777 points.
The potential litigation and class action lawsuits arising from the financial crisis have spread far beyond those parties directly involved with the subprime mortgage market. As the plunging stock markets show, the contagion has infected the whole financial institution world and the prospect of global recession could see the contagion spread into the commercial market.
Angry shareholders, who have watched with horror as the value of their shares has been destroyed by the crisis, will be seeking compensation. The result of which will be that casualty writers writing professional liability protection are set to face a slew of D&O and E&O related claims.
And, with US Treasury Secretary Henry Paulson warning that more financial institutions are expected to fail and shares in Morgan Stanley and Merrill Lynch slumping by 25% on concerns they may struggle to survive the credit crisis, the ensuing litigation, class actions and claims activity could be a scary prospect for shareholders.
Robert Hartwig, chief economist at the Insurance Information Institute (III), says the likes of the crisis has never been seen before.
"Typically D&O and E&O claims expand in times of economic distress particularly with banks. There has been a contagion of the crisis spreading beyond the original players in the subprime mortgage area so it is likely that more professional liability suits are going to occur," says Hartwig. "You can't tell how much this will be because we are still in the middle of it and it takes many years for the cost to be known. The situation is not comparable to the Enron and WorldCom crash. It is not really comparable to any previous period in time."
A tidal wave of claims
As shareholder lawsuits mount in the wake of the financial market meltdown, Nigel Brook, partner at law firm Clyde & Co, warns that the insurance industry could face a wave of class action lawsuits.
"When there is a sharp fall in share prices there is almost a knee-jerk reaction with class actions brought on behalf of shareholders," he says. "It is getting on for 130 class actions directly related to subprime. There is now any number of potential extra claims. There could be a tidal wave of these."
The financial institutions market, and to a lesser extent the real estate market, have been hit with a flood of subprime-related lawsuits in the past year. According to a report released by Marsh, more than 80 firms have had federal securities class action claims filed against them for subprime-related disclosure issues.
The report was released before the collapse of Lehman Brothers and the takeovers of Merrill Lynch, Wachovia and Washington Mutual. In September alone, lawsuits were launched against: Merrill Lynch chief executive John Thain and the firm's board of directors over its buyout by Bank of America; Lehman Brothers CEO Richard Fuld and the board for allegedly misleading investors before filing for bankruptcy; and AIG CEO Robert Willumstad and his board for alleged mismanagement.
With such a spate of lawsuits on the horizon, Carrington at Guy Carpenter expects the profitability of professional liability writers to be hit hard.
"We are in for a rough ride in terms of results. Inevitably there will be more claims activity and I doubt many could have predicted this spike in claims," says Carrington. "D&O premium in the US is around $10bn and E&O is around $13bn. If a single event will take out $8bn of that total there will definitely be some losses."
The market for D&O insurance remains generally soft, save for firms with subprime or other credit-related issues. According to Marsh, during the first two quarters of this year Fortune 500 companies were benefiting from 10% to 20% reductions in rates.
Given the long-tail nature of D&O claims, it could be several years before the full impact of today's economic turmoil and litigation activity is felt by D&O insurers and is fully built into their pricing models. According to figures from MarketScout, professional liability pricing fell by 9% in September and D&O liability fell 8%.
"We have seen some evidence that prices have gone up but it is too early to say," says Carrington. "In the long-term, professional liability rates will go up and insurance and reinsurance buyers will have to pay more but it will take a while for these losses to crystallise."
The competitive financial institutions market in 2007 has changed as the subprime crises spread. The insurance market for management liability is producing sharply different renewal outcomes for those businesses directly exposed to the subprime credit meltdown and those that are not.
According to Marsh, large organisations with a market capitalisations of $10bn and above have had average rate increases of 31% in the first two quarters of the year, mid-size organisations have had increase of between 5% and 10% while those firms directly hit by subprime or the credit crunch have had average increases of 70% with a maximum increase 585%.
Insurers will hope that the financial crisis will push up rates for the wider casualty market, which remains largely soft. According to MarketScout, workers' compensation rates were down 6% in September, employment liability fell 9%, and fiduciary liability fell 7%.
If the financial crisis turns into a global recession, Carrington at Guy Carpenter says losses could spill over into other liability classes, which could improve pricing conditions.
"If we go into a full-scale recession loss activity will go up across classes. You would see that spill over into other liability classes," he says. "If the recession is headed off, however, the loss activity will remain pretty contained in the professional liability region."
Hartwig at the III says there has been some levelling off in the decline in rates as casualty capacity starts to reduce. He expects insurers will respond by being more disciplined in their underwriting as they record both realised and unrealised losses on their investment portfolios.
"The ability to generate underwriting profits diminished through very competitive pricing conditions. Pricing has been in negative territory for four years in a row. But in the face of higher underwriting losses and lower investment returns, the reality is that globally insurance capacity is shrinking," says Hartwig. "The arithmetic of this is insurers face some expected losses and if the funds from their investments continue to decline this will put pressure on their underwriting performance."
Collateral damage
So far lawsuits from shareholders have been largely aimed at financial institutions. But the plunging stock markets have wiped billions of dollars off the shares of companies that are essentially wholly unconnected to the crisis, such as manufacturers and retailers.
Concerns have broadened to industrial markets as the US's biggest carmakers General Motors and Ford suffered a large scale sell-off. General Motors' stock fell 31% on fears that it could be driven into bankruptcy by banks' reluctance to offer car loans to motorists.
Several retailers have filed for bankruptcy this year. Even those that do not file for bankruptcy face decreased sales, which could cause retailers to miss their earnings projections. Large firms in manufacturing and other industries could face write-downs in their investments in mortgage backed securities in the third quarter. All of which could lead to more shareholder lawsuits.
Hartwig at the III says this is a concern for insurers, although it is questionable whether blame can be truly laid on directors and officers.
"There is concern given the problem is spreading beyond the financial sector and other entities such as manufacturers and retailers are having problems," says Hartwig. "Whether that is something that will produce issues on professional liability is debatable. Because this has morphed into a global recession, a firm's poor sales don't mean it is the mistake on the part of the management. It is hard to place blame on the management of a company when it is basically collateral damage from the crisis"
While the debate about whether the spate of lawsuits will spread into other industries rages on, one thing is for certain – directors and officers will definitely be looking to increase their D&O cover. Hartwig says crises of this kind always focus the minds of managements protecting themselves.
According to Carrington at Guy Carpenter, after the Enron and WorldCom scandals in the early part of the decade many directors and officers struggled to buy D&O cover. This has insulated the market slightly from potential claims, but Carrington expects a greater push from directors to buy cover this time round, in particular A side cover - which protects directors and officers in the event a company goes bankrupt and the actual individuals rather than the firm are liable.
"The investment banks and Wall Street banks were experiencing difficulty buying insurance before the credit crunch happened. After Enron and the laddering crisis of the early part of the decade, investment banks found it hard to buy cover and effectively self-insured their exposure. This has provided a dampening on losses," says Carrington. "This time we have already seen some A side D&O coverage because directors are demanding it. If their insurance policies are not enough their assets are in the firing line."
But it is no guarantee they will find things any easier this time round. If anything conditions are more severe than in the post-Enron world. In addition to higher premiums, financial firms are facing more restrictive terms and conditions, lower limits and higher deductibles. And if D&O losses reach the levels they potentially could, capacity for this risk could be scarce.
"People at banks will perceive a need going forward but capital will be harder to come by," says Brooks at Clyde & Co. "For those who write cover it will become harder because of the losses but I am not sure anyone who has written this business will get destabilised."