AIG's risk, the industry's reward?

These jarring events have produced a seismic shift within the insurance industry, creating both challenges and opportunities whilst also elevating the importance of developing new risk management strategies. Independent market analyst Datamonitor says the past weeks events will have a long-term effect on insurers technology strategies and expects they will look to increase their investment in risk management and compliance systems in 2009 by far more than they planned in the first half of 2008.

Given the current economic climate, the financial markets may well be considering whether other insurers are at risk. While the only certainty in today's market is uncertainty, Datamonitor believes that AIG was a one-of-a-kind event within the insurance sector.

Collecting premiums

Unlike other insurers operating within the life and non-life market, AIG was heavily involved with credit default swaps (CDS), which are unregulated quasi-insurance products that protect against bond defaults. For years, CDS were a profit center for AIG. Essentially, AIG was collecting premiums for covering credit products such as mortgage backed securities that, at the time, were not defaulting. The size of AIG's CDS exposure reached $440 billion, which exceeded what the company could pay in claims. Realizing that AIG had excessive exposure to CDS, rating agencies reduced its rating, forcing the insurer to put up greater amounts of collateral. This event triggered the downward spiral that eventually forced the federal government to intervene.

While AIG was in a class by itself in terms of CDS, the events of last week are directly and adversely affecting a number of insurers. Insurance companies are larger consumers of debt and equity. The lower share price of AIG, Lehman Brother's bankruptcy and the sale of Merrill Lynch to Bank of America is raising concern among insurance portfolio managers. On Tuesday September 16, MetLife announced that it had $800 million of investments between AIG and Lehman. "MetLife is continuing to assess the recoverability of these investments," the company said in a press release. The Hartford also has exposure, particularly $127 million in subordinated Lehman debt.

Proactive

On the positive side, the US government has turned proactive. After coming to the aid of AIG, the federal government drafted a plan to buy and gradually unwind the illiquid assets plaguing the balance sheets of financial service institutions. The estimated $700 billion plan, which was being debated at the time of publication, has two potential positive effects.

First, the plan, by steadying the banking industry, should boost lending, thus lowering the cost of capital and keeping the economy chugging along. Second, the plan will allow the government agency to purchase illiquid assets from a number of financial service companies, including insurers. By enabling an orderly sale of assets (as opposed to a fire sale) the plan should mitigate write-downs among insurers.

A key concern, however, is the price tag. At $700 billion, the plan will increase the national debt to $11.3 trillion dollars, although the government should be able to recoup some if not all of the money from the sale of the assets. In reaction to the nation's indebtedness, the dollar weakened against the euro in the days after the plan was announced.

The beginning of the end?

Although it is too soon to tell, the recent events could mark the beginning of the end of the soft market. For the last three years, premiums of nearly all commercial lines as well as some personal lines have been falling and this in combination with withering investment income has had a crushing effect on the industry's bottom line. This could change, however. Many times after a market shock (for example, September 11) the industry gains greater pricing power. Furthermore, a weakened and distracted AIG could cause a supply shock that puts upward pressure on prices. A shaky economy, however, may temper demand, making it difficult to pass on higher premiums.

Furthermore, insurers have a chance to gain market share from AIG. While AIG's insurance units are solvent, the market has another perception. According to a survey of 1,000 insurance agents and brokers conducted by Insurance Journal, 44% of AIG policyholders have requested to move their account. Some 62% of the producers said they expect to place less business with AIG. This shift in consumer and agent perception presents competing insurers with a great opportunity.

Plans to increase investment in risk management

Lastly, the past week's events will have a long-term effect on technology strategies. At present, insurers place great emphasis on risk management. According to a Datamonitor survey* of 200 global insurers conducted in the first half of 2008, 61% and 47% of non-life and life insurers, respectively, said they were planning to increase investment in risk management and compliance systems in the 2009. While these are healthy figures, Datamonitor anticipates even greater spending in light of the recent events.

Vendors must react to this demand by not simply providing more of the same but by designing innovative ways to re-engineer the risk management practices of insurers. The old assumptions simply do not work. "Safe" bets, like Lehman debt, proved poisonous. Furthermore, the current tools failed to account for the labyrinth of unregulated and loosely agreed-to credit default swaps. While new regulations should help mitigate these problems, next generation risk management systems must be able to quickly capture and evaluate complex transactions from every corner of the enterprise. In short, vendors have an opportunity to differentiate themselves by grasping the new realities of risk and designing relevant solutions.

Notes

*Datamonitor's report Catching Up: Online Direct Sales in U.S. Personal Lines Insurance (Strategic Focus) provides insight into the technology and strategic dynamics currently taking place within the insurance landscape. The report also explores the market drivers and discusses ways to overcome the inhibitors.