Is The Insurance Industry Next??

Most People Think…

• When they pay their auto and home insurance premium it goes into a no-risk pot of money that is only used to pay claims, commissions and fees.

The Realty Is…

• Your Premium is placed into a “General Fund” where Insurance Companies are free to invest it anyway they want.

With the 2001 Stock Market Collapse…

Hedge Funds Provided a Very Attractive Alternative

Hedge Funds Invested in High-Risk Mortgages

• They were “pots of money” meant to be loaned for higher/high risk mortgages.

• The funds made money when people made their payments.

• As long as home values went up they made money through foreclosures and re-sales.

And Other Hedges….

• Using risky derivatives.

• Borrowed Money

• Very Little Regulation

• Increased Risk

• All Gambling on a Higher Return!

Which Seemed to Good to Pass Up!

• “Zurich International Life’s new hedge funds • Reacting to investor demands for hedge fund products,

Zurich International Life has launched its own hedge fund of funds, the new strategy targets non-UK investors according to the released statements. For some time Zurich investors have demanded hedge fund vehicles, due to the popularity of such products.

• The launching of the Zurich International European Absolute Fund and Zurich International Global Absolute Fund is in line with such demands. The new portfolios would be actively managed by HSBC Republic Investments, according to the statement. Such hedge fund product is also aimed at investors who are interested in diversifying their investments. Both hedge fund strategies would be denominated in both the Euros as well as the US dollars” (Hedgeco)

Which Created a New Set of Problems:

• Zurich Capital to settle in hedge fund investigation

• SIFMA SmartBrief | 08/31/2007

• To settle accusations that it backed hedge funds involved in dishonest trading and assisted them in concealing the activity, Zurich Capital Markets will pay penalties of $16.8 million. Zurich said that it would pay the fine without admitting wrongdoing and that funds had already been set aside to cover the payment. Wall Street Journal, The (subscription required) (05/08)

• Zurich Financial Pays $16.8 Million in SEC Fund Probe (Update1) By David Scheer

• May 7 (Bloomberg) -- Zurich Financial Services AG, Switzerland's biggest insurer, will pay $16.8 million to settle U.S. Securities and Exchange Commission accusations it helped hedge funds make trades that hurt mutual-fund investors.

• Zurich Capital Markets, a U.S. subsidiary, helped four hedge funds disguise their identities to avoid detection when making frequent trades in mutual-fund shares, a practice called market timing, the SEC said in statement today.

• ``By knowingly financing their hedge funds clients' deceptive market timing, ZCM reaped substantial fees at the expense of long-term mutual-fund shareholders,'' Mark Schonfeld, director of the SEC's regional office in New York, said in the statement.

• The case stems from a U.S. regulatory crackdown, starting in 2003, on trading abuses in the $10.8 trillion mutual-fund industry. Sanctions against the Zurich-based insurer are dwarfed by fines in some similar cases, such as Bear Stearns Cos.' $250 million settlement in 2006.

• Zurich Capital Markets, which is winding down operations, neither admitted nor denied wrongdoing in agreeing to settle the case, the Washington-based SEC said.

• ``It was in the best interests of the company to resolve this matter with the SEC and thus eliminate the burden, expense and uncertainty of potential enforcement proceedings by the commission,'' Zurich Financial said in a statement. ``ZCM has fully cooperated with the commission.''

• The subsidiary didn't make any timed trades of its own, the company added.

• Market timing exploits inefficiencies in pricing and can increase transaction costs borne by long-term investors.

• The settlement includes a $4 million fine and forfeiture of $12.8 million in profits. The money will be distributed to mutual-fund investors harmed by the trading, the SEC said.

Searching for Greater Returns

• “Still, over time, institutional money, seeking greater returns than could be gained through investing in traditional long-only funds, turned to hedge funds to bolster returns, especially since 2000, when U.S. equities stopped generating good numbers. Suddenly hedge funds weren’t exotic, highly risky investments for the superrich. They were sexy new toys for pension managers. And billions in everyday folks’ retirement funds were at risk.” (After Amaranth)

Living on Borrowed Money…

• Unlike mutual funds, hedge funds are not as tightly regulated by the SEC, and so it is unknown how many funds will be affected by the defaults. Since hedge funds use sophisticated derivatives, the impact of any downturn will be magnified. This is because derivatives allow hedge funds to essentially borrow money to make investments, creating higher returns in a good market, and greater losses in a bad one.

Hedging the Hedge…

• “How's that? The hedge funds raking in fat profits from the meltdown in the subprime market have cleaned up by betting on a decline in the ABX subprime index, which measures the cost of insuring against defaults on subprime bonds. The index, created by London-based Markit Group, tracks 20 asset-backed bonds with a low investment grade credit rating. Beginning last fall a number of hedge funds began shorting the index—betting on a decline—either as a way to minimize their exposure to subprime bonds in their portfolios, or simply to profit from an anticipated sector rout. The ABX short bet came up a big winner when the index plunged in February, leading to a 34% decline for the year.” (Business week)

A Run on Hedge Funds?

• Hedge-fund redemption shock• Investors looking to cash out this fall may be met with an

unpleasant surprise.• By Grace Wong, CNNMoney.com staff writer

August 23 2007: 12:40 PM EDT

• LONDON (CNNMoney.com) -- Investors are expected to hit hedge funds with a flood of redemption requests this fall,

but those who try to withdraw their money may be in for an unpleasant surprise.

• Most hedge funds have "lock-ups," a minimum period of time during which investors agree to tie up their money and

not make any withdrawals

Cont….

• Once that period ends, investors generally can redeem their stakes as long as they give advance notice, usually 45 to 90 days before the quarter end. Although that cut-off has

passed for many funds for the current quarter, investors can still put in requests to get their money out by year-end.

• But hedge funds also can slow withdrawals, or suspend them altogether. While they're usually loath to do this,

since it can signal that a fund is on the verge of collapse, current conditions may result in more funds not letting

investors take their money out - at least not immediately.

Cont.• Hedge funds have been hard hit by the recent turmoil in the

market. Two Bear Stearns hedge funds heavily invested in securities backed by subprime mortgages blew up in June.

Ensuing volatility claimed funds at Sowood Capital Management and led to big losses at so-called quantitative

funds, including some run by Goldman Sachs (Charts, Fortune 500) and others.

• The losses sparked panic in the market, as well as worries that more problems will surface at other funds. That's raised expectations that hedge-fund investors, which include institutions like university endowments and

pension funds, will try to rush to get their money out before losing more. That, in turn, can unleash a vicious cycle: As

hedge funds lose cash, they're left with less money to invest, which can make it difficult for the funds to recover

and hasten a downward spiral.

Cont.

• To avoid that scenario, hedge funds can make it tougher for nervous investors to bail out. For example, they can slow redemptions by imposing a "gate," which allows them to

cap the amount investors withdraw during a given period - usually at 20 percent of the fund's net asset value,

according to David Nissenbaum of law firm Schulte Roth & Zabel, whose hedge-fund practice dominates the industry.

• They can also block withdrawals completely, for instance when they can't accurately value the fund's assets or don't have the money to meet requests, legal experts say. Bear Stearns (Charts, Fortune 500) froze withdrawals on a third fund this month, although the reason for the suspension

was unclear. Bear Stearns did not return calls seeking comment.

• And that unease is fueling expectations for investors to keep cashing out. Credit funds and those exposed to

subprime mortgages are the most at risk, analysts say, but amid the liquidity squeeze, some investors who need cash are even unwinding positions in funds that are performing

well.• Of the more than 9,000 hedge funds that currently exist, at

least 2,000 are vulnerable to "runs on the bank" by investors, according to a memo law firm Morrison &

Foerster recently issued to its clients.• Pension funds are especially likely to be pressured to pull

their money in volatile times, said Evan Flaschen, a bankruptcy specialist at law firm Bracewell & Giuliani who

represents many hedge funds.• "There will continue to be redemptions because so much

money invested in hedge funds is from pension funds and state trust funds who assumed returns were always going

to go up," Flaschen said.

• It's unclear how many investors will end up fleeing hedge funds, but pressure is expected to mount as the end of the

year nears. The problems at quantitative funds didn't surface until this month, which means nervous investors in funds requiring a 60- or 90-day advance notice weren't able to make withdrawal requests for the third quarter ending in

September. They may rush to the exits at the first opportunity in October.

• "There is a growing concern that we could be looking at substantial redemptions in the fourth quarter," Nissenbaum said, which could pose a big challenge for the hedge-fund

industry.• If funds take the extraordinary actions of using the "gate"

or suspending redemptions, "this will be a real test to see whether investors can forgive and forget or if this will

remain a black mark on the record of fund managers," he

said.  

So What Happens To Insurance Premiums?

• When return on investment turns into major losses in the company’s General Fund?

• When they can’t get out of a Hedge Fund?• When higher foreclosures lead to increased claims

losses?• When there is no short-term money to bail them

out?

For Zurich/Farmers Insurance

Return on Average Equity (2006)19.83% 19.00% 19.00%

Shorting The Market May be theOnly Option Left.