THE ORIGINS OF THE CREDIT CRUNCH AND THE EMERGENCE OF A REINSURANCE

CRUNCHReinsurance Trends and Lessons to be learned from the

Global Financial Crisis The African Perspective.

Rajni Varia

We have witnessed the most difficult economic environment of the last 30 years

Global GDP growth, real % p.a.

-2

-1

0

1

2

3

4

5

6

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Oil Crisis Early 90s recession

Dot-com bust

Credit crunch

Source: IMF

While there are many interlinked causes, they all centre around a very human failing: GREED

0

2

4

6

8

10

12

1980 1985 1990 1995 2000 2005

USA household savings rate, % FTSE 100 Index

We believed the good times would never stop

3000

3500

4000

4500

5000

5500

6000

6500

7000

2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: IMF, Yahoo Finance

In the housing market, we believed prices would rise forever, though experts warned us they

were too high

What caused this?

UK House Prices, £ ‘000

0

50

100

150

200

1995 2000 2005 2010

“[House prices in the ] United Kingdom… also still seem overvalued by most conventional measures “

IMF, September 2006

Source: UK Land Registry

A buyer who only considered the “guaranteed” returns and ignored the risks

Wow! The Jones’ next door have made £100,000 on their

house! I want some of that

So we gave them…

• 110% loans to help those who couldn’t afford the down-payments• Discounted mortgaged

interest rates during the initial periods to help those who couldn’t afford the repayments• Self-certified incomes to

help those who didn’t have a regular income

A broker who didn’t care about the risks and just wanted to get the commission

Well, we don’t actually lend you the money – a bank will do that – sow e don’t care if you repay the loan. We still get our commission.

You guys are awesome! You are really willing to work with guys like me

Wow! Lets get started

A bank that didn’t really carry or understand the risks they were selling

US mortgage backed CDO outstanding, $ tn

8.98.98.5

7.1

5.95.2

4.74.1

3.63.33.02.72.5

96 97 98 0302012000 0499 05 06 07 08

Source: SIFMA

I’d better get rid of these crappy mortgage loans. They are starting to stink up my office. Thankfully the really smart guys in New York will buy them and perform their financial magic! I’ll call them right away

New mortgage file

Investment banks that were too far from the customer to understand the risks

Source: Realtytrac

US properties with foreclosure activity, ‘000

890803

735766740650

528447

334

240

Q4Q1 Q1 Q2Q2 Q3 Q4 Q1 Q2 Q3

2007 2008 2009

Sure, individually these are pretty crappy loans, but if we pool them together, only some of them will go bad – certainly not all of them. And since house prices always go up, we really have nothing to worry about

RSG Investment Bank of Wall Street“Trust the Really Smart Guys for all your investment needs”

So what happened?

Investment bank can’t pay and goes under

Banks stop lending

Economy worsens and jobs are lost

Customer can’t pay the mortgage

Bank claims from investment bank

The credit crunch is born

We all knew this. So what?

Lets consider the African Insurance/Reinsurance market

We have brokers who are only interested in the commission

Let me get this right... You get me cheaper premiums, extremely wide coverage, and even reimburse cost of hiring an expert who will help me maximise my claim. How can you afford this?

We don’t actually cover the risks – an insurer does that and we still earn our commission

Ace Insurance Brokers“We give you more for less”

Wow! Lets get started then. You said i don't need to complete a proposal form!

We have underwriters looking for growth...

I have brought you a new client.. I used our slip. ...Please don't ask too many questions..no, there’s no proposal form- i know the risk..

Big Insurance Company“Your trusted and largest insurer”

So we give them…

• 10% discounts• Riders• Extensions• Delete all exclusions• Extended payment

terms• A real case had 127

special clauses!

If you do not want it ,I have many more insurers waiting to take it …

No problem, I will give you whatever you want….

The insurance company does not retain the risk....

Source: Realtytrac

Net retention for selected insurers, as a percentage of gross retention

I’d better get rid of these crappy risks. They are starting to stink up my office. Thankfully the really smart reinsurers will take them from me. I’ll call them right away

Big Insurance Company“Your trusted and largest insurer”

Poorly Rated Risks file

1740

105

814

1034

73

845

7ABC

Average: 8.5% of gross retention

DEFGHIJKLMNO

Reinsurer.. We need to support our clients and provide local capacity...

Supersmart reinsurer of Africa“Trust the really smart guys”

Sure the risks may look bad, but I’m sure we’ll make enough investment returns to cover our losses. Besides, we’ve grown our market share!

Combined ratio for selected reinsurers, %

1009899999988

96969188

9797100102105

200620052004 2007 2008

A

B

C

What are the trends?

• Worsening claims ratios• Declining underwriting profits• Inability to build up reserves to pay for future

catastrophic claims.

We must learn our

lesson

?So what might happen next?

Reinsurer can’t pay and goes under

Insurance company can’t pay and goes underRates rise, breaking

circle? ORCapital flows in reducing rates again?

Customer buys cheap insurance and maximise claims

Insurance company passes the claims on to the reinsurer

Will we break the cycle or perpetuate it?

Real Example of an All Risk Policy with “free” special clauses

• Sum insured: $40m• Premium: $48,000• 126 special clauses, increasing the scope of the

policy, reducing protection for the insurer and encouraging moral hazard and bad behaviour on the part of the insured, for example• Several clauses deleted (e.g., Electrical, Petrol

and Mineral Oil Warranty)• 85% average condition + 15% capital additions

ie 30% in total• Claim preparation costs• Accidental error or omission/misdescription

clause• Stock declaration condition deleted

• Are adequate additional charges levied for these clauses?? I think not!

MD

BI (Profits + ICOW)

Additional ICOW

Claims preparation cost

Loss adjustor fees & expenses

Claim details

$5.766m

$3.056m

$556k (12Xpremium)

$37k (0.8Xpremium)

$501k (10Xpremium)

The insurers retained only 3.6% of the claim!

African Reinsurance Trends

• International Reinsurers are either withdrawing completely or reducing their support

• Major African Reinsurers are realising the need to pay greater attention to the bottom line as opposed to the top line

We are learning

our lesson-hopefully

Future survival - what the insurer needs to do• Need to Return to the Basics-adhere to a code of

ethics/underwriting:• -The Insured, Insurer and Reinsurer must all have an interest

and benefit from loss prevention/minimisation• Check quality of Risk/ client • Proposal forms• Risk surveys• Understand and clearly define scope of cover• Proper Rating and pricing of Risks• Adequate excess• Pay attention to the Bottom line !

Future survival - what the reinsurer needs to do

MUCH MORE STRINGENT APPROACH TO ENSURE PROFITABILITY AND LONG TERM SURVIVAL.

• Clearly specify the scope of cover provided • Limit the automatic underwriting capacity • Link commission to performance of the

reinsurance contract

Proportional treaties

• Increased priorities• Technical pricing of working and catastrophe

covers

Non-proportional

treaties

!

Rating agencies have a mixed outlook for 2009• Changed outlook for Reinsurance Industry from stable to

negative –”too much capacity without certainty of capital” (Global Reinsurance Industry outlook 2009)

• Changed from Stable to Negative - ”Reinsurers ability to replenish capital after a major loss in the present economic climate” a key concern (Global Reinsurance Review 2009)

• Maintaining a stable outlook in 2009 for the global reinsurance sector, which implies that the majority of 2009 reinsurer rating actions are likely to be affirmations, with only a modest number of anticipated rating or outlook changes (AM BEST-2009 Special Report: Global Reinsurance – Market Review. Reinsurers Stay Afloat in Sinking Economy“)

APPENDIX: Real life example of an all risks policy

23

Real Example of an All Risk Policy-special clauses

• Electrical clause deleted• Petrol and Mineral Oil Warranty deleted• 72 hours clause – including all natural perils, riots

and strikes• 85% average condition• Accidental error or omission/Misdescription clause• Adjoining buildings• All other contents – US$ 20,000• Appraisement Clause – US$ 20,000• Architects, quantity surveyors and consulting

engineers clause• Automatic reinstatement of loss clause

24

• Breach of warranties/conditions clause• Bush fire• Cancellation (30 days) clause• Claims preparation clause – US$ 50,000• Cost of demolition/clearance of debris clause – US$

50,000• Cost of re-erection clause• Capital additions clause – 15%• Definition of building clause• Definition of property clause• Fire Brigade clause (municipal or private)

25

• Mortgage clause• Lien clause• Municipal scrutiny fees clause• Public utilities clause• Reinstatement of value clause – New for old• Temporary removal (internal and external)• Rent receivable, payable and rental value• Contract price clause• Computer system records clause• Contract works – US$ 20,000

26

• Cross liability clause• General interest clause• Goods in trust and /or commission• Import Duty clause• Landlord’s fixtures and fittings• Other insurances clause• Parked vehicles• Payment on account clause• Property of employees and visitors – US$ 5,000, in

total• Public Authorities clause

27

• Riot, strike and civil commotion• Spontaneous combustion• Subrogation waiver clause• Tenants clause either with the client as a tenant or

the client as an owner• Vehicle loads clause – US$ 10,000• Un-occupancy – 30 days• Arbitration clause• Stock declaration condition deleted• Malicious• Accountants clause

28

• Fire protection/security installation in operative clause

• Joint venture clause• Protection of property clause• Disposal of salvage clause• Supplier or Manufacturers guarantee or warranty• Property in course of construction• Protection of Manufacturer’s guarantee• Functional unit clause• Co-insurers to follow the leader

29

CLAUSES APPLICABLE TO SUB-LIMITS

Machinery Breakdown• Foundation /refractory brickwork• Surrounding Properties • Replacement Repairs• Including Overtime, night work and expenses and

airfreight• Fundamental unit• Expediting expenses 50%• Additional/replacement machinery• Replacement capacity conditions

30

Business Interruption• Alternative basis clause• Additional increase in cost of working• Finds and penalties• Business increase clause• Forward exchange losses• Hire in plant • Departmental clause• Interests on loss sales• Loss of interests

31

Business Interruption (Cont)

• Suppliers extension• Customer extension• Prevention of access• Public utilities• Public telecommunication• Accidental damage• Payment on account

32

Money• Definition of Money Clause• Assault Clause/employees effects• Deletion of keys clause• Money held by employees/directors – US$ 2,000• Definition of transit – in transit• Cash box extension• Premium adjustable annually on actual annual carry

33

Money (Cont)

• Deletion of keys clause• Fire, explosion, earthquake and all other special

perils• Infidelity of employees – 14 days• Cancellation Notice – 30 days• Including riot and strike• Payment on account clause

34

Burglary• Including hold up• Including theft from the open – US$ 10,000• Including goods held in trust• Cost of replacement of lost safe keys• Payment on account clause

35

Electronic Equipment• Damage by power surge/interruption damage• External Data Media – US$ 10,000• Increased cost of working/hire costs• Including fire, lightening, allied perils• Including theft• Including All Risks worldwide cover for movable

equipment including but not limited to laptops and projectors

• Reinstatement of loss• Replacement basis of cover

36

Electronic Equipment (Cont)• Including expediting expenses• Including temporary removal• Replacement of basis of cover• 72 hour clause of all natural perils and riot and

strike• 85% average condition• Malicious damage• Accidental error or omission• Automatic reinstatement of loss clause• Breach of warranties/conditions clause

37

Electronic Equipment (Cont)• Cancellation (90 days) clause• Claims preparation cost – US$ 2,000• Temporary removal (internal & external)• Import duty clause• Payment on account 75% clause• Subrogation waiver clause• Mechanical and electrical breakdown including

power interruption and surge • Portable/mobile equipment but excluding motor

vehicles licensed for road use