Insurers may be at the centre of the next big crisis; As banks are finding some business too costly, insurers are moving in

December 26, 2013 7:14 pm

Insurers may be at the centre of the next big crisis

By Patrick Jenkins

As banks are finding some business too costly, insurers are moving in, writes Patrick Jenkins

It would make a good pub quiz question: what was the most costly bailout of the 2008 financial crisis?Royal Bank of Scotland? Citigroup? Many assume so. Of course, the biggest failure of them all was not a bank at all, but insurer AIG.In total, AIG needed $182bn of bailout money from the US government – more than twice as much as the next biggest casualty, RBS – although by last year, like most of the American bailout cases, the federal investment had turned a profit. The fact remains, however, that the biggest financial sector collapse in the history of capitalism was a group that was nominally an insurer, but one that diversified so fast that it became impossible to manage or regulate.

In the aftermath of the financial crisis, politicians, regulators and the general public have focused almost obsessively on the banks. But the recent troubles of Britain’s RSA – five years after AIG’s disastrous collapse – are a useful reminder that insurers need watching, too.

Thankfully the UK’s biggest non-life insurer is not a vast company – RSA has barely £23bn of assets compared with the $1tn balance sheet AIG had when it failed. It is also relatively straightforward, largely writing insurance cover on buildings and cars rather than anything more rarefied. Nor is there any suggestion, despite a capital need estimated at up to £1bn, that RSA’s problems are insoluble.

Nevertheless the case of RSA, like AIG before it, should sound alarms. The emergence of a black hole in the group’s Irish business is a reminder that judging risk and accounting for it fairly can be even harder for an insurer than for a bank.

Back in 2007, before the first signs of trouble had emerged at AIG, even senior management were blind to the dangers the group was running. In August of that year its then chief risk officer spoke of a “very modest and remote” chance that the mounting crisis in markets would spill over to hurt AIG. Martin Sullivan, its then chief executive, joked: “That’s why I am sleeping a little bit easier at night.”

Within four months, AIG’s accounts showed close to $2bn of unrealised losses. Within a year it had to be bailed out.

AIG’s problems were focused on insurance-like securities, which collapsed in value during the crisis, making a nonsense of accounting norms. But even accounting for simple insurance business can be unreliable. There is huge scope for judgment when deciding if premiums paid or promised should be treated as “earned” revenue. Reserving for losses can be even more subjective.

The ability of management and regulators to stay on top of the risks is harder still when the company is growing through mergers and acquisitions. AIG had been bullish about M&A. Likewise, RSA’s problem Irish business grew through aggressive deals. And so did the troubled Australian insurer QBE that, largely owing to problems within US businesses that it acquired, issued a massive profit warning earlier this month.

Today it is all the more important to shine a bright light on insurers as many prepare to broaden their business models away from plain old underwriting. In this, infamously, AIG was a pioneer, albeit a misguided one. Five years later – like other subsectors of the financial services industry such as asset managers and hedge funds – insurers and pension funds are looking to fill emerging gaps in the banking market left by the retreat of traditional lenders.

As banks have found some business rendered punitively expensive by new capital regulations, insurers are moving in to finance infrastructure projects and lend to companies. Some pension funds and life insurers have also branched out into the potentially lucrative business of betting on natural disasters by buying so-called catastrophe bonds.

In short, insurers are now a crucial part of the so-called shadow banking sector – an emerging hotch-potch of financial groups that are filling the vacuum left by shrinking banks.

All of this change presents new risks to insurance company investors, and potentially to the broader financial system – despite the widespread view that the financial crisis is all but over. The withdrawal of central banks’ massive doses of quantitative easing could yet disturb the fragile health of the financial system, particularly the fast-growing but relatively unobserved shadow banking sector.

To be fair, it is an issue that some regulators are alive to. In a parting interview in October from his role as deputy governor of the Bank of England, Paul Tucker told the Financial Times that regulators needed to “up their game” to avoid the “absolutely disastrous” recreation of old banking risks in other parts of the financial system. Global regulators on the Financial Stability Board have also highlighted the importance of supervising shadow banks. It recently included nine insurers among its list of globally systemic financial institutions that should be closely monitored and held to higher levels of capital adequacy.

But much more needs to be done. There are still no global standards on capital, amid persistently uneven accounting practices. In a symbolic contrast with the realm of banking, the bosses of insurance companies still appear able to reinvent themselves for the post-crisis world. Sir Fred Goodwin and Chuck Prince, the men who led RBS and Citigroup to near-collapse, have become pariahs of the financial sector. The same cannot be said of Mr Sullivan, the former AIG boss. This year he popped up as chairman of an insurer at the venerable Lloyd’s of London market.

The underwriter is called Antares – named after the red star – in case it comes up in a pub quiz.