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Bad Bank Concept in Insurance Industry

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Bad Bank Concept in Insurance Industry

By Manoj Kumar, ACII (UK), CPCU (USA), ARe (USA), ARM (USA), FIII (India). MBA

President & Managing Partner, Bancassurance Consultants Worldwide Ltd. (BCWL)
Website: www.bc-worldwide.com | Email: manoj@bc-worldwide.com

This article was published by Gulf Insurance Review from UK in December 2009 issue.

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The direct impact of current financial crisis was unlikely, had insurers not been involved in the structured financial products which otherwise have been the domain of specialized financial institutions. AIG and Swiss Re were humbled, though did not perish unlike their banking counterparts. The beating that the world’s largest insurer and the second largest reinsurer took was mainly on account of their underwriting of guarantees and credit default swap (CDS) instruments.

Global economy continues to nosedive despite relentless efforts by governments and regulators to put the economy back on rails. Global leaders who met in Davos in January 2009 at the World Economic Forum meeting called to develop a swift and coordinated policy response to the most serious global recession since the 1930s and talked about splitting of banks and other financial institutions into good banks and bad banks. Good bank/Bad bank concept has been hailed as the only panacea under the current difficult times.

So what is a bad bank and how does it relate to the insurance industry? A bad bank is an aggregate of toxic assets transferred from various troubled banks into a separate legal entity. Such assets are bought into a bad bank at discounted prices and run by experts who are specialists in recovery and toxic assets. Toxic assets in the current financial context refer mainly to mortgage backed securities and includes funded as well as non-funded exposure of the banks.

Bad bank concept is as relevant to the insurance and reinsurance industry as it is to banks. Large insurers mainly in North America and Western Europe have been underwriting bonds, performance guarantees, decennial liability and structured financial products including credit default swaps (CDS) and collateralized debt obligations (CDO) for a long time. Some large players from the insurance industry including AIG and Swiss Re recently suffered heavy losses due to their exposure to such instruments though their core insurance businesses remains strong as ever. Let’s first understand how these instruments work and how are they related to the insurance industry.

Credit default swap (CDS) when bought by an investor is essentially an insurance on its investment or deposits. It means that the seller or insurer of the credit default swap guarantees the creditworthiness of that investment or in other cases of a securitized loan. Accordingly, when these securities are downgraded by the rating agencies, the risk of any default on the loans is covered by the insurer of the swap and not by the investor. Similarly, Collateralized debt obligations (CDO) are also investment grade security though different from credit default swaps in its structure as it is backed by a pool of bonds, loans and other assets which are generally non-mortgage in nature.

AIG suffered losses because its 377 member strong financial products unit in London which is part of its financial services group wrote intricate financial contracts known as credit derivatives. These derivatives insured debt holders against defaults. This unit sold credit default swaps and other innovative but complex financial contracts allowing buyers to insure securities backed by mortgages. As subprime crisis exploded and home values dropped dramatically, the value of the underlying mortgages too declined. AIG had to reduce the value of the securities substantially on its books pushing it consequently on the brink of insolvency and forcing the federal government to intervene with a $150 billion package.

Swiss Re was the only other major player in the insurance industry to have suffered losses due to the financial crisis on a scale inviting global attention. The reinsurer suffered because it’s Credit Solutions Unit had underwritten swaps (CDS) on the investments of two specific clients in 2006 and 2007 that included mortgage backed securities. The portfolio thus got exposed to subprime mortgage and finally spiralled into writing off by Swiss Re the loss of $1.1 Billion from its books.

There are though number of other insurers and markets globally who write such financial structured products but they don’t appear anywhere close to the crisis that Swiss Re and AIG underwent. The reasons are not too far to comprehend. Subprime phenomenon has been a gift of the US to the world and whichever institution (read banks and insurers) participated in risks which were backed by US based mortgages as underlying assets, paid a heavy price.

Insurance industry though affected by the global recession and despite having issues with its asset base, does not appear to be toying with the idea of segregating its toxic assets on the lines of good bank / bad bank concept. AIG decided to sell off some of its profit making units in order to repay the federal loan and Swiss Re preferred to seek capital infusion from Berkshire Hathaway rather than splitting the company. Such confidence can be attributed to two factors; one, their robustness and spread in terms of asset allocation and two, relatively lesser exposure to mortgage backed securities. There is one exception though; MBIA Insurance Corporation of US separated its risky structured financial products from its regular and healthy bond business in early 2009 by using an existing subsidiary as the vehicle to transfer toxic assets away from the main insurance company.

The insurance industry is a barometer of overall economic conditions prevailing in the marketplace and its fate is generally interlinked with other financial institutions. There is a definite decline in volumes, investment income and overall profitability but it is due to the overall economic downturn rather than any systemic failure. Considering the state of global economy, the insurance industry appears to have done remarkably well compared to their peers in the banking industry and have shown a greater resilience and character and proven that they are better risk managers than banks.

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