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The Actuary The magazine of the Institute & Faculty of Actuaries
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GI: History repeating itself?

For an actuarial student working through perhaps the most severe economic contraction since the Great Depression, it has been an intense, stressful, yet stimulating, experience. The fall of Lehman Brothers and the near collapse of AIG were era-defining moments that captured my attention and encouraged me to take an active interest in commercial issues. We on the committee of the London Market Students’ Group (LMSG) organise events for senior actuaries working in general insurance to present directly to the next generation of actuaries.

If we are going to learn the lessons of previous crises and meet the considerable challenges of the future, it seems vital that past experiences and commercial awareness are passed down effectively. In this article, we compare the role of securitisation and derivatives in the current economic crisis with the LMX spiral, which was at the heart of the problems that engulfed Lloyd’s of London in the early 1990s. It is just one example of the lessons that can be learned from history and the value of awareness of past developments in the insurance industry. As with any summary, the complexity of all the issues is not fully captured.

The credit crunch
The majority of actuaries will be familiar in some way with the role derivatives played in the economic crisis. To briefly summarise, bankers bundled together large numbers of unconnected loans and mortgages to create Collateralised Debt Obligations (CDOs). These CDOs were constructed in the belief that default risk could be largely diversified away. The bundles were then split into tranches with different levels of risk and return.

If defaults occurred, losses would be allocated first to the riskier tranches, with senior tranches only affected under incredibly unlikely scenarios. Many commentators have described it as a trillion dollar game of ‘pass the parcel’, with banks folding up high risk loans with less risky loans and selling the securitised ‘parcel’ on to investors and other banks. The recipient would retain their chosen layer of risk and sell the rest. It was also common for the recipient to enter into a credit default swap to insure against defaults in the layer held.

The most publicised CDOs were made up of subprime loans, where mortgages were offered to borrowers with poor credit histories. These borrowers paid a higher rate of interest so the resulting CDOs would theoretically make higher returns. However, problems began to emerge that would eventually send tremors through the financial system. With brokers and banks keen to receive commissions, mortgage lending began to resemble an assembly line in which loans were made, constructed into CDOs and instantly sold to investors.

The CDOs went on to be sliced and diced so many times that the risk could only be determined using complex computer models. There was limited information on the likelihood of widespread mortgage defaults in the event of a severe house price crash. A nationwide housing crash had not occurred in the US for 70 years, so data on default trends and correlations was extremely scarce. Banks and investors were initially unconcerned, as they believed risk had been efficiently dispersed throughout the system. However, the fact was that they were holding complex parcels of debt worth billions of dollars without fully understanding where it originated, who was holding the other layers and who was insuring it. They were exposed to massive counterparty risk and the risk that their default assumptions would prove wildly optimistic.

The LMX spiral
We now rewind more than two decades to Lloyd’s of London in the 1980s, when investors were flocking to become Names of Lloyd’s by putting up their personal funds to underwrite different lines of insurance risk. To increase capacity under fi erce competition from international insurance companies, Lloyd’s syndicates wrote larger lines on excess of loss insurance and reinsurance policies. Many of these policies reinsured long-tail US general liability risks, which included future asbestos claims as well as large property risks. They were known as London Market Excess of Loss (LMX) policies. Syndicates looked to disperse the risk by placing further reinsurance within the London market.

The risk was reinsured over and over again, with the chain commonly passing back through the same syndicates or companies later on in the process without them realising. At each stage, the premium reduced and brokers received commission for replacing the risk. The resulting ‘LMX spiral’ was complex and sometimes ended with one insurer holding the parcel at the end of a long reinsurance chain on a policy that was considered unlikely to be impacted.

Disaster struck on various fronts in the late 1980s with a large number of catastrophe claims, asbestos claims and pollution claims filtering through. As the claims were passed from one reinsurer to another, each attempt to work out their exposure to the multitude of claims coming in and reserve for them accordingly. This was extremely difficult due to the complex nature of the spiral, the likelihood of future disputes over policy wordings with other reinsurers and the possibility of these counterparties being declared insolvent.

If reinsurers further along the spiral reneged on their payments, the liability for the claims would switch back to earlier reinsurers. Each time a claim passed around the market, it would go a little further up the reinsurance programme until it reached levels many times that of the original market loss. Lloyd’s Names (which typically had unlimited liability, no longer the case today) were tapped for more and more cash as the claims came flooding in and the structure of the LMX spiral compounded their problems.

The LMX losses were concentrated in Lloyd’s and the London market, though the insurance market as a whole was affected. It was a disastrous time for the insurance industry and resulted in similar regulatory upheaval to that which we are beginning to see in today’s banking sector. It is worth noting, however, that the insurance industry was largely able to resolve the issues without significant contributions from the taxpayer, unlike those that are a feature of the recent banking crisis.

The most obvious lesson from reviewing these past crises is that no amount of diversification and reinsurance is a substitute for prudent risk management. In both examples, higher returns were sought with a higher level of risk taken on. While house prices were going up in the US and no catastrophic events occurred in the insurance market, the profits would come rolling in. However, both risks were underpriced with their respective levels of correlation underestimated. Upfront commissions gave brokers the incentive to spread the risk ever more widely, and companies failed to monitor accurately the resulting risk exposure.

Risk mitigation is a vital tool in any company’s risk management strategy, but when structures become complex and opaque, it can be a hindrance. It becomes near impossible to measure counterparty risk, and the reserves required to meet inflated loss estimates can cripple an organisation already in crisis.

Back to the future
Returning to the present day, Lloyd’s of London is in a much healthier position. It recorded resilient £1.9bn pre-tax profits last year, has not experienced an insolvency since 2003 and numerous syndicates are looking to raise capital to increase capacity. Equitas, set up in 1996 to reinsure Lloyd’s 1992 and prior liabilities and provide a solution to the crisis described, has also transferred all of its liabilities to a new company in June this year and achieved its objective of bringing finality to Lloyd’s Names.

However, this does not mean Lloyd’s and the London market as a whole do not face current and future challenges. Many observers believe fraudulent claims will rise during the recession. This is against the backdrop of reduced investment returns, reinforcing the need for underwriting discipline.

Implementation of Solvency II is also on the horizon, presenting opportunities as well as considerable challenges for actuaries. Embedding a truly holistic risk management framework in all businesses could potentially prevent future crises, or at least reduce their severity. To achieve this, actuaries will have to build close relationships with pricing, underwriting and claims, as well as management teams.

Michael Folkson is an associate consultant for PwC and is on the committee of the London Market Student Group