The economy and financial institutions have fallen on hard times and many businesses are now asking about the status of the insurance industry. With the near collapse of American International Group, the insurance industry has and will continue to be impacted by the financial turbulence.
It's no secret that AIG has been experiencing serious financial difficulties primarily related to its short-term illiquidity, and the company recently posted a $24.5 billion third-quarter loss. This situation results primarily from AIG's purchase and guarantees of mortgage-backed securities and its involvement in credit default swap contracts.
AIG owns property and casualty insurance companies as well as life insurance companies in the United States, insurance brokerages, reinsurance companies and financial service companies.
In September, the Federal Reserve Bank of New York agreed to provide a two-year, $85 billion revolving-credit facility to AIG that will ensure the company can meet its liquidity needs. In return for this, American taxpayers received a substantial majority (79 percent) ownership interest in AIG.
In October, the Federal Reserve Board authorized another transaction to provide AIG with an additional $37.8 billion on top of the $85 billion line of credit already extended, which AIG has reportedly tapped for $61 million. The interest rate on the initial $85 billion loan was 8.5 percent on top of LIBOR - the London Interbank offered rate, a common short-term benchmark - now at about 3 percent, bringing the total to about 11.5 percent.
But that's not all. AIG also has to pay 8.5 percent interest on the unused portion of the loan and was forced to pay a 2 percent upfront commitment fee.
On Nov. 10, the government and AIG restructured the original $123 billion deal and replaced it with a new $150 billion package. The original agreement did not come close to stabilizing AIG and would likely have forced the company to quickly sell assets while paying massive interest rates on those loans. The original deal also did not address the root cause of the problem; AIG continued losing billions on credit default swaps and other financial instruments.
The $150 billion deal provides $60 billion in credit for five years with a reduced interest rate, reportedly 3 percent plus LIBOR, approximately 6 percent total. In addition, the U.S. Treasury will purchase $40 billion of newly issued AIG preferred stock, with a 10 percent annual interest payment to the government. The taxpayers would remain a 79.9 percent equity owner in AIG.
The Federal Reserve also will create two new financing entities. The first entity will acquire the residential mortgage-backed securities. Under this arrangement, the Fed will inject $20 billion and AIG $1 billion.
The second entity is designed to stabilize the credit default swap contracts. The Fed will capitalize this entity with $30 billion, and AIG will pitch in $5 billion.
The second entity's arrangement may be difficult to work out with AIG trading partners: banks and financial institutions on the other side of AIG's credit default swap contracts. Through a complex set of transactions, these partners could be negatively impacted. What a mess.
Undoubtedly, AIG will not be the only insurance company affected. Regulatory and rating agencies already are providing more scrutiny and oversight. Likely, some ratings will be downgraded, and it will be important for consumers and agents to monitor their insurers closely.
Economic uncertainty, hurricane losses and several years of softening pricing have caused tougher market conditions for insurers. Declines in the market value of these insurers' investments have also led to significant declines in balance sheet assets, capitalization and profitability for many companies. Life insurers with exposures to variable annuities and other products linked to equities have greater risk and volatility concerns. Although profits have dropped for the industry in the first half of 2008, insurers averaged a 5.4 percent return.
As we look forward to 2009, several factors lead us to believe we'll see pricing start to stabilize, then slowly start to rise or firm in the commercial property and casualty sector.
These factors primarily include reduced investment returns and underwriting losses. Combined ratios (losses plus expenses, compared with premiums collected) climbed nearly 10 points to 102.1 in the first half of 2008. This amounted to a $5.6 billion underwriting loss for the industry. This decline in profitable underwriting will cause insurance companies to rely upon investment income for returns. You can imagine what is occurring in companies' investment portfolios - tough times. These two developments point to the end of the soft (declining) pricing in the commercial property/casualty insurance marketplace.
As we move into the future, industry rating agencies will provide increased scrutiny and possible downgrades to some insurance companies. The commercial insurance marketplace will start moving toward firmer pricing and tighter underwriting standards. Positioning your business by making sure your property values are adequate, safety programs are documented, and your preventable losses are held to a minimum will enable your business to obtain the best coverage and pricing as the market starts to shift.
Richard Ollis is president of Springfield-based Ollis & Co., an independent risk, benefit and insurance agency. He may be reached at Richard.Ollis@ollisco.com.[[In-content Ad]]
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