impact of credit crunch on european insurance by delloit

Insurance BreakfastTuesday 4 December 2007

Impact of the credit crunch on the European Insurance Industry.

Deloitte2 © 2007 Deloitte AG. All rights reserved.

Agenda

• Welcome Prof. Herbert Lüthy

• The Credit Crunch and theEuropean Economy Ian Stewart

• Impact on the European Insurance Industry Prof. Herbert Lüthy

The Credit Crunch and the European Economy

Ian Stewart, Deloitte Research 4th December 2007


How it all started

Rising US sub-prime mortgage defaults

Rising US sub-prime mortgage defaults

Losses and downgrades on related ABS assets

Losses and downgrades on related ABS assets

Loss of confidence in ABS globally due to lack of transparency of

value/losses

Loss of confidence in ABS globally due to lack of transparency of

value/losses

Wider flight from risk in credit and other markets

Wider flight from risk in credit and other markets

Risks flow back to banks’ balance sheets

Risks flow back to banks’ balance sheets

Money markets tighten as liquidity hoarded

Money markets tighten as liquidity hoarded

Continued deterioration in US housing market and further downgrades in

ABS values

Continued deterioration in US housing market and further downgrades in

ABS values

Investment Banks announce substantial Q3 and post Q3 losses and

predict challenging Q4

Investment Banks announce substantial Q3 and post Q3 losses and

predict challenging Q4

Estimates of total US sub-prime losses are increasingas banks announce further details of their exposures.

Up to $50bn of losses and write-downs announcedby investment banks with significantly more expected in Q4[source: FT, various bank analysts]

Credit conditions have tightened as liquidity has beenhoarded to cover. Realised warehousing risk at end of Septestimated at $300bn

Increasing downside risk of global economic impacts– with recession in the US a growing possibility

Investment banks are now facing unprecedented challengesto the business models that have driven the significant shareof profits growth in recent years


July October NovemberSeptemberAugustJune

Early 2007: Slow down in US housing market

• US housing activity at near recession levels and mortgage arrears rise sharplyMid 2007: US Subprime problems

• Unprecedented level of repayment problems

August 10th: Europe liquidity problems

• ECB injected € 94.8 billon into the money markets as interbank lending vanishes due to concerns about banks’ subprime exposure

• Overnight Euro money markets were at 4.62% - highest level for 6 years

Mid June: Losses in CDO funds

• Two Bear Stearns CDO hedge funds suffer heavy losses amid a rapid decline in the market for subprime mortgages

September 14th: Northern Rock

• Northern Rock seeks emergency financial support from the Bank of England

European banks announce losses

• German rescue: IKB require rescue due to subprime exposure

• BNP Paribas freezes $2.2 billion worth of funds, citing subprime issues

Mid-June: Banks uncertain about value of own assets

• Cut back on other commitments

• Exacerbated rising risk aversion

Mid Sept: US Fed cuts Federal funds target rate by 50 bp –Equity markets rally

• Dow Jones Industrial Average and the S&P 500 touched all time highs

Fitch says it may cut the AAA credit ratings of bond insurers, raising concern that such action could trigger a wave of downgrades of some of the $2.5 trillion of bonds they insure

October: Investment Banks, particularly Citigroup and Merrill Lynch, announce substantial Q3 and post Q3 losses and predict challenging Q4

Mid July: S&P cuts ratings on some top-rated mortgage bonds

Mid November: An economist at Goldman Sachs releases a report that suggests losses in the credit market could reach $400 billion and financial institutions may cut their lending by $2 trillion

Timetable for the credit crisis


-42%

-82%-92%

-98%

0% 0% 0%

12%

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

posi

tive

impa

ctne

gativ

e im

pact

Note: 46% see no impact on their business

A CFO view on the credit crunch: a problem for others?

Survey conducted21st September and 2nd October. “Overall, how do you think recent developments in credit markets will affect the UK Economy, UK Corporate sector, availability of credit for UK corporates and your business?”

Availability of credit for UK corporates The UK economy The UK corporate sector

Your business


Global economy strong…but how quickly will it slow?

1

1.5

2

2.5

3

3.5

4

4.5

5

5.5

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

Global GDP growth: % change year on year

Source: IMF


Transmission channels from financials to the real economy

A

Financial market

development

Wealth

Bank lending

Non bank lending

Uncertainty

Output of financial services

Spending by firms and

households

Prospects for activity &

inflation

A The extent of bank lending depends on several factors, such as borrowers’ financial positions, ratio of banks’ capital to their assets, price and availability of bank funding


A key worry: plentiful liquidity + cheap credit = debt boom

0

100

200

300

400

500

US Japan Germany UK France Italy Spain Netherlands

Tota

l Lia

bilit

ies

as a

% o

f Nom

inal

GD

P 20002007Europe’s joined in the debt boom too


Spread of 3 month money over ECB repo

Rising risk aversion has led to a flight to liquidity and a sharp rise in 3 month interest rates

-0.5-0.4

-0.3-0.2-0.1

00.10.20.30.4

0.50.60.70.8

0.91

1999

2000

2001

2002

2003

2004

2005

2006

2007


Banks’ declared losses

14.6%131.91.20.7Bear Stearns1.7%761.31.3Wachovia0.9%1391.31.3JPMorgan1.8%851.51.5Goldman Sachs7.8%866.73.13.6UBS5.5%623.43.4Deutsche3.7%189734Bank of America4.0%682.72.7Barclays

18.7%458.48.4Merrill Lynch11.5%15217.5116.5Citigroup

% of Market Cap

Market CapitalisationTotal

Additional announced estimates of Q4 losses and write-downs

Q3 Structured credit and leveraged loans losses and write-downs

Source: Deloitte Research and press reports


Asset bubbles are followed by a collapse in prices….this takes time…and can be painful

1000

1500

2000

2500

3000

3500

4000

4500

5000

5500

Nov/97 Nov/98 Nov/99 Nov/00 Nov/01 Nov/02 Nov/03 Nov/04 Nov/05 Nov/06 Nov/07

It took more than 2 years for the dot.com bubble to deflate


US banks have become much more unwilling to lend

- 2 5

- 15

- 5

5

15

2 5

3 5

4 5

55

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

US credit conditions: net % of banks tightening lending terms to corporates


50

75

100

125

150

175

200

225

250

275

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

UK banks relative to the broad equity market

Banks tend to under perform when the economy is weak:

they are under pressure now


Good news…global growth doesn’t just depend on the US anymore

Change in oil consumption, % (1996 to 2006)

05

101520253035404550

BRICs The rest of the world G7

%


Key features of the crisis

Sub prime was a result of easy credit and financial innovation. Other asset classes have similar characteristics

Financial markets were slow to react to bad news. US housing slowdown started in 2006, sub prime meltdown didn’t start in earnest until Spring 2007

It’s been worse than expected. A financial event has become an economic problem

Downside risks have emerging simultaneously. Record oil prices, the lagged effect of past rate hikes, financial stress


What else could go wrong?

• US sub prime defaults are likely to rise further – risk that it spread to other parts of the US housing market• The full impact of recent events on financial institutions may not be fully apparent – risk of further write-offs• Crystallisation of warehousing risk + strain from SIVs/conduits- risk balance sheet damage impedes credit creation hitting leveraged trades• Strains in the commercial real estate sector - risk of further balance sheet damage, confidence effects• Equities are up on the year - risk that weaker growth leads to weaker equity markets• The dollar remains in downtrend - risk of sharp downward correction which hits confidence


Europe – areas of vulnerability

• ECB rates have doubled to 4.0% in the last 2 years• 40% appreciation in Euro since 2000 low• Compressed high yield spreads• Surge in low quality bond issuance, credit derivatives• Buoyant real estate and equity prices• Rise in household and corporate exposure to short rates• Household debt/GDP ratio has risen 45% in the last 10 years• Corporate gearing has risen 60% in the last 10 years• Housing valuations stretched in a number of European economies

Problems in European covered bond and European Government bonds illustrate risks


Prolonged economic stagnation seen in US

Europe experiences medium term decline in growth

Slower growth in Asia and Latin America

US recession; resumes slow growth in 2008

Normal growth on hold until at least 2009

Europe slows more quickly than expected

US GDP growth declines moderately in Q3-Q4

2007

US normal real growth resumes by Q3-Q4 2008

No significant effect on growth in Europe or Asia

Further credit constriction

Adequate credit not available for normal operation

of economy

Bank balance sheets worsen

Credit is constricted; spreads stay high

Increasing defaults prolong the crisis

European banks suffer earnings loss and modest

credit decline

Confidence returns in credit markets

No significant slowdown in credit

Sub-prime defaults impact equity prices of some

financial institutions

Japan in 1990s1990-91 recession and Savings & Loans problems1998 credit crunch

FRB liquidity infusion and bail outs are insufficient

ECB lowers interest rates sooner than expected

FRB provides liquidity

US Government sets up agency to assist

homeowners

FRB floods market with liquidity

Interest rates are lowered

Scenario 1:Consensus (around 12 months)

Scenario 2: Worse than expected (1-2 years)

Scenario 3: Large Impact (several years)

Key Actions Taken

Market Reaction

Comparable Event

Economic Outcomes

Likelihood UNLIKELYPOSSIBLEEXPECTED

Scenarios for the Credit Crunch


US slowdown in ‘07 spreads in ‘08

0.8

1.3

1.8

2.3

2.8

3.3

Jan/0

6Apr/

06Ju

l/06

Oct/06

Jan/0

7Apr/

07Ju

l/07

Oct/07

1.9

2.1

2.3

2.5

2.7

2.9

Mar/07

Apr/07

May/07

Jun/0

7Ju

l/07

Aug/07

Sep/07

Oct/07

Nov/07

US

Germany

UKUS

Germany

UK

Evolution of 2007 GDP forecasts Evolution of 2008 GDP forecasts


Something is changing in the global economy

50

250

450

650

850

1050

Jan/2003

Jul/2003

Jan/2004

Jul/2004

Jan/2005

Jul/2005

Jan/2006

Jul/2006

Jan/2007

Jul/2007

Jan/2008

Monsanto Share Price

China Market Price Index

Gold Bullion U$/Troy Ounce


The Effect on Global GrowthWhat the consensus expects:

• The US bears the brunt of the slowdown.

• The Euro Area and Japan are expected to “de-couple” from the US

• Emerging economies remain buoyant

*Average growth rate between 1992 and 2006Source: The Economist, IMF, Deloitte

138%7.17.57.9Emerging economies

98%2.12.92.7United Kingdom

119%2.02.62.6Euro area

191%1.82.02.2Japan

71%2.12.03.3United States

2007-08 forecast as % of average rate*

2008 forecast

2007 forecast

2006 actual

What the Consensus Expects for Global Growth

Impact on the European Insurance Industry



Overview

• The direct impact on insurers– Claims experience– Investment portfolios– Relevance of liquidity– Investment policy and strategy

• The indirect impact on insurers– Regulation– Trust– Financial Statements– Consumer demand structure– Economic impact

• Conclusion



Direct impact on insurers

D&O Insurance

Credit Insurance

Legal protection insurance

Recommendation: Analysis of the insurance contracts

Claims



Direct Impact

Investments: Market information*

27.2169Swiss Re

27.6186Zurich FS

0.4135Swiss Life

-52Baloise

-30Helvetia

Structured Products in billion CHF**

Total Assets in billion CHF

Company

* Source: SAL.Oppenheim / www.cashdaily.ch

** Structured products (including Subprime Mortgages, ABS, MBS, CDO)



Direct Impact

• Investments: Analysis and Valuation– Analysis of the investment portfolio: Does the company have an end-to-end view

of its investment vehicles or are there significant amounts invested in opaque or unregulated investments?

• CDO• SIV• real estate• mortgages

– Valuation of structured products• Appropriate vetting process regarding the use of counterparty prices• Appropriate vetting process for model parameters (correlations, recovery rates, …)• SST requirement: Quantification of hidden options and hidden guarantees



Direct Impact

• Investments: Review– Review of processes to analyse the risk profile of new investments– Review of investment policy– Review of investment strategy

• The volatility and turmoil of the capital markets could lead to a change in the investment strategy

• Investments: Liquidity– Impact of liquidity

• Not usually an important theme for insurers• Some solvency stress scenarios lead to high levels of policyholder lapsation• Important as direct respectively indirect impact

– Liquidity management – Monitor the need to adapt liquidity planning• Examine and reconsider existing processes to monitor liquidity



Indirect impact on insurers

• Regulation– After the equity market crisis the insurance regulator established risk based

systems to quantify risks (esp. risks of structured products). – Can we avoid impairments by following regulatory requirements?– Solvency II is not in place yet / SST is implemented

– Principles versus rules based regulation: The credit crunch highlights some advantages of principles based regulation




• Trust– Impact of information „trickle“ over time– Potential damage to trust of shareholders / policyholders / creditors / …– Important to avoid: new surprises / valuation issues / liquidity problems

• Impact on Financial Statements and Annual Reports – Financial Review and Preview– Impairments / Reduction of hidden reserves / Reserving– Widening spread between Government Bonds and Swaps exacerbates debate

around „risk free rate“ (IFRS, EEV, SST, Solvency II)– Special focus on valuation because of the public pressure and the sensitivity of

the market




• Change in consumer demand structure– Volatility can lead to more risk averse investing– Potential increase in propensity to save– Increased popularity of insurance products with higher guarantees– Increased demand for credit protection




• Economic Impact

– Liquidity of the market regarding credit instruments• Impact on value• Possible impairments• Solvency

– Reduction of the equity markets – Solvency• Impact on value• Solvency

– Customer demand reduction• Recession• Impact on growth and value



Conclusion

• Insurers must fully understand the products they‘ve sold• Insurers must fully understand what they`ve invested in• Capital scenarios/stress tests should be designed to reflect all potential

risks

While the initial impact on the insurance industry has generally been less severe than on some banks, the volatility of capital markets and the time lag in information flowing through the system doesn`t rule out further negative impacts.

“As is common in such situations, one should first focus on the current status, but also immediately prepare for the future.”

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