Investment, PMI, and Insurance Companies in the Financial Crisis


Added on  2019-09-26

11 Pages2363 Words202 Views
Financial Crisis-An Insurance Sector Perspective1 | P a g e
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Table of ContentsPage no.IIntroduction.. 3IICredit Default Swaps – A build up to the crisis.. 3IIIImpact on specific insurance sector segments and companies.. 4IVLearnings from the after-effects.. 8VConclusion.. 92 | P a g e
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I. IntroductionThe financial crisis seems to have had a minimal impact on the insurance sector vis-s-vis thebanking sector whose solvency was endangered. However, insurance sector has been affected inadverse ways. This essay discusses the build-up of the financial crisis with a specific financialinstrument at the core of it in Section II, its impact on the specific insurance segments andcompanies in the US in section III, some lessons learnt from this crisis in section IV. Section Vconcludes.II. Credit Default Swaps (CDS) – A build up to the crisisExperts have presented a diverse view on the role of the insurance sector in the financial crisiswith some backing the insurance sector to cushion the volatility as against few experts blamingthe insurance product (CDS) as the root cause for the crisis. This is per views expressed by ChiefExecutive of Allstate (an US insurance company) as below:“It was, after all, an insurance product that contributed to the risk that almost brought down the globaleconomy. It should be no surprise that a big insurer like AIG would be a major issuer of credit defaultswap. What is surprising is the claim that insurance did not contribute to the recent market failures, and thereforeinsurers don’t need to consider how to prevent them from happening again.1At the epicenter of the crisis is the fundamental shift in the bank’s business model from theircore of tendering loans and holding them until maturity to distributing credit risks. These wereconceptualized through innovative financial instruments viz. Credit default Swaps (CDS). ACDS is a bilateral agreement designed explicitly to shift credit risk between two parties. In aCDS, one party (protection buyer) pays a periodic fee to another party (protection seller) inreturn for compensation for default or similar credit event by a reference entity2. It is a particular1 The New York Times, 20092 Panagiotis Papadopoulus 3 | P a g e
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type ofswapdesigned to transfer thecredit exposureoffixed incomeproducts between two ormore parties. The buyer of the swap makes payments to the swap’ssellerup until thematuritydateof a contract. In return, the seller agrees that, in the event that thedebt issuerdefaultsorexperiences anothercredit event, the seller will pay the buyer the security’spremiumas wellallinterestpayments that would have been paid between that time and thesecurity’smaturitydate3.A covered CDS is wherein the protection buyer owns instruments issued by the reference entity.Thus it helps the owner of the asset / instrument to manage the risk associated with theinvestment which is similar to the insurance contract. In case the protection buyer does not ownparticular reference obligation, the covered CDS engulfs the shape and form of a ‘naked’ CDSthus divulging from the motive of insurance onto speculation4. If an insurer acts as a protectionseller, then it is exposed to a negative impact due to an increase in credit risk. Huge CDS lossesare inevitable against a fall in the value of a portfolio of mortgage-backed securities. Followingthe subprime crisis, AIG’s credit portfolio depreciated by USD 11 billion in Q4 2008 with a lossof USD 5.3 billion5. Numerous U.S. insurers have already begun to set up reserves for potentialclaims following the financial crisis.III. Impact on specific insurance sector segments and companiesa. US mortgage insurance companies:The crisis began with the US residential mortgage market and these entities survivalhinged on mortgages retaining or increasing in value. Thus the US mortgage insurancecompanies witnessed the brunt of the financial crisis, 2007. These insurance companies3 Investopedia, 20154 New York State Insurance Department Circular Letter , 20085 Sjostrom, 20094 | P a g e
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