DOOMSDAY AND REINSURANCE PART DEUX ERNST N. CSISZAR DEPARTMENT OF INSURANCE STATE OF SOUTH CAROLINA

A RECAP OF PART ONE WHAT IS SYSTEMIC RISK? –Confidence and interdependence WHY WORRY ABOUT SYSTEMIC RISK? –Source of potential financial crises WHO WORRIES ABOUT SYSTEMIC RISK? –The Financial Stability Forum and others

WHY WORRY ABOUT SYSTEMIC RISK IN THE RE INSURANCE SECTOR? –The recent involvement of reinsurers with other financial institutions WHAT CAN BE DONE ABOUT SYSTEMIC RISK? –Policy development and crisis prevention, containment, and management

SYSTEMIC RISK - THE CONTINUATION What factors drive the continuing concern about insurance and reinsurance as sources of systemic risk? –“The house of cards” scenario –“The perfect storm” scenario

The house of cards Reinsurers and credit markets Credit transfer between insurers / reinsurers and other economic sectors –The effect of slumping global stock markets in investment portfolios of reinsurers –The downturn in corporate credit markets Defaulting bonds e.g., Worldcom, Enron etc. Exposures through commercial surety bonds

The international payments settlement process –Loss of faith in financial system –Fear of system-wide default

The structure of credit-related products: –Credit enhancements –Credit derivatives e.g., credit default swaps –Collateral debt obligations e.g., guarantors and investors The impact of credit downgrades

The issues –Naïve capital –Risk concentrations –Financial contracts versus contracts of good faith Fiduciary aspects Disclosure requirements Proof of loss Contested contracts Reinsurance culture vs. financial institutions’ culture: contest now and pay later vs. pay now and contest later

The problem: –No one knows Opaque transparency Inadequate disclosure Lack of oversight

The perfect storm Reinsurers and the real economy Insurance as a “foundation” industry –The “glue” of our economy –Global capacity at a 1999 high based on $720 billion in capital and surplus Global financial performance of the industry –25% loss of capital and surplus in 2001 and 2002 –Poor underwriting results –Poor investment results –Inverted risk / return relationship

Causes: –Self-inflicted wounds 1980 – 2002: $439 billion in underwriting losses Recent dismal investment results –Catastrophes $100 billion in last three years –Asbestos claims $160 billion

–Liability exposures Product liability and medical malpractice losses –New risks Toxic mold and information technology risks Further terrorist activities

What can be done to improve performance? Further reduce capital Reduce risk Improve net profits, particularly from underwriting operations –Public and regulatory resistance to higher rates –Financial rating downgrades THE PERFECT STORM! A REAL NEED FOR NEW CAPITAL

THE WORK OF THE IAIS AND FSF Disclosure and transparency –Task Force Re –Development of a database for reinsurers