Insurance BreakfastTuesday 4 December 2007
Impact of the credit crunch on the European Insurance Industry.
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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
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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
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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
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-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
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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
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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
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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
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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
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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
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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
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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
Deloitte14 © 2007 Deloitte AG. All rights reserved.
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
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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
%
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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
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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
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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
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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
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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
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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
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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
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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
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Impact on the European Insurance Industry
Direct impact on insurers
D&O Insurance
Credit Insurance
Legal protection insurance
Recommendation: Analysis of the insurance contracts
Claims
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Impact on the European Insurance Industry
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)
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Impact on the European Insurance Industry
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
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Impact on the European Insurance Industry
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
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Impact on the European Insurance Industry
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
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Impact on the European Insurance Industry
Indirect impact on insurers
• 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
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Impact on the European Insurance Industry
Indirect impact on insurers
• 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
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Impact on the European Insurance Industry
Indirect impact on insurers
• 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
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Impact on the European Insurance Industry
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.”