With their snappy name and flashy mathematical formulae, “quants” were the stars of the finance show before the credit crisis erupted. Now the complex models of risk that they developed are accused of misleading banks about the safety of subprime-laced securities. Small wonder that investment bankers are working overtime to fix what went wrong.
One source of wisdom they may overlook is the staid world of insurance. After all, what could the green-eyeshade brigade of actuaries possibly teach the wizards of Wall Street? Several important lessons, reckon some insurers, who point out that much of their industry has thus far avoided the worst of the credit crisis.
Although a few firms—including Swiss Re, a big reinsurer due to report its 2007 results after The Economist went to press—face billions of dollars of write-downs on ill-judged involvement in America’s mortgage crisis, much of the European industry has so far come out relatively unscathed. Announcing a record profit for 2007 on February 25th, Munich Re, another big reinsurer, boasted it had just €340m ($514m) of subprime-related exposure, or less than 0.2% of its investments.
American insurers have a slightly bigger slug of subprime holdings than the Europeans, but analysts are sanguine. Fitch, a rating agency, notes that America’s life-insurance industry could probably weather $7 billion-8 billion of unrealised losses, though damage on such a scale would harm some firms.
This is a very different story from the bursting of the dotcom bubble. Back then, returns on insurers’ equity portfolios plunged just as liabilities on everything from life policies with guaranteed pay-outs to directors-and-officers (D&O) insurance soared, almost bringing the industry to its knees. Banks fared far better.
So what can banks learn from the insurers now the boot is on the other foot? Raj Singh, a former investment banker who recently became chief risk officer of Swiss Re, points out that the banks’ risk models, which try to put a value on how much they should realistically expect to lose in the 99% of the time that passes for normality, draw on reams of historical data. But this can produce a false sense of security.
Insurers looking at, say, catastrophe risks have relatively few data points and thus tend to have a healthy scepticism of models. They more often brainstorm their own scenarios. “In insurance, we have to think the unthinkable all the time,” says Mr Singh, pointing out that the industry came up with a scenario of a multiple plane crash above a metropolitan area well before the attacks on New York’s World Trade Centre in 2001.
Scenario-building usually involves insurers’ senior managers, whereas in many banks the “stress testing” of risk models is the preserve of quants. Moreover, in banks different teams often track different risks, masking potentially catastrophic correlations between them. Smart insurers are increasingly aware of the way in which life, property, business interruption and other risks interact—a portfolio risk-management approach encouraged by both regulators and investors.
Insurers have a list of other things banks can learn too, including the idea that getting a customer to retain a part of a risk reduces moral hazard—something investment banks’ pass-the-risk-parcel approach to securitisation blithely ignored. Swiss Re’s Mr Singh notes that insurers have a respect for risk that is reflected in the status of the chief risk officer, who is treated as an equal partner in senior management. In investment banking, he claims, such people tend to get sidelined when the good times roll—though big investment banks such as Merrill Lynch and Morgan Stanley have belatedly rejigged their risk set-ups.
Pots and kettles
Yet, the insurers should not get carried away. Although many have performed better than the banks, some of them have tripped up nonetheless. Worst-hit are America’s bond insurers which, lemming-like, rushed into guaranteeing dodgy asset-backed securities that eventually threatened a further meltdown in credit markets. Such fears were partially assuaged this week when Moody’s and Standard & Poor’s (S&P), two credit-rating agencies, affirmed the top-notch ratings of MBIA, one of the biggest bond insurers. S&P also affirmed its AAA rating on Ambac, another big insurer that is trying to raise billions of dollars of capital from a group of banks.
Then there are the mortgage insurers, another obscure corner of the industry that is a financial black hole. Big mortgage underwriters such as MGIC and PMI Group may well see their credit ratings cut soon. MGIC recently revealed that it lost almost $1.5 billion in the last quarter of 2007 alone, as mortgage defaults soared.
Such problems will seep into the mainstream industry via reinsurers such as Swiss Re and XL Capital, which underwrote some of the specialists’ risks. Red lights are also flashing in the D&O market because of an expected flood of litigation linked to the credit crunch. On February 24th HSH Nordbank, a German lender, sued UBS to recover millions of dollars of losses it incurred on a portfolio of credit derivatives sold to it by the Swiss bank. Bear Stearns reckons liability insurers could lose up to $8 billion-9 billion on claims related to such lawsuits. That is a big number—until you compare it with the banks’ total subprime write-downs, already well above $100 billion.
But the biggest losers are those who tried hardest to behave like banks and sought to jettison their industry’s plodding image. A case in point is American Insurance Group (AIG), the world’s largest insurance company, which recently had to write down $4.9 billion of swaps related to collateralised-debt obligations. Swiss Re has already written down $1 billion or so on two related credit-default swaps. Such mishaps suggest insurers, too, need to remember that modelling risks is not necessarily the same thing as managing them.