Effect of Financial Crisis on Insurance Business

Banking & Insurance
Effect of Financial Crisis on Insurance Business

João Ferreira Leandro Barbosa Luís Leão Mikolaj Mokwinski

Index
Introduction .........................................................................................................................................3 How do insurance companies work? ...................................................................................................4 Modern financial crisis affects the activity of insurers by 3 main mechanisms ..................................6 Examples of the crisis influence on different types of insurance companies......................................6 One of the most famous examples of the collapse of the insurance company on the market...........7 How the insurance industry will change in several years ? .................................................................9 World insurance market presently.......................................................................................................9 Role of Insurance industry in a modern economy .............................................................................11 The role of insurance companies as shock absorbers in this crisis....................................................12 Risks and effects of financial crisis in different insurance services....................................................14 Mortgage insurance .......................................................................................................................14 Life Insurance .................................................................................................................................15 Financial guarantee insurance .......................................................................................................16 CONCLUSION ......................................................................................................................................18 Literature List .....................................................................................................................................20

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Introduction
The purpose of this seminar is to discover the effects of financial crisis on the insurance business and to identify some issues related to the insurance role in this financial crisis and try to understand how the insurance companies are important on this last years crisis. Insurance basically is a financial arrangement that redistributes the costs of unexpected losses. Insurance involves the transfer of potential losses to an insurance pool. The pool combines all the potential losses and then transfers the cost of the predicted losses back to those exposed. Unexpected losses can occur and the role of insurance companies is to ensure the costs of that losses , and insurance companies can predict these kind of losses and repay that losses to their customers. An insurance system redistributes the cost of losses by collecting a premium payment from every participant (insured) in the system. In exchange for the premium payment, the insurer promises to pay the insured’s claims in the event of a covered loss. We can say that the insurance system protects their costumers from financial losses by paying them back the amount of the loss. With the insurance service investors and entrepreneurs can be more confident about their business , because they have all insured, and insurance companies are always there if something jus to go wrong. The level of economic activities are determined by insurances, because if a country as a good insurance system the level of economic activities will be high because everyone is so much more confident about their business and in the end the economy will just grow ! Insurance companies affects all the areas that have goods that can be insured , so we can say that insurance companies deals with lots of different targets like Banks, Manufacturing Industry, Construction industries, people and small companies. So insurance companies are a very diversified areas. Business enterprises take insurance for almost every aspect of their business, banks, per example insure the loan they lent, etc. So we can say that insurance companies work in all the areas and they are like a foundation to all the financial world.

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How do insurance companies work?
The primary function of insurance is to provide economic protection of entities from the risks they are exposed to. In an attempt to fulfil this function in the best possible manner, insurance companies carry out maturity transformation of small funds collected from the premiums paid by insured entities into large funds (reserves). Thanks to the financing mechanism based on reserves, the funds insurance companies set aside to meet future liabilities are free funds that can be invested until the maturity of the corresponding liabilities. By investing the available funds, insurance companies are trying to obtain an adequate return in the form of interest and capital gain at as little risk as possible. When doing so, an insurer must not place at risk the timely payment of liabilities to policyholders. For this reason the funds from the reserves need to be invested in line with statistical expectations of loss in the future. Insurance company investment policy principles of liquidity, safety, and profitability are not in any way different from those applying to companies in other industries. Nevertheless, the purpose of insurance business assigns relative importance to these principles; i.e., it establishes priorities among them. Due to its basic function of providing protection from risk, each insurance company has primarily to take into account the safety of its allocations when making investment decisions. Consequently, the primary direction of insurance reserves should be conditionally risky assets, such as government bonds, long-term bonds of public companies, and bank deposits. In addition, the safety principle is also achieved through investment diversification, as well as through maintaining the share capital and solvency margin at the prescribed level when investing funds, in order to prevent a possible erosion of the company capital.

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How financial crisis has influenced on the insurance market ?
The value and the structure of assets of insurance companies, as the leading institutional investors in the world, have suffered the corresponding detrimental effect of the global financial crisis. In the period of recovery from the crisis insurance companies are trying to redefine their investment policies. The large numbers of challenges insurers are currently faced with in the field of investment, as well as the possibilities of overcoming them, are becoming one of the most topical issues among theoreticians and practitioners in the field of insurance. The financial have affected not only a banking crisis but of course insurance industry too. Representatives have regularly emphasized, and the solvency of the insurance sector as a whole does not appear to be threatened. Nonetheless, insurance companies have also been affected, and in mostly adverse ways. The exposure of most insurance companies to the significant aggravation in global financial markets has been primarily stocks, which simultaneously experienced during this crisis. In comparison to the problems that the world is measured in the banking sector and the capital, the insurance sector has been affected by the financial crisis the least. Based on International Monetary Fund estimates that losses from mortgage products can be estimated at 1.4 trillion. Until now, financial companies recorded losses amounted to 760 billion U.S. dollars with more than $ 600 billion to banks accounted for. Insurance loss on this account is estimated at 80-90 billion, of which more than $ 50 billion in Department I and more than 30 billion in Department II (mainly financial insurance). through their investment portfolios. This is not surprising as the assets are largely held in bonds and episodes of significant valuation pressures

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Modern financial crisis affects the activity of insurers by 3 main mechanisms
∑ decrease in the value of assets (ie investments in insurance). This effect is usually the bigger the more risky instruments, especially equity-type instruments (mainly shares) the insurer has on its books. A significant modification to the mechanism of his actions bring insurance products where the investment risk is borne by policyholders, ∑ increase the level of commitment by the increase in claims of the products

(especially all financial products, and some products liability and D & O (Directors and Officers Liability Insurance) or E & O (Errors And Omissions Insurance).) The more products of this type weigh in a portfolio insurer the more potential losses, ∑ by the appearance of liquidity gap (casus AIG) as a result of the general decline in liquidity in the financial markets because of the panic (and thus through the mechanism of cash flows.)

Examples of the crisis influence on different types of insurance companies
• Mortgage insurers in the United States have been at the epicentre of the crisis and have been hard hit. Their financial health is largely determined by housing market and foreclosure developments, which are not expected to improve rapidly. • Life insurance companies, especially in the United States, have come under significant market valuation pressures, as investment losses rose, while the costs of hedging to limit the downside of equity-based contracts with guaranteed returns spiked. • Financial guarantee insurance companies have been under rating and market pricing pressures and the large entities have lost their triple-A rating status, which was the core of their business model. • Some large insurance–dominated financial groups were affected either through their institutional links to banks or their in-house units performing investment-bank-like
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activities. For example, the world’s largest insurance group collapsed as a result of losses

incurred through its financial product unit, which had been a major seller of credit protection. The government extended parts of its financial safety net to this financial group, as its role as a counterparty to systemically important banks appears to have made this company itself systemically important.

One of the most famous examples of the collapse of the insurance company on the market
One of the greatest and most known insurance company which is American International
Group (AIG) was viewed by many people like really stable and trust-worthy organization, consisting of a global financial service holding company with 71 US based insurance companies and 176 other financial service companies. Overall, the global-regional dimension of the loudest cases revealing the plight of the insurers have a history of AIG, Fortis, Aegon and ING. At the same time, at least in the context of AIG should be emphasized that the problems that resulted from its corporate non-insurance activities. Other cases concern while insurance companies operating in the life insurance sector. This is due to the fact that life insurance division as opposed to the insurance department on the one hand, it provides a savings products, on the other hand has a long-term. His risky assets may include instruments that are in situation general decrease the value of assets under severe strain. In the case of the stock market downturn, investment policy mistakes and the loss of funds needed to pay benefits to insured persons, may result in the need to obtain additional funds (from the owner, the state or other investors) in order to maintain an adequate level of solvency. This is particularly true in a situation where both the insurer shares listed on the stock market (as a result of emerging information-such as financial difficulties. ING or made copies of the cooperation received from banking and insurance of the fallen banks - npAIG, Aegon) lose value, causing that the ratio of assets to liabilities of changes to its detriment. It turns out that you have the capital may be too small for the scale of liabilities. This was the case even in the case of Aegon (at the end of October 2008, its shares lost value 15%) and ING (at the same time, the value of its shares fell by 27%). You have to emphasize, however, that the scale of the collapse of the insurance market as a result of the loss of value of their assets is as yet very limited especially given the fact that
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in 2006 the assets were a total of nearly 19 billion USD. The loss of only 1% of their value would be equal to the loss of the order of 190 billion USD. This means that, in general, they lead a prudent investment policy. In the case of the U.S. in the fight against the crisis was rather nationalization of insurance (for example, the planned nationalization of AIG and Prudential and Metlife), while in Europe frequently used financial loan. So far in the global or regional level there were no new ideas for the rehabilitation of the insurance sector. Only just in the United States and Germany approved public assistance programs can also refer to a possible stabilization of the situation in this area. In general, however, so far sectoral regulations remain unchanged, which may result in a deepening of regulatory arbitrage to contact insurers such as life partners-credit institutions, as in the case of the latter, in all developed countries, there are deposit guarantee schemes (besides offering in connection with the crisis better protection for depositors) and in the case of insurance, they exist only in the states (which often guarantee limits are much lower than those used in the banking sector). It does not seem, however, within the next time something like this was about to change the topic. Also there were no new ideas for the wider governance of the sector, but do not rule out the effect of nocturnal emissions here in the banking sector. At the critical moment of the rules and regulations on risk management in the company did not materialize. The risk management models initially used for this purpose did not measure the risk of future collateral calls or write-downs and more sophisticated risk management models were reportedly not effectively applied until after 2006, by which time the company had already built up most of its exposure to derivatives. In 2008, the company’s Financial Product unit reported a spectacular loss of around USD 10 billion for the full year 2007 and, later, an even higher loss for the first half year of 2008. In March 2009, AIG reported, at USD 60 billion, the highest quarterly loss a US corporation has ever reported, marking also the fifth straight quarterly loss for that company. Financial market indicators of the parent company’s health deteriorated especially during fall 2008 and spring 2009.

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How the insurance industry will change in several years ?
The world around us is still changing. Area of business included insurance has suffered from crisis and now is flourished again in better way. There are few thing that might will have change for sure. For example increasing amount of business will be transacted electronically. We will be able to see the aggregators move more strongly into the commercial sector. At the top end of the market, more companies will investigate and implement self-insurance strategies for perceived cost benefits. There will be more consolidation at carrier and broker level that ever before. The market may or may not harden. Definitely we could say that the way insurance company deal with our customers will change. The rise and rise of social media provides a really interesting medium for building relationships at the individual customer level. Much of it is untested for commercial purposes, in this context it is not hard to conclude and predict that social networks like Twitter, Facebook, Linkedin and whatever the next iteration of all of these looks like will become the next marketing and customer engagement battlefield. The companies that have suffered most in the insurance space as a consequence of the credit crisis are chiefly those that combined insurance and banking operations. This is where regulators and supervisors will be alert in the future. Insurance companies branching out into risky ventures (such as banking or financial guarantees business) or other riskier players (such as banks or financial guarantors) moving into insurance, creating possible transmission mechanisms previously unnoticed. It is of particular importance that the new solvency II framework is implemented without delay. It will introduce a holistic view for all business, investment and operational risks of an insurance company and it places a strong focus on the quality of internal risk management. From an economic point of view, Solvency II offers the best possible regulatory framework to diligently implement the lessons learnt from the crisis and to ensure the sector’s long-term viability.

World insurance market presently
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Today, after a fall in profitability in the insurance industry as a result of the global financial crisis, the sector around the world to re-focus on internal processes, reducing costs and improving the efficiency of business processes. We can distinguish three clear indicators that the implementation in the insurance industry to help it return to profitability improved: ∑ cost management and efficiency are critical lever insurance organizations increase productivity, ∑ administration of insurance policies indicate systems as the next priority, ∑ in the coming years, to carry out investments in several areas of administration policies is important for insurers.

Cost and efficiency are important factors: although the premiums increasing in some markets, a few insurers have enough strong competitive position to be able to raise premiums. Many insurers is thus a difficult choice, and differentiated products for the most valuable customers, and to focus on low price and standardization offers. Insurers in other sectors than life must ensure lasting results in the coming years. They also need to ensure minimization of claims, the cost of sales and other operating costs. Basic operational area - government policy - is the area in which the transformation can offer lower costs and benefits for the customer. Administration policies is the next priority to reduce costs and improve operational efficiency: many leading insurers admit that they can not continue to rely on aging and inflexible systems administration policies. Old systems block the further expansion of business and hamper the ability to compete on the client with-centric market. The transformation of systems of administration policies has been recognized as a priority
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for the next two years, the vast majority of European (93%) and North American insurers (67%). Only in the area of young markets of Asia and the Pacific, only 36% of respondents indicated that it will be a priority, because those markets have been opened up insurance in the last decade, and many companies have implemented modern systems of government policies.

Role of Insurance industry in a modern economy
The role of insurance companies nowadays are very diversifies, so they focusin some general points like promote financial stability and security at both the national and personal levels, this point is very important because stability is the main point to a good economy, because if the economy is constantly going up and down insurance companies cannot predict the losses and is a lot more difficult to work with that. Encourage productive investments and innovation through the mitigation of the financial consequences of financial misfortune is another main point that insurance companies focus, because is very important to support new projects and new business so the economy can grow , because stability is not enough to make a economy grow. Another important point is to mobilize savings. And finaly , another main point of insurance companies is to contribute to an efficient use of capital based on insurer's role as significant institutional investors, because insurance companies have to be sure of the business they make so the risks can be the less as possible . The insurance business is the central part of the capitalisation process of a modern economy. It creates huge capital assets as we can see. The insurance mechanism allocates assets according to market forces where needed and this in a largely stable environment.

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The existence of insurance gives the chance of planning the processes with more certainly, avoiding risks that exist in the general business process.

The role of insurance companies as shock absorbers in this crisis
• Insurance companies are major players in global financial markets

Insurance companies are major investors in financial markets. On aggregate, the largest investors worldwide are investment funds, followed by insurance companies and pension funds Moreover, a part of the assets under management of private equity and hedge funds are owned by insurance companies (and pension funds), making these investors major players in global financial markets.

As we can see on the graphic Insurance companies are one of the big investors , so we can conclude that insurance companies are very important in the financial world and they guarantee the success of many businesses.

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Insurance companies have the capacity to adopt investment strategies with long-

term horizons
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Insurance companies, especially life insurance companies, are financial institutions with longer-term liabilities than commercial and investment banks and thus they have the capacity to adopt strategies with longer-term horizons. Insurance companies are a very stable element of the financial system ans sometimes it seems like the crisis just don't affect the insurance companies because of their stability, and the capacity of stabilising of the insurance companies. One important fact and a main reason for this stability is that insurance companies do not sell into falling markets, when many other types of investors do. The insurance function has tended to have a stabilising effect during the current

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financial crisis • As we can see insurance companies continue to provide insurance coverage althought the crisis and they have the ability to reinvest the preceeds in financial assets. As we can see on the graph below the premium incomes have continued to increase especially in life insurance business until 2007. But global insurance premium income may have fallen for the first time since 1980.

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Risks and effects of financial crisis in different insurance services
To a better understanding of the consequences of the financial crisis in the insurance sector we must know what risks the different types of insurance have in nowadays market. With that purpose we are going to talk about mortgage insurers, life insurance companies and financial guarantee insurance companies mainly related to the US because, as we said before, there's where the crisis started. Mortgage insurance Mortgage insurance is an insurance policy which compensates lenders or investors for losses due to the default of a mortgage loan. Mortgage insurance can be either public or private depending upon the insurer. They have been at the United States the most affected sector of the crisis and have been hard hit. Their financial balance is largely determined by housing market and foreclosure developments, which are not expected to grow fast in the previous years. Looking at the problems at the epicenter of the crisis, the mortgage sector, one finds mortgage insurance companies in the United States having the most direct exposure of any insurance sector 14

to mortgage credit risk and consequently being the institutions most rapidly hit in a significant manner. This outcome is not so surprising given that the crisis started in the United States residential mortgage market and that these entities’ core business consists of guaranteeing to other financial service companies that either individual loans or a portfolio of mortgages will retain their value. Moreover, they insure relatively high-risk or otherwise non-standard loans (e.g. the absolute amount of the loan exceeds specific limits). As a result of mortgage market developments since the second half of 2006, there have been sizable losses on the part of several of these entities, which have depleted substantial amounts of the capital buffers that many of them had been able to build up beforehand. Already in April 2007, New Century Financial Corporation, a leading US subprime mortgage lender, filed for Chapter 11 bankruptcy protection. The largest independent US mortgage insurers (MGIC Investment, PMI Group, and Radian) have posted significant quarterly as well as full-year losses. Rating agencies predict a return to profitability to be an unlikely event before 2010. At least one of the ten largest US mortgage insurers by 2008 sales has entered “run-off”, continuing to pay claims and book profits or losses from previously sold policies, but not writing new policies. mortgage insurance companies implemented several rounds of underwriting changes that should result in more conservative credit portfolios going forward. But the legacy portfolios remain large and their performance will only stabilize, as US housing markets stabilize and foreclosure rates fall, which is unlikely as long as real activity growth is weak and unemployment rising. That said, home prices in the United States have shown signs of stabilizing as judged by developments in the Federal Housing Finance Agency's seasonally adjusted purchase-only house price index and the ShillerCase composite index of the top 20 metropolitan statistical areas in the country.

Life Insurance Life insurance is a contract between an insurance policy holder and an insurer, where the insurer promises to pay a designated beneficiary a sum of money upon the death of the insured person. Depending on the contract, other events such as terminal illness or critical illness may also trigger payment. The policy holder typically pays a premium, either regularly or as a lump sum. Life Insurance companies have come under significant market valuation pressures, as investment losses rose, while the costs of hedging to limit the downside of equity-based contracts with 15

guaranteed returns spiked. Life insurance companies came under market valuation pressures, reflecting to no small extent the losses on their own investments in stocks and in mortgage-backed securities. While these companies tend to have relatively limited exposure to lower quality residential mortgage backed securities (RMBS) and structured financial instruments (such as CDOs) involving such securities, they are nonetheless significant investors in many securities markets, including equity and corporate bond markets, where valuations declined almost simultaneously. On the liability side, the decline in government bond interest rates implied a substantial increase in actuarial liability levels.

Financial guarantee insurance Financial guarantee is an non-cancellable indemnity bond that is backed by an insurer in order to guarantee investors that principal and interest payments will be made. Many insurance companies specialize in financial guarantees and similar products that are used by debt issuers as a way of attracting investors. The guarantee provides investors with an additional level of comfort that the investment will be repaid in the event that the securities issuer would not be able to fulfill the contractual obligation to make timely payments. It also lowers the cost of financing for issuers because the guarantee typically earns the security a higher credit rating and therefore lower interest rates. Likely as life insurance companies, financial guarantees insurances have been under rating and market pricing pressures and the large entities have lost their triple-A rating status, which was the core of their business model. As a result of mortgage market developments since the second half of 2006, there have been sizable losses on the part of several of these entities, which have depleted substantial amounts of the capital buffers that many of them had been able to build up beforehand. Already in April 2007, New Century Financial Corporation, a leading US subprime mortgage lender, filed for Chapter 11 bankruptcy protection. The largest independent US mortgage insurers (MGIC Investment, PMI Group, and Radian) have posted significant quarterly as well as full-year losses. Rating agencies predict a return to profitability to be an unlikely event before 2010. At least one of the ten largest US mortgage insurers by 2008 sales has entered “run-off”, continuing to pay claims and book 16

profits or losses from previously sold policies, but not writing new policies. In addition, many of these companies have written variable annuities contracts, several of which have guaranteed minimum income streams or other guarantees that are costly to fulfil in deteriorating capital market valuations and environments of low (or moderate) government bond interest rates. While the increase in corporate spreads may provide some offset (as they promise higher nominal returns), this offset comes at the price of increased credit risk. Thus, valuation pressures reflected in many cases the combination of adverse developments affecting both the asset and the liability sides of the balance sheets of these entities, giving rise to important assetliability management challenges.

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CONCLUSION
The financial crisis originated in the U.S. and later became a global crisis having a direct influence on insurance markets. Besides being the most severe financial crisis faced by capitalist economies since 1929, is also a social crisis, which affected the activity of insurers reducing the value of assets, increased the level of commitment of increased complaints of products and a lack of appearance liquidity in financial markets. Insurers were at the epicenter of this crisis and bank were hit hard and are now under pressure from the recovery of markets and prices. It was inevitable, given the unstable nature of the insurers, and the consequence of ideological developments caused by the global crisis. Many companies went bankrupt because capital was too small for the size of the liability, but this crisis many errors are corrected and new opportunities arise. At the top of the market, more companies will investigate and implement strategies for self-insurance cost benefits realized. There will be more consolidation at carrier and broker ever. The market may or may not harden. Definitely we can say that the way the insurance company will change with our customers. The rise of social media provides a very interesting way to build relationships at individual customer. After a decline in profitability in the insurance sector as a result of the global financial crisis, the sector around the world to re-focus on internal processes, reduce costs and improve the efficiency of business processes. Cost and efficiency are important factors to differentiate products in order to attract customers, focusing on low-priced offerings standardization and ensure lasting results in the coming years. It is also necessary to ensure the minimization of claims, the cost of sales and other operating costs by investing in the funds available, so insurance companies try to get an adequate return in the form of interest and capital gain with the least risk possible. Another topic addressed in this work is for us that stability is the key point for a good economy, because if insurance companies are constantly going up and down cannot predict losses, another important point is to mobilize savings and encourage productive investments in innovation by mitigating the financial consequences of financial doom. The existence of these insurance gives the opportunity to plan with more certainty processes, avoiding risks that exist in the business process in general. As you can see in the graphs presented in the body of this work insurance companies are a major investor, therefore, we conclude that the insurance companies are very important in the financial world to ensure the success of many companies. Insurance companies, especially life insurance companies, financial institutions are more long-term liabilities of commercial banks and investment and thus they have the ability to adopt strategies with longer term and are at the very ANS stable financial system. The mortgage insurance is also one of the important points of this 18

work that we know a little more of Mortgage insurance is an insurance policy which compensates lenders or investors for losses arising out of a mortgage loan. Looking at the problems at the epicenter of the crisis, the mortgage sector, is the mortgage insurance companies in the United States with more direct exposure to any sector insurance risk mortgage and therefore faster than the institutions reached significantly. Another insurance treaty is life insurance that pressure recovery reflecting significant market for losses on their own investments in equity and mortgagebacked securities. Moreover, many of these companies have written contracts variable annuities, several of which have guaranteed minimum income streams or other guarantees that are costly to comply deterioration in capital market valuations and environments of low (or moderate) rates interest on government bonds. While the increase in corporate spreads can provide some compensation.

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Literature List
- http://www.genevaassociation.org/Portals/0/CRO_Forum_Resp%20Crisis (online at 20/11/2012);

- http://www.iaisweb.org/__temp/Insurance_and_financial_stability (online at 20/11/2012);

- http://www.naic.org/documents/topics_white_paper_namic.pdf (online at 20/11/2012);

- http://www.towerswatson.com/research/3068 (online at 20/11/2012).

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