The events in financial markets over the last year, and in particular the past few months, are a stark reminder that insurance enterprises have exposures well beyond the risks assumed from their insurance policies. The credit crisis, which initially began with an increase in the incidence of defaults on U.S. subprime mortgages, has quickly extended to every corner of the global financial market and resulted in a dramatic change in the competitive dynamics of the financial services sector.

At this critical juncture, insurance company management needs to protect the organization’s assets and capital base, maintain liquidity, and mitigate the exposures to losses that may be developing. These and other actions should be taken to protect ratings and to maintain the confidence of customers and distributors.

Business implications

The business model for insurance enterprises is not likely to fundamentally change. However, a number of the implications of the current crisis are apparent.

The Impact from Equity and Fixed Income Markets

In a persistent equity market downturn, life insurers will likely experience a sales decline in equity-based products. Depressed equity markets result in reduced fees, increased guarantee values and diminished variable annuity/variable life earnings. Volatile equity markets have driven hedging costs higher, further reducing profitability. Products without guarantees may suffer a noticeable decline in cash inflows.

Additionally, products with guaranteed interest rates will need to be evaluated to determine how the current environment impacts the organization’s obligations. Moreover, the regulatory pressures that emanated from the banking sector will renew insurance regulators’ focus on product suitability and disclosure issues related to customer offerings.

Clearly, all types of insurance organizations have significant exposure to the debt and equity markets in their investment portfolios. Unrealized losses will further weaken balance sheets and Other Than Temporary Impairment (OTTI) changes will depress year-over-year earnings. As the profitability of certain lines of business is evaluated, management will need to consider whether its deferred acquisition cost asset is impaired.

Securities Lending Programs

Securities lending programs have historically been an avenue for insurance and other organizations to earn additional income from their investment portfolios. In these transactions the insurance organization may have the right to use the collateral provided by the borrowing entity and invest the funds in other securities. However, insurance organizations should be mindful that the collateral is typically short term in nature. Investing collateral in illiquid or less liquid positions can result in a duration mismatch when the collateral is required to be returned.

Securitizations

Insurance securitizations might be viewed as the industry’s version of packaged mortgage-backed securities. In the short term, the constriction of credit markets is eliminating the ability to execute these transactions. Heavy users of securitizations and off-balance sheet corporate vehicles to manage capital needs will come under greater scrutiny as investors evaluate these structures and the magnitude of such risk transfers. This is critically important for life insurance companies with significant XXX and AXXX exposures where bank letters of credit are becoming extremely scarce and expensive.

Global Regulatory Coordination

Insurance regulators worldwide are expressing concern about how multiple national regulators will manage the meltdown of a global institution. Without clear protocols for regulatory coordination, local regulators may reflexively strengthen their claims on local resources, dramatically reducing the benefits of geographic risk diversification and increasing consolidated capital requirements.

Capital Requirements

Available capital will be adversely affected by investment portfolio devaluations and impairment charges, increased life and annuity product guarantee values and weaker business volume. As regulators and rating agencies reevaluate capital issues, it is likely that requirements will increase. Upward pressure will come from mounting credit risk provisions and requirements for structured products, mortgage-backed securities and equities. Additional capital will be needed to cover reinsurance risks and provide protection from exposure to credit and liquidity risks.

Next steps

The implications of the credit crisis require insurance organizations to take steps both to protect the organization and, at the same time, to create potential opportunities. Continued volatility and uncertainty are likely to pervade the markets for the foreseeable future. Inactivity would clearly result in increased losses for organizations that do not understand their current exposures or establish processes to cope with the uncertainties. At a minimum, the following considerations should be evaluated by management in the context of the current crisis:

o Pricing of Investments and Derivatives Portfolios. Management should evaluate its pricing and price validation policies and procedures to determine whether the current processes adequately address escalating current issues. This overview should include:

–The increasing demand for improved governance.

–Stronger price validation controls.

–More comprehensive independent model review.

–Enhanced management reporting.

If the market perceives a lack of strength in management’s pricing process or if errors occur, a crisis in confidence could rapidly result in a dramatic destruction of shareholder value.

o Counterparty Exposure Analysis. Management needs to quickly identify and aggregate exposures to companies in distress or at risk. Actively mitigating pre-and post-bankruptcy exposures through netting, and identifying, exercising and managing transactional trigger events will be critical to loss mitigation. No one knows if, when or which financial institution will be the next to suffer a loss of confidence and start a downward spiral. Organizations need to understand their exposures to all material counterparties and have sound mitigation strategies that provide rapid response in the event of a new crisis.

o Liquidity and Cash Flow Analysis. The quality of liquidity management, cash flow forecasting and working capital management should be challenged and revised to recognize the current market environment. Management typically relies on a presumed set of available sources of cash to meet working capital and liquidity needs. However, management should now consider whether those sources of cash will be available in times of crisis. Stress scenarios and cash alternatives need to be considered or organizations could find themselves in situations where funds are unavailable at the time they are needed most. Regulators may become more rigorous in requiring companies to demonstrate that they can enforce their financial support arrangements.

o Operational Requirements. Management should evaluate the impact of the recent financial crisis and its implications for the organization’s operational needs. An immediate need will be to minimize the impact of counterparty bankruptcy or future insolvencies. This action requires identifying and exercising bankruptcy/insolvency trigger events, determining which contracts will automatically terminate upon bankruptcy, and utilizing master netting provisions and cash-settling contracts before they become entangled in bankruptcy courts. Managing the movement of cash and netting of exposures, putting in place new netting and novation agreements and actively managing exposures before bankruptcy are critical. These actions can have a material impact on realizing cash recoveries in a timely manner.

Many organizations will discover that they are not able to address critical needs due to resource constraints. Timely loss mitigation is heavily dependent on flawless operational execution over the next few months.

o Transactions and Restructuring. Insurance organizations are in the process of evaluating sales of distressed, as well as prized operations to unlock liquidity and survive financial turmoil. Early planning, tight management of due diligence, ability to identify and understand the key issues rapidly and effective negotiation skills are critical in today’s environment of short/compressed deal deadlines or restructuring events. Some significant assets may become available. Organizations that cannot take advantage of these opportunities will discover their more prepared and nimble competitors have achieved a strategic advantage.

o Regulatory Compliance. Companies need to ensure that their reporting and compliance frameworks are capable of meeting demands that regulators are likely to place on any insurer whose financial stability is questionable. Additionally, insurance organizations can expect that insurance regulators are likely to review and increase the capital requirements for all insurance enterprises, further pressuring the profitability of operations.

o Tax Analysis. As the period of uncertainty unfolds, management will need to be keenly aware of tax issues that could arise. Any write-down in asset values may create a deferred tax asset (requiring evaluation and determination as to whether it may be recognized). In addition, the losses sustained by some companies will result in tax losses that may be carried back or forward. The losses may be limited in an acquisition context or may impact the recognition of other tax attributes such as the foreign tax credit. Understanding the tax implications–both cash tax and financial statement impact–of these changes is critical in viewing the broader picture.

While uncertainty lies ahead, the recent market events illustrate that insurers can take action to help safeguard ratings and assets, and to mitigate exposure to loss. Organizations that are well positioned, prepared and nimble may well be able to capitalize on the dislocation in the market.

Peter R. Porrino and Robert W. Stein are LexisNexis contributing authors and are, respectively, Ernst and Young’s Global Director of Insurance Industry Services and Ernst and Young’s Global Leader of Actuarial Services. Peter R. Porrino can be reached at peter.porrino@ey.com. Robert W. Stein can be reached at robert.stein@ey.com.