As the US financial industry begins to assess the
damage wrought by the subprime retail mortgage industry’s endless
unravelling, insurers can hope that a relative lack of exposure
buoys confidence in a jittery market.
With each new day bringing a fresh round of
rating downgrades and earnings warnings, insurers holding
instruments tied to adjustable rate retail mortgages are facing
intense scrutiny. The US mortgage industry is taking billions of
dollars in write-downs on collateralised mortgage, debt and loan
obligations, as well as residential and even commercial
mortgage-backed securities tied to subprime assets or products. The
result is a sort of self-fulfilling prophecy, as analysts look for
any ties to the subprime industry, and insurers seek to
contextualise fairly limited exposure in an environment in which
any ties are suspect.
Limited exposure
Thanks at least in part to fresh memories of huge losses in the
collapse of asset-backed investments in the early 1990s, most US
insurers had limited their current exposure to no more than a few
percentage points of their total investment portfolio.
Rating agency Fitch’s review of the general account investment
portfolios for US life insurers indicates that direct exposure to
suspect subprime and the slightly less risky Alt-A residential
mortgage collateral is relatively limited in the aggregate and
largely concentrated in the high investment-grade securities with
significant structural protection.
Further, and more importantly, Fitch found that there are no
individual US life insurers with a direct exposure that would be
considered a credit issue. Consequently, Fitch has not taken any
negative rating action on any US life insurer due to
subprime-related credit issues in 2007 to date.
The industry has limited exposure to subprime through investments
in real estate exposed companies, such as mortgage originators or
asset managers, and through investments in alternative investments
such as hedge funds with subprime concentrations.
“Fitch’s review of US life insurers’ subprime exposure leads us to
conclude that the industry’s exposure is manageable,” said Douglas
Meyer, a managing director in Fitch’s US Insurance group.
“Subprime-related investments account for 1.9 percent of the
industry’s general account invested assets. Further, over 93
percent of subprime-related fixed income securities held by life
insurers are rated AAA or AA, which provides significant structural
protection to higher-than-expected mortgage defaults.”
Meyer also noted that industry exposure to subprime investments
rated A or below accounted for 2.1 percent of total adjusted
statutory capital.
“Our primary concern at this point is the risk that deterioration
in the residential mortgage market will spill over into other
sectors of the credit markets,” he said.
Withstanding volatility
While Fitch expects further deterioration in the performance of
subprime residential mortgages, particularly for the late 2005 and
2006 vintage years, it noted that its analysis suggests that the
insurance industry is well positioned to withstand current market
volatility given its focus on high investment grade securities,
relatively stable liability profile and positive cash flow.
In addition to dealing with exposure issues, insurers, along with
the rest of the financial services industry, can only wonder what
the regulatory and political response to the subprime crisis is to
be, and can only hope that the cure is not worse than the
disease.
While limited in scope, subprime investments have popped up not
only in life insurers’ portfolios, but also in those of many
property insurers, reinsurers, and even health insurers. Composite
insurer MetLife, for example, reported $2.3 billion of subprime
residential mortgage-backed securities, and estimated unrealised
losses of about $29 million on the portfolio as of the end of the
second quarter. That is a manageable number, and analysts reacted
calmly to the announcement.
After reporting strong second-quarter earnings, MetLife’s
executives say the company expects strong performance from its
investment portfolio this quarter.
Steve Kandarian, MetLife’s chief investment officer, said during
the company’s quarterly earnings call that he expects investment
income to remain impressive, despite difficult credit markets and a
slowdown in initial public offerings.
Subprime accounted for only about 1 percent of MetLife’s unrealised
losses, he said. The investment portfolio was the core of MetLife’s
solid second-quarter results – an 83 percent increase in net
income, to $1.13 billion.
Composite insurer Prudential Financial reported holding $8.5
billion of its asset-backed securities collateralised by subprime
mortgages, with $7 billion of that total issued between 2005 and
2007. But it also noted that most of that total resides in the most
highly rated tranches, and estimates that a 40 percent drop in
housing prices underlying those securities would yield total credit
losses of only $150 million over five years.
Secondary effects
It is not the direct exposure, but the secondary effects of the
subprime fallout, that are wreaking havoc. Title insurer First
American took a $342 million reserve strengthening charge in the
quarter as it saw claims surge, thanks to unprecedented level of
defaults and foreclosures.
No one knows when the worst will be past in subprime, either.
Analysts expect further deterioration in subprime mortgages,
specifically in the 2005 and 2006 range, as a huge wave of
adjustable rate mortgage loans moves into the reset phase. The
combination of low interest rates on adjustable-rate mortgages and
institutional money flowing into the mortgage market seeking higher
returns resulted in intense competition in the subprime mortgage
origination market, which in turn led to more relaxed underwriting
standards.
Insurers could be exposed to further subprime mortgage problems
through investment in residential mortgage-backed securities,
asset-backed securities and collateralised debt obligations. There
is also subprime exposure through what insurers term alternative
investments, which typically means hedge funds with subprime
risk.
Assessing subprime exposure in alternative investments can be
especially challenging because some hedge funds sold subprime
exposure short, and benefited from the industry’s troubles.
The longer-term concern for the insurance industry is further
deterioration in other sectors of the credit market as a result of
subprime mortgage problems. Currently, it is apparent in the market
how liquidity has been negatively affected by fear over subprime
mortgages, which has led to a repricing of credit risk.
Finally, there is the spectre of government intervention, which
grows less likely as the crisis seems isolated in the subprime
markets. The Federal Reserve can certainly make a difference by
lowering interest rates, in addition to the cut in the discount
rate it’s already made. State lawmakers are likely to pass laws to
protect homeowners who have been the victims of predatory
lending.
As foreclosures mount in late 2007 and in 2008, the subprime
mortgage issue promises to be a major presidential campaign issue.
That means no shortage of uncertainty for the financial services
industry for months, even years, to come.
