This past week, in conjunction with the PLUS International Conference in San Francisco, the insurance information firm Advisen issued an updated forecast of insurance losses likely to arise from the credit crisis. As reflected in its November 5, 2008 press release (here), Advisen is now estimating aggregate D&O and E&O losses of $9.6 billion, up from the firm’s February 2008 $3.6 billion forecast. The firm also issued separate reports detailing its analysis of D&O losses (refer to report here) and E&O losses (report here).
Advisen has not only increased its estimate since February, it has widened the scope of what it is estimating. Thus, for example, the earlier estimate referred only to projected losses from securities class action lawsuits. The most recent estimate includes anticipated losses from derivative lawsuits, governmental investigations and other matters. The more recent forecast includes other items not incorporated into the prior estimate, such as an estimate for defense fees incurred on dismissed claims. For these and other reasons, some caution is advised in comparing the two estimates, as the overall increase in part reflects differences in the estimation process.
In addition, Advisen’s aggregate $9.6 billion forecast falls within a broader range of estimated combined D&O and E&O losses of from $6.8 billion to $12.1 billion. The sheer breadth of this range (reflecting a potential swing of as much as $5.3 billion) underscores the continuing difficulty of attempting to quantify the insurance industry’s potential credit crisis-related losses.
There are several considerations that make any current attempt to quantify the insurance industry’s credit crisis related exposure particularly challenging.
1. What are We Measuring?: Both the credit crisis and the associated litigation have expanded and evolved since the started to emerge in early 2007. Moreover, as a result of the dramatic events that shook the global financial markets in September and October 2008, what began as a subprime meltdown has now become a more generalized downturn affecting the broader economy. As I have emphasized in recent posts (refer here and here), the broader economic turmoil has produced its own associated litigation, and further litigation seems highly likely.
Because of these recent developments, it has become increasingly difficult to define with precision what is and what is not "credit crisis-related." The lines defining the category have blurred to the point that it may be difficult to say with any certainty what is being measured. The absence of definitional clarity makes both descriptions and predictions particularly precarious. The very attempt to quantify credit crisis related losses implies a categorical precision that may no longer exist.
2. Measurement Distortions: Most attempts to describe the credit crisis exposure reference the total number of securities lawsuits. While this total is important, the reality is that the number of lawsuits is greater than the number of companies sued. Several companies have been sued multiple times on behalf of different sets of putative claimants, as the Advisen report duly notes. To the extent the successive lawsuits hit the same insurance program, they are less likely to increase the insurance industry’s overall losses.
Moreover, as I discussed here, early returns suggest that the courts have proved skeptical that investor losses in the context of a marketwide meltdown are the result of fraud. It is far too early to generalize from these early returns, but to the extent the courts remain skeptical, the overall potential impact of this litigation could be diminished.
In addition, the insurance losses on any particular claim will vary widely depending not only based upon the issues affecting the underlying liability exposure, but also affecting the extent of insurance coverage triggered. Issues such as retentions, program structure, limits availability, as well as overall terms and conditions, could significantly affect the extent to which the payment of insurance proceeds is triggered in any particular claim.
As the Advisen report notes, these issues are particularly relevant for claims against companies in the financial sector, as many of these companies carry very large self-insured retentions or have limited their insurance coverage protection solely to Side-A only protection. These coverage-related issues could substantially determine the extent of insured losses in many claims, which in turn could substantially affect the insurance industry’s aggregate exposure.
3. The Uncertainty of Events to Come: Any estimate of the insurance industry’s overall credit crisis-related exposure necessarily encompasses not only projections about the lawsuits that have already been filed, but also incorporates assumptions about the number and seriousness of lawsuits yet to be filed. In addition, the estimate also includes certain assumptions about how much longer the new lawsuits will continue to emerge.
Advisen suggests that the losses will spread into 2009, reflecting an apparent presumption that the accumulation of lawsuits will run only through 2009. My crystal ball is no better than any one else’s, but my own view is that lawsuits associated with the current economic crisis will continue to emerge for some time to come, and more specifically will continue well beyond the end of 2009. But the critical issues here is that any attempt to estimate the insurance losses entails certain assumptions about the lawsuits yet to come, and the magnitude of the losses estimated will vary materially depending on the assumptions used.
The foregoing analysis suggests a number of competing considerations, some of which might imply larger overall insurance losses, some of which cut the other way, and some of which that will have an uncertain impact. For that reason, I think it is particularly difficult to try to estimate the insurance industry’s overall exposure from the credit crisis related litigation. As a result, I have no opinion one way or the other about the accuracy of Advisen’s estimate.
That said, I agree with Advisen that the insurance industry’s overall losses are going to be very large, and that whatever the loss projection might have been in February 2008, developments since that time suggest that the number almost certainly has increased. Moreover, as a result of the events in the financial marketplace during September and October 2008, there are increased prospects for further significant losses to continue to accumulate across a wide variety of companies and across a wide variety of industries. There is every possibility that Advisen will find it necessary to increase its estimate in the future.
I think the most recent developments in the financial markets may be particularly significant for the insurance industry’s ultimate losses. These events included some enormously significant events, including, for example, the largest bank failure in U.S. history, the bankruptcy of one of the largest investment banks, and the government’s bailout of the largest insurance company. At the same time, commodity prices and currency exchange rates changed direction abruptly and significantly. These and other developments will continue to reverberate through the global economy for months and perhaps years.
One of the direct consequences from these developments is that there will be significant additional litigation, and this additional litigation will emerge for some time – as I noted above, the litigation could well continue to emerge beyond the end of 2009. Because of the turmoil in the global financial market, this litigation is widely dispersed across the entire economy. That is, unlike the litigation exposure that prevailed in the early stages of the subprime meltdown and credit crisis, which was concentrated in the financial and real estate sectors, the litigation exposure now ranges across most industries and many companies.
Is the D&O Insurance Industry Headed for a Hard Market?: The insurance industry in general has not yet reacted fully to these developments. To be sure, and as fully noted in the Advisen report, companies in the financial sector are now seeing D&O insurance price increases and a more challenging underwriting environment. The Advisen report also suggests, correctly in my view, that there are a variety of factors that potentially could lead to a hardening market ahead, including in particular the losses associated with Hurricane Ike and other catastrophic events, as well as the marketplace disruptions involving AIG and the investment losses that have accumulated at other leading carriers.
All of that said, other than with respect to companies in the financial sector, there is little present evidence of a market turn. For most companies, conditions remain competitive, and both pricing and available terms and conditions remain attractive.
A harder market may well lie ahead, as Advisen suggests. The question is how far ahead. I doubt companies generally will experience a hard D&O insurance market until insurers are reporting substantial calendar year losses across their D&O portfolio.
The Advisen report suggests that the credit crisis-related losses will be spread "across 2007, 2008 and 2009." However a close reading of the Advisen reports reveals that Advisen is referencing "accident years" not "calendar years." Losses associated with claims in a particular accident year may not be fully developed until years later. An insurer recognizes a loss only when the claim is paid or a reserve against the ultimate amount is finally established. The calendar year in which the loss is finally recognized may be years after the accident year in which the claim first arose. The lag time to the ultimate loss in the professional liability insurance lines can be as long as three years or more. The lag time creates a risk (all too often realized) of loss underreporting.
Another danger of the lag time is the possibility that carriers may misunderstand their own loss experience, which could produce a mismatch between the risks assumed and the pricing charged. Exacerbating this concern is the insurers’ delayed recognition that the litigation threat from the evolving credit crisis has spread to the larger economy. Simply put, current pricing may not reflect the existing litigation exposure.
The interaction of these factors suggests the possibility that the arrival of the harder market could be delayed but could be even more disruptive when it arrives. The carriers that are the slowest to recognize the changed circumstances will be the ones that experience the most disruptive impact.
Of course, to the extent that AIG’s travails and other carrier’s investment portfolio woes produce a shortage of insurance capacity, the hard market’s arrival could be accelerated. But my own view is that predictions of a hard market for D&O insurance could be premature until the insurers begin to recognize serious calendar year losses in the professional liability lines.
More Bank Closures: In what has become a regular Friday night ritual, after the close of business on Friday November 7, 2008, the FDIC announced the closure of two more banks.
First, the FDIC announced (here) that state regulators had seized and the FDIC had been appointed the receiver of Franklin Bank of Houston Texas. Second, the FDIC also announced (here) that it had been appointed receiver of Security Pacific Bank of Los Angeles, California, after the bank was closed by state banking authorities.
These two bank closures represent respectively the eighteenth and nineteenth bank closures so far during 2008. The FDIC’s complete list of bank closures during the period October 1, 2000 through the present can be found here. Of the 19 bank closures year to date, thirteen have occurred since July 1, 2008. Moreover, after the close of business for the past four Fridays in a row, the FDIC has announced at least one bank closure.
The year to date number of bank closures already represents that highest annual total since 1993, at the tail end of the last era of failed banks. More to the point, the pace of bank closures, which has increased in the second half of 2008, has accelerated over the past four weeks.
For anyone who remembers the last era of failed banks, these bank closures represent a particularly ominous sign. They also represent one more reason why I believe that the turmoil from the credit crisis, and associated litigation, will continue for some time to come.