Reports of new write-downs and revelations of banks' increasing exposure to sub-prime debt have been an ongoing feature of 2008. Although it is not yet clear precisely what and how many problems for the reinsurance market might be caused by the sub-prime crisis, the types (and numbers) of claims being made are becoming clearer, in the US at least.
Background to the sub-prime crisis
Sub-prime debt was organised into complex securitised structures, which are ultimately underpinned by real assets (properties which are the security for sub-prime mortgages). If those assets lose value, so do the securities which use them for collateral. Losses may also occur where, even though the real assets at the bottom of the 'chain' may still have value, if there is no market for a securitised product, its value has to be written down, to zero in extreme cases.
As well as claims which may come through to reinsurers, the reinsurance market has, as with other sectors, suffered from declining asset values, and may face liquidity problems if future capital is required. Also affected are ART deals relating to sub-prime debt, such as the insurance of credit default swaps or other similar instruments.
Before considering what types of claim may arise from sub-prime losses, reinsurers will be considering what is a 'sub-prime loss'. Definitions can be drawn widely or narrowly. Some may think that to be classified as 'subprime', an underlying loss should have a subprime element, such as a write-down due to sub-prime securities being valued at zero.
Others may wish to draw a definition more widely, seeing sub-prime as ultimately responsible for the wider current financial difficulties. Debate will focus on whether one can really categorise a loss resulting only from the credit crunch and not from subprime loans (such as Northern Rock) as a 'sub-prime loss'. There will inevitably be grey areas.
Current claims
It has been reported that, from January 2007 to March 2008, 448 sub-prime related law suits have been brought in the US. Notably, filings increased substantially in the first quarter of 2008.
It seems that the largest section of these claims have been borrower class actions, suing sub-prime lenders. Commentators in the US say these actions will not threaten companies' balance sheets as the plaintiffs will not be able to receive high levels of damages. The other major category is securities-related claims, a little over half of which are fraud class actions. These cases have the potential for large awards and focus mainly either on the issuers of sub-prime mortgages (shareholders claiming failure to disclose the risk) or on businesses that issued, underwrote or advised on sub-prime based securities. Auditing and legal malpractice claims, by contrast, remain in single figures. However, it would be surprising if further D&O and E&O claims were not made.
Some of these actions will be dismissed, many will be complex and expensive to litigate. US attorneys are reported as taking the view that there are more law suits to come.
At the time of writing, press reports indicate that total global losses caused by the subprime crisis will not be catastrophic for the reinsurance market. Lloyd's has reported only limited exposure to sub-prime losses (albeit with the caveat that it is not expecting its exposure to become clear until the second half of 2008). It may be some time before it is clear what issues are created for the reinsurance market. We provided a preliminary analysis of those issues in the Spring 2008 edition of RIRt Notes. We summarise those issues and provide some further thoughts here.
Notification
The Court of Appeal's decision in AIG v Faraday (2007) that a 'loss' for the purposes of a notification condition was the underlying loss, not the loss to insurance, presents reinsureds with difficulty in deciding when to notify. It seems that reinsureds are understandably opting for early notification, often notifying when there is only a newspaper or other report of an insured suffering grave losses, prior to any litigation actually starting. This underlines the problem with the Faraday case - it presents reinsurers with the difficulty of reserving on a number of notifications which are fairly speculative.
Aggregation clauses
A key issue is the distinction between 'per event' and 'originating cause' wordings; in the former, each negligent act is probably the 'event', rather than, for example, a fund collapse which forms the factual background. In the latter, cover may be wider. Therefore, if retrocession cover is 'per event', there may be a gap in the chain of reinsurance.
Allocation
Particularly in 'Losses Occurring During' policies, the reinsured must show that the loss occurred during the period of reinsurance. Where a number of actions may have caused losses over a period of time, doubts as to the courts' practical approach (allocating by holding that losses occurred at the same rate over time) were raised by the Court of Appeal's decision in Wasa v Lexington (2008). This is being appealed to the House of Lords, whose decision will be key in this area.
Follow the settlements
Even where proof of loss is not required, a reinsured must still show they acted in an honest and businesslike way in settling the claim, and that it was covered under the reinsurance - this may present difficulties in recovering from reinsurers claims paid under outside pressure (e.g. from the media or regulators), without terms of coverage being verified or obvious other defences being pursued.
Non-disclosure
Disclosure at placement is crucial. Timing will be vital. What did the reinsured know of the sub-prime crisis and the position of its insureds at the time of placement?
Conclusion
Although the nature of sub-prime claims in the US is becoming clearer, it will be some time before the precise impact of those claims into the reinsurance market becomes known. We hope this article has provided food for thought on the issues which might arise.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.