Transcript The Subprime Crisis from an Insurance Perspective 5-22-2008

The Subprime Crisis from an
Insurance Perspective
5-22-2008
1
Sub-prime Loans
What is a Sub-prime Loan?
A Sub-prime loan is a type of mortgage loan made to borrowers who have at
least one of the following characteristics: (1) low credit scores; (2) the inability
to post the traditional 20 percent down-payment for a home; and/or (3) the
inability to fully document their income. As a result, these borrowers do not
qualify for conventional mortgages and the best market interest rates.
2
Subprime Overview
FIRST TIER
SECOND TIER
THIRD TIER
Bond Insurer
Banks
B
O
R
R
O
W
E
R
S
Lender
Transaction
vehicle
(SPV)
Investors
Insurance
companies
Hedge
Funds/
SIVS
Broker
Transfer of
Ownership/Risk in
pool of assets
Issue
Commercial
Paper
• Fund manager
(offering
memorandum/side
letter)
Investment
Professionals
High net
worth
individuals/
companies
• Custodian (Bank)
• Rating agencies
• Lender
• Asset Manager (Bank)
• Arranger (Bank)
• Collateral
Agent/Trustee (Bank)
• Lawyers
• Lawyers
• Accountants
• Accountants
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• Lawyers
• Accountants
Sophisticated
investors
A Brief History of the Sub-prime Market
§
§
§
§
§
In the mid-to-late 1990s, U.S mortgage lenders began offering mortgage
products to would-be homebuyers who did not otherwise have the credit
history to qualify for a mortgage loan.
Lenders offered mortgages with initially low monthly payments to those
borrowers with low credit scores, an inability to fully document their
income and/or the inability to post the traditional 20 percent downpayment for a home.
Most of the loans involved a lower interest rate for the first three, five or
seven years of the loan. At the end of the initial period, however, the rate
would adjust to the then-prevailing (and inevitably much higher) rate.
Millions of Americans who could not previously afford to buy a home were
obtaining these mortgages, which in turn created a huge boom in demand
for housing. At the same time, this resulted in a dramatic rise in
appraised home values, which in turn led existing homeowners to treat
their houses as the piggy bank source of home loan credit lines.
Sub-prime loans in the U.S. were approved in record numbers.
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Overview of the
Origination and Securitization Process
1.
2.
3.
When a prospective borrower seeks to finance the purchase or
renovation of a home, refinance an existing loan, or monetize existing
home equity, the borrower may go directly to a lender or a mortgage
broker, who typically has access to various loan products.
Once the loan is approved and funded, the lender will generally pool
the loan with other like loans and transfer them into a bankruptcyremote securitization trust, or special purpose vehicle/entity (“SPV” or
“SPE”).
Lenders may continue to service the loan on the SPV’s behalf or
contract with another party which provides loan servicing. The SPV
then uses an underwriter to issue and market various residential
mortgage-backed securities (“RMBS”). These securities are split up
into tranches. Tranches are sections or slices of the same security.
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Overview of the
Origination and Securitization Process (Con’t)
4.
5.
Rating agencies generally issue a credit rating on the securities or
tranches. Higher credit ratings are assigned to those tranches
benefiting from credit enhancements, such as priority on payment of
the funds the RMBS generates and/or credit insurance purchased from
a third-party bond insurer.
Institutional or individual investors such as hedge funds or managers
of collateralized debt obligations (CDOs), purchase the securities and
then re-securitize the RMBS, along with other assets, into a CDO.
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What Happened?
• Rapid growth in subprime sector
• “Exotic” mortgages to subprime
borrowers
• U.S. home real estate slump
• Borrowers can’t refinance, default on
mortgages
• Lenders can’t fulfill buyback provisions
• Writedowns of CDOs and other
investments
• Global credit crunch
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Subprime Mortgage
Originations
Source: Hammond Associates
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Subprime Mortgages First
Reset Date
% Outstanding Mortgages
35%
30%
25%
20%
15 %
10 %
5%
0%
2004 &
E a rlie r
2005
2006
Source: FitchRatings
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2007
2008
2009
Writedowns
• More than $400 billion in
writedowns reported to date
– Financial institutions worldwide
– CDOs, investments in lenders, etc.,
credit default swaps
10
Subprime D&O Losses
How bad can it be?
Advisen forecast:
$3.6 billion
(Range: $2.6 billion - $4.4 billion)
Against $6.25 billion NEP (U.S.)
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Subprime D&O Losses
• Advisen forecast methodology
– Historic trends in settlements versus
market cap drop
– Estimated number of SCAS filed
– Estimated number of suits dismissed
– Typical limits and retentions for financial
sector D&O programs
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Litigation Targets
FIRST TIER
SECOND TIER
THIRD TIER
Bond Insurer
Banks
B
O
R
R
O
W
E
R
S
Lender
Transaction
vehicle
(SPV)
Investors
Insurance
companies
Investment
Professionals
Hedge
Funds/
SIVS
Broker
Transfer of
Ownership/Risk in
pool of assets
Issue
Commercial
Paper
• Fund manager
(offering
memorandum/side
letter)
High net
worth
individuals/
companies
• Custodian (Bank)
• Rating agencies
• Lender
• Asset Manager (Bank)
• Arranger (Bank)
• Collateral
Agent/Trustee (Bank)
• Lawyers
• Lawyers
• Accountants
• Accountants
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• Lawyers
• Accountants
Sophisticated
investors
[email protected]
Two-Year Lull in Securities Filings Comes to an End
● Between mid-2005 and the second half of 2007, securities filings had been
well below historical averages, leading some experts to question whether
there might have been a "permanent shift" to a lower level of securities
lawsuit filings.
• The typical lawsuit alleges that the
● Before such a theory could be further contemplated, however, the two-year
originated,
sold
bought
lulldefendants
came to an abrupt
end in the second
half or
of 2007.
From August to
November, plaintiffs filed the most securities fraud lawsuits in a four
high-risk mortgage loans while concealing
month period since 2004.
over many years their poor performance.
● A majority of the new lawsuits filed were related to the collapse of the Subprime market
● Continued financial marketplace volatility and the evolution of the Subprime lawsuits indicate that lawsuits will not subside.
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D&O and E&O Market Conditions:
Sub-prime Related Filings
1.
2.
3.
In 2007, attorneys filed approximately 278 Sub-prime related actions.
Broadly speaking, the actions can be divided up based on allegations into
the following categories: (1) borrower class action lawsuits, (2) securities
related lawsuits; (3) contract lawsuits; (4) employee class actions; (5) and
bankruptcy and other related actions.
Nielsen, Jeffrey, Sub-prime
Mortgage and Related Litigation: 2007 Looking Back at What’s Ahead,
Navigant Consulting, February 2008. The vast majority of the actions,
totaling 251, are still active. Id.
By far the most prevalent lawsuits were borrower class action lawsuits,
encompassing 43% of the total number of actions. The remaining lawsuits
include Securities related lawsuits (22%), contract lawsuits (22%)
employee class actions (9%) and bankruptcy and other related actions
(4%). Id.
California is the forum of choice for the majority of plaintiffs, hosting 28%
of the Sub-prime lawsuits. New York is a close second, providing venue
for 22% of the lawsuits. Delaware and Pennsylvania are also home to 8%
and 5% of the Sub-prime lawsuits respectively. Id.
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Current Regulatory Action
• Investigations
•
•
•
•
•
•
SEC opened at least 36 investigations.
Investigations by attorneys general of NY, CA,
IL, MA, CT, OH.
FBI investigating 14 firms.
EU announced investigation into rating agencies.
FSA: review of UK sub-prime market, referred 5
firms to enforcement actions.
• Investigations by authorities in Germany,
Switzerland, France, Japan, South Korea and
Singapore
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Number of Securities Class Action Filings 2001-2007
Source: Cornerstone Research. Securities Class Action Case Filings. 2007: A Year in Review. Copyright 2008 by Cornerstone
Research.
Number of Securities Class Action Filings
2001 - 2007
226
214
189
179
178
166
116
2001
2002
2003
2004
17
2005
2006
2007
Total Settlement Amounts 2001-2007
Source: Cornerstone Research. Securities Class Action Settlements: 2007 Review and Analysis. Copyright 2008 by Cornerstone
Research.
TOTAL SETTLEMENT DOLLARS BY YEAR
2001 - 2007
Do llars in M illio ns
$17,618
$9,693
$6,962
$2,002
$2,856
$2,559
2001
N = 93
2002
N = 109
2003
N = 94
$3,407
2004
N = 109
2005
N = 119
2006
N = 92
Settlement dollars adjusted for inflation; 2007 dollar equivalent figures shown.
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2007
N = 111
Median and Average Estimated Damages 2001-2007
Source: Cornerstone Research. Securities Class Action Settlements: 2007 Review and Analysis. Copyright 2008 by Cornerstone
Research.
MEDIAN AND AVERAGE ESTIMATED DAMAGES BY YEAR
2001 - 2007
Dollars in Millions
$6,508
Median Estimated Damages
Average Estimated Damages
$2,479
$2,382
$2,013
$1,958
$1,088
$612
$151
2001
$356
2002
$217
2003
$358
2004
$346
2005
$341
2006
Estimated damages adjusted for inflation; 2007 dollar equivalent figures shown.
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$210
2007
Settlements With Estimated Damages of 1 Billion +
Source: Cornerstone Research. Securities Class Action Settlements: 2007 Review and Analysis. Copyright 2008 by Cornerstone
Research.
SETTLEMENTS WITH ESTIMATED DAMAGES IN EXCESS
OF $1 BILLION BY YEAR
2001 - 2007
% of settlements w ith Estimated Damages in Excess of $1B
Total Settlement Dollars f or Cases w ith Estimated Damages in Excess of $1B
as a % of All Seelement Dollars
72%
73%
98%
88%
78%
67%
48%
27%
13%
2001
17%
2002
29%
35%
24%
18%
2003
2004
20
2005
2006
2007
Settlement Funds With Non-Cash Components
Source: Cornerstone Research. Securities Class Action Settlements: 2007 Review and Analysis. Copyright 2008 by Cornerstone
Research.
SETTLEMENT FUNDS WITH NON-CASH COMPONENTS BY YEAR 2001 - 2007
% of Settlements
w ith Non-Cash
Componenents
65%
62%
60%
Median % of Total
Settlement Value
f rom Non-Cash
Componenets
46%
45%
40%
16%
14%
9%
2001
40%
2002
2003
7%
2004
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8%
5%
2005
2006
5%
2007
Characteristics of Sub-prime Lawsuits:
Parties Involved in Sub-prime Litigation
Parties in plaintiffs’ firing line include:
•
Mortgage Lenders/Bankers/Brokers/Originators
•
Real Estate Brokers and Agents
•
Appraisers
•
Loan Correspondents
•
Commercial or Retail (Lending) Banks
•
Investment Trusts and Banks
•
Investment Funds/Investment Advisors and Asset Managers
•
Ratings Agencies
•
Directors and Officers
22
Characteristics of Sub-prime Lawsuits:
Parties Involved in Sub-prime Litigation (Con’t)
•
•
•
•
•
•
•
Real Estate Investment Trusts (REITs)
Trust Fund/Pension Plan Fiduciaries
Law Firms
Auditors, Accountants and Accounting Advisors
Bond and Mortgage Insurers
Issuers/Financial Underwriters
Securitization Trustees
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Characteristics of Sub-prime Lawsuits:
General Allegations
1.
2.
The typical Sub-prime lawsuit generally alleges that the targeted
defendants were involved in brokering, promoting, marketing,
originating, subsidizing, selling, purchasing or facilitating high-risk
loans without understanding or properly managing their ramifications.
In some cases, claimants reportedly are alleging and coming forward
with evidence that the target defendant(s) knew of and/or actively
concealed the past or anticipated future poor repayment performance of
borrowers who (with hindsight) should not have been granted loans;
By way of example, looking at the investment context, claimants
brought actions against entities which originally packaged and/or sold
securities based on mortgage portfolios without regard to the inherently
weak nature of the underlying mortgage. Claimants have also brought
actions against publicly-traded companies, financial institutions and
others which purchased such securities, alleging concealment of the
existence, exposure, or true performance of the high-risk loans in their
portfolios.
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Impact of Subprime Losses
on D&O Pricing
• Most likely will not be enough to
turn D&O cycle overall
• Pricing impact localized
• Impact will be short-lived
25
Impact of Subprime Losses
on D&O Pricing
• Advisen survey of 110 financial
sector risk managers
– 90% renewed at expiring or lower past
12 months
– 14% with coverage enhancements
– However, trends indicate more
increases in coming months
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Impact of Subprime Losses
on D&O Pricing
Changes in Renewal Premiums
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
All
Subprime
No Sub
All
D&O
Decrease
Subprime
E&O
No Change
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Increase
NoSub
Impact of Subprime Losses
on D&O Pricing
% policies w. increased premium
% Programs Renewing with Increases
30%
25%
20%
15%
10%
5%
0%
2Q07
3Q07
4Q07
D&O
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E&O
Jan '08
Impact of Subprime Losses on
D&O Pricing
SCAS Filed
600
500
400
300
200
100
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
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Impact of Subprime Losses on
D&O Pricing
ADVx™ D&O v. Composite
220
200
180
160
140
120
100
2Q01
1Q02 4Q02
3Q03
2Q04
D&O
30
1Q05
4Q05
Composite
3Q06
2Q07 1Q08
Impact of Subprime Losses on
D&O Pricing
Surplus as % GDP
0.04
0.038
0.036
0.034
0.032
0.03
0.028
0.026
0.024
0.022
0.02
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: AM Best, USBLS
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Impact of Subprime Losses on
D&O Pricing
Policyholders’ Surplus as % GDP v.
ADVx™ D&O
0.04
220
200
0.035
180
0.03
160
140
0.025
120
0.02
100
19951996 19971998 19992000 200120022003 20042005 20062007
Copyright 2007, Advisen Ltd.
Surplus/GDP
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ADVx
Types of Policies Affected
•
•
•
•
Directors & Officers Liability
Fiduciary Liability
Partnership Liability
Errors & Omissions
• Lawyers
• Auditors
• Financial institutions
• Credit Risk Insurance
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Subprime D&O Losses
Who has the exposure?
Financial Institution D&O Market Share
1. AIG
19.42%
6. ACE
4.72%
2. Lloyd's
16.82%
7. Hartford
2.72%
3. XL
11.42%
8. Arch
2.65%
4. Chubb
9.66%
9. AXIS
2.06%
5. Travelers
5.93%
10. CNA
1.96%
Source: Advisen
Based on $420 million of financial institution D&O premium written in 2006 – 2007.
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Subprime E&O Losses
Who has the exposure?
Financial Institution E&O Market Share
1. AIG
34.72%
6. XL
4.64%
2. Lloyd's
10.26%
7. HCC
3.89%
3. Chubb
8.52%
8. Zurich
2.72%
4. ACE
6.01%
9. CNA
1.90%
5. Travelers
5.25%
10. AXIS
1.81%
Source: Advisen
Based on $340 million of financial institution E&O premium written in 2006 – 2007.
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Characteristics of Sub-prime Lawsuits:
Borrower Class Actions
Generally, plaintiffs in borrower class action lawsuits filed suits against
defendants, mortgage bankers, loan correspondents, commercial banks, title
insurance companies and others. The allegations in these actions are
grounded in claims that the defendants violated several common law, state
and federal statutes when they:
1. Inadequately disclosed mortgage terms and conditions of products
such as adjustable rate mortgages (ARMs), including the costs and
effects of rate resets, and alleging causes of action grounded in,
inter alia, (1) State Unfair Competition Laws (i.e., California Business
& Professional Code §17200); (2) Truth in Lending Act 15 USC
§1601; (3) Breach of Contract/Breach of the Covenant of Good Faith
and Fair Dealing; and (4) Violations of State Consumer Laws (i.e.,
California Consumer Legal Remedies Act §1770).
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D&O Liability Insurance
Coverage A
Coverage B
Entity Coverage
Coverage provided
directly to D&Os who
are not being
indemnified by their
company, because
indemnification is not
permitted or the
company is bankrupt.
Coverage provided to
the company to the
extent that it pays
settlements,
judgments, damages
and/or defense costs
for its D&Os it is
obligated to indemnify.
Coverage provided to
the company for
claims made directly
against the company
involving the
company’s securities.
Not all policies include
“entity” coverage.
Small or No Retention
Substantial Retention
Substantial Retention
37
Typical D&O and E&O Policy Exclusions
§
The Insurer shall not be liable to pay any Loss under this Coverage Part in
connection with any Claim made against any Insured Person based upon,
arising out of, directly or indirectly, or in any manner contributable to, in
whole or in part:
38
Typical D&O and E&O Policy Exclusions:
Personal Profit Exclusion
§
the gaining in fact of any personal profit or advantage to which they were
not legally entitled.
39
Typical D&O and E&O Policy Exclusions:
Fraudulent/Intentional Acts Exclusion
§
the committing in fact of any deliberate criminal or deliberate fraudulent act,
or any willful violation of any statute or regulation.
40
Fraudulent/Intentional Acts Exclusion
§ When an Insured has committed intentionally wrongful acts, or conduct that
amounts to criminal activity, public policy may preclude the enforcement of
otherwise validly issued coverage.
§ In most states, it is contrary to public policy to permit a policyholder to
insure against liability arising from his violation of a criminal statute or
consequences of his acts that are intentionally caused.
§ Some polices may include wording that might be viewed as providing
coverage for the type of conduct precluded by public policy. Most courts will
consider void policy wording that is contrary to public policy prohibitions
against insuring intentionally harmful conduct.
§ In addition, most policies also provide that the term “Loss” does not
include matters “which are uninsurable under the law pursuant to which the
policy shall be construed.”
41
Typical D&O and E&O Policy Exclusions:
Breach of Contract Exclusion
Any and all amounts owing under a written, oral or other contract, including,
but not limited to, back pay, front pay, salary, wages, severance, and any other
benefit or obligation; however, this exclusion shall not apply if the Insured
would be obligated to the claimant even in the absence of a contract.
42
Typical D&O and E&O Policy Exclusions:
ERISA or Pension Trust Liability Exclusion
Any actual or alleged violation of ERISA or any similar law, regulation,
ordinance or provision, in connection with any “employee pension benefit
plan,” “employee welfare benefit plan” as defined in 26 U.S.C. §1002, or
“employee stock ownership plan” as defined in 26 U.S.C. §4975, of the
Company, Subsidiary or Not-For-Profit Outside Entity. This exclusion shall also
include failure to maintain Employee benefit and welfare administrators
coverage (“Pension Trust Liability”).
43
Typical D&O and E&O Policy Exclusions:
Non-Monetary Relief Exclusion
1.
any and all Loss, excluding Defense Costs, based upon, arising out of
directly or indirectly, or in any manner attributable to, in whole or in part,
equitable relief, including, but not limited to, accountings, disgorgements, and
claimants’ attorneys’ fees;
2.
the cost of any non-monetary or equitable relief including, but not
limited to, any costs associated with compliance with any injunctive relief of
any kind or nature imposed by any judgment or settlement; and/or;
3.
the costs associated with providing any reasonable accommodations
required by, made as a result of, or to conform with the requirements of, the
Americans With Disabilities Act and any amendments thereto or any similar
federal, state or local statute, regulation, or common laws.
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Underwriting Decision Process
• The challenge is always to identify “good risk”
and in doing so, we assess the following criteria:
–
–
–
–
–
–
–
–
Financial structure/ performance
Company history
Board composition & executive management
Management’s relationship/commitment with and to
their shareholders
Standards of corporate governance
Accounting practices
Business/product/geographic diversification
Reputation, brand equity and stability
45
Pricing Risk
• Pricing is a careful exercise, which takes into consideration
the individual risk characteristics of the account, which
include:
–
–
–
–
–
–
Industry
Claims/ loss history
Size of market capitalization
Location/ jurisdiction
M&A activity
Financial performance: cash flow, profitability, liquidity, asset
quality and stock performance.
• Credit Exposure Questions will be part of the renewal
process!
– Practices in this area
– What investigations are being conducted
46
Thank You!
It has been our pleasure to speak with you
this afternoon. If you would like a copy of
this presentation, please send an e-mail
to Joe Schneider: [email protected]
Please join us for cocktails upstairs!
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