Estimating the Credit Crisis Insurance Losses

The arrival of the harder market could be delayed but could be even more disruptive when it arrives.

On Nov. 5, 2008, the insurance information firm Advisen issued an updated forecast of insurance losses likely to arise from the credit crisis, estimating aggregate directors and officers (D&O), and errors and omissions (E&O) losses of $9.6 billion, up from the firm’s February 2008 $3.6 billion forecast. 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.

There are several considerations that make any present attempt to quantify the insurance industry’s credit crisis-related exposure particularly challenging.

What We Measure

Both the credit crisis and the associated litigation have expanded and evolved since the problem emerged in early 2007. What began as a subprime meltdown has now become a generalized downturn affecting the broader economy. The economic turmoil has produced its own associated litigation, and further litigation seems highly likely. It has become increasingly difficult to define what is and what is not “credit crisis-related.”

The absence of definitional clarity makes predictions particularly precarious. The very attempt to quantify credit crisis-related losses implies a categorical precision that may no longer exist.

The Uncertainty of Events to Come

Any estimate of the insurance industry’s overall credit crisis-related exposure necessarily incorporates assumptions about the number and seriousness of lawsuits yet to be filed. The estimate also includes certain assumptions about how much longer the new lawsuits will continue to emerge. Advisen suggests that the lawsuits will continue to accumulate into 2009; I believe they will continue to emerge well beyond the end of 2009. But any attempt to estimate 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.

These considerations suggest 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, it is particularly difficult now to try to estimate the insurance industry’s overall exposure from the credit crisis related litigation.

That said, 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.

The insurance industry has not yet reacted fully to these developments. To be sure, companies in the financial sector are now seeing D&O insurance price increases and a more challenging underwriting environment. In addition, several factors could indicate 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.

Companies generally are unlikely to experience a hard D&O insurance market until insurers are reporting substantial calendar year losses across their D&O portfolio.

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 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.

Hard Times Coming

As a result, 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, if AIG’s travails and other carriers’ investment portfolio woes produce a shortage of insurance capacity, the hard market’s arrival could be accelerated.