S&P Report Warns Insurers on Financial Guarantees

Following Enron’s collapse and the lawsuit filed by JP Morgan Chase against several insurers, Standard & Poor’s undertook a thorough review of the risks involved in underwriting financial guarantees as opposed to traditional surety bonds. Their conclusion: “Surety insurers should not be seduced by high premiums into underwriting financial guarantees.”

In a report issued yesterday, S&P pointed out the difference in accepting liability risks on specific projects, such as construction completion bonds, and the dangers insurers run when they take on “risk from the banking world.”

Mark Puccia, a managing director with Standard & Poor’s insurance ratings group, noted that “Banks are sophisticated in managing credit risk, but that’s less often the case with insurers. There’s a real concern insurers are accepting risk they’re less familiar with.”

The JP Morgan lawsuit over Enron’s gas delivery contracts certainly illustrates Puccia’s conclusion. Morgan claims it insured the future delivery of natural gas by Enron to Moragn’s offshore subsidiary Mahonia Ltd. As Enron is bankrupt, it can’t deliver the gas, and therefore Morgan wants repayment of the money it advanced to buy it. The insurers claim that Morgan in effect loaned the money to Enron, which would have eventually ended up delivering gas to itself. They’ve refused to pay on the policies, and the litigation is likely to last for some time while investigations continue into Enron’s collapse and the exact nature of the policies, i.e. surety contracts, or financial guarantees.

S&P points out that, although the business is profitable, it’s extremely risky, especially so when an economic recession hits and bankruptcies rise. Puccia further warned of “other very large exposures where insurers are now recognizing they have taken on surety business with many of the same risk characteristics as financial guarantees, especially in the oil and gas transmission area.”

There are warning signs that an underwriter should recognize. S&P Director Thomas Upton put it succinctly, stating, “As professionals, you’re supposed to look a gift horse in the mouth occasionally.”

The report explains that, “For surety bonds covering supply agreements, typical premiums are about 0.1% of the exposure. For construction projects, 2% is the norm, but insurers should be wary, analysts say, when they are commanding reported premiums of 2.5%-10% for delivery coverage and up to 15% for construction.” Fred Sklow, a director of S&P’s insurance ratings group, warned that, “Such huge differences should not escape the notice of insurers’ senior managements. A flag should go up somewhere. Someone should raise the question.”

If flags aren’t raised, the results can be catastrophic. If Morgan wins its lawsuit, it collects over $1 billion, plus interest and court costs, effectively doubling the net underwriting losses of $ 870 million incurred in 2000 (as against net premiums written of around $3.3 billion). The report concludes that the problems have “greatly reduced surety underwriting capacity.” This development together with “soaring premium rates, a slowing economy, and a drastic reduction in payout limits as insurers spread their risk,” presents U.S. commerce with very difficult conditions.

The full report, Alarm Bells Ringing in U.S. Surety Market, is available on RatingsDirect, Standard & Poor’s online research database, at http://www.ratingsdirect.com/. It can also be found under ‘Property/Casualty.’