Estimating Insurance Losses From the Credit Crisis

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. That said, several considerations make any attempt to quantify the insurance industry’s credit crisis-related exposure particularly challenging.

1. What are We Measuring? The credit crisis and 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.

2. Measurement Distortions. Most attempts to describe the credit crisis exposure reference the total number of securities lawsuits. But several companies have been sued multiple times on behalf of different sets of claimants. If successive lawsuits hit the same insurance program, they are less likely to increase the insurance industry’s overall losses.

Courts so far have proved skeptical that investor losses in the context of a market-wide meltdown are the result of fraud. It is too early to generalize, 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 based on 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 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 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; they could continue to emerge well beyond the end of 2009.

Attempts to estimate insurance losses entail certain assumptions about lawsuits yet to come, and the magnitude of the losses estimated will vary materially depending on the assumptions used. Due to the existence of competing considerations, it is particularly difficult 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. Whatever the loss projection might have been in February 2008, developments since that time suggest 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.

However, 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.

As a result, the arrival of the harder market could be delayed, and 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.