1 January 1970Asset management analysis

Financial crisis: the asteroid threat

The title of this paper may be rather dramatic and lead readers to believe that it will promote a theory of a cataclysmic cosmic event, something akin to the asteroid strike that is thought to have seen off the dinosaurs. Actually the topic is rather more prosaic than that, but it deals with an event no less catastrophic to our industry.

While captive insurance companies may be established for a number of corporate reasons, a primary one is to deal with the transfer of risk from the parent, while retaining premium, or a measure thereof. It is hoped the captive will in time turn a profi t and build up reserves for any future loss.

Money will inevitably fl ow in to the reinsurance industry as the capital markets hunt for investment returns and it is the threat from the markets—both to our industry and the fabric of the captive insurance network—that I intend to explore.

"The greatest threat to our operations comes from the capital markets, with the financial crash of 2008-2009 leaving us in no doubt regarding their ability to devastate the industry."

The theory I will advocate is multi-faceted and has areas of complexity that would require a tome of considerable dimensions for me to expound my views and theories as to what went wrong. Neither format nor space will allow this and it would not serve the purpose to try to compress words of in-depth technicality into the space available. In any case, there are people better qualifi ed than I todo that, those with a more detailed knowledge of the intricacies and structures of reinsurance protections and the mysteries and fl aws of the capital markets.

What I wish to do is present you with a different view of the perils I believe threaten our industry—threats that were previously deemed so remote that we discounted them as fantasy.

Cosmic predictions

Most of you will have heard the prophecies of the doomsayers that in 2012 there would be a cosmic event of considerable importance— some may say of dire consequence—to our planet. It was the planetary alignment when the sun came between the earth and the centre of our galaxy, the Milky Way. All sorts of cataclysmic events were predicted, but December passed without any events of particular note. That is another story altogether, but there are parallels with our industry.

Until now we have always considered our underwriting teams as the most serious threat to our operations, even if the scale and number of underwriting failures has been limited. Now however it is evident that the greatest threat to our operations comes from the capital markets, with the fi nancial crash of 2008–2009 leaving us in no doubt regarding their ability to devastate the industry.

Is this likely to change? Have the capital markets learned their lesson? Will we now encounter a sea change in their approach to the machinations and manipulation of the markets and the creation of apparent wealth? Perhaps, but I do not believe so. The reason for this is that peer pressure will drive most, if not all, of the players down the same road.

Why would this be? Simply put, it is because boards of directors and shareholders will not accept a different path. It is therefore likely that the focus will remain on short-term gain, coupled with ongoing longterm uncertainty.

So will we need to wait another 79 years before the next financial crash? I do not believe so. Globalisation and our current global corporate structures will not allow such a period of respite. History will repeat itself and in a shorter time than the capital markets would have us believe.

There is, essentially, one plan, one methodology that most investment houses have followed to maximise earnings and that, regretfully, has proved to be grievously flawed. So how do we protect ourselves against this threat? There are four marked lines of defence.

The auditor

First, there are the auditors. Their task is not to tell us that, in their opinion, a reinsurer’s investment portfolio is sound and its philosophy prudent. We would, however, expect a better standard than Arthur Andersen displayed at the rather undistinguished end of its existence. The irony is that:

  • Aruther Andersen did not lose its ability;
  • Its staff did not lose their expertise; and 
  • They didn not lose their knowledge. 

The question becomes: did the staff of Arthur Andersen become corporately incompetent? No, I do not believe so. What I believe happened is that they lost their moral compass.

The rating agency

The next line of defence is the rating agency. It is here that that we should expect a more holistic approach, as they examine companies and assess their financial strength. They must look beyond the financial details of a particular company and examine the capital markets globally while expounding their views on the reality of their supposed wealth. In effect, does the Emperor really have new clothes? They need to join the dots for us.

The regulator

Third in line are the regulators. Again we should perhaps expect a more intrusive approach to what is going on throughout the capital markets. Perhaps it would be a good idea to ban the capital markets from trading in the types of instruments that produced a short-term gain for a few but were never based on real, tangible wealth—and that is an exceedingly diplomatic comment. Regulators should be given more powers and have the confidence that they will be free from political interference.

The government

Governments around the world should examine the validity of many financial instruments and if they are in any way spurious then they must take swift action to ban them. No half-measures should be tolerated if governments are to have the confidence and respect of the populace at large and, of course, the business community.

The solution

The capital markets must abandon the casino and get out there and assist in the generation of real, tangible wealth. They must be much more accountable (and a little humility and repentance would not go amiss), remembering that they are charged with the care, custody and guardianship of other people’s money.

Now, back to the asteroid threat. Imagine that we have no knowledge of events in 2008–2009 and a new, big and brash reinsurer bursts on to the scene that we will call the Universal Planetary Reinsurance Company.

What would happen if this fictitious reinsurance company had:

  • Auditors with the moral compass of Arthur Andersen;
  • The ethics and business plan of Enron; and
  • A banker of the breed of Lehman Brothers; coupled with
  • A government more concerned with preening itself for re-election rather than watching the barbarians? 

To leave you with a final thought, I would argue that our global economy is so interlinked and has been allowed to binge to the point of financial gluttony that perhaps there is little point in any single company trying to be prudent, or trying to be moral. The next financial tsunami may well wash away the guilty, but taking with them the innocent … and that is a truly frightening thought.

Ian Sangster is CEO of QIC International. He can be contacted at: