1 September 2011Life

The contagion of a Greek tragedy

The term ‘tragedy’ can be traced back to Classical Greece, its origins derived from the words for ‘goat song’, a choral composition sung before the ritual sacrifice of the animal. Greece’s present tragedy echoes much of the term’s original meaning—Greece now unhappily playing the role of the sacrificial animal. Its predicament is largely a product of its own long-term fiscal ill discipline, but the pain it will endure for years to come will be stark. The recent bailout by the EU, which reduced interest on the eurozone rescue package, artificially strengthened Greece’s ability to borrow, and extended the maturity on current and future loans, helped matters, but still leaves the country in a hole—if a less deep one than prior to the deal. However, both Moody’s and Standard & Poor’s reacted to the news by cutting Greece’s debt rating, viewing the eurozone’s move as a ‘selective default’. Real default looms, even with the EU’s €109 billion injection, the concern being that Greece will contaminate other troubled European economies. And looking to the likes of France, Italy and Spain, it would appear that the contagion has already spread.

Greece’s unhappy kinsmen

Greece’s pain looks set to be only the start, with Ireland, Portugal— and more significantly—Italy and Spain all looking as though they might slide into the financial abyss, with the rather uncharitably named PIIGS proving that the mantle given them a time ago by Goldman Sachs was not entirely unwarranted. Ireland and Portugal never really climbed out of the recent recession, but recent rumblings suggest that France, Italy and Spain’s economic ascent may yet be short-lived. Contagion from troubled EU economies appears to be spreading, raising the prospect of a dreaded ‘double dip’, as was predicted by some back in 2008.

Adding further fuel to the fire, political horseplay between Democrats and Republicans in the US regarding raising the country’s debt ceiling helped to generate sufficient market uncertainty to prompt a creditratings downgrade. Debate over the debt ceiling wasn’t the sole driver behind the move—the first in the US’s history—but it appears to have served as a trigger. And the latest twist in the ongoing crisis is the downgrade of Japan’s credit rating, the Asian powerhouse the latest in an unhappy line of leading nations facing the censure of the ratings agencies—this time Moody’s. All this paints a grim picture, with issues in Europe, the US and now Japan likely to have significant ramifications for the global financial markets. Should Italy or Spain go belly-up, following Greece, Ireland and Portugal on the road to default, things would likely get a whole lot worse, creating an investment environment best described as ‘troubled’.

Reinsurers will likely find themselves unhappily caught up in the ensuing drama, but the questions remains: what impact will events in Europe and the US have on Bermuda reinsurers, and how can they mitigate against the effects of an increasingly troubled investment environment?

Under the microscope

In response the situation in Europe, A.M. Best said that re/insurers will have to “re-examine their underwriting leverage” in response to events. The ratings agency warned that if firms do not pay attention to such concerns in the present economic climate, then their rated financial strength could well be impaired. The ratings agency added that firms with sovereign debt could not expect to maintain leverage at “historic levels”, with their recommendations suggesting that a shift towards corporate stocks might be in the offing. And speaking with Tatsuhiko Hoshina, president and chief executive officer at Tokio Millennium Re, it is clear that, for his company at least, a shift towards a more corporate focus on its US investments is likely. Addressing the ongoing debt crisis in the US, Hoshina said that Tokio Millennium maintains a “very conservative” investment portfolio, with a heavy weighting to US governments and agencies with a weighted average credit rating of AAA for the entire portfolio, but said that given the uncertainty around the implicit guarantee of government-sponsored agencies and the negative state of the US government finances, the company has begun to diversify into more corporate bonds. However, the crisis in Europe, the US and Japan has made a flight to quality that bit harder, with traditionally conservative instruments such asgovernment bonds not the safe harbour they have previously been. As A.M. Best outlined, economic crises traditionally “cause portfolios to shift away from emerging market assets toward high credit quality assets in the developed world”, but with concerns focusing on formally ‘safe-hand’ jurisdictions such as Italy and the US, ensuring assets maintain their worth has become that bit more complicated.

Bermuda players: well positioned

Nevertheless, addressing reinsurers’ investment in conservative instruments, Brian Schneider, senior director at Fitch, said that much had been learnt during the recent economic crisis. Bermuda players have moved to de-risk their portfolios and maintained increasingly “clean and conservative positions” that will help insulate them from the present crisis in the capital markets. With conditions making yield problematic, he said that the majority of players are “staying very short right now” with an emphasis on cash “given the volatility of the market”. He added that there were few opportunities for reinsurers to “go out on the yield curve”, encouraging firms to maintain existing positions, which emphasise diversity and do not generally contain risky concentrations of those sovereign instruments currently under fire.

"There were few opportunities for reinsurers to go out on the yield curve, encouraging firms to maintain existing positions, which emphasise diversity and do not generally contain risky concentrations of sovereign instruments currently under fire."

Addressing Bermuda’s exposure to European debt, Brad Kading, president and executive director of the Association of Bermuda Insurers and Reinsurers, said that “ABIR members manage their investments carefully against their own guidelines for minimising risk in investments. Generally, insurance underwriters take the view that the risk they assume should be in underwriting accounts not in investment accounts. European sovereign debt investments would be well diversified in the aggregate investment portfolio.” However, with the US and Japan now finding themselves in hot water, it seems likely that a combination of troubled European, US and Japanese investments could result in worrying accumulations of risk on even the most diverse of portfolios. As A.M. Best outlined, with re/insurers being “large-scale investors in US treasuries and government-backed instruments”, they are likely to experience “a larger impact from a decline in the credit quality of the US government than many other industries because of the asset leverage insurers hold”.

However, talking with Schneider, he was confident that Bermuda reinsurers don’t face significant issues in the short term. Rather the concern is how matters will develop from an investment standpoint going forward. As Schneider made clear, “the opportunities for investment returns are definitely more limited” at present, with perhaps the most interesting dynamic being its potential impact on underwriting. With investment returns down, Schneider suggested that conditions will encourage greater underwriting discipline. On the investment side, he said that Bermuda players had learnt valuable lessons in the recent economic crisis, with firms “opting to stay fairly clean”, more happy to take on risks on the liability side of the book when the pricing is right. Asked if conditions may yet build to a ‘perfect storm’, Schneider said that it was possible, with the wind season a potential “wild card”, but it was clear from talking with him that the investment environment is unlikely to prove a significant worry for Bermuda reinsurers.