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Enron: who knows what skeletons will emerge? |
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The collapse of Enron has numerous implications for the insurance industry, not least on the credit risk side. But identifying them, let alone quantifying them, is not proving to be an easy task – either for the insurers themselves or for the analysts who cover them.
Insurance companies have moved strongly into the credit derivatives business in recent years – writing credit default swaps in particular – and multiline insurers have also moved into the credit enhancement business, which was formerly the preserve of monoline financial guarantee companies such as FSA, MBIA and Ambac.
Enron’s messy collapse has triggered a process of unravelling and unwinding the company’s derivatives positions that could take several months – and also triggered at least some of the default and bankruptcy contracts in the derivatives markets.
Losses relating to Enron exposure will be felt extensively throughout the insurance and reinsurance industry, quite apart from straight investment losses. John Hancock, for instance, has already announced $320 million of investment exposure, heading a lengthening list of life insurers and general insurers that have announced asset losses. In Europe, Axa has declared a fixed income exposure of e200m.
Standard&Poor’s estimates that the direct exposure of US insurers alone to Enron on the asset side is more than $3.5 billion. Besides being owners of Enron bonds, insurance companies are big buyers of collateralized debt obligations (CDOs), many of which had Enron as a component and are likely to suffer ratings downgrades and losses as a result.
Besides losses on the insurance and reinsurance of directors’ and officers’ liability, writers of protection on Enron default swaps will also be hit, as will writers of conventional financial guarantees and writers of non-traditional financial guarantees or sureties.
In terms of surety exposure, Chubb has announced a $220 million loss, Swiss Re estimates its exposure to be $173 million while CAN, Travelers, Safeco, Hartford, St Paul and Partner Re have all announced smaller exposures. Others such as Ace and XL – which became big writers of credit enhancement and credit derivatives during the recent soft insurance market in an effort to maintain high returns on capital – have said their exposures to Enron are minimal.
Morgan Stanley estimates that the industry-wide surety exposure to Enron will top $2 billion, although the firm cautions that it is difficult to get any clear view. But the derivatives exposures present an even more complex and murky picture. “The more you look into this, the more confusing it gets,” says one equity analyst.
As a triple-B credit in derivative markets where high credit ratings are preferred, Enron had to put up collateral to enter into trades with many of its counterparties – usually commercial and investment banks. Normally such collateral is high-grade, liquid government securities or cash. To minimize its cash needs, Enron often substituted surety bonds from insurance companies or letters of credit and guarantees from banks and other parties. This had the effect of transferring the risk beyond the natural counterparties, which would otherwise have been a relatively small group of companies.
In turn, those with Enron exposure often sought to protect themselves by obtaining credit protection in the form of credit default swaps, letters of credit or guarantees.
“We did some deals with Enron and they always said they were willing and able to enhance their credit, and that they had no problem getting up to triple-A through enhancement at modest cost,” says one insurance company executive.
Industry observers are in no doubt that there will be many more skeletons coming out of cupboards as the Enron mess starts to sort itself out over the coming months. “I get kind of worried when I see how few announcements have been made by insurance companies about their exposures, in comparison to those made by the banks,” says one leading consultant. “I know what kind of business they have been writing in recent years and it concerns me that their risks may have been aggregating in an unexpected way.”
Insurance executives say the industry will absorb the losses from Enron comfortably enough. “I would be very surprised if Enron was a significant event to the insurance industry – if you compare it with September 11, for instance,” says a risk transfer specialist. “But it may well affect the enthusiasm of some insurers to be involved in these markets and products.”
“The insurance industry has not always been very good at taking the time to understand the risks that it is underwriting,” says a consultant. “This means they get used as a source of naïve capital from time to time.”
In terms of credit derivatives, he adds: “How well did they understand the product and the risks involved in what they were doing? And why do insurance companies seem to think they are better at pricing credit risk than banks? Anyone who writes a lot of credit will tell you that this is an exceptionally cyclical business. All credit tends to go bad at the same time.”
Identifying which firms are most exposed is virtually impossible at this stage. But it is a fair bet that the disputes among insurance companies over contracts and claims relating to Enron will be on a scale unlike anything ever seen before in the capital markets.
“We haven’t seen anything like this before. There are going to be disputes breaking out all over the place and the ISDA documents will come under a huge amount of pressure,” says one broker.
“The only people who are going to enjoy this are the lawyers.”
