Collateral damage

Editor's letter

The debate over the steps and missteps of September and October 2008 will rage for years. How did regulators miss the danger of Lehman going under? Why was AIG allowed to become the Long-Term Capital Management of credit derivatives? Will the Henry Paulson or the Alistair Darling approach to bank bailouts and depositor protection ultimately prove more economically beneficial?

Aside from a few egregious examples of poor governance such as AIG, the biggest impact on insurance companies and pension funds has been in terms of collateral damage. They were not responsible for the pressure cooker effect of reckless lending, overleveraging of balance sheets and tightening credit spreads in the way that banks collectively were. Nor were they responsible for weak banking regulation or government misjudgements that stoked the crisis.

However, the galloping destruction in asset value and extreme volatility that swept the global markets from Lehman Brothers onwards has proved difficult for insurers and pension schemes. Questions about their own solvency and liquidity have grown.

At times, these concerns have appeared overdone, and some commentators have seemed too quick to lump insurers with banks, or to forget about all the lessons learned since the last downturn. That said, sometimes life is not fair. The role of risk management is to think about all the unfair, nasty things that can happen and try and prepare for them in a cost effective way.

Recent events do no more than emphasise to insurers and pension funds how risk management is supposed to work. It starts with the balance sheet. Does anyone still doubt today that a solvency-based approach based on market-consistent assets and liabilities (at least for non-state institutions) should not be the essential starting point?

Next comes risk governance. One-in-two-hundred year events are not laboratory curiosities cooked up by your actuary. Sometimes they can happen every week. Is it part of your business model to survive such events or not? If you bought insurance against such risks, was it watertight when you needed it? In such environments, the 'use test' becomes a 'survival test'.

Then there is communication and transparency. Today, insurance companies and pension funds once more find themselves criticised for opacity. Since we launched Life & Pensions over three years ago, we have followed the debate over economic capital, embedded value and funding ratios in detail.

It is a truism that every model is wrong. But can it be any surprise that those firms which have put the most effort into calculating and reporting these kinds of numbers are doing better than those that haven't?

Part of the collateral damage of the crisis is that there will be fewer places to hide for those players that take lax or unorthodox approaches to risk management. For example, the UK's mysterious Universities Superannuation Scheme (USS) refuses to discuss the impact of recent volatility on its equity portfolio, prompting some stakeholders to worry about its governance and regulation. Across the Atlantic, state level regulators told our recent US pensions briefing some shocking stories about the governance lapses by local government plans that permit stretched actuarial assumptions to drive cities into bankruptcy.

In the insurance and pensions sector, we hope the worst is over. But the message of poor governance is that additional collateral damage of the credit crunch may be yet to come.

Cover image: Interior of the Jin Mao Building

Design & Architecture: Skidmore, Owings & Merrill

Location: Pudong, Shanghai, China.