IN RECENT YEARS THE BUSINESS of lending has converged with that of insurance: Banks can insure the loans they make against default; securitization, which allows for risk to be divided up and parceled out, borrows much from traditional insurance practices; credit-risk models emulate actuarial calculations; and the risk premiums on loans aren’t much different from the policy premiums charged by conventional insurers.
Insurance, like lending, is a highly cyclical business. When premiums are high and losses low, capital flows into insurance. But over time competition drives down policy rates. Premiums decline to the point where they are insufficient to cover liabilities. A crisis occurs that can only be resolved through losses and capital contraction. Something along those lines occurred at Lloyd’s of London in the late 1980s. The Lloyd’s catastrophe should have provided a cautionary tale for those who sought to revolutionize the financial world by turning the provision of credit into a branch of insurance.
The Corporation of Lloyd’s produced losses of nearly £3 billion ($6 billion) in 1990. This may seem like chickenfeed today, but at the time it was almost enough to bring down the 300-year-old insurance market. Many outside investors (known as Names), who provided capital with unlimited personal liability, were forced to sell their homes to cover losses, and several committed suicide. The problems that crippled Lloyd’s can be attributed to three sources: an excess of capital, reckless underwriting and swelling losses from U.S. asbestos claims.
This financial scandal is brilliantly told in Adam Raphael’s book, Ultimate Risk: The Inside Story of the Lloyd’s Catastrophe (Bantam Press, 1994). The underwriting capacity of Lloyd’s expanded rapidly in the 1980s, as more Names signed up. Premiums declined as too much money chased too little business. Much of this new money went to syndicates providing reinsurance (known as excess of loss, or LMX) to other Lloyd’s underwriters. This type of insurance produced big premiums and fat profits during normal times, but it also had the potential to generate vast losses. The outside Names had little understanding of the risks they were running — they were, as an 18th-century Lloyd’s underwriter is quoted in the book as having observed of an earlier generation, “lured by the golden but delusive bait of Premiums . . . drawn like Gudgeons into the vortex of this perilous Abyss, insurance.”
After a string of good years, the underwriters of LMX policies had become complacent. Their appetite for risk was bolstered by incentive arrangements that handed them a large portion of the profits in any year but no share of the losses. As Raphael relates, “All the risks were one way — the Names stood to lose everything down to their last shirt button, their agents nothing at all.”
One of the more perilous activities of LMX syndicates involved reinsuring asbestos and pollution claims on policies dating back to the postwar period. “The underwriters,” writes Raphael, “were seduced by the steady stream of premium and investment income which such business produced. Claims were few, the profits were good, and no one at Lloyd’s realized that a time-bomb was ticking away.” This last was not strictly true. Some of the smarter Lloyd’s insiders grasped at an early stage the potential extent of the asbestos claims: They sought to protect their own exposure by reinsuring with less well informed underwriters.
The ease with which insurance risks could be laid off created its own moral hazard. “The availability of exceptionally cheap reinsurance led to basic principles being flouted,” according to Raphael. “Primary insurers and reinsurers were able to accept dubious risks, confident that however bad the claims record turned out to be, they could lay off the risk and still make a handsome profit.” As a Lloyd’s official document later attested, the practice of reinsurance “undermined standards of underwriting across the market, as underwriters no longer had to exercise prudence in pricing the incoming risk correctly.”
A striking feature of the Lloyd’s reinsurance market at the time was the famous spiral. Underwriters retained only a part of the risk on their books, passing on the rest. This process was repeated many times over, resulting in a layering of risk. Losses literally spiraled upwards. For instance, the explosion at the Piper Alpha oil rig in the North Sea in 1988 cost Lloyd’s some £900 million in net losses but generated some £15 billion in claims. The reinsurance spiral was so complex and internecine that it turned out insurers were reinsuring their own reinsurers.
It took a long time for Lloyd’s to recognize the true size of its losses — profits at some syndicates were manipulated and exaggerated for years. When the losses were finally announced, they were concentrated at a handful of syndicates. The Names at these syndicates couldn’t and wouldn’t pay, which in turn threatened to bring down the whole Lloyd’s market. London’s Daily Telegraph summed up this fiasco as a “unique combination of greed, criminality and incompetence.”
Or perhaps no longer quite so unique. Developments in the credit markets over recent years have much in common with Lloyd’s during the 1980s: Excess capital drove down risk premiums. Yield chasers were attracted, during a period of low defaults, to the higher rates paid on the riskiest loans. Banks have lent irresponsibly, whether to subprime home buyers or leveraged buyouts because they could earn exorbitant fees while laying off most of the risk with outsiders. Asymmetric incentive structures, whether in the form of bonuses for bankers and profit shares for hedge fund managers, encouraged lenders to pursue short-term profits without considering likely eventual losses.
Credit default swaps and synthetic collateralized debt obligations have created a credit spiral. Losses on subprime loans have multiplied several times over with credit default swaps. The U.S. housing collapse, like asbestos claims, was flagged long in advance. Some smart insiders, such as Goldman, Sachs & Co., have used credit insurance to hedge their positions. Other banks, however, have not been as clever. Credit risk has left by one door of the bank only to reenter through another. Banks have tried to hedge their credit exposure and yet have taken on similar risks with trading desks. Citigroup, for instance, recently reported losses of $2.2 billion on its fixed-income operations.
The modern securitized credit system is far more complex than Lloyd’s system was in the 1980s. No one knows where credit losses lie nor, like those old asbestos claims, how big they will grow. Some players have delayed realizing losses by using questionable in-house models rather than market prices to determine current values. When Merrill Lynch & Co. revalued its securitized bond portfolio in late October, its losses climbed by two thirds, to $8.4 billion. The key difference between Lloyd’s and the modern credit system concerns the distribution of risk. Lloyd’s was a closed shop, where risk was concentrated in the weakest players.
The current credit crisis, on the other hand, has a truly global reach. Financial institutions ranging from Australian hedge funds to Taiwanese banks have been hit with losses on American subprime loans. Nevertheless, several concentrated pockets of risk exist in the financial world, including prime brokers, bond insurers, government-sponsored entities and derivatives counterparties at the Wall Street banks.
Last, it’s uncertain where the losses will fall when the multitrillion-dollar credit default swaps spiral starts to unravel. Picking up premium income while writing insurance at uneconomic rates may seem like a good idea until the claims start coming in. Only as mortgage and corporate loan defaults rise will we discover whether modern credit insurers have sufficient reserves to cover losses. The experience of Lloyd’s suggests we shouldn’t be too confident on that front.
Edward Chancellor, an editor at Breakingviews.com, is the author of Devil Take the Hindmost, a history of financial speculation.
