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By DAN REYNOLDS, senior editor of Risk & Insurance®.

Observers of the world of financial services risk management are watching a sector that acts as if it is holding its collective breath.

If they became insolvent, the reasoning went, the entire global financial system was at risk of collapse. And that may be true, a global collapse may have been staved off through U.S. government intervention. But there is so much uncertainty that remains for those who manage that sector's risk.

Large banks are now facing regulation that seems bent on determining that they not become too large. And smaller, regional banks are under tremendous pressure. Their cost of risk is rising and they seem unable to generate enough in their loan portfolios to create enough revenue to lessen the pressure.

Unemployment is still above 9 percent nationally and the residential housing market is still weak. Those two elements are the underpinnings of most regional banking business, and that is not good news for those banks. It makes managing their risk a dicey and expensive proposition.

"I think that a lot of these community banks that we are supporting, a lot of them were based in real estate or were lenders to developers, and so you were seeing these portfolios continue to deteriorate, and without the ability to raise capital they are not able to make new loans which enables them to grow their business," said Chris DiLullo, a Washington, D.C.-based senior vice president with Lockton Cos. LLC, who works mostly with middle market financial sector clients.

California, the nation's biggest job market, has shown some improvement since May 2010, but according to the latest figures from the Bureau of Labor Statistics, that state's May 2011 unemployment rate was still a nasty 11.7 percent, compared with 12.4 percent the year before. Not all that much improvement there.

Such traditional economic bulwarks as Florida, with an unemployment rate of 10.6 percent, and Michigan, with a jobless rate of 10.3 percent, also still have high levels of joblessness.

So what does this mean for insurers? Having banks that are hobbling around on one foot means that insurers are taking far smaller pieces of each financial institution's risk.

Kevin Kelley, the CEO of Bermuda-based specialty insurer Ironshore and the former CEO of insurer Lexington, remembers the days when Lexington and its parent company AIG sought large chunks of the business of Fortune 2000 finance companies. That's a behavior that Kelley said no one will be seeing much of anymore.

"It wasn't uncommon for us to have 60 percent to 70 percent of a Fortune 2000 account and our goal always was to try and cross-sell more into that account," Kelley said.

"I really do think because of what has occurred in the financial services meltdown no company today is going to be allowed to gain that kind of position as a counterparty insurance risk and that is not meant to be critical of AIG or anybody else. It is just a fact of life.

"Any imbalance in counterparty exposure is going to be looked at acutely and dealt with and we do the same thing here in terms of looking at our reinsurance counterparty risk," Kelley said. "That is regardless of what we think of a client or rather a reinsurer we don't want anybody to dominate our portfolio because of the uncertainty that continues to be associated with the future."

Another behavioral change, according to another financial sector risk management professional, is that financial sector risk managers are getting much more access to the C-suites. The financial sector has been chastened by its failures and is seeking to do a much better job of vetting its enterprisewide risk.

"I think there is more of a holistic look at risk across the firm and I think financial institutions are looking at different silos of risk, what could potentially take down the firm," said Brian Wanat, a managing principal and national practice leader for Aon Risk Solutions Financial Services Group.

"Is it overzealous regulators? Is it fraud? Is it reputation? Is it errors and omissions? And seeing what they can do within those silos of risk to either minimize it or transfer it or negate it etc., so it absolutely positively has more board time these days.

"Given the fact that the insurance market has been a buyers market for the last number of years I think a lot of folks are keenly interested in using some of that savings to potentially buy broader and more coverage and transfer more risk," Wanat said.

"So those who have not purchased more insurance are buying it or at least looking at it, those that currently buy it are buying more limit and broader coverage so there is insurance has never been more important when it comes to these products."

And that may well be true, but if you read every line of a U.S. Senate panel's recent report on the financial meltdown, you get a picture, at least from a reputational risk perspective, of a financial sector whose reputation may never recover, no matter how much risk transfer occurs.

Just look at the stock price of Citigroup Inc. The stock valuation of the massive bank, part of which is still owned by the U.S. government, is still languishing at 1993 levels despite a market capitalization that rivals many other big banks that are trading much higher.

The big rating agencies, the Moody's and the Standard & Poor's, and investment banks Goldman Sachs and Deutsche Bank come off very poorly in the report, which was authored by the Permanent Subcommittee on Investigations, Committee on Homeland Security and Government Affairs. The subcommittee was chaired by U.S. Sen. Carl Levin, a Democrat from Michigan, along with U.S. Sen. Tom Coburn, an Oklahoma Republican, the ranking minority member.

For one, the panel attacked the "pay to play" approach that is still in place in the issuance of financial-sector ratings. How can any rating agency give an objective analysis of a bank's position, if that bank is paying that agency tens of thousands for that service?

"Evidence gathered by the subcommittee shows that the credit-rating agencies were aware of problems in the mortgage market, including an unsustainable rise in housing prices, the high risk nature of the loans being issued, lax lending standards, and rampant mortgage fraud,'' according to the Senate subcommittee report published on April 13.

"Instead of using this information to temper their ratings, the firms continued to issue a high volume of investment-grade ratings for mortgage-backed securities," the report's authors wrote.

In addition, the report lambasts the likes of investment bank Goldman Sachs for urging clients to invest in mortgage-backed securities and at the same time betting against them.

The report lists four major causes for the financial sector collapse:

-- Lenders introduced greater amounts of risk by selling complex home loan derivatives rife with high risk and poor underwriting.

-- Credit-rating agencies listed mortgage investments as safe investments when they knew they weren't.

-- Federal banking regulators "stood on the sidelines" as large financial institutions invested in these risky mortgage-backed securities.

-- Investment banks added to the risk by creating unregulated swaps that allowed investors to bet on the failure of the mortgage-backed securities.

In June, J.P. Morgan Chase & Co. agreed to a $153.6 million settlement with the U.S. Securities and Exchange Commission on charges that it misled investors about the due diligence provided for housing market related securities that it sold to investors.

Goldman Sachs settled similar charges from the SEC for a record $550 million in 2010.

"The case study examines in detail four collateralized debt obligations that Goldman constructed and sold called Hudson 1, Anderson, Timberwolf and Abacus 2007-AC1. In some cases, Goldman transferred risky assets from its own inventory into these CDOs; in others, it included poor quality assets that were likely to lose value or not perform. Goldman's short position was in direct opposition to the clients to whom it was selling the CDO securities, yet it failed to disclose the size and nature of its short position while marketing those securities," according to the Senate report.

The Senate committee report calls on regulators to implement several measures to forestall any more investment bank abuses.

Those measures include reviewing structured financial transactions, limiting proprietary trading exceptions, designing strong conflict-of-interest prohibitions and studying the role of federally insured banks in designing, marketing and investing in structured financial products.

And June's settlement from J.P. Morgan isn't the end of the story. Many observers think that more Federal Deposit Insurance Corp. consent orders are going to be issued for a host of banks that find themselves in distress; that and there will be more investor class-action lawsuits.

But perhaps the biggest fault for this fiasco lies with Congress itself. It was the U.S. Congress in the space of three years that repealed Glass-Steagall, barred the federal regulation of swaps and encouraged the retention of securitized mortgages with investment-grade ratings

"I just have to believe another shoe or shoes are going to drop here," Ironshore's Kelley said. "The government doesn't want to see a lot of litigation in this area but I think you can't have a meltdown of that size without some litigation cost."

Meantime, the cost of insurance for distressed community banks is already prohibitively expensive, Lockton's DiLullo said. "I would say for banks that are in distress it can be very expensive, it can be multiples of what they paid in the past," DiLullo said.

For insurers who want a piece of the business of larger banks, going very carefully is now the way, Ironshore's Kelley said. The syndication model, with a number of underwriters sharing the risk as opposed to just a few, is the way now.

Kelley points to the success of Lloyd's of London, which in this soft market has seen double-digit growth in its combined syndicates.

"Their growth rate over the last three years is in the 25-plus range and that is in a market that has, as you know, been soft on the insurance side, so that is certification of what we believe to be this trend," Kelley said.

August 23, 2011

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