Summary: The real story here will be if Crystal Credit closes per its current terms and conditions. Will capital market investors buy under-priced credit risk, originated by P&C (re)insurers, except at a big discount? Will Swiss Re shareholders happily accept a "haircut" as the price of a "marquee" for management? Fortunately, potential investors don't have to labor over all this. Crystal Credit is nothing new. If it doesn't stack up to comparable deals already in the market--Steer Clear!

Last Thursday, December 8, 2005, the Wall Street Journal reported in an article titled Swiss Re Steps up Risk Shift that Swiss Re, the world's largest reinsurer, is now in the market with a Euro 252 million bond issue, to securitize its trade credit insurance policies.

Despite the announcement, Swiss Re is being cagey. The reinsurer "has been assessing investor interest in the issue…[and] declined to comment on its plans, but investors [who have been approached, expect the issue]…to be closed by the end of the year". And no mention, whatsoever, about pricing.

Anyway, you have to ask why they seek publicity about a private placement [?] that is still under negotiation [??]. Perhaps, new management is setting the stage for a "marquee deal" announcement [???].

Some observers characterize Crystal Credit as an innovative, insurance-linked securitization (ILS), that expands and breaks new ground in the tiny--mere $6.5 Billion outstandings after nearly 10 years--ILS market. However, the issue has absolutely nothing to do with "conventional" Property & Casualty insurance risks (e.g. earthquake, hurricane, auto) that have been ILS'ed, before.

Keep these distinctions--ILS vs CDO, "P&C insurance" vs "capital markets"--in mind as you read through the Offering Memorandum, if you can get a copy. Rating agency capital charges differ for the same credit risk , depending upon its form (e.g. trade credit policy vs loan or guarantee). It so happens that agency capital charges for credit risk documented in P&C insurance policy form are materially lower than capital market forms, nothwithstanding that the underlying obligor is the same. The lower the required capital, the lower the price (i.e. "premium", on the underlying trade credit policies). When there are 2 prices for the same risk, 1 party has 1 big problem. That is why P&C insurers (their "product" guys, NOT their asset managers) are at the bottom of the credit food chain.

That is also why banks and finance companies lay-off their lending portfolios to P&C Insurers, "buying protection", in insurance policy form, to achieve capital relief. It generally makes no sense to move credit risk the other way around, from the P&C industry (lower capital charge) to the capital markets (higher capital charge)--unless they sell the underlying assets at a big discount.

How do Swiss Re shareholders feel about this? Is a "marquee" for management worth the price of the haircut?

It sure will be interesting to see how Moody's handled this. When they rated tranches of Crystal Credit--B, Ba2 and Baa2--were they using their P&C or their capital markets capital charges? They say "an A is an A is an A". However, when "an A is an A . . AND a C", it raises serious questions about Moody's credit rating policies.

Commercially, investors who buy credit risk portfolios originated in P&C (re)insurers' product lines do so at grave risk. P&C companies compete against banks, who understand credit and price it to the capital markets. In contrast, P&C insurers lack "credit culture" and habitually under-price credit risk, when compared to the capital markets. This is one of the reasons why they blow-up and destroy shareholder value, perpetuating the "insurance cycle".

Before you rely on agency ratings to invest in P&C insurance policy-originated credit risk, do the following reality checks:

Check out McKinsey's excellent work, "The Journey", which evidences a 6.5% historical P&C Industry ROE, compared to mid-teens ROE for other financial service sectors going back some 20 years (sorry, no link).

See also Swiss Re's share price [under]performance, halving in value over the last five years.

Finally, recall another Swiss Re "marquee deal" in 2000. Back then, they used insurance form to structure what they said was "a first of its kind" wrap of a natural gas production payment credit facility. (See the October 9. 2000 edition of National underwriter for an article titled Swiss Re New Markets Targets Energy Sector.)

So far, so good--except that money-center bank energy teams have routinely done production payment loans since the mid 1970's.....even so, it took Swiss Re a "good 9 months" to close....and it was for Enron! Ultimately, they lost over $60 million. (See the PR Newswire for 12/19/2001 titled Swiss Re Reports Loss Estimate Resulting from Enron Bankruptcy).

Something tells me Crystal Credit could be in the market a long time, as well. However, if Swiss Re's new management needs a "marquee" to build market presence, they will close "something" at some point ("finite"?). It would be nice to compare the deal(s) terms, before and after, though.

Fortunately, investors don't have to wrestle with issuer motivations or Crystal Credit's ratings in pricing the deal. They can just price to a comparable credit risk, say a middle market bank Collateralized Loan Obligation [CLO], and see if it stacks up. If it doesn't, STEER CLEAR!

Aside from this, the 3Q call was uneventful. Revenue pressures continue. New competitors, alternative "financial guaranty" products (e.g. senior-subordinated structures) and narrow credit spreads that persist in virtually all credit markets--all challenge the 15+% ROE the company has until recently been generating for investors. However, anyone who follows the industry knows this.

But what about the adequacy of that $92 million on $1.1 billion notional principal amount??? On one hand, you could say that ABK, known for its relative "transparency", is conservatively provisioning its Katrina exposure.

"Everyone" knows--and the rating agencies support the view, through allocating next-to-zero capital charges to "municipal" debt--that munis don't default, they just restructure. So, "$92 million is conser... ", you get the picture.

Alternatively, ABK could, also conservatively, argue: "we might have to pay some debt service on bonds of a few hard-pressed localities--BUT we will recover in full. Munis HAVE to make us whole--or they will look bad in the capital markets and be precluded from future borrowings, which they can't... etc., etc. Therefore--we're NOT booking ANY Katrina provision".

Yet another alternative--if you don't buy the "munis can't default, so I can't lose" argument, you could say that the entire principal amount -- $1.1 Billion -- is at risk! This is because "contagion" spreads quickly in the financial markets. Borrowers ape behavior of similar borrowers who have "gotten away with it", especially government borrowers.

Recall that a few months ago, Argentina simultaneously "cleared its name" and reneged on $ Billions owed private investors. WSJ: Bondholders await Argentine Payment. Now, you read that in Africa, Zimbabwe says it may have to nationalize investments to compensate for the economic losses of its own making... and then there's Venezuela: WSJ: Chavez Says Venezuela to Cancel All Existing Mining Concessions.

Once you go the route of questioning rating agency muni capital charges and therefore financial guarantor muni exposure, why stop at Katrina exposure? Why stop at AMBAC? Yes, it is scary--I mean, at least half the financial guarantors' $ Trillion+ guaranty portfolios are muni risk.

This wouldn't be the first time rating agency models have not performed as advertised. Remember Asia and emerging markets (1997), Russia (1998), Enron (2001), CDOs (2002... going forward)???

One thing missing from Ambac's 3Q earnings call: Disappointing that Ambac did not address efforts as regards new businesses to generate "15+% ROE" for shareholders. Yes, credit spreads are narrow. But what else is management doing?

The point here is that ABK's $92 million Katrina provision is neither "too little" nor "conservative". It just "is". And for now, it provides a good opportunity to legitimately stockpile earnings reserves, should competitive revenue pressures continue and "15+% ROE" be a thing of the past.

The article begins:

Insurance companies for years have been buying insurance policies for themselves that are akin to the product at the center of a criminal investigation into whether American International Group Inc. helped a cellphone distributor manipulate its earnings. Critics say the policies are sometimes insurance in name only. That is because the premiums or other payments are so big that the seller assumes little or no risk, making them like loans that help buyers smooth their earnings and shore up their stock price. The reason: Insurance proceeds count as income and offset losses, while a loan must be counted as a liability -- a debt that must be paid off over time.

I'm posting all of this to my new weblog because I'm planning to do a follow-up blog post on the issue, now that nearly a year has gone by. Stay tuned.

Very good and timely article. Keep digging, you've just begun unraveling the ball of string...

You got it. Finite is a loan (usually with indeterminate due date). Finite "smoothing" has spread beyond reinsurance into mainstream corporates world-wide, to the detriment of F/S users. Most main (re)insurers actively underwrite these products in several forms. Paradoxically, few insurers "make money" on finite because they don't manage it as credit risk. FASB itself, is one of the causes of finite's murky disclosure.

For follow-up articles, you may want to consider that..........

"AIG [refers to a] one-of-a-kind policy". AIG is INCORRECT. AIG, and many other major (re)insurers have several groups that offer finite insurance, many in competition with each other, at the same company. Just check leading insurer websites and you will see references to finite solutions. And many conventional product lines (e.g. D&O, surety, workers comp, business interruption, etc.) are structured in finite form to achieve the same result. This enables carriers to truthfully claim: "we don't write finite anymore [we closed the finite dept]", while writing earnings-smoothing covers in other guises. Continuing investigations [SEC, Spitzer, CT, Cal, NJ] will likely show that finite earnings-smoothing structures have spread far beyond the P&C industry, where they originated and are pervasive, into mainstream corporates, in the US and overseas. Virtually all (re)insurers are selling these.

"the economics favor the insurer". NO--they are neutral. That's like saying "economics of debt favor borrower over lender" or vice versa. The market clearing price doesn't favor either. Finite is oddly an under-priced loan and capital markets penalize under-pricing quickly, with disasterous results. Consider Centre Solutions--long the leading light in finite insurance. Look at their WSJ ads circa 2002: (effectively) "we can do things the capital markets can't". Centre lost Zurich over $1BN from credit-related covers (one wonders how many of these were reinsured by Converium). In practice, very, very few (re)insurers manage finite as credit risk; those that do get the capital market spread, nothing more.

"disclosure is murky...industry specialists have a hard time deciphering [significant risk transfer from in-substance loans]". YES and NO. Financial (re)insurance disclosure is governed by FASB 113, which practitioners find easy to structure around. Deciphering is a problem because the insurance industry is complex to outsiders [even experienced industrial analysts who are unfamiliar with it].

* So, a P&C securities analyst reviewing a P&C insurer can possibly identify finite exposures in the insurer. However, not being familiar with commercial practices in other--energy, transportation, retail, banking, etc,--sectors, he would find it difficult to identify accounting effects on earnings or f/s elsewhere in industry (in the absence of a meltdown). Similarly, an industrial securities analyst familiar with his industry specialty will have a hard time finding earnings smoothing via a finite arrangement.

* This is because the finite "policies" masquerade in different forms. One major Financial Services company recently entered into an earnings-smoothing arrangement [i.e. finite deal] with a major reinsurer, under the guise of a "marketing joint venture", where credit losses in one year were, through the arrangement, spread over several years.

In my view, FASB itself is a cause of "murky disclosure". FASB 113 and FASB 133 (for derivatives) contain quantitative tests which structurers/auditors model, pass and take comfort in. Perhaps recent SEC decisions moving auditors to consider qualitative materiality of F/S presentation will clarify these and other disclosure issues?

This arcane area needs some sunshine to get it up to capital market--professional and disclosure--standards. Hope this helps your pursuits. Thanks and regards.

Insurance (let alone Reinsurance) is "that industry...over there" to the overwhelming majority of us. Say you meet a random character in town. He tells you "I work in aerospace (or energy, or banking, or whatever)" and you have a broad idea of what goes on there, whether he's a travel agent or airline CEO (hmmm...maybe on his way to a meeting arranging D-I-P financing). However, with insurance, you really don't know (...must be actuary, or....oh oh!..."look--I don't need anymore insurance, nice to meet ya, have to run!").

Then, Insurance insiders reinforce this perception. "We don’t know our Cost of Goods Sold until AFTER we sell the product", they say. Some of the industry is highly regulated, in the US--by states. Product lines employ specialized underwriting techniques, actuaries and their own technical jargon. Further, Property & Casualty ("P&C") Insurance is bought and sold in opaque and illiquid markets. However, P&C Insurers, as a group, generate a low 6% historical average return on equity (!) which is well below the rest of industry--and which helps explain why it's "different". Whether this low return is due to low inherent risk--or questionable commercial practices--in the P&C industry remains a topical issue today.

In Other Words... will be a dialog "on insurance issues" between YOU, our visitors, and someone who has "been there, done that" (me). I'll start with a piece giving my take on a topical issue, say every 1-3 weeks or so, more or less often as events occur. In addition, I'll keep an eye on the financial media and offer comments on "newsy" developments. I'll focus on P&C Insurance, initially--since the industry remains in the spotlight of New York State Attorney General Elliott Spitzer and SEC investigations.

In Other Words... will assist "financial" visitors unfamiliar with the insurance industry. You are skilled in your line of work, be it banking, hedge fund portfolio management, corporate treasury, government regulation, commercial law, business media--but you want to cut through the jargon and fluff and discover what is going on in this arcane industry. Alternatively,.....

In Other Words... will assist "industry insiders" who need to make a compelling case, in Plain English, for their business model to outsiders, be they prospective investors, lenders, regulators--or other "reasonable persons".

In Other Words... Throughout all this, I want and need your views--but you'll have to be a PRMIA member to comment.

Perhaps together, we can make sense of this "opaque and illiquid" market?

I have been a corporate banker, reinsurer, business start-up manager and portfolio manager, at major institutions and boutiques in the financial services industry, in the US and emerging markets, for more than 20 years. I hold degrees from Columbia (MBA) and Cornell(BS).

As Managing Director at GE Insurance Solutions (ERC), the reinsurance arm of GE Capital, I focused their Insurance/Capital Markets convergence strategy and started-up a credit enhancement business, including processes of asset origination, underwriting and portfolio metrics, surveillance and team building.

I had global responsibility for developing and managing a $3 billion portfolio of investment grade and B-I-G credit risks embedded in P&C products that had the highest ROI of any business line. I built a Web-based internal underwriting service to control distribution and identify problematic risk exposures for remedial action.

My "credit" skills have few equals, anywhere. As a direct result of my efforts, GE Capital:

• Avoided "Enron". And $200 million + losses and resulting high-profile litigation that embroiled nearly every major reinsurer.
• Curtailed "Finite Insurance" sales. Virtually alone in the industry, I flagged these controversial products, long before prosecutions made headlines that destroyed reputations at the highest executive levels. Today, per WSJ (5/3/05), ERC "earns less than 1% of global premium from finite insurance" sales.
  
  
• Controlled broker distribution. My Web-based internal advisory service processed 300+ proposals, across multiple product lines, avoiding inadequately structured transactions, broker conflicts and upgrading documentation.
  
  
• Avoided Argentina. Right before Peso/$ parity ended, I led the due diligence team that identified flaws in the model of a surety insurer, recommended against acquisition and prevented losses of $30 million +.

• Control distribution
• Integrate product silos
• Upgrade systems
• Uniform credit risk management for Assets and Contingent Liabilities

EDWARD J. GREBECK
P. O. Box 112
New Canaan, CT 06840-0112
_________________________________________

Tel: 203-329-1539
Mobile: 203-326-0177
edgre@optonline.net