Financing the Business Sector - Case Study Example

Financing the business sector during the credit boom and the credit crisis (2004-2010): The Case of the Insurance Sector in the United Kingdom 2010 Introduction The international finance crisis that began with the sub-prime problem in the United States in 2007 spread around the world in the middle of the year, gathered force in 2008 as a number of global banks went bankrupt and inter-linked stock markets affected growth processes in the developed as well as the developing world. While most of the international financial crises of the 1990s erupted from the emerging economies in Asia and Latin America because of inadequate domestic monetary and fiscal regulations, the 2007-08 crisis had its roots in the developed world because of spiraling asset prices, especially house prices, on the back of loose monetary policies and lax lending standards (Mohan, 2008). On the other hand, emerging economies in Asia were less affected by the financial crisis because of decoupling of economic growth in this region from the developed world. As a result, to tide over the crisis following reduced business in the home countries, many companies in the United States and the United Kingdom have been aggressively expanding in Asia. In particular, insurance companies in the west, which have been predominantly dependent on the booming home property sector over 2004 to 2007, found their revenues falling drastically since 2007, leading to significant consolidation of the sector and expansion in Asia rather than in the home countries. Besides, insurance companies based in the United Kingdom had been better protected from the financial crisis than the US ones since they had been maintaining substantial capital buffers since 2003. This paper will discuss the sources of growth of the global financial system during 2004 to 2007, on which the origins of the financial crisis of 2007 lay, the impact of the crisis on the global insurance sector, with particular reference to the UK, and the fallout in terms of restructuring of UK insurers, with examples of a large player (Prudential Insurance), a medium-sized insurance broker (Jardine Llyod Thomson) and a small insurance underwriting company (Novae Group). Credit boom The sub prime crisis that erupted in August 2007 was feared to result in depression in the global markets in a manner similar to the 1929 crash followed by the Great Depression. The crisis in a way was the result of a prolonged period of low interest rates in the United States and Europe, which prompted demand for mortgages. Over the period 1997-2007, the pound lost value against most other currencies primarily because of the development of the financial services sector. London grew as a major financial center as the UK attracted huge doses of foreign investments. Investors from many of the countries that had trade surpluses with the UK began to acquire financial and real estate assets in the UK, which was supported by a low interest rate regime that also induced consumer credit in housing boom (Price Waterhouse Coopers, 2009). This set in force speculative activities in the stock exchanges and in the real estate market which led to the crash of many financial institutions, like the Northern Rock, in the UK. By 2007, economic activity had grown on the basis of consumer spending and business services. Since 1999, UK households had been deficit spending, implying that they were borrowing in the mortgage market and selling assets to the non-residential sector, mostly corporate entities. At the same time, the US housing sector had been booming as banks had lowered interest rates to stave off the depression after the dotcom bust in 2000. Banks in the US as well as the UK found them over-exposed to credit, particularly in the sub prime accounts that had low credit rating. Investors had been buying securities backed by these uncertain assets (Economist, 2007, a). The collaterals were formed when rating agencies clubbed together individual assets that were found to be risky into collateral debt obligations (CDOs) of banks. Defaults in these sub prime accounts in 2007 resulted in a snow balling effect on the entire monetary economy as the CDOs were downgraded and banks found themselves burdened with illiquid assets (Economist, 2007,a). Assets that are based on these collaterals became impossible to trade. By October 2007, multinational financial institutions like Merril Lynch had to report huge losses on account of write-down of non-recoverable loans (Economist, 2007, b). The developments in structured finance and the increasing sophistication of the credit market resulted in over-burdening of financial institutions with illiquid assets. The same instruments that had assisted central banks to diversify risks and manage inflation earlier became to source of illiquid assets. The effect of the mortgage market on the economy is not new. The housing market affects monetary policies, thereby affecting interest rates and financing of companies, through direct effects on the user cost of capital, expectations of future movements of housing prices and the supply of housing as well as indirectly through effects on the real economy. The latter influence works through wealth effects of housing prices, credit effects of consumer spending and the subsequent effects on housing demand. The housing sector has the potential to result in overall financial instability both in the real and monetary economies and eventually lead to a situation in which the central banks are unable to stabilize the situation (Mishkin, 2007). Housing wealth was also accompanied with non-housing wealth through the stock markets. However, consumption spending reacts to housing wealth more than it does to non-housing wealth, as has been found by various studies (Mishkin, 2007). The housing market and US monetary policy have been intricately linked with each other for a long time. Particularly in the 2000s, the fed induced a boom in the housing market by keeping interest rates low. This was perhaps a result of the spiraling of housing prices since the mid-1990s at the height of the dot com boom. The housing boom began in 1998 when assets in the west coast cities of Seattle, San Diego, Lons Angeles and San Francisco went through the roof (Shiller, 2007). Thereafter, home prices not only spiraled across the United States but also across Europe, the United Kingdom and Asia. Then, with house prices on a rising spree, there was little risk of delinquency on mortgages. Credit crisis Delinquency and foreclosure began to grow since the mid-2000s, culminating in the sub prime crisis (Taylor, 2007). Since the housing boom could not be explained by rise in construction costs, much of it was in effect speculative bubbles. Besides, with the credit market becoming more and more sophisticated, the housing market developments affect consumer expenditure as well, thereby having an economy-wide effect (Muellbaur, 2007). With the availability of collaterals and liberalization of the credit markets, the housing market had a ‘wealth effect’ through the stock market. For about a decade, availability of housing credit and spiraling of house prices, a large number of families in the United States and the United Kingdom accumulated significant wealth (Muellbaur, 2007). This was also supported by developments in information technology in the financial system, sharing of credit history between institutions, development of securitization and derivatives. As a result, consumers altered their spending pattern as they got more loans on the housing assets. Although lenders, that is, banks and financial institutions, spread their risks across assets and economies, borrowers increased their vulnerability to changes in the housing market. It was found that as house prices rose, first-time house buyers had to save hard while existing house owners tended to increase their consumption spending by an amount higher than the increase in the value of the asset. This meant that existing house owners increased their exposure by a higher amount purely on the basis of expectation of the continuing spiral. At the same time, banks, insurance companies and financial institutions too formed highly leveraged off-balance sheet securitized vehicles to hold some of their securities at higher rates. As interest rates began to rise by the mid 2000s, the rate mortgages were reset higher that induced many of the borrowers to default (ILO, 2009). Impact of the Credit Crisis on the Insurance Sector The City of London has emerged as the international insurance market comprising insurers and reinsurers. Key players are the UK insurance companies, Lloyd’s Syndicate and foreign insurance companies, with a number of non-resident companies with no direct business in the UK but operating through the Lloyd’s syndicates. UK companies authorized by the regulator, FSA, can simultaneously operate in the member states of the European Union as well as in Iceland, Norway and Liechtenstein and, with a branch, in Switzerland (HN Revenue and Customs). The insurance market comprises of life insurance and general insurance, including motor vehicles and health, as well as the insurance brokerage companies. The first impact of the global financial crisis was a downward spiral of house prices, including commercial property. Since insurance costs are directly related to house prices, profitability of insurance companies worldwide was hit hard by the financial crisis in 2007. As consumer spending was hit by job losses as a result of the financial crisis, non-life insurance companies too faced reduced revenues. Besides, with consolidation of many financial institutions, insurance intermediation through brokers also found their fortunes dwindling. The brokerage industry went into a consolidation phase, with the emergence of ‘super brokers’ like Towergate, Oval and Giles, which soon led to rise in commissions demanded by the brokers (Stride, 2008). The push to acquire volumes in the times when property valuations were low meant that rates and premiums continued to fall. Since insurers fix the premium on the basis of the “rebuild” cost rather than the market value, the financing of the insurers depends on the construction industry rather than on values of house properties. With the credit crisis during from 2007 onwards, the construction companies had been slashing prices to get as much business as possible as a result of insurance bills fell. However, many insurance companies did not reduce the premium rates as they had to pay claims on flood damages (Telegraph, 2009). Most UK insurers did not face the brunt of the global crisis as did their US counterparts because they were forced to keep aside large chunks of their capital buffers in 2003 as part of the regulatory requirement. As a result, UK insurers are well-placed to take over markets across the world, particularly those that US insurers like AIG, which have been most strongly hit by the crisis, are forced to exit (ABI, 2010). The effect of the credit crisis was worse on the insurers than it was on the reinsurers, the latter having accumulated healthier capital for cushioning than insurers had. Insurers faced reduced capital of about 25 to 30 percent globally but this did not stop them from buying reinsurance as part of their safety net. Demand for reinsurance capital emerged from capital erosion of insurers and lack of capital alternatives as the debt market fell and insurance valuations declined. Insurers’ asset valuations fell to the lowest levels and the ability of insurers to raise capital through equity or rights issues were limited because of the low book values and price multiples as well as low ratings of insures. Investment incomes were also low to offset the underwriting losses and asset devaluations (Aon Benfeld, 2009). Prudential Insurance Prudential Insurance is the largest insurance company in the UK, has operations in 12 countries in Asia and also owns Jackson National Life in the United States. Globally, it has 21 million customers (Insurance Companies UK, n.d). In 2010, the insurer took over Hong Kong based American International Assurance, AIG’s life insurance wing that have been struggling in the financial crisis since the bailout of the parent company, for GBP23bn in a bid to aggressively expand in the far eastern market in view of the slump in the domestic market and also the continuous fall in sterling over the recent past. Compared to the western markets, the markets in China, Indonesia and Korea have grown an enviable savings fund with relatively less developed insurance and financial markets. For Prudential, Asia has been a key market and in 2009, it accounted for 44 percent of its new business profit after tax. The combined group, including Prudential Health and others has 60 percent of new business profit after tax generated from Asia. Prudential leads in seven of the 13 Asian markets it operates in. Besides, the market in Asia is driven by demographics, with larger proportions of young population, and long term economic growth. In contrast, sales from the UK market fell 12 percent as the company deterred from underwriting businesses or sell products that required large amounts of capital to be backed (ABI, 2010). The global financial crisis and the difficulties of US insurers, most particularly AIA, have thrown up opportunities for Prudential in markets were AIA had greater market share. For example, AIA leads in six out of the 13 Asian markets, including Thailand and the Philippines, where Prudential has been attempting to increase market share. In particular, south east Asia – Indonesia, Malaysia, the Philippines, Thailand and Vietnam – where the Asian crisis of 1997 was followed up with stricter financial vigil and hence was less affected by the US-led global meltdown in 2007, offers lucrative business prospects. Insurance penetration in these markets is low, with insurance written being only about 5 percent of GDP (Dunkley & Ahmad, 2010). Jardine Lloyd Thomson Jardine Lloyd Thomson (JLT), the largest UK insurance broker that competes with US brokers Aon and Marsh, restructured its business in 2009 even though its turnover from retail and London market operations grew. The company is engaged in risk management advice, insurance and reinsurance broking and provision of employment benefit services. As the underwriting business of the company’s various lines of distribution grew, Thistle – the company’s general underwriter – became a major focus after the acquisition of the specialist UK insurance managing agent, Ingham (Insurance Age, 2010). JLT also acquired HSBC’s insurance broking business in a bid to grow through acquisitions (Insurance Age, 2009). Novae Group Novae Group, founded in 1986 as SVB Holdings, is an insurance underwriting company and one of the major beneficiaries of the dotcom in the late 1990s, having insured start-ups and medium enterprises, suffered heavy claims damages when the boom burst but regained with London’s emergence as a financial hub. Restructured under the leadership of Matthew Fosh, who has expertise in derivatives, the company entered into reinsurance business and expanded in Asia after the meltdown (Harrington, 2009). The group also formed Zurich-based Novae Re which now underwrites reinsurance of property, liability, agriculture, engineering and other specialist businesses through the Lloyd’s Syndicate since 2007 (Greenwald, 2009). Performance Comparison Small insurers and brokers flourished during the emergence of small and medium enterprises and the city of London as the financial hub in the early 2000s, which brought about smaller companies like Novae under the radar. Following the dotcom bust in 2001, these companies’ sales growth fell drastically. On the other hand, large insurers like Prudential, which did not face significant upturn during the boom also found their sales growth much reduced. Subsequently, with the credit boom, smaller insurers and brokers performed better. During the credit crisis, these companies could weather the storm better while large insurers like Prudential had to expand into untapped overseas markets to maintain profitability. Sales growth (% p.a) year-on-year Net profit growth (% p.a) year-on-year Return on equity Operating Margin Conclusion The global financial crisis in 2007 was the result of the housing boom supported by low interest rate regimes in most economies. With the emergence of sophisticated financial engineering and collateral derivatives, financial institutions in the US and the UK became over-exposed to sub-prime accounts that soon began to default as consumers increased spending on the basis of housing wealth. Insurers and insurance brokers thrived on the housing and financial services boom. The credit crisis that erupted in 2007 with the subprime crash in the US soon spread across the world including the UK. Insurers faced decline in revenues as house values crashed. Large insurance companies like Prudential have been expanding abroad, particularly in Asia which have remained relatively insulated from the downturn and face the prospects of a growing market on the basis of economic growth. On the other hand, smaller insurers like JLT and insurance brokers like Novae have restructured and consolidated businesses to focus on the City of London, which, too, have had better capital buffers than the US markets. Works Cited ABI, Prudential Gambles with Asia with $35bn deal, March 1, 2010, http://www.abi.org.uk/Media/Articles_and_Speeches/47754.pdf Aon Benfeld (2009). Reinsurance Market Outlook, January, http://www.aon.com/attachments/AON_Reinsurance_Market_Outlook_2009.pdf Economist (2007a), “The game is up: Banks in trouble”. August 16, 2007 Economist (2007b). “Financial Markets: Spooking investors”. October 25 Economist (2007c). Northern Rock: Soft-touch Regulation. October 11 Dunkeley, Jamie and Kamal Ahmad (2010) Prudential and Aviva draw battle lines in global insurance war, Telegraph, March 6, http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/insurance/7385185/Prudential-and-Aviva-draw-battle-lines-in-global-insurance-war.html Greenwald, Judy (2009). Novae Re formed to Tap Improving Reinsurance Market, Business Insurance, August 20, http://www.businessinsurance.com/article/20090820/NEWS/908209985 HM Revenue and Customs, The UK Insurance Market: The London Market, http://www.hmrc.gov.uk/MANUALS/gimanual/gim1230.htm Harrington, Een (2009). Novae set to merge Novae Insurance with Novae Syndicates, December 6, Telegraph, http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/6745000/Novae-set-to-merge-Novae-Insurance-with-Novae-Syndicates.html Insurance Companies in United Kingdom, http://www.insurancecompaniesinuk.com/ Insurance Age (2010). JLT to restructure business to maximise benefits of managing general underwriter Thistle, March 2, http://www.broking.co.uk/insurance-age/news/1594332/jlt-restructure-business-maximise-benefits-mga-thistle Insurance Age (2009). JLT acquires HSBC Insurance Brokers business, http://www.broking.co.uk/insurance-age/news/1564056/jlt-acquires-hsbc-insurance-brokers-business International Labor Organization (2009), Impact of the Financial Crisis on Finance Sector Workers, Issues Paper for discussion at the Global Dialogue Forum on the Impact of the Financial Sector on Finance Sector Workers, http://www.ilo.org/wcmsp5/groups/public/---dgreports/---dcomm/documents/meetingdocument/wcms_103263.pdf Mishkin, Frederic S (2007). “Housing and Monetary Transmission Mechanism”. August. Board of Governors of the Federal Reserve System Mohan, Rakesh (2009). Global Financial Crisis – Causes, Impact, Policy, Responses and Lessons. Speech at the 7th Annual India Business Forum Conference. London Business School. 23 April 2009. Accessed on March 24, 2010 from http://www.bis.org/review/r090506d.pdf Muellbaur, John (2007). “Housing, Credit and Consumer Expenditure”. Revised on September 14. Presented at “Housing, Housing Finance and Monetary Policy”, an economic symposium sponsored by the Federal Reserves Bank of Kansas City on August 31-September 1 2007 Price Waterhouse Coopers (2009). The Future of UK Manufacturing: Reports of its Death are Exaggerated. Observations, analysis and recommendation, April, http://www.pwc.co.uk/pdf/UKmanufacturing_300309.pdf Shiller, Robert J (2007). “Understanding Recent Trends in House Prices and Home Ownership”. Presented at “Housing, Housing Finance and Monetary Policy”, an economic symposium sponsored by the Federal Reserves Bank of Kansas City on August 31-September 1 2007 Stride (2008), How the Financial Crisis is affecting the UK Insurance Market, October 21, http://www.stride.co.uk/insurance-news-and-articles/commercial-insurance-articles/business-insurance/how-the-financial-crisis-is-affecting-the-uk-insurance-market/87/ Read More