Insurer, Protect Thyself

The implications of the credit crisis require insurance organizations to take steps both to protect the organization and, at the same time, to create potential opportunities. Continued volatility and uncertainty are likely to pervade the markets for the foreseeable future. Inactivity would clearly result in increased losses for organizations that do not understand their current exposures or establish processes to cope with the uncertainties. At a minimum, the following considerations should be evaluated by management in the context of the current crisis:

o Pricing of Investments and Derivatives Portfolios. Management should evaluate its pricing and price validation policies and procedures to determine whether the current processes adequately address escalating current issues. This overview should include:

–The increasing demand for improved governance.

–Stronger price validation controls.

–More comprehensive independent model review.

–Enhanced management reporting.

If the market perceives a lack of strength in management's pricing process or if errors occur, a crisis in confidence could rapidly result in a dramatic destruction of shareholder value.

o Counterparty Exposure Analysis. Management needs to quickly identify and aggregate exposures to companies in distress or at risk. Actively mitigating pre-and post-bankruptcy exposures through netting, and identifying, exercising and managing transactional trigger events will be critical to loss mitigation. No one knows if, when or which financial institution will be the next to suffer a loss of confidence and start a downward spiral. Organizations need to understand their exposures to all material counterparties and have sound mitigation strategies that provide rapid response in the event of a new crisis.

o Liquidity and Cash Flow Analysis. The quality of liquidity management, cash flow forecasting and working capital management should be challenged and revised to recognize the current market environment. Management typically relies on a presumed set of available sources of cash to meet working capital and liquidity needs. However, management should now consider whether those sources of cash will be available in times of crisis. Stress scenarios and cash alternatives need to be considered or organizations could find themselves in situations where funds are unavailable at the time they are needed most. Regulators may become more rigorous in requiring companies to demonstrate that they can enforce their financial support arrangements.

o Operational Requirements. Management should evaluate the impact of the recent financial crisis and its implications for the organization's operational needs. An immediate need will be to minimize the impact of counterparty bankruptcy or future insolvencies. This action requires identifying and exercising bankruptcy/insolvency trigger events, determining which contracts will automatically terminate upon bankruptcy, and utilizing master netting provisions and cash-settling contracts before they become entangled in bankruptcy courts. Managing the movement of cash and netting of exposures, putting in place new netting and novation agreements and actively managing exposures before bankruptcy are critical. These actions can have a material impact on realizing cash recoveries in a timely manner.

Many organizations will discover that they are not able to address critical needs due to resource constraints. Timely loss mitigation is heavily dependent on flawless operational execution over the next few months.

o Transactions and Restructuring. Insurance organizations are in the process of evaluating sales of distressed, as well as prized operations to unlock liquidity and survive financial turmoil. Early planning, tight management of due diligence, ability to identify and understand the key issues rapidly and effective negotiation skills are critical in today's environment of short/compressed deal deadlines or restructuring events. Some significant assets may become available. Organizations that cannot take advantage of these opportunities will discover their more prepared and nimble competitors have achieved a strategic advantage.

o Regulatory Compliance. Companies need to ensure that their reporting and compliance frameworks are capable of meeting demands that regulators are likely to place on any insurer whose financial stability is questionable. Additionally, insurance organizations can expect that insurance regulators are likely to review and increase the capital requirements for all insurance enterprises, further pressuring the profitability of operations.

o Tax Analysis. As the period of uncertainty unfolds, management will need to be keenly aware of tax issues that could arise. Any write-down in asset values may create a deferred tax asset (requiring evaluation and determination as to whether it may be recognized). In addition, the losses sustained by some companies will result in tax losses that may be carried back or forward. The losses may be limited in an acquisition context or may impact the recognition of other tax attributes such as the foreign tax credit. Understanding the tax implications–both cash tax and financial statement impact–of these changes is critical in viewing the broader picture.

While uncertainty lies ahead, the recent market events illustrate that insurers can take action to help safeguard ratings and assets, and to mitigate exposure to loss. Organizations that are well positioned, prepared and nimble may well be able to capitalize on the dislocation in the market.

Peter R. Porrino and Robert W. Stein are LexisNexis contributing authors and are, respectively, Ernst and Young's Global Director of Insurance Industry Services and Ernst and Young's Global Leader of Actuarial Services. Peter R. Porrino can be reached at [email protected]. Robert W. Stein can be reached at [email protected].