Could Hurricanes Blow Subprime Debt Investors Away?

What happens if large-scale hurricane losses arise when securitized debt markets are tanking or seizing up? Might reinsurers be required to fund claim payments at the same time they face losses and illiquidity in their investments?

In 2005, hurricanes Wilma, Rita, and Katrina wreaked devastation in Florida, New Orleans, and much of the Gulf Coast. Insured losses set a record for a single year. Catastrophe reinsurance providers took a significant hit, but they generally stood behind their promises to pay catastrophe claims.

Reinsurers don't issue policy promises with hot air. After writing business and accepting premium payments, they don't just take the money and run, either. They invest those funds, and investment portfolios stand behind their insurance promises. Reinsurers have been paying their record 2005 losses with cash generated by liquidating investments.

As the 2007 hurricane season is getting under way, another storm has been brewing. "Subprime" mortgages and other loans have been growing in number and losing value. Investment bankers have developed huge pools of securities based on bewildering arrays of these assets. Uncertainty about the value of these securities has generally risen, and liquidity in the market has been drying up.

With fewer people willing to trade a growing share of these securities, "market" prices are growing scarce. Market prices are available for derivatives on these securities, however, and the recent news hasn't been good. In the past few weeks, the derivatives markets have been indicating accelerating losses. This is true across the rating spectrum, with even "AAA" instruments falling in value significantly.

All Reinsurers Are Not Alike
Among the publicly traded reinsurance companies, there is a wide range of practices for investments in mortgage- and asset-backed securities. At one end of the spectrum are firms with minimal exposure, like  Fairfax Holdings (FFH) and its subsidiary  Odyssey Re ,  IPC Holdings ,  Transatlantic Re ,  Renaissance Re (RNR), and  Everest Re (RE). These firms hold very little securitized debt. Catastrophe reinsurance is important to Odyssey, IPC, and Ren Re, but their risk of any combined hurricane-investment storm season is minimal.

At the other end of the spectrum,  Endurance Specialty Holdings ,  Allied World Assurance Company Holdings ,  Axis Capital Holdings (AXS),  Platinum Underwriters  and  XL Capital  each had more than one third of their fixed-maturity investments in mortgage and asset-backed securities at the end of 2006. None of these firms have reported significant deterioration in the value of their portfolios, at least through the first quarter of 2007. However, accounting returns may be lagging reality, as they often do.

Raining in the Backyard, Snowing in the Front?
In Sir Arthur Conan Doyle's mystery "Silver Blaze," a prize horse is stolen from a stable on the eve of a race. Sherlock Holmes picks up a significant clue when he learns that the stable dog didn't bark during the evening. The conspicuous silence points the way to solving the crime.

Amidst increasingly widespread concern in securitized debt markets, and how much "prime" debt is really "subprime," some dogs haven't been barking. In this case, the dogs are accounting results.

Any way you look at the reported results, there doesn't seem to be a significant problem in the investment portfolios of the reinsurance firms that I follow, at least through the first quarter of this year. The reported investment results for firms with relatively high concentrations in mortgage- and asset-backed securities have yet to show any significant deterioration. In fact, their investment portfolios actually appear to have outperformed those for reinsurers with low exposure to those areas. This is true even in the first quarter of 2007, when concerns about subprime securitized debt markets intensified.

Like the quiet dog at the stable, this could point to a bigger problem. The accountants may know the miscreants a little too well, or they might be muzzled by their standard-setters. We must also realize that reinsurers holding significant securitized debt positions may indeed be invested in well-performing segments of the markets. Even if they aren't, in a few years we may be able to look back at the current mess and be able to say with confidence (and hindsight) that this was a great buying opportunity. Experts will then laugh at the Cassandras.

Given these possibilities, we have raised our sensitivity to reinsurer management communication about investment results. We have yet to change most of our fair value estimates because of this issue alone, but that might not be the case after 2007's second-quarter earnings results come in, and market conditions deteriorated significantly in July. We encourage investors to listen carefully to the upcoming earnings conference calls for discussion about this topic.