Subprime crisis could lead to D&O, E&O claims

Lawsuits already have been filed by borrowers, investors and other affected parties

By Phil Zinkewicz

Although the effects of the current subprime mortgage crisis on home buyers may be obvious to even the most casual observers, the potential ramifications, as far as the insurance industry is concerned, have yet to be fully explored.

For home buyers, developments have been devastating. A recent poll of 1,744 mortgage brokers released in August 2007 showed that 57% of mortgage broker customers with adjustable rate loans were unable to refinance into a new loan to avoid higher monthly payments. The survey also found that a third of home purchase closings were canceled in August alone. Lehman Brothers has stated that roughly 5 million adjustable rate mortgages will reset to higher rates in the next 18 months. Economists are warning that the housing slump could deepen if those home owners are unable to refinance loans, as lenders tighten underwriting guidelines and home values stagnate or fall.

But for the insurance industry, opinions vary as to whether some portions will benefit from the subprime mortgage crisis, some will only be slightly scarred by recent developments, or some will face claims that will total near-catastrophic proportions.

For example, in an interview with Reuters, Michael Fraizer, chief executive of Genworth Financial, a retirement and mortgage insurer spun off from General Electric Co. last year, said he expects his company to benefit from the subprime mortgage crisis as government-sponsored enterprises write more mortgages.

“We have an opportunity for revenue growth as Freddie Mac and Fannie Mae take more of the market,” he said. “That’s good because they may require mortgage insurance.”

He said that Fannie and Freddie’s share of all mortgage loans under-written rose to 70% in August from below 35% in June 2006, according to his company’s statistics. Because they are government-sponsored, both Fannie and Freddie require home buyers who borrow more than 80% of their home’s value to get insurance from companies like Genworth, he said.

As to the investment risk from subprime market problems, Dr. Steven Weisbart, vice president and chief economist for the Insurance Information Institute (I.I.I.), says that the vast majority of U.S. insurers have little or no exposure to the volatility in the subprime mortgage market because much of their investments are in the highest-rated bonds or stocks with no direct ties to lenders.

“This conclusion is based on the recognition that, both by law and the nature of their business, insurers generally limit themselves to the low-risk end of the investing universe,” says Weisbart. “Even for the very small share of their investments directly exposed to subprime and near-prime loans, insurers mainly invest in ‘slices’ of those investments that, according to the bond-rating agencies, are as safe as the safest corporate bonds. Thanks to conservative portfolio management strategies and restrictive state regulations, insurance companies have a very small portion of their total investments in risk loans of any type.”

Weisbart says also that about 53% of life/health insurers’ invested assets were in the highest-rated class of bonds and 19% were in the next highest-rated class as of year-end 2006. The comparable percentages for the invested assets of property/casualty insurers in the bond market were 67% and 4%, respectively, he says.

“Common and preferred stocks are a small part of the investments of life/health insurance companies, at 4.6% of net admitted assets as of year end 2006,” Weisbart adds. “They are a moderate part of the investments of property/casualty companies at 16%.”

Weisbart says that insurers’ portfolios are still vulnerable to broad market sell-offs caused by fears originating in the subprime sector, but direct losses will be very limited and insurers’ tendency to hold securities on a long-term basis implies that the effects of short-term market volatility will likely be minimal.

However, Weisbart does say that the current subprime mortgage market turmoil holds out the “possibility” that claims may be filed by directors and officers liability (D&O) insurance policyholders as well as those with errors and omissions (E&O) coverage.

“It is likely that some actions will be brought that will trigger the defense benefits in these policies and possibly also some payouts under the liability benefit provisions,” says Weisbart. “Typically, these claims take a long time to develop. As such, it is much too early to estimate the dimensions of the claims experience that may emerge from the recent credit market developments. Many providers of D&O coverage tend to be among the largest and most financially sound insurers,” he says. So for Dr. Weisbart, the current subprime mortgage turmoil is “manageable” in terms of the insurance industry.

That is not entirely the view, however, of Grahame Chilton, chief executive of Benfield, the world’s fourth-largest reinsurance broker. Speaking with reporters in Monaco during the annual Rendez Vous de Septembre meeting, Chilton said the insurance and reinsurance industries could face claims of up to “a billion dollars” from the subprime mortgage crisis. Unlike some reinsurers that have sought to soothe investor concerns over possible claims coming from directors and officers policyholders, Chilton said the industry could be facing major problems.

“I think they’re wrong,” Chilton said in referring to those who have played down the insurance industry’s vulnerability to the subprime mortgage situation. “I think the D&O claims may be sizeable. You have the potential for a billion dollars of D&O claims to come through.”

Kevin M. LaCroix, an attorney and director of OakBridge Insurance Services, a specialized insurance intermediary focused exclusively on executive liability coverages, is also concerned about the effects of the subprime mortgage situation on the D&O market. LaCroix, who is also chair of the Directors’ & Officers’ Symposium for the Professional Liability Underwriting Society (PLUS), told Rough Notes that a year ago, he did not think the so-called crisis would have a major effect on the insurance industry.

“Today, I think this is a very serious situation indeed,” he said. “It already may be potentially far more serious for the D&O industry than the options backdating scandal.”

LaCroix said that the subprime mortgage “meltdown” has already produced a wave of lawsuits, including securities class action litigation. “Even though we are clearly only at the beginning of what will undoubtedly be a very long-developing story, the question is already being asked: What impact will the subprime mortgage mess have on the D&O insurance marketplace? In one sense, it may be too early to ask that question. We are probably only at the very top of the first inning in what will probably be an extra-inning contest.”

The OakBridge executive gave a rundown of only some of the litigation developments that have already occurred. He pointed to:

• Borrowers suing lenders: These lawsuits allege that lenders have misrepresented aspects of their mortgage loans. For example, a class action brought by 1,600 borrowers against NovaStar Mortgage recently settled for $5.1 million. The NovaStar lawsuit alleged that the broker or lending officer who placed the mortgage was financially rewarded for steering borrowers to higher interest rate loans.

• Borrowers suing financial institutions: Borrowers have sued a unit of Lehman Brothers for its investment involvement with a subprime mortgage lender, essentially on the theory that the Lehman unit was an enabler that encouraged unsavory tactics and practices from which Lehman profited.

• Regulators suing lenders: In June, Ohio Attorney General Marc Dann sued 10 mortgage lenders, accusing them of pressuring real estate appraisers to inflate home values, a practice Dann claims left borrowers with homes that can’t be sold and loans that can’t be refinanced. In addition, 49 states announced on July 12 of this year that Ameriquest Mortgage had agreed to pay a class of 481,000 borrowers $325 million for not properly disclosing terms of home loans.

• Financial Institutions suing lenders: According to recent press reports, a subsidiary of Deutsche Bank has filed at least 15 lawsuits seeking as much as $14 million from mortgage companies, alleging they failed to buy back loans with early defaults. Subsidiaries of Credit Suisse and UBS reportedly also have filed similar lawsuits.

• Investors suing financial institutions: In April, Bankers Life sued Credit Suisse Group alleging that it lost money on investment grade bonds backed by subprime mortgages sold by the bank. Bankers Life is seeking to recover about $1.3 million for losses of principal, interest and market value.

Said LaCroix: “Investor concerns about mortgage-backed securities are likely to continue. Moody’s has recently indicated that it intends to cut its credit ratings on a group of collateralized debt obligations (CDOs), the day after Moody’s and S&P both said they would downgrade hundreds of subprime-mortgage-backed bonds widely held by CDOs. Undoubtedly, these downgrades (and others likely to come in the months ahead) will affect asset values for investors holding these assets.”

How far will the subprime mortgage debacle reach, and how much will it cost? Saying that it would be premature, LaCroix would not put a dollar figure to the situation. However, regarding how far into the overall economy it will spread, LaCroix said: “There will be the universe of companies whose financial fortunes were driven by the availa-bility of easy credit for home buyers: home builders, home improvement companies, home furnishing retailers, appliance manufacturers, construction materials companies, not to mention real estate brokers, surveying companies, title insurance companies and everybody else whose fortunes may shrink in an era of tighter lending guidelines and a housing stock oversupply driven by a crescendo of defaults and foreclosures.” *