In this commentary, Peter R. Perrino and Robert W. Stein of Ernst & Young LLP assess the implications of the current financial and credit crisis for insurance companies and recommend actions they can take to help safeguard ratings and assets and mitigate exposure to potential losses. The authors state that a number of the implications of the current crisis for insurance organizations are apparent. First, “life insurers will likely experience a sales decline in equity-based products. Depressed equity markets result in reduced fees, increased guarantee values and diminished annuity/variable life earnings. Products without guaranties potentially face a significant decline in cash inflows. Insurance regulators are likely to focus on product suitability and disclosure issues as to customer offerings.” As all kinds of insurance organizations have significant exposure to declining debt and equity markets in their portfolios, unrealized losses will further weaken balance sheets. The constriction of credit markets is eliminating the capability of executing insurance securitizations. Moreover, “heavy users of securitizations will come under greater scrutiny as investors evaluate these structures and the magnitude of such risk transfers.” The authors see this as critically important for life insurance companies with significant XXX and AXXX exposures. Regulators and rating agencies are likely to increase their capital requirements for insurers. Additional capital also will be needed to cover insurance risks and to provide protection from exposure to credit and liquidity risks. Given the current crisis and volatility in conditions, the authors recommend that management should be proactive to protect their organizations and to create potential opportunities. Thus, management should evaluate their organizations’: • Pricing of investments and price validation policies and procedures (The authors warn, “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”); • Exposures to material counterparties and its mitigation strategies to provide rapid response in the event of a new crisis; • Quality of liquidity management, cash flow forecasting and working capital management to meet potential challenges and opportunities; • Operational requirements such as the need to minimize the impact of counterparty bankruptcy or future insolvencies;• Ability to take advantages of opportunities presented by the sales of distressed, as well as prized operations to unlock liquidity and survive financial turmoil; • Ability to properly demonstrate tax basis in a sold entity, which may be difficult for entities purchased or created long ago; • Reporting and compliance frameworks’ capability to meet demands that regulators are likely to impose in a time of financial instability; • Ability to identify and understand a model’s limitations and assumptions as well as the risks it doesn’t capture in order to avoid product mispricing; and • Awareness of tax issues that could arise as the period of uncertainty unfolds. The authors’ conclude, “Organizations that are well positioned, prepared and nimble may well be able to capitalize on the dislocation in the market.”
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