Sub-Prime Liability

The subprime mortgage crisis may lead to a surge in professional liability claims that will spread across the United States and global economies in ways that havent been seen from one event.
With past stock-options scandals and the savings-and-loan collapses of the 1970s, the lawsuits involving directors and officers or errors and omissions covers that followed were fairly tightly focused on the companies or industries involved.

But here the losses have a ripple effect that goes out through the economy as whole, because of the way these were marketed, said Bill Boeck, senior vice president of the Financial Service Group at Lockton Cos. Inc., and a lawyer with more than 20 years of experience in professional liability litigation.

In a briefing paper, Guy Carpenter & Co. said one "reason why the impact is likely to be greater than it appears is that investors may begin to file against companies not involved in subprime lending but which felt the disruption caused by the subprime mortgage market.

An example cited by Carpenter, Boeck and others is the fate of U.K. mortgage lender Northern Rock, which was not involved in subprime lending. It did heavily utilize short-term debt to fund its lending, however, and when that financing dried up in the subprime-sparked credit crunch, the company needed emergency funding from the Bank of England to stay afloat. But it lost 90% of its market value, said Guy Carpenter: The net result, of course, was litigation, with various institutional investors filing lawsuits against Northern Rocks directors.

Stanford Law Schools Securities Class Action Clearinghouse Web site listed 32 class-action lawsuits filed in relation to subprime-related issues. The companies involved run the gamut from direct mortgage companies and banks, home builders, Wall Street firms, Moodys Corp., the rating agency, and the parent of rating agency Standard and Poors, McGraw-Hill Cos.

You see the banks and lending institutions, not surprisingly, said Robert P. Hartwig, president of the Insurance Information Institute. And there are a number of suits against builders, who have been hard hit by this.

The Guy Carpenter brief predicted that more litigation is on the horizon for 2008.
The classes that appear to have the most exposure are alternative investment funds (e.g. hedge funds, private equity funds), real estate agents and mortgage brokers, said the brief. While hedge funds historically have not been large purchasers of insurance (10% to 15% of 8,000-plus funds), their increased interest in buying D&O and/or E&O, as well as the significant rate hardening on existing funds, seems to indicate that attitudes are changing.

Individual lawsuits are also blossoming, said Boeck, targeting bond insurers, appraisers and accounting firms that worked for companies directly or indirectly involved in subprime lending, and managers of 401(k) plans and pensions that lost money because of subprime investments.
There are various suits against people in the real estate industry -- anybody involved in funneling a borrower to a lender, he said.

As the subprime crisis continues to unfold, and the credit crunch and other related issues spread out in the economy, it is difficult for the industry to be sure how big the insurance impact will be. These kinds of professional liability claims trail well behind the breaking events that give rise to claims and litigation.

Hartwig noted that some investment banks and others had reported possible insured losses ranging into the low billions of dollars as the subprime mess began attracting attention earlier this year, but most have refrained from doing so of late. Theres a sense there that they dont have a lot of good information on which to base it, he said.

Boeck said that it could be a year to 18 months before the volume of litigation is understood, with three troublesome issues of securitized subprime mortgages resetting to higher payment rates between spring of 2008 and spring of 2009, and with a large number of foreclosures likely to follow.

At that point, well be outside of the blast zone, he said, but added that it could be late 09 or afterward before definitive answers are available.

A hardening of reinsurance pricing in 2008 seems unlikely, Carpenters brief said, except for insurers who are overweight in the affected sectors (e.g. home builders, subprime lenders).
An exception to the soft market, Boeck said, is companies affected by subprime issues.
The market is soft, and it is very competitive, he said. We frequently are able to negotiate premium reductions while getting enhancements. But for companies that are in the middle of all this, the negotiations can be brutal. If youre a lender involved in subprime and youve seen claims, perhaps even a securities suit, youre renewal can be an absolute nightmare. Weve seen that happen. These negotiations can be an absolute nightmare.

Some clients have been nonrenewed by insurers because of subprime problems. I wouldnt say its common, but it has happened, Boeck said.

At the end of the day, their decision is going to be motivated primarily or significantly by their feelings about the management of the company, Boeck said of the insurers. If they feel the managers of the company screwed up and may screw up again, then theyll walk.

(By Alyn Ackermann, senior associate editor, BestWeek: Alyn.Ackermann@ambest.com)Copyright 2007 A.M. Best Company, Inc.