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Convergence
Trouble
Convergence of the banking and insurance
sectors would create a global capital market. However, the path
is lined with obstacles
When bankrupt energy trader Enron Corp. filed for bankruptcy in
December 2001, JP Morgan Chase (Chase) estimated that Enron and
its entities owed it $965 million worth of unsecured loans, letters
of credit and derivatives.
Chase had
signed natural gas and oil forward sales contracts with Enron
Natural Gas Marketing Corp and Enron North America Corp. It paid
a premium, through its offshore entities, Mahonia and Mahonia
Natural Gas, to the insurers in return for cover against a default
by Enron on these contracts. The insurance companies included,
among others, St. Paul Fire and Marine, Hartford Fire, as well
as, Travelers Casualty and Surety and Travelers Indemnity. The
latter two insurers belong to Citigroup, an archrival of Chase.
The fulfillment
of the contracts would have meant that Enron had repaid a $2 billion
loan to Chase. However, the repayment was only half-complete when
Enron filed for bankruptcy. Chase claimed a sum of $1.1 billion
from the insurers, the remaining amount being accounted for through
outstanding letters of credit. Chase issued surety bonds to the
insurers, which would insure it against default by Enron.
The insurers
refused to fulfil the claims, stating that the contracts were
defective. They stated that the contracts constituted disguised
loans from Chase to Enron, and provided evidence to prove their
allegations. In March, a US District Court ruled in favour of
the insurers, permitting them to withhold the claims, and set
a trial date for December.
Urge
to Merge vs. Need to Diverge
The tussle
between an investment- banking heavyweight like Chase and major
US insurers, over Enron-related claims has brought forth the differences
between the functioning of the two industries. The much talked
about convergence between the banking and insurance industries,
seems to have reached a critical phase in its evolution.
According
to observers, such issues between banking and insurance companies
appear to have increased in recent times. On the one hand, banks
want access to the large capital reserves of insurers; while insurers
want to increase their returns by utilising the infrastructure
of banks. On the other hand, basic cultural differences and regulatory
issues are causing conflicts, and slowing down the progress towards
their convergence.
A few such
differences between the insurance and banking/capital market points
of view are outlined below:
Regulation:
-
In several countries, the banking and insurance sectors are usually
subject to different regulations. However, the two have some common
characteristics. For instance, insurance companies have large
investment portfolios, which they seek to diversify, like banks
do. Both sectors are concerned that if the overlapping areas are
not properly regulated, then it would be detrimental to their
best interests.
Pricing: -
Capital markets attempt to predict the price they can expect from
the market for a product/service. In contrast, insurers, while
formulating policies, begin by identifying the basic cost of the
risk involved.
Risk: -
Capital markets aim to transfer risks by pricing them appropriately.
Insurers enumerate the risks they cover, and those they do not,
and support this with documented legal evidence.
Repayment: -
In case of problems with repayment, capital markets prefer to
strike new deals with revised prices, to ensure at least a minimum
return on their investment. Insurers need to prove that a particular
claim is due before actually fulfilling it. Until then, the claim
remains outstanding.
In the case
cited above, the insurers were assumed to have taken over Chase’s
credit risk in the form of derivatives contracts. However, they
later claimed that the contracts were defective. It may be possible
that they perceived taking on a specific risk, and not the overall
credit risk involved.
Chase, on
the other hand, may not have taken into account the true potential
for systemic (i.e. risk over which they had no control) and legal
risks. It had assumed that the risk had been transferred out of
its balance sheet, but this was not the case.
Conclusion
Banks should
realise that insurance does not provide an unconditional guarantee.
They should thus be more specific about the kind of coverage they
seek. Otherwise, insurance would not serve the purpose they presume
it would, i.e. their risk would not be transferred to the insurance
companies.
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