The U.S. and world financial systems are experiencing a ’shock loss’, characterized in the re/insurance industry as a loss event that can lead to substantial financial difficulty. This initially arose out of the sub-prime mortgage asset class, but soon spread to other asset-backed securities. Billions of dollars of investors’ money is disappearing in a wave of defaults and additional billions of dollars worth of securities will be ‘marked to market’. No one currently knows the extent or the magnitude of the problem.

Insurers and reinsurers should observe the current sub-prime mortgage problems with great interest. Not only will some have exposure to these securities in their investment portfolios, but there are also parallels that exist between this risk class and our own. I believe that many of the lessons that are now being painfully learned by investors have already been taught in our business.

First, growth became more important than profitability. In the sub-prime area, a whole system of brokers, companies, bankers, rating agencies and asset managers was set up and geared to the production of loans and derivative securities. Inevitably, underwriting standards slipped, inappropriate risk got into the system and the ultimate risk taker is going to pay the price.

Second, there was an over reliance on third parties for the evaluation and modeling of the risk. It’s apparent that many of the investors in these securities were completely dependent on the rating agencies’ models and evaluations. When a risk taker is dealing with complex, new and dangerous risks, there must be in-house evaluation capabilities to be successful longer term.

Third, shock losses tend to expose broader systemic issues. In this case, lack of liquidity has led to a breakdown in the continuity of offer and acceptance and ultimately the ‘freeze’ that we are currently seeing.

I think that these lessons will be increasingly important as the reinsurance market converges with the capital markets. Capital market solutions to risk transfer share many characteristics of traditional reinsurance products, including cyclicality in pricing driven by supply and demand as well as susceptibility to shock losses. We call our shock losses things like ‘catastrophes’ or ‘casualty reserve development’, while the capital markets suffer ‘credit crunches’ or ‘bear markets’.

While capital markets may be marginally more efficient seven years out of eight, I believe the reinsurance market can handle the ‘shocks’ better than the capital markets; we’re less likely to freeze up and leave the client without capacity. There is also less leverage and less ‘herd behavior’ in reinsurance. The result is a greater ability and willingness to provide capacity and continuity of offer, and to pay the claim in times of stress.

The current problems in the credit markets can both affirm some hard won truths that we’ve learned in our markets, as well as reveal some lessons to heed as convergence of the capital markets and reinsurance markets continues. That is, there should be convergence, not dominance. And the core skill of assuming risk lies in the evaluation, valuation and management, not in the packaging and selling of risk.