the dangers of dependence on reinsurance

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Criteria | Insurance | Property/Casualty: The Dangers Of Dependence OnReinsurance

Publication date: 08-Dec-2005 05:07:39 EST

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(Editor's Note: This criteria article was originally published on Dec. 8, 2005. We are republishing this article following our periodicreview, completed on March 31, 2011.)

An insurer's or reinsurer's prudent use of reinsurance or retrocession protection is generally considered a positive factor in the analyticalrating process used by Standard & Poor's Ratings Services. Situations can arise, however, where reinsurance use turns into reinsurancedependence. In such circumstances, the cedent's commercial viability is considered excessively reliant on its ongoing ability to cede alarge proportion of its gross exposure to reinsurers and retrocessionnaires on beneficial terms. This may be particularly relevant for theupcoming renewal season because scarce reinsurance capacity in energy and catastrophe-prone lines implies "hard" pricing that maywell prove prohibitive to smaller cedents that have become too used to acting as a fronting company and passing on most or all of therisk to reinsurers.

In due course, reinsurance reliance can also come to have a solvency and cash flow dimension when the reinsurers' share of thetechnical reserves and current receivables is so large relative to the cedent's own cash flows and capitalization that any failure to pay bya principal reinsurer could threaten a major decline in the cedent's own financial strength, irrespective of whether that delay is the resultof legitimate legal dispute, coercive commutation, or even outright default by the reinsurer. The timeliness of payments can also becrucial.

This article discusses Standard & Poor's analytical approaches to such situations, and constitutes a supplement to the general ratingcriteria normally applied to the analysis and rating of insurers and reinsurers. It expressly focuses on traditional reinsurance and does notaddress the rather different problems associated with nontraditional reinsurance, notably the covers variously described as finitereinsurance, financial reinsurance, or alternative risk transfer. The specific issues relating to nontraditional reinsurance were the subjectof a separate article, "Property/Casualty Insurance Criteria: Adjusting For Finite Reinsurance," published March 14, 2005, onRatingsDirect, Standard & Poor's Web-based credit analysis system.

This article also outlines Standard & Poor's intention to introduce a risk charge in its risk-based capital model of 20% of the amountoutstanding against the reinsurers' share of those technical reserves relating to asbestos, environmental pollution, and other similarlylong-tail lines where there may be an increased possibility of legal dispute concerning the exact terms and duration of the reinsurancecover. The charge will become effective in 2006, based on 2005 financials. Where the charge results in a material worsening of capitaladequacy, we would ultimately expect companies to hold more capital or be assessed as having lower capital adequacy, which couldhave rating implications.

We recognize that reinsurance dependence issues are more likely to affect a casualty writer than a property writer. This is due to thelonger time lag for casualty business between the purchase of reinsurance cover and the triggering of payments from the reinsurer to thecedent in the event of losses.

Standard & Poor's also recognizes that the risks of dependence on highly rated affiliate reinsurers are generally significantly lower thanwhere third-party reinsurers are involved and that, for this reason, the issues arising are unlikely to be significant rating factors forcedents that use such affiliates. There are situations, however, where the reinsurance is provided by an unrated or low-rated affiliate. Inthese circumstances, these issues could be material to the cedent's financial strength.

The Impact Of Reinsurance On The Analytical Rating ProcessThe purchase of reinsurance protection can affect the outcome of the rating analysis under seven of Standard & Poor's eight categoriesof insurer and reinsurer financial strength analysis. Only the assessment of investments is not directly affected by the manner in whichreinsurance protection is used. Those elements of the rating analysis that are affected are therefore competitive position, managementand corporate strategy, enterprise risk management, operating performance, liquidity, capitalization, and financial flexibility. Each of theseanalytical areas is discussed in more detail below.

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Standard & Poor's, Criteria | Insurance | Property/Casualty: The Dangers of Dependence on Reinsurance (2005), available at http://www.standardandpoors.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245335215457

the fixed operational costs of the underwriting entity itself. The issue is whether an insurer's reliance on reinsurance is such that its abilityto write targeted business could be materially weakened in the event of the reduction or removal of reinsurance cover. Such a situationcould arise when an insurer's target market is one where large exposures are common, and the ability to quote for a significantpercentage of any risk is a prerequisite for active participation in the sector. If the insurer does not have the capacity to carry large risksor aggregations of exposure on its own balance sheet, however, it is obliged to cede or retrocede the greater part of the exposure andpremium assumed. In such situations, the dependence on ongoing reinsurance protection on reasonable terms is high, just as there is anequally high subsequent dependence on those reinsurers to fund their share of any large losses that may occur.

For Standard & Poor's, possibly the best analytical tool for assessing reinsurance dependence risk is the cession rate, defined as theratio of total premiums ceded to gross premiums written. A cession rate averaging more than 30% may indicate a significant reliance onreinsurers' support relating to competitive position. In these situations, Standard & Poor's will seek to investigate in greater depth thestrength of the relationships between the insurer and its reinsurers and the likely resilience of those relationships in times of financial andmarket stress.

Credit analysts are nevertheless aware of many examples, such as those of local insurers in the Arabian Gulf, where significant use ofreinsurance may be only a feature of a single line of business, usually energy related. Because the premiums and concentratedexposures associated with energy are so large, however, most local insurers will routinely cede to the larger international and globalreinsurers up to 100% of the good-quality energy business they are obliged to front under local legislation. This leads to an oftensignificant differential between gross and net premiums written, but does not automatically imply reinsurance dependence because theinsurers concerned would simply cease writing energy business if they could not find appropriate reinsurance protection. This wouldmerely lose them a fronting commission that is usually modest relative to their earnings on other retained business lines.

Although we recognize that the business models prevalent in certain markets are by their nature heavily dependent on reinsurance forsound economic reasons, Standard & Poor's analysis will factor in the risks arising from this dependence as appropriate. These marketsinclude the U.S. program business sector; the U.S. excess and surplus lines sector; specialist marine, energy, and aviation insurers; theEuropean credit and surety insurance sector; and some insurers in the Arabian Gulf.

Management and corporate strategy

Standard & Poor's assessment of an insurer's management and corporate strategy may be negatively affected by evidence of theinsurer's strategic reliance on reinsurance--that is, where the purchase of extensive reinsurance protection has developed into a keyelement of strategy. Where an insurer's competitive position is materially reliant on reinsurers' continuing support, this risk to thebusiness model and therefore the financial strength of the insurer will be factored into Standard & Poor's assessment. Another riskrelated to a strategic reliance on reinsurance is the potential for reinsurance costs to spiral and for terms and conditions to move in favorof reinsurers. Such a development could weaken the operating performance of an insurer and call into question its business model.

Extensive use of reinsurance may also imply high tolerance of counterparty credit risk arising from the financial strength of reinsurers,with a high level of risk tolerance having a negative impact on the assessment of management and corporate strategy. A related issue isthe potential exposure to asset concentrations arising from relationships with reinsurers. Such concentrations may indicate a weaknessin risk-management controls. If this were found to be the case, it would also be considered a significant negative factor.

Enterprise risk management

Risk management will soon become a separate, major category of our analysis of insurers and reinsurers. In our published full analyses,the new category will be titled "Enterprise Risk Management". The evaluation of ERM will be a part of each (re)insurer's next annualreview with Standard & Poor's, and will include consideration of risk-management issues surrounding the use of reinsurance.

Operating performance

The key analytical issue regarding operating performance is the potential for the impact of reinsurance protection to mask the underlyingunderwriting performance of an insurer. Standard & Poor's looks more favorably on those insurers that are able to write businessprofitably over a sustained period on a gross basis--that is, before the impact of reinsurance protection--than those that routinely rely onsuch protection to achieve profitability. This is because underwriting competence is a core skill for an insurer and a driver of goodfinancial strength, and because dependence on the availability of appropriate reinsurance to achieve profitability is a potential strategicweakness.

For these reasons, Standard & Poor's analyzes operating performance both at the gross and the net level after the impact of reinsuranceprotection, even where the reinsurance protection is provided by a related party. Where an insurer's reinsurance program predominantlytakes the form of proportional reinsurance, the performance of the insurer will not normally look materially different whether it is gross ornet of reinsurance. Where, however, there is significant utilization of nonproportional reinsurance protection, there may be materialdifferences, at which point the analysis of gross operating performance becomes a key analytical undertaking.

Key measures of gross operating performance for a property/casualty insurer are the gross loss ratio and the gross combined ratio,defined as follows:

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(In these calculations, gross claims incurred are gross claims paid, plus loss-adjustment expenses, plus the gross change in outstandingclaims and incurred-but-not-reported [IBNR] loss reserves.)

Where material differences between gross and net operating performance are apparent, Standard & Poor's assesses the sustainability ofrelationships with reinsurers, especially where reinsurers have received an uneconomic return over a long period. Such situations couldlead to the withdrawal of reinsurance support or to materially worse terms, conditions, and pricing for the insurer. Such developmentscould impair competitive position, operating performance, and even capitalization.

Liquidity

An insurer's liquidity is weakened by on-balance-sheet material assets that constitute reinsurance recoverables. This is because, unlikeliquid assets such as cash, quoted bonds, and equities, there are obstacles to the immediate realization of the value of such receivableassets. Although reinsurance receivable amounts due are considered more liquid than recoverables on outstanding and IBNR lossreserves, they are nevertheless subject to counterparty credit and timing risks. For these reasons, an asset may be due for collectionfrom a reinsurer but not immediately collectable at a time when the cedent has already paid the related claim. It is recognized that theexistence of collateral, LOCs, and cash loss clauses provided by the reinsurer offsets this risk and, in addition, that the cedent cancomplement balance-sheet liquid assets with lines of credit and other forms of financial flexibility.

An additional issue is that, regarding recoverables on outstanding and IBNR loss reserves, the cedent may record a recoverable asseton its balance sheet that may not match the size of the equivalent liability posted by the reinsurer. The liability may be set at a lowervalue or even, in some circumstances, not be recognized at all. This situation could create a liquidity crunch when the cedent needs tocollect the recoverable.

Capitalization

Where reinsurance recoverables are material assets on an insurer's balance sheet, their appropriate analytical treatment is considered akey issue for capitalization. Counterparty credit risk and the risk of failure to collect reinsurance recoverables--especially for asbestos,environmental pollution, and other similarly long-tail liabilities--on time or in full are addressed through appropriate charges in Standard &Poor's risk-based capital adequacy model. For the purposes of measuring these risks, reinsurance recoverables are defined to includeamounts due, plus recoverables on outstanding and IBNR loss reserves not yet due, net of those recoverables secured by LOCs orcollateralized reinsurance deposits. To ensure that its assessment of these risks is prospective, Standard & Poor's also takes account ofany potential material increase in this asset arising from the probable maximum loss scenario calculated by the insurer, usually based ona one-in-250-year catastrophic loss probability.

Aggregate exposure to the reinsurance recoverables asset is measured through the reinsurance leverage ratio, which is defined below.

Standard & Poor's opinion of the capitalization of insurers with high absolute or comparative exposure in this respect will be negativelyaffected, even where the capital adequacy ratio is to some extent an offsetting positive feature. High exposure is defined as areinsurance leverage ratio of more than 30%.

Standard & Poor's performs sensitivity analysis on the impact of failure to collect reinsurance recoverables in full by running variousscenarios on the capital model and the capital adequacy ratio that the model produces. The volatility of outcomes may then be factoredinto our view of capitalization.

Concentration risk arising from reinsurance recoverables relating to a single reinsurance group is addressed as a quality of capital issue,such risks being a negative feature of capitalization and the rating overall. Where there are significant, concentrated exposures, Standard& Poor's will explore the longevity and strength of the relationship between the cedent and the reinsurer. Standard & Poor's obtains ananalysis of reinsurance recoverables by reinsurance group, and compares the size of counterparty exposure with total adjusted capital(according to Standard & Poor's risk-based capital model). Standard & Poor's considers reinsurance recoverables with one counterpartygreater than 10% of total adjusted capital to be significant. For the purposes of this benchmark, exposure to a number of Lloyd'ssyndicates is aggregated and treated as a single exposure, in recognition of the structure of the Lloyd's Market (A/Watch Neg).Concentrations of intragroup reinsurance recoverables, where the reinsurer is highly rated, are considered less of a risk.

Financial flexibility

To the extent that an insurer can readily purchase additional reinsurance protection to improve its capitalization by transferring risk off itsbalance sheet, that insurer will, all other things being equal, be considered to have greater financial flexibility than a similar insurer thathas already made extensive use of reinsurance protection. Standard & Poor's factors this into its overall assessment of financialflexibility, an assessment that will also be influenced by other material factors such as profit retention, access to additional share capital,hybrid equity, the ability to issue debt, and the possibility of disposing of investment and other assets quickly.

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accounting provisions against such risks.

Counterparty credit risk

For some time, counterparty credit risk arising from reinsurance recoverables has been addressed through a capital charge derived fromdefault and recovery rates calculated by Standard & Poor's. This is applied to the unsecured recoverables from reinsurers and a totalcharge is derived from the specific rating category of each reinsurer to which there is exposure.

Asbestos and environmental pollution recoverables charge

The potential for failure to collect reinsurance recoverables on asbestos, environmental pollution, and other similarly long-tail liabilities infull is addressed by a charge on the relevant reinsurance recoverables.

The potential for disputes about the liability of reinsurers for asbestos and environmental pollution losses is widely acknowledged withinthe insurance industry and has been commented on by Standard & Poor's (see "Insurers And Reinsurers: The Context For Conflict,"published Jan. 29, 2004, on RatingsDirect). The liability of reinsurers for these losses is uncertain to a significantly greater extent than forany other class of loss. At industry level, there is a mismatch between the reinsurance recoverables asset held by insurers and theliability reserves held by reinsurers, and there are many examples of primary writers making provision for the potential failure to collectsuch recoverables in full.

For these reasons, unsecured reinsurance recoverables on asbestos and environmental pollution liabilities are subject to a charge of20%. The scale of the charge is based on Standard & Poor's experience in the U.S. primary commercial lines sector and is subject toadjustment to reflect specific circumstances. If an insurer has already set aside a provision at 20% or higher, for example, an additionalcharge may not be justified. Conversely, there may be a case for increasing the charge. The charge is 20% irrespective of the creditquality of the reinsurer because the key issue is the coverage of the insurance policy. The charge is therefore in addition to the existingcounterparty credit default charge in Standard & Poor's risk-based capital adequacy model. The charge does not apply to intragroupreinsurance recoverables where the reinsurer is highly rated.

Primary Credit Analysts: Simon Marshall, London (44) 20-7176-7080;[email protected] Carvalho, New York (1) 212-438-7178;[email protected] Jones, London (44) 20-7176-7041;[email protected]

Secondary Credit Analysts: David Anthony, London (44) 20-7176-7010;[email protected] Iten, New York (1) 212-438-1757;[email protected] Ader, New York (1) 212-438-1447;[email protected]

Additional Contact: Insurance Ratings Europe;[email protected]

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the dangers of dependence on reinsurance

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