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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
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Criteria | Insurance | Property/Casualty: The Dangers Of Dependence On Reinsurance

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 periodic review, 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 analytical rating process used by Standard & Poor's Ratings Services. Situations can arise, however, where reinsurance use turns into reinsurance dependence. In such circumstances, the cedent's commercial viability is considered excessively reliant on its ongoing ability to cede a large proportion of its gross exposure to reinsurers and retrocessionnaires on beneficial terms. This may be particularly relevant for the upcoming renewal season because scarce reinsurance capacity in energy and catastrophe-prone lines implies "hard" pricing that may well prove prohibitive to smaller cedents that have become too used to acting as a fronting company and passing on most or all of the risk to reinsurers. In due course, reinsurance reliance can also come to have a solvency and cash flow dimension when the reinsurers' share of the technical reserves and current receivables is so large relative to the cedent's own cash flows and capitalization that any failure to pay by a principal reinsurer could threaten a major decline in the cedent's own financial strength, irrespective of whether that delay is the result of legitimate legal dispute, coercive commutation, or even outright default by the reinsurer. The timeliness of payments can also be crucial. This article discusses Standard & Poor's analytical approaches to such situations, and constitutes a supplement to the general rating criteria normally applied to the analysis and rating of insurers and reinsurers. It expressly focuses on traditional reinsurance and does not address the rather different problems associated with nontraditional reinsurance, notably the covers variously described as finite reinsurance, financial reinsurance, or alternative risk transfer. The specific issues relating to nontraditional reinsurance were the subject of a separate article, "Property/Casualty Insurance Criteria: Adjusting For Finite Reinsurance," published March 14, 2005, on RatingsDirect, 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 amount outstanding against the reinsurers' share of those technical reserves relating to asbestos, environmental pollution, and other similarly long-tail lines where there may be an increased possibility of legal dispute concerning the exact terms and duration of the reinsurance cover. The charge will become effective in 2006, based on 2005 financials. Where the charge results in a material worsening of capital adequacy, we would ultimately expect companies to hold more capital or be assessed as having lower capital adequacy, which could have rating implications. We recognize that reinsurance dependence issues are more likely to affect a casualty writer than a property writer. This is due to the longer time lag for casualty business between the purchase of reinsurance cover and the triggering of payments from the reinsurer to the cedent in the event of losses. Standard & Poor's also recognizes that the risks of dependence on highly rated affiliate reinsurers are generally significantly lower than where third-party reinsurers are involved and that, for this reason, the issues arising are unlikely to be significant rating factors for cedents that use such affiliates. There are situations, however, where the reinsurance is provided by an unrated or low-rated affiliate. In these circumstances, these issues could be material to the cedent's financial strength.

The Impact Of Reinsurance On The Analytical Rating Process

The purchase of reinsurance protection can affect the outcome of the rating analysis under seven of Standard & Poor's eight categories of insurer and reinsurer financial strength analysis. Only the assessment of investments is not directly affected by the manner in which reinsurance protection is used. Those elements of the rating analysis that are affected are therefore competitive position, management and corporate strategy, enterprise risk management, operating performance, liquidity, capitalization, and financial flexibility. Each of these analytical areas is discussed in more detail below.
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the fixed operational costs of the underwriting entity itself. The issue is whether an insurer's reliance on reinsurance is such that its ability to write targeted business could be materially weakened in the event of the reduction or removal of reinsurance cover. Such a situation could arise when an insurer's target market is one where large exposures are common, and the ability to quote for a significant percentage of any risk is a prerequisite for active participation in the sector. If the insurer does not have the capacity to carry large risks or aggregations of exposure on its own balance sheet, however, it is obliged to cede or retrocede the greater part of the exposure and premium assumed. In such situations, the dependence on ongoing reinsurance protection on reasonable terms is high, just as there is an equally 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 the ratio of total premiums ceded to gross premiums written. A cession rate averaging more than 30% may indicate a significant reliance on reinsurers' support relating to competitive position. In these situations, Standard & Poor's will seek to investigate in greater depth the strength of the relationships between the insurer and its reinsurers and the likely resilience of those relationships in times of financial and market stress. Credit analysts are nevertheless aware of many examples, such as those of local insurers in the Arabian Gulf, where significant use of reinsurance may be only a feature of a single line of business, usually energy related. Because the premiums and concentrated exposures associated with energy are so large, however, most local insurers will routinely cede to the larger international and global reinsurers up to 100% of the good-quality energy business they are obliged to front under local legislation. This leads to an often significant differential between gross and net premiums written, but does not automatically imply reinsurance dependence because the insurers concerned would simply cease writing energy business if they could not find appropriate reinsurance protection. This would merely 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 for sound economic reasons, Standard & Poor's analysis will factor in the risks arising from this dependence as appropriate. These markets include the U.S. program business sector; the U.S. excess and surplus lines sector; specialist marine, energy, and aviation insurers; the European 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 the insurer's strategic reliance on reinsurance--that is, where the purchase of extensive reinsurance protection has developed into a key element of strategy. Where an insurer's competitive position is materially reliant on reinsurers' continuing support, this risk to the business model and therefore the financial strength of the insurer will be factored into Standard & Poor's assessment. Another risk related to a strategic reliance on reinsurance is the potential for reinsurance costs to spiral and for terms and conditions to move in favor of 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 is the potential exposure to asset concentrations arising from relationships with reinsurers. Such concentrations may indicate a weakness in 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 annual review 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 underlying underwriting performance of an insurer. Standard & Poor's looks more favorably on those insurers that are able to write business profitably over a sustained period on a gross basis--that is, before the impact of reinsurance protection--than those that routinely rely on such protection to achieve profitability. This is because underwriting competence is a core skill for an insurer and a driver of good financial strength, and because dependence on the availability of appropriate reinsurance to achieve profitability is a potential strategic weakness. For these reasons, Standard & Poor's analyzes operating performance both at the gross and the net level after the impact of reinsurance protection, even where the reinsurance protection is provided by a related party. Where an insurer's reinsurance program predominantly takes the form of proportional reinsurance, the performance of the insurer will not normally look materially different whether it is gross or net of reinsurance. Where, however, there is significant utilization of nonproportional reinsurance protection, there may be material differences, 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 outstanding claims 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 of relationships with reinsurers, especially where reinsurers have received an uneconomic return over a long period. Such situations could lead to the withdrawal of reinsurance support or to materially worse terms, conditions, and pricing for the insurer. Such developments could 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, unlike liquid assets such as cash, quoted bonds, and equities, there are obstacles to the immediate realization of the value of such receivable assets. Although reinsurance receivable amounts due are considered more liquid than recoverables on outstanding and IBNR loss reserves, they are nevertheless subject to counterparty credit and timing risks. For these reasons, an asset may be due for collection from a reinsurer but not immediately collectable at a time when the cedent has already paid the related claim. It is recognized that the existence of collateral, LOCs, and cash loss clauses provided by the reinsurer offsets this risk and, in addition, that the cedent can complement 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 asset on its balance sheet that may not match the size of the equivalent liability posted by the reinsurer. The liability may be set at a lower value or even, in some circumstances, not be recognized at all. This situation could create a liquidity crunch when the cedent needs to collect the recoverable. Capitalization Where reinsurance recoverables are material assets on an insurer's balance sheet, their appropriate analytical treatment is considered a key 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 include amounts due, plus recoverables on outstanding and IBNR loss reserves not yet due, net of those recoverables secured by LOCs or collateralized reinsurance deposits. To ensure that its assessment of these risks is prospective, Standard & Poor's also takes account of any potential material increase in this asset arising from the probable maximum loss scenario calculated by the insurer, usually based on a 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 negatively affected, even where the capital adequacy ratio is to some extent an offsetting positive feature. High exposure is defined as a reinsurance 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 various scenarios on the capital model and the capital adequacy ratio that the model produces. The volatility of outcomes may then be factored into 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 an analysis 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 counterparty greater than 10% of total adjusted capital to be significant. For the purposes of this benchmark, exposure to a number of Lloyd's syndicates 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 its balance sheet, that insurer will, all other things being equal, be considered to have greater financial flexibility than a similar insurer that has already made extensive use of reinsurance protection. Standard & Poor's factors this into its overall assessment of financial flexibility, 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 from default and recovery rates calculated by Standard & Poor's. This is applied to the unsecured recoverables from reinsurers and a total charge 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 in full 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 within the 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 for any other class of loss. At industry level, there is a mismatch between the reinsurance recoverables asset held by insurers and the liability reserves held by reinsurers, and there are many examples of primary writers making provision for the potential failure to collect such recoverables in full. For these reasons, unsecured reinsurance recoverables on asbestos and environmental pollution liabilities are subject to a charge of 20%. The scale of the charge is based on Standard & Poor's experience in the U.S. primary commercial lines sector and is subject to adjustment to reflect specific circumstances. If an insurer has already set aside a provision at 20% or higher, for example, an additional charge may not be justified. Conversely, there may be a case for increasing the charge. The charge is 20% irrespective of the credit quality of the reinsurer because the key issue is the coverage of the insurance policy. The charge is therefore in addition to the existing counterparty credit default charge in Standard & Poor's risk-based capital adequacy model. The charge does not apply to intragroup reinsurance recoverables where the reinsurer is highly rated. Primary Credit Analysts: Simon Marshall, London (44) 20-7176-7080; simon_marshall@standardandpoors.com Laline Carvalho, New York (1) 212-438-7178; laline_carvalho@standardandpoors.com Rob Jones, London (44) 20-7176-7041; rob_jones@standardandpoors.com Secondary Credit Analysts: David Anthony, London (44) 20-7176-7010; david_anthony@standardandpoors.com John Iten, New York (1) 212-438-1757; john_iten@standardandpoors.com Steven Ader, New York (1) 212-438-1447; steven_ader@standardandpoors.com Additional Contact: Insurance Ratings Europe; InsuranceInteractive_Europe@standardandpoors.com

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