Reinsurance Exposure Put UnderSpotlight

Among the many risks faced by insurance companies today,reinsurance exposure is one that has gained an increasing profileas the soft market unraveled.

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With reinsurance leverage reaching a peak, the quality ofreinsurance counterparties declining and over-reliance onreinsurance becoming evident in a number of recent failures, thisrisk exposure is attracting increased attention in today'soperating environment.

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During the last soft market for commercial insurance, primaryinsurers' reinsurance exposure–and hence their associated operatingleverage–grew in response to a number of factors. In some lines ofbusiness, primary insurers had, for several years, increased thesize of gross coverage limits they offered in an effort to growtheir top lines without further eroding already weak premium ratesand coverage terms. Excess reinsurance was used to manage down thenet risk associated with these higher exposed limits.

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In other lines, particularly specialty, some insurers chasedpremium volume in novel and/or unfamiliar areas, using reinsuranceto hedge not only their risk appetite, but their inexperience aswell.

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For these groups of ceding companies, and others as well,another strong motivation for growing use of reinsurance (andretrocession) was the very modest cost of reinsurance relative tothe feared (and in retrospect, actual) weakness of primary pricing.In its extreme form, this use of advantageous reinsurance became anend in itself, with insurers trading for profit through reinsurancearbitrage.

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Finally, as many old-line commercial insurers revise theirexisting estimates of the cost of asbestos claims upwards, theyalso add reinsurance exposure to the extent that a portion of thatadverse development is estimated to be recoverable underdecades-old reinsurance contracts.

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The combined effect of these various trends has been to increaseenterprise risk among commercial insurers.

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Among other risks, the 9/11 terrorist attacks highlighted theextent to which many insurers could become exposed to reinsurancecollectibility problems following a severe event. The extent towhich reinsurance was used to leverage gross underwriting capacityvaried considerably among firms with exposure to 9/11 losses, withsome firms looking to cede the lion's share of their total loss toreinsurers.

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Clearly, this event shows that some commercial insurers can beheavily reliant on reinsurance as a substitute for capital, despitethe fact that correlation between the credit risk of reinsurers andtheir primary clients may be high for extreme events.

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Moody's considers reinsurance to be an imperfect substitute forcapital, because of a general decline in reinsurers' creditquality, an erosion of its reliability, and because its credit riskis correlated with the more extreme events under which cedingcompanies are likely to call upon it.

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Not so long ago, the reinsurance market–especially at the upperend–was characterized by its reasonably stable competitivestructure, by substantial tangible and economic capitalization, bystrong margins, and by extremely high credit ratings. Much haschanged. Beginning in the late 1990s, with possibly unprecedentedweakness in commercial property-casualty insurance prices,reinsurers found themselves subject to a seemingly continuousparade of stress events.

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Among the most prominent of these stresses were the implosion ofthe Unicover workers compensation carve-out pool; a precipitousdecline in equity markets in the United States and Europe; wretchedresults in financial lines including credit-default protection,commercial surety, and directors and officers liability; andescalating asbestos-related claims settlements.

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These events have taken their toll on primary insurers andreinsurers alike, as reflected by the overall decline in creditratings in the sector. And although dramatic rate increasesimplemented over the last two years have helped to divert attentionaway from these unpleasant events, Moody's remains concerned–basedon our preliminary actuarial assessment of primary insurerreserves–that further adverse development may be incurred onbusiness written in the late 1990s.

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This concern is also quite relevant to reinsurers, who receiveinformation about loss activity on a lagged basis and thus may tendto lag their clients in the reporting of loss development.

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Five years ago, more than one-half of the reinsurance ceded inthe United States was to “triple-A” rated companies, most of whomhave since been downgraded. This shift downward in reinsurancecredit quality has come at exactly the same time that aggregateexposure to reinsurers has been growing. These two negative forcesare creating a squeeze on primary insurer operating leverage thatcontinues today.

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The growth in reinsurance leverage and the decline in quality ofreinsurance counterparties are worrying trends to be sure, butMoody's believes that a generalized erosion in the reliability ofreinsurance as a hedging tool is at least as troublesome, if notmore so. Here, reliability is intended to capture the likelihoodthat the ceding insurer will collect, on a timely basis, all moniesthey believe themselves reasonably owed, without resorting tounreasonable litigation/arbitration, and where the capacity of thereinsurer to pay such amounts is not in doubt.

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Once upon a time in reinsurance, commercial relationshipsbetween reinsurers and their clients were loosely governed by amutually recognized code of conduct under which the reinsurer wouldfollow the fortunes of its clients. When both parties mademoney, this chivalry was easy enough to maintain, but it began tocome under pressure when the market turned soft in the mid-to-late1990s.

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Today, there continues to be a commitment to this doctrine inmany relationships, but there are also many cases where CatchMe If You Can might be a better slogan.

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The decline in reliability of reinsurance is reflected in a risein a number of unhelpful behaviors, including outright refusal topay apparently valid claims, though the methods are typically moresubtle than that.

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While these techniques are of greatest value to reinsurers inrun-off, who are not worried about aggravating ongoing clientrelationships, they are increasingly being used in activerelationships as well. Some examples would include:

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Denying the claim and raising fraud as a defense to payment(even in situations that would seem to prohibit such a denial).

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Deferring a decision on the claim until the completion of anextensive, and extended, review of underlying documentation, whichmight enable the reinsurer to find a reason to deny the claim butat least allows the reinsurer to retain the float longer.

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Implicitly or explicitly threatening to deny the claim,asserting that the loss is not a covered peril based on a noveland/or convoluted theory of loss, in order to establish a basis fornegotiating the claim amount downward.

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Routinely opting to litigate rather than settle claims.

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Nothing in these comments should be construed as suggesting thatreinsurers are seeking to effect a wholesale disavowal of theirfinancial responsibilities. The effect of these trends onreinsurance reliability is likely to be marginal.

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Having said that, if a reinsurer is able to successfully“negotiate” away as little as 5 percent of what it owes to a cedinginsurer, the loss (or decrease in asset value) to the cedingcompany would dwarf the expected loss implied by the reinsurer'sinsurance financial strength rating assigned by the rating agency.For example, the expected loss associated with a reinsurer's “A2″rated credit over five years would be less than one-half of onepercent.

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Ted Collins is managing director for propety-casualty andreinsurance at Moody's Investor Service in New York.

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(C) 2003 Moodys Investors Service Inc. All rightsreserved.


Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, July 21, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.


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