As Reinsurance Recoverables Percentage Drop, Concern Is On The Back BurnerTemporarily

The numbers suggest that reinsurance recoverables are less of an issue for ceding insurers these days, but market dynamics could change that in a heartbeat, experts warn.

Concerns about the ability of primary insurers to collect on promises made by their reinsurance partners were strong enough to make it onto National Underwriter's top-10 story list in 2003, but with primary insurers retaining more risk last year, the issue was barely on anyone's radar screen in 2004.

The good times have also been reflected in the shrinking percentage of surplus that recoverables monies owed to the primary companies by their reinsurers represent.

However, at $174 billion for 2003, recoverables still represent nearly half of industry surplus and present challenges to numerous companies particularly those with balance sheets that may not be all that robust to begin with.

Also troubling is the rise in dollars that are in dispute between primary and secondary companies, reflecting to a certain extent a transformation from a relationship-based way of doing business to one that is more transactional.

Nevertheless, three years of a hard market have gone a long way toward reversing the trend in terms of the percentage of surplus that is owed to primary insurers.

Adam Klauber, managing director for Chicago-based Cochran, Caronia Securities LLC, recalls a markedly different time shortly before the Sept. 11 attacks transformed not only global politics but also insurance industry pricing dynamics.

“I think the pendulum has swung the other way from 2001, when recoverables were a rapidly increasing risk for the insurance industry,” Mr. Klauber said.

Today, insurance companies are retaining more risk as they have built up capital and like the profit potential of the risks they see. “But the needle does not move that quickly, so you will see [recoverable reduction] more next year than this year,” he added. “You will see it go down materially next year.”

Others disagree, or at least look at the situation from a different perspective.

As a Westport, Conn.-based executive vice president for London-based reinsurance intermediary Benfield Group, Robert Bredahl must deal with the concerns of his clients primary insurers and some face the challenge of managing sizable recoverable portfolios.

“I still think it is a significant problem, and I think it is too early to say the situation is improving,” Mr. Bredahl said.

He takes little comfort from the figure moving from 59 percent of surplus in 2002 to 48 percent a year later. “I think that is just a function of how the financial metrics are moving,” he said. “As the companies retain more risk, they are not quite as leveraged as a percentage of surplus, but I dont think it is an important measurement.”

He also noted that for many companies, recoverable balances exceed surplus, while in some cases particularly for program writers outstanding recoverable balances can be several times that of surplus.

Mr. Bredahl and others in the industry point to the increasing number of disputes between insurers and reinsurers as pieces of the recoverable puzzle, noting that many of those disputes arise from the months that sometimes go by between the time the risk is ceded and a formal contract is signed.

“This practice, while the norm in our industry, sometimes can expose all parties to potential disagreements and misunderstandings, Mr. Bredahl said a tradition that came back to haunt both insurers and reinsurers in the World Trade Center coverage dispute.

Benfield has developed what it terms “contracts at inception, whose usage it hopes will one day become standard industry practice.

“To the fullest extent practical, and in the face of considerable industry inertia, we will provide full documentation at the inception of an insurance contract, he explained.

This would replace a system in which secondary insurers assume risk solely on the basis of a so-called “slip,” which provides only the sketchiest of terms, with the understanding that full documentation could come later which could be weeks or months.

“The problem is that the underwriting processes of the brokers, the reinsurance and insurance companies have been set up to deal with the historic convention, and that is after the deal is done, the reinsurance companies are on the hook,” Mr. Bredahl said.

Clint Harris, vice president at Conning Research in Hartford, recently conducted a study of the recoverables issue and reported that while the absolute growth may have slowed from 29 percent in 2001 to 6 percent in 2003, the so-called “expectations gap” between cedents and reinsurers rose 22 percent.

Much of that gap estimated by Conning to be in the $14-to-$24 billion range last year can be attributed to incurred-but-not-reported charges stemming from asbestos and other environmental long-tail risks.

In addition, there was still a 35 percent increase in 2003 in those claims that have already been paid by the cedent but are in dispute with the reinsurer. The dollar value of that category now stands at $4.5 billion.

“There is a greater opportunity for dispute when you operate outside the pro-rata formula,” Mr. Harris said. “It is a movement away from the follow-the-fortunes doctrine. That certainly has been happening of late, and it could be an explanation for an increase in disputes.”

An analyst for Chicago-based Fitch Ratings, James Auden, said the official numbers may very well mask the dispute picture.

“This is due to the statutory reporting convention that narrowly defines disputed recoverables as those subject to litigation, arbitration, or where a formal notification of coverage denial has been issued,” he said.

As for the future, the era of relative ratings stability for reinsurers, with a few notable exceptions, will last as long as underwriters have the discipline to avoid the sometimes lethal marketshare wars of the last decade, analysts contend. If such a shift in discipline occurs, the rise of recoverables in both absolute as well as percentage-of-surplus terms will push the issue from the back burner to the front in relatively short order, these observers predict.

“Technically, the hard market is over, but the question now is, Does the strong-profits market go for another year or two? And how quickly does that erode before you have to start worrying about the fundamental strength of these companies?” Mr. Klauber said. “But it will probably be 2006 or 2007 before we start those kinds of worries.”

Reproduced from National Underwriter Edition, April 29, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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As Reinsurance Recoverables Percentage Drop, Concern Is On The Back BurnerTemporarily

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