Fitch Ratings last week warned insurers against “ill-conceived diversification” of business lines and territories, undertaken solely to produce better scores in rating agency capital models, suggesting that such attempts might in fact lead to downgrades.

In a joint comment released from Fitch's Chicago and London offices, analysts wrote that “concentrated insurers that diversify simply to benefit from rating agency and regulatory capital treatment are unlikely to see material benefits from this strategy in the early years, and in fact, could experience ratings downgrades.”

The rating agency explained that while it is true that within an economic capital model such as Fitch's Prism model, “all else equal,” an insurer that is diversified will require less capital than one that is concentrated, “all else equal” is never true in the real world.

In particular, Fitch explained that the “operational risks associated with an unfocused or poorly controlled diversification strategy, especially during the transitional period of rapid organic growth into new lines of business or via acquisitions, are likely to far outweigh the diversification benefits.”

Fitch added that analysts use judgment to determine operational risk charges, suggesting they are likely to select high charges to capture when they feel there are elevated risks in such a scenario.

“Fitch believes that it is time to set the record straight,” the rating agency said at the opening of the report, noting that in recent months, comments have been made within the insurance industry and disseminated through the insurance media that have suggested insurers are being “forced” to diversify due to the capital charge benefits.

In fact, this issue came up during several third-quarter earnings conference calls of Bermuda-based insurers and reinsurers. For example, John Charman, chief executive of Axis Capital, blamed rating agency incentives to diversify books of business for “severe pricing pressure” on international property business.

Competitors have been wrongly provided with “incentives to diversify against U.S. natural perils,” he said. Pressed to identify parties providing the incentives, he said that a rating agency is encouraging competitors to diversify into businesses they “don't have experience to be underwriting.”

“That will, in certain areas, fuel [short-lived] competition and cost their shareholders a lot of money,” he said. “Don't forget, they have to be aided and abetted by the boards and managements of those…businesses,” he added.

During a recent interview, Chris Klein, head of counterparty risk for Benfield Group in London, agreed. “The new orthodoxy is diversification–both territorially and by class,” he said, noting that A.M. Best, which has issued the most start-up ratings, looks for diversification away from catastrophe risk by start-up companies in Bermuda.

“The concern that established players have” in sectors targeted for diversification purposes “is that this increases supply. It puts pressure on rates already under pressure from soft original pricing,” particularly U.S. casualty and U.K. liability classes, he said.

Mr. Klein said a danger of diversifying to dilute catastrophe risk is that companies get into classes they don't understand and where they don't have an established market presence.

“How, then, do you convince people they should buy from you instead of their long-established supplier? The usual way…is by offering a competitive price,” he said.

In its comment last week–”In Pursuit of Diversification: Treatment in Economic Capital Models and Prism”–Fitch analysts said they view “today's environment as being ripe for companies to overreach for diversification,” explaining that blocks of business have become available with some companies “undiversifying,” and that many companies have “excess” capital they are looking to put to use.

“Not all rating agencies are the same, and there are material differences in the way agencies assess insurers' capital adequacy,” Fitch added.

The comment is available on the Fitch's Web site at www.fitchratings.com.

“Operational risks associated with an unfocused or poorly controlled diversification strategy, especially during the transitional period of rapid organic growth into new lines of business or via acquisitions, are likely to far outweigh the diversification benefits.”

Fitch Ratings

Special Reports /

Fitch Issues Warning On Diversification

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