Reinsurance Exposure Put Under Spotlight

Reinsurance Exposure Put Under Spotlight

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

With reinsurance leverage reaching a peak, the quality of reinsurance counterparties declining and over-reliance on reinsurance becoming evident in a number of recent failures, this risk exposure is attracting increased attention in today's operating environment.

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

In other lines, particularly specialty, some insurers chased premium volume in novel and/or unfamiliar areas, using reinsurance to hedge not only their risk appetite, but their inexperience as well.

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

Finally, as many old-line commercial insurers revise their existing estimates of the cost of asbestos claims upwards, they also add reinsurance exposure to the extent that a portion of that adverse development is estimated to be recoverable under decades-old reinsurance contracts.

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

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

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

Moody's considers reinsurance to be an imperfect substitute for capital, because of a general decline in reinsurers' credit quality, an erosion of its reliability, and because its credit risk is correlated with the more extreme events under which ceding companies are likely to call upon it.

Not so long ago, the reinsurance market–especially at the upper end–was characterized by its reasonably stable competitive structure, by substantial tangible and economic capitalization, by strong margins, and by extremely high credit ratings. Much has changed. Beginning in the late 1990s, with possibly unprecedented weakness in commercial property-casualty insurance prices, reinsurers found themselves subject to a seemingly continuous parade of stress events.

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

These events have taken their toll on primary insurers and reinsurers alike, as reflected by the overall decline in credit ratings in the sector. And although dramatic rate increases implemented over the last two years have helped to divert attention away from these unpleasant events, Moody's remains concerned–based on our preliminary actuarial assessment of primary insurer reserves–that further adverse development may be incurred on business written in the late 1990s.

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

Five years ago, more than one-half of the reinsurance ceded in the United States was to “triple-A” rated companies, most of whom have since been downgraded. This shift downward in reinsurance credit quality has come at exactly the same time that aggregate exposure to reinsurers has been growing. These two negative forces are creating a squeeze on primary insurer operating leverage that continues today.

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

Once upon a time in reinsurance, commercial relationships between reinsurers and their clients were loosely governed by a mutually recognized code of conduct under which the reinsurer would follow the fortunes of its clients. When both parties made money, this chivalry was easy enough to maintain, but it began to come under pressure when the market turned soft in the mid-to-late 1990s.

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

The decline in reliability of reinsurance is reflected in a rise in a number of unhelpful behaviors, including outright refusal to pay apparently valid claims, though the methods are typically more subtle than that.

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

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

Deferring a decision on the claim until the completion of an extensive, and extended, review of underlying documentation, which might enable the reinsurer to find a reason to deny the claim but at least allows the reinsurer to retain the float longer.

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

Routinely opting to litigate rather than settle claims.

Nothing in these comments should be construed as suggesting that reinsurers are seeking to effect a wholesale disavowal of their financial responsibilities. The effect of these trends on reinsurance reliability is likely to be marginal.

Having said that, if a reinsurer is able to successfully “negotiate” away as little as 5 percent of what it owes to a ceding insurer, the loss (or decrease in asset value) to the ceding company would dwarf the expected loss implied by the reinsurer's insurance 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 one percent.

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

(C) 2003 Moodys Investors Service Inc. All rights reserved.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, July 21, 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.