Do Reinsurer Rating Triggers Create Dangerous Conditions?
Some of the most intriguing comments to emerge from NU's recent interviews with rating agency analysts centered on the use of their financial strength ratings by reinsurance brokersor, as some analysts see it, their misuse.
Standard & Poor's addressed the controversy in written comments as well as in a followup Q&A.
"Brokers have long used ratings as one of the filters to be applied when selecting reinsurers for their clients. For short-tail business, the minimum hurdle can often be as high as 'A-minus,' rising to 'double-A-minus' for long-tail business," wrote the New York-based rating agency.
"S&P has long argued that this is not an effective use of ratings as it creates arbitrary rating cliffs, whereby the reinsurer can find business drying up when it can still be considered creditworthy in the absence of the hurdle. Indeed, a 'triple-B'-range rating is considered 'good,'" S&P said.
"The existence of [rating-related] triggers in contracts can be yet more dangerous," the agency added. "These can result in the requirement to collateralize claims reserves, void contracts, or even force contract rescission and return of premiums if the [reinsurer] rating falls below a certain level. Consequently, the reinsurer can suffer a sudden and potentially fatal liquidity crunch."
NU asked S&P Director Stephen Searby to clarify the intent of the comments.
Q: Does S&P believe that ratings should not be used to measure quality, or is it that the minimum rating is simply being set too high? How should brokers measure reinsurer quality for ceding company clients?
A: "What we're trying to say is that ratings are designed to measure to financial strength on a relatively smooth continuumvarying from 'triple-C' to 'triple-A,'" Mr. Searby responded. "For a broker to set a minimum security level, we think represents the wrong use of ratings," he continued. In reinsurance, particularly, he said, "you don't want an overconcentration of reinsurers. You want diversity among your reinsurers."
"A sensible way to [measure quality] is to say I want some 'double-A,' 'single-A' and 'triple-B' reinsurers on my program, but I'm prepared to pay more for 'double-A' security," he said, drawing a parallel to the way a debt market works. "If you buy a 'triple-A' bond, you expect to receive a lower coupon than [for] a 'triple-B,' and we would argue that [reinsurance brokers] should be using ratings in the same way."
Q: But that's not happening, is it?
A: "It's not happening explicitly. We're aware that brokers are looking into it," Mr. Searby said.
He also said that for a long time, certain slices of good quality business have only been offered to better-rated reinsurers. In other words, brokers are prepared to accept reinsurers of a variety of security levels, but the better reinsurers get the better quality business, he explained, suggesting that this sort of "verticalization" is a better use of financial strength ratings than downgrade clauses.
Robert DeRose, assistant vice president for Oldwick, N.J.-based A.M. Best, also said better rated companies get a bigger share of business and have more say in contract terms and conditions. "They lead the programs," Mr. DeRose said.
Commenting specifically on the use of downgrade clauses, Mr. DeRose expressed some different concerns than did S&P. "Some lower-rated reinsurers have, I think, wrongly maintained a position in the marketplace, in part due to [brokers'] ability to sell these [clauses]," he said, adding that brokers have sold downgrade clauses or triggers, "I think, as a false sense of security."
Expanding on the point, he said that if a reinsurer has a rating less than an "A," brokers say, "Let's get this downgrade clause and that's going to provide you with the protection that you needand that you're just as good going with an 'A'-rated or 'A-minus'-rated company as you are going with an 'A-plus' or an 'A-double-plus.'"
Reproduced from National Underwriter Edition, September 16, 2004. Copyright 2004 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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