Reinsurance Recoverables – Are They Ignored Assets?
Reinsurance recoverables can be one of the largest assets on any insurance company's balance sheet and, like the bonds in which insurance companies typically invest, they are subject to credit risk.
On the one hand, investment departments of insurance companies recognize that they are buying an asset when purchasing bonds. They are willing to pay more (i.e. have less yield) when buying higher-rated securities. If the investment departments do not like the credit outlook of a certain security? They can often trade out of it, as most bond markets are pretty liquid.
So why don’t reinsurance departments recognize the credit exposure of reinsurance in the same way?
Many do. For those companies, reinsurance is one piece of a long-term, holistic approach, recognizing that highly-rated reinsurance (and the asset it will eventually become) can cost more. Here are a few things to consider when choosing a reinsurer:
- The potential long-tail nature of the asset being purchased (liability recoverables can be on the balance sheet for upwards of 50 years)
- Rating agency and regulatory requirements for capital
- The difficulty of trading out the credit position
Unlike bonds, it is difficult to trade out of reinsurance recoverables if you do not like the credit outlook for a particular reinsurer. The only likely buyer for the asset is the same reinsurer via a commutation - so it’s important to get it right the first time.
As mentioned earlier, there is another aspect that should be taken into consideration – the Solvency Capital Requirement in the Solvency II regulation. In the standard model, reinsurance can be used to reduce the Solvency Capital Requirement because part of the cedant's underwriting risk is transferred to the reinsurer. The underwriting risk module comprises mainly premium risk, reserve risk and catastrophe risk, and reinsurance can have a risk-reducing impact on all of these elements.
Nevertheless, we need to remember that the reinsurance transaction also adds risk in the counterparty default risk module. (For more on this mechanism, read Ralf Quick’s blog, “The Crucial Role of Reinsurance in Solvency II”).
The bottom line is that reinsurance departments should expect to pay more for reinsurance with a lower credit risk, just like their colleagues in the investment department expect to pay more for bonds with lower credit risk. Not all reinsurance is the same.