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Perspective

Why Reinsurers' Financial Strength Is Important

March 29, 2015| By Jim Greenwood | Enterprise Risk Management | English

Region: U.S.

In the most recent 2015 Flaspöhler survey of life/health reinsurance buyers in the U.S., financial security was rated the second most important factor after financial value.

For years financial security has been identified by buyers as one of the most important factors. The importance of financial strength is clear when considering the potential downside risks of a financially unstable reinsurer to the ceding company (claim reimbursement issues; talent and management resources needed to manage a reinsurance issue; financial consequence and associated rating agency and regulatory impact; etc.).

Despite their claim of the importance of a reinsurer's financial strength, many reinsurance buyers seem only to utilize a basic rating scale of “strong enough or not strong enough” when selecting a reinsurer. Buyers generally look for a minimum financial strength rating from the ratings agencies and do not recognize the credit risk differences between the reinsurance companies that meet their minimum requirements.

While this view does not hold true for all buyers, it certainly is held by many. And while it certainly can be argued that reinsurance buyers, as a group, are sophisticated, astute and financially savvy, when it comes to evaluating credit risk, the capital markets, ratings agencies and other financial services companies may have more refined perspectives about credit risk. For example, many reinsurer buyers will not differentiate price based on superior financial strength and will treat all the reinsurance as the same. The variations of a reinsurer’s shareholders’ funds as a percentage of premium can be seen in the chart below and highlights the differentiation amongst the group.
 
Sources: A.M. Best’s Special Report, “Global Reinsurance—Segment Review, How Relevant Is the Underwriting Cycle?”, September 2014, 
Gen Re Analytics

When it comes to credit risk, the ratings agencies don’t treat all reinsurers the same; their capital models vary based on the financial strength ratings of the reinsurer. In the chart below from Standard & Poor’s (S&P) capital model, an AA-rated insurer buying reinsurance from an AA-rated reinsurer will need to hold 1.51% of the reinsurance recoverable risk as capital. This number increases to 2.06% of the reinsurance recoverable risk for a single A-rated reinsurer. S&P’s capital model has the following capital requirements regarding reinsurance:

 

To put it another way, an insurer reinsuring $500 million of recoverables with an A-rated reinsurer should hold more than $2.5 million in capital as compared to their being reinsured with an AA-rated reinsurer.  Please note this is before the diversification benefit calculation.

Capital markets also differentiate based on credit risk. The bond markets, where there are significant differences in coupon rates depending on the credit of the bond issuer, provide a simplified example. Comparing the bond coupon rates for a Berkshire Hathaway (BRK) 10-year note and a compilation of other reinsurers' bonds, the coupon is about 100 basis points higher on average for the non-BRK notes. The bond market recognizes the additional risk associated with the non-BRK notes and would provide for a price differential as shown below:

 

Let’s now look at a reinsurance transaction that would mimic the cash flow of the bond and reinsured with the lower-rated company. In comparing this to a 10-year reinsurance transaction that has no differential in price, the reinsurance transaction from a bond buyer’s perspective would be the following: 

 
 

In this simple example, the bond buyer would consider this a discount of 8% and therefore underpriced. In other words, the bond buyer would view the reinsurance asset from the compilation of companies is worth 8% less on a net present value basis when compared to a similar asset from BRK. Reinsurance transactions are more complex so we are not implying that a 10-year reinsurance transaction should have that same differential in pricing; however, we believe there should be some element of price differential in reinsurance transactions.  And the longer the term, the greater the differential.

Concentration of mortality risk within the life/health reinsurance marketplace is another important factor for consideration. Over the last 20 years the reinsurance industry has consolidated significantly, yet mortality risk reinsured has expanded greatly. Currently, over $7 trillion of mortality risk is reinsured in the U.S. and the vast majority is reinsured with only five companies. The chart below highlights the change over the last 20 years in the amount reinsured as well as the number of reinsurers and the concentration in a handful of companies.

The above information is based on the business reinsured in the U.S. but when determining a reinsurance company’s mortality risk, the international exposure should also be considered. 

This concentration cuts two ways. The first, as highlighted above, is of concern to the industry from the perspective of a significant mortality event. The second concern is to an individual company and the concentration of mortality risk reinsured by one or a handful of reinsurers. Most companies have procedures in place regarding the amount of credit risk to one entity whether it is from the investment, reinsurance or supplier perspective. This should be a significant item of review during the reinsurance buying process.

The reinsurance transaction can be complex as there are many factors to consider in selecting a counterparty.  The best practices for the reinsurance-buying process should include procedures that include a risk charge based on the reinsurer’s credit quality, mortality risk exposure and the ceding company’s concentration of risk reinsured to the reinsurer.  As insurers, the commitments we make are long term.  We should do our best to ensure we can expect similar long-term commitments from reinsurers.

 

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