Insurance and reinsurance focused rating agency A.M. Best is seeking comments from interested parties and market participants on a newly published draft criteria report titled “Rating Reinsurance/Insurance Transformer Vehicles.”
The convergence of the reinsurance and capital markets has produced a range of new platforms and instruments for transferring insurance and reinsurance risk between parties and ultimately into the hands of capital markets investors or investment funds.
These structured products, such as catastrophe bonds, industry loss warranties (ILW’s), sidecars, derivatives and investment-linked insurance products, provide an opportunity to transform risk from insurable interest into a derivative instrument and vice versa.
Transactions such as these are typically achieved with the use of a transformer vehicle, which acts as the bridge between re/insurance markets and the capital markets. Increasingly these transformer vehicles are also used in part to: overcome the regulatory hurdles that may be encountered by an insurance entity trying to write credit derivative products; to access or add additional market capacity, particularly from ILS sources; and to facilitate investors’ growing interest in reinsurance or insurance-linked securities and investment products.
A.M. Best says that as these transformer vehicles are distinct corporate legal entities which have characteristics and features similar to a normal insurance or reinsurance company, they are covered in the main by its usual credit rating methodology.
Because reinsurance transformer vehicles have a unique use-case there are rating considerations that need to be taken into account, which are not covered by the typical Best credit rating methodology. As a result it has published this draft criteria report to highlight considerations which are unique to the evaluation of transformer vehicles and the process they undertake to transfer risks between counterparties.
The draft criteria report describes A.M. Best’s approach to rating or evaluating a transformer reinsurance vehicle or an insurer or reinsurer licensed or designated as a special purpose insurers or vehicle in various regulatory jurisdictions, which have the primary business of assuming and ceding insurance risks funded by various capital-market instruments.
A.M. Best says that the uniqueness of a transformer reinsurance transaction deserves additional analysis when evaluating the capital a transformer holds to fund its exposures. Other unique issues A.M Best says need to be considered include: the type of product warehoused in the transformer vehicles; the intended short life span of the transformers; and in addition to reinsurance, the use of other capital-market instruments (i.e., swaps, letters of credit, financial guarantees, contingent arrangements, derivative contracts, etc.) as mechanisms to cede all or a portion of the exposures contained in these vehicles.
In general when rating a transformer A.M. Best relies to a degree on documentation provided by the sponsor or other independent third-parties. The draft rating criteria details the types of documents submitted for evaluation as well as how A.M. Best approaches evaluating the risk modelling work the transaction was subjected to and the various counterparties that feature within a transaction.
The collateralized nature of reinsurance transformer transactions is also assessed, with A.M. Best determining the capital required to fund the transformer vehicles exposures, with the capital adequacy and ability to cover its retained risks a key element in a transformers rating.
Given the importance and prevalence of the transformer vehicle and the special purpose insurer to the insurance-linked securities (ILS), collateralized reinsurance and catastrophe bond market as a transactional tool, it is advisable that market participants review the draft criteria and provide any feedback or comments directly to A.M. Best.
A copy of the draft criteria report can be found via the A.M. Best website here (PDF, may require login).
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