Collateralized retrocession reduces reinsurers systemic risk: S&P

Based on an analysis of extreme loss scenarios, Standard & Poor’s says that it does not consider reinsurers’ catastrophe risk exposure to be a source of systemic risk and that collateralized retrocession helps to reduce interconnectedness in the sector.

The latest report in rating agency S&P’s series of Global Reinsurance Highlights, that it has published in the run-up to the 2014 Monte Carlo Reinsurance Rendez-vous, looks at how reinsurance contributes to the interconnectedness of the insurance industry.

In November of this year the Financial Stability Board (FSB) will reveal whether it has chosen to designate any reinsurance firms as global systemically important insurers (G-SIIs). Any such designation as systemically important could result in additional oversight, new capital requirements and resolution plans, says S&P.

S&P says that it recognises the interconnectedness between insurers and reinsurers which arises as a result of reinsurance coverage. In the eyes of the FSB this could add risk to the sector, as could interconnectedness with financial markets.

The theory is that the failure of major players could result in a chain of insurance or reinsurance company defaults, however in S&P’s view catastrophe risk exposure is not a source of this type of systemic risk for the insurance sector and one of the reasons for this is the growth of collateralized sources of retrocessional protection.

“Our analysis of the catastrophe exposure of reinsurers and the interconnectedness of their retrocession coverage indicates that high levels of capital adequacy are protecting the sector from systemic risk,” explains S&P.

Because of the distribution of risks and the high levels of capital, the risks of insolvency are lessened in the face of extreme loss events, the rating agency says. Furthermore, the use of fully-collateralized retrocession reduces this systemic risk even further, due to the diversification of risk capital into the capital markets with full-collateral available for claims payments when required.

One of the stated benefits of the entry of capital markets investors into reinsurance via the insurance-linked securities (ILS) market and instruments such as catastrophe bonds and collateralized covers, is the spreading of risk to a much larger and broader pool of capital.

When catastrophe bonds were first developed twenty or so years ago, the thinking was to tap the capital markets as a large source of capital able to take on the very largest peak catastrophe risks, while removing some of those exposures from the traditional reinsurance capital pool.

In this way the development of the capital markets, ILS and catastrophe bonds has been hugely beneficial for reducing the chances of any systemic failure among reinsurers should the very largest peak events occur. The growth of ILS and alternative capital to approximately 20% of the property catastrophe reinsurance market should be seen as positive in this light.

So, S&P says that systemic risk from catastrophe events is currently limited by two things, high levels of reinsurer capitalisation and the growing use of collateralized catastrophe reinsurance and retrocession. However, should capital levels fall or use of collateralized catastrophe covers decline then S&P warns that systemic risk could rise.

S&P undertook the following assessment of the ability of insurance and reinsurance to withstand catastrophe extremes:

We assessed the existence of this systemic risk by analyzing reinsurers’ catastrophe risk exposure using data from our annual catastrophe risk surveys. We investigated the effect of very extreme catastrophe events on rated global reinsurers’ balance sheets and the extent to which we believed reinsurers would rely on their uncollateralized retrocession protection to avoid bankruptcy.

Specifically, we assessed the impact of losses as a result of extreme events modeled to occur less frequently than once every 500 years; and three extreme events occurring in the same year.

With natural catastrophe losses unpredictable and having the ability to cause severe shocks to insurer and reinsurer balance-sheets, it is no surprise that this will be one area that receives focus as the FSB decides on who to name as systemically important.

S&P points out that reinsurance firms typically view retrocession protection as their defence against massive shock-losses, limiting the amount they would have to pay from their own balance-sheets. That means that the quality of retrocession is also important, as are the way that retro covers respond to events.

S&P estimates that around 30% of retrocession is on a collateralized basis, which it notes protects the reinsurer cedents from credit risks as any claims payments are made from collateral accounts and so not reliant on another reinsurers credit worthiness or capital adequacy.

This is one of the most important aspects of the insurance-linked securities (ILS) market and catastrophe bonds, that the money required to pay claims is ring fenced and cannot be eroded by other events that occur. This means that the retro protection buyer can rely on the capacity being there when they need to call on it, as long as the event qualified under the terms of a transaction.

Still, most retrocession is not collateralized still and that means that whether a reinsurer benefits from the indemnification that their retro should provide will depend on whether the retrocessionaire has defualted or not.

In many cases reinsurers and their retrocessionaires share the same risk profile and are exposed to the same events. This is, of course, not ideal. If a material nonpayment of retro claims occurred, a reinsurer could find itself in financial stress no matter how strong its balance sheet appeared before hand.

S&P explained more of its methodology:

We investigated the effect of very extreme catastrophe events on rated global reinsurers’ balance sheets and the extent to which we believed reinsurers would rely on their uncollateralized retrocession protection to avoid bankruptcy. Specifically, we assessed the impact of losses as a result of extreme events modeled to occur less frequently than once every 500 years; and three extreme events occurring in the same year. For the latter, we combined realistic disaster scenarios, as defined by Lloyd’s, covering U.S. hurricane, U.S. earthquake, and Japanese typhoon.

S&P found no evidence of systemic risk based on an aggregation of catastrophe risk. Primarily, this is due to the strong capital adequacy of rated reinsurers, S&P explained, meaning that almost all would survive these stress tests even if uncollateralized retro failed to pay out.

The reinsurers that would become insolvent as a result of these stress tests would do so even if their retro paid out, found S&P, demonstrating the importance of high levels of capitalisation in the reinsurance industry.

S&P also found that the large retrocessionaires are some of the best capitalised reinsurers in the market, which indicates they would likely be able to meet their obligations to buyers under the stress test scenarios.

No evidence was found by S&P that retrocession is concentrated in just a few companies and in the rating agencies opinion the industry does not have material credit exposure to one or a few reinsurers.

Even if capital was eroded enough that, after meeting claims, a reinsurer couldn’t meet regulatory requirements for capital S&P believes that the industry could recapitalise itself. Both shareholders and other third-party capital providers would see the attraction in recapitalising the industry at that time.

Knock-on effects of major natural catastrophes could weaken the sector, such as equity market disruption, but these scenarios are the most severe and it would require a major downturn in the global economy as a result to really harm reinsurers.

Systemic impact from catastrophe losses on insurers is also limited, S&P found, as most limit their exposure, cede peak risks to reinsurers and to ILS and as the largest reinsurers are expected to survive, claims are likely to be paid.

Downgrades after major events are of course possible for both insurers and reinsurers, but S&P’s analysis suggests that impact to ratings could be limited after these stressed scenarios. As a result S&P does not consider natural catastrophe risks as a systemic risk for insurers or reinsurers.

S&P warns that should the major retrocessionaires reduce their capitalisation or should reinsurers start to use less collateralized retro products then the potential for systemic risk after major catastrophe loss events could rise. The rating agency intends to monitor the sector for any changes here.

The full-collateralization of insurance and reinsurance risk, through ILS, catastrophe bonds and other collateralized reinsurance vehicles, has reduced the systemic riskiness of the sector it seems. With broader pools of capital now available to disseminate risk, diversifying the sector capital base and allowing reinsurers to transfer risk to capital markets investors, the development of ILS and reinsurance convergence is a positive for reducing systemic risk.

It will be interesting to see whether the FSB notices the benefits of collateralised reinsurance protection and whether it mentions ILS in its analysis of reinsurance firms systemic importance. Could a recommendation be that the reinsurance sector makes use of more diversification of capital through ILS and collateralized covers? Regulators should take note of this fact: spreading risks more widely, to new, diversified pools of capital is a positive overall for the health of both reinsurance and insurance.

You can access this report via the S&P website here.

Read all of our pre-Monte Carlo coverage, including all of S&P’s reports here.

View a video on this topic from S&P below: