Diversification a benefit, as long as it’s for the right reasons: S&P

A report from rating agency Standard & Poor’s highlight the benefits diversification can bring to a reinsurance or insurance business model, but only so long as the company is diversifying for the right reasons, which raises questions given the current soft and challenging market.

For the majority of reinsurance or insurance companies a level of diversification within their businesses is essential. Diversification of risks underwritten enables capital to go further, in terms of regulatory and rating benefits applied.

Of course diversifying the portfolio of risks underwritten also enables reinsurance firms to ensure that they are not solely exposed to one major peril, making their businesses more sustainable and often appealing to shareholders.

Diversification can be across more than just the risk or peril, it’s also geographic, based on expected loss or attachment probabilities, product, trigger and structure based as well. It’s an essential part of the fabric of the insurance and reinsurance market, as well as the majority of insurance-linked investment strategies, but only if it’s for the right reasons.

“We assess diversification, such as successful geographic and product diversification in our business risk profile analysis and investment portfolio diversification by obligor and sector in our risk position analysis. We may also assess a more-quantitative diversification benefit in our risk-based insurance capital model,” commented Standard & Poor’s credit analyst Deep Banerjee.

But S&P warns that “not all diversification is equal in terms of its potential impact on credit-ratings.”

Bannerjee explains; “Although we often acknowledge the benefits of a well-diversified insurer in our ratings, we may find some forms of diversification to be credit negative.”

S&P cites those credit negative diversifying factors to be where a re/insurers has a “chronically underperforming business segment,” thus the diversification benefit is eroded.

Or a strategy that sees an insurer or reinsurer “diversifying into a country or business segment with which management is not familiar” could detract from credit quality rather than support it, S&P explains.

S&P also notes that “in a stressed environment, insurers generally benefit from having less-correlated risks.” By stressed we assume that means due to losses or other factors which we suspect would include the highly competitive and softened reinsurance market environment.

And that leads us to the point of this article.

If reinsurers are increasingly being pushed to new regions, risks, perils and to cut their prices there, to levels near their cost-of-capital as some of the largest reinsurance firms admitted, what does this mean for the diversification benefit, does it have the same level of credit quality? And is this diversification for the right or wrong reason?

It’s hard to believe that all the moves by reinsurers over the last year to pull-back on property catastrophe risks and divert capacity to other lines, which were perhaps not specialties until the catastrophe market softened so far, have been with the same level of discipline as they would underwrite in markets they had been in for a long time.

Even if new teams are hired, the temptation to cut prices and expand terms in order to begin to build a book at a new reinsurer can be high for underwriters, making the risks of diversifying perhaps stronger in a softened and competitive reinsurance marketplace.

If a reinsurer began to show signs of having diversified for the wrong reasons, or without the right risk controls in place, we’d imagine the rating agencies will take a very dim view. With so many reinsurers having expanded into new lines in the last year or two, the risk of this happening to some could be higher than we think.

So diversification is another factor to keep an eye on, in a softened, competitive and increasingly disrupted reinsurance market.

Of course, interestingly, the ILS market can go two ways here, with the fully diversified model adopted by many, but increasingly sophisticated and experienced investors looking for more peril concentration. That of course can provide an advantage, even over diversified players, as the investor seeking the concentrated risk return can often have the most efficient capital advantage.