A.M. Best’s proposed BCAR revisions could impact ILS demand: WCMA

Proposed revisions of A.M. Best’s Capital Adequacy Ratio (BCAR) has the potential to positively and negatively impact demand for reinsurance and insurance-linked securities (ILS) capacity, according to Willis Capital Markets & Advisory (WCMA).

Ratings agency A.M. Best’s BCAR is used to assess the strength of an insurance or reinsurance balance sheet, which the firm uses to assign ratings to re/insurance companies.

Following an announcement from A.M. Best that during the first-quarter of 2017 it hopes to implement changes to its BCAR methodology; WCMA has discussed the potential fallout from certain changes to BCAR for players in the reinsurance and ILS space.

“Among the factors reviewed is the treatment of catastrophe risk. The changes could have a potential impact on reinsurance and ILS cover needs for US P&C re/insurers,” said WCMA.

Specifically, the change WCMA is referring to concerns catastrophe risks no longer being mitigated via diversification with other types of risks, meaning cat risks will be treated as a separate category under new BCAR methodology.

To achieve this, explains WCMA, A.M. Best has chosen to shift catastrophe risk from “a deduction to the Available Capital to an increase in the Required Capital.”

BCAR methodology comparison - Source: WCMA

The above diagram provided by WCMA compares the current, and proposed catastrophe risk BCAR revisions from the ratings agency.

“This is a very conservative approach with respect to most insurers’ internal capital models and could potentially lead to a severe deterioration of the BCAR for certain diversified US insurers, and therefore their rating,” says WCMA.

WCMA raises an important point, underlining the potential for re/insurers to see their BCAR decline owing to a need to hold catastrophe risks under Required Capital.

Another proposed amendment to A.M. Best’s BCAR methodology is that the ratings agency will now calculate multiple BCARs on several return periods, which includes a 1/20, 1/100, 1/200, 1/500, and 1/1000 year return.

WCMA explains that for catastrophe risks A.M. Best will continue to use the relevant PML on a per-occurrence basis, which has both positives and negatives for the reinsurance and ILS sector.

One positive for the industry is the potential for increased reinsurance demand, which could filter down to greater demand for diversified, efficient ILS capacity backed by capital markets investors.

WCMA explains that regarding “certain perils where much of the risk is beyond 1/200 (e.g., New Madrid earthquake) this change could drive additional demand.”

Reinsurers and ILS players are increasingly looking for new opportunities to increase revenue at times of market turmoil, which is underlined by persistent rate declines, so any potential uptick in demand will likely be welcomed by the sector.

WCMA notes that while the use of a per-occurrence view and the calculation of multiple BCARs based on several return periods has the potential to grow demand, it will also “give much more clarity about the robustness of a re/insurance company to various stress tests, even at levels which are more conservative than other rating agencies.”

With that being said, WCMA also explains that a per-occurrence view isn’t as accurate as an aggregate basis, as insurers and reinsurers might still be exposed to the occurrence of multiple medium sized events.

“This latest point is one which penalizes ILS markets over rated-entities greatly, as ILS investors are particularly well suited to support aggregate covers,” said WCMA.

Furthermore, any insurers or reinsurers that has a strong focus on its A.M. Best rating “may indeed focus optimising its 1^st and 2^nd event retentions as opposed to looking at its AEP curve,” explains WCMA.

As a result of this WCMA highlights the potential for the overall reinsurance spent for U.S. re/insurers might “modestly increase as attractiveness of ILS capacity is reduced.”