The UK’s Prudential Regulation Authority (PRA) of the Bank of England has warned that general insurers may fare worse in their stress tests, after the hardening of reinsurance and retrocession pricing is expected to drive more retained losses.
The UK’s insurance market passed the latest round of stress tests, but clearly there are some concerns over the way reinsurance and retrocession pricing has moved.
The stress tests already found that general insurers in the UK have a material dependence on reinsurance, when the most impactful loss event scenarios are tested against.
“The level of reinsurance dependency varies materially by each participating entity, reflecting both the differing scales of losses that it is exposed to, and the differing reinsurance and capital strategies adopted,” the PRA explained.
General insurers “in aggregate ceded more risk than they retain under the stressed scenarios,” the PRA said, which is in line with historic trends of reinsurance protection strategies, to manage low frequency high severity loss potentials.
Natural catastrophe event scenarios resulted in losses that caused the full erosion of some general insurers lower reinsurance layers, in the 2022 stress tests just reported on.
It was common for this to trigger the need to reinstate reinsurance in many cases, however, the full erosion of reinsurance limits was uncommon when running the stress test scenarios, the PRA explained, as “the magnitude of losses was generally contained within the design of participants’ reinsurance programmes.”
However, current reinsurance and retrocession market conditions could have a bearing on how well the UK’s general insurers would fare under a repeat of the stress tests, using their 2023 reinsurance towers.
The PRA explained that, “In light of the current hardening of global reinsurance and retrocession markets, which is expected to continue into 2023 (particularly impacting property damage, business interruption, and speciality lines of business), it is possible that Insurance Stress Test (IST) participants may, in future, retain higher levels of net loss relative to their gross losses than in the current IST 2022 NatCat and cyber underwriting scenario results.”
“This highlights the ongoing material financial reliance that UK firms have on the availability, contractual performance, and structural suitability of their reinsurance protections, along with the financial stability of their reinsurance counterparties, to mitigate their own risk of financial instability following material catastrophe losses,” the PRA added.
Stating that, “This reinforces the need for firms to have robust and effective reinsurance management and governance procedures in place to manage counterparty concentrations and monitor the ongoing financial and strategic stability of their reinsurance counterparties.”
The PRA intends to undertake “targeted supervisory investigations with selected firms to assess potential reinsurance risks to their financial and business model stability” through 2023 as a result of this.
Finally, the PRA also highlighted securitisation of insurance risks as a form of reinsurance, but noted this alongside collateralisation of reinsurance limits is a “modest feature” of the UK marketplace.
Interestingly though, the UK’s PRA points to the counterparty credit risk associated with reinsurance, which is clearly not a factor with insurance-linked securities (ILS) and collateralised reinsurance deals, given the cash is held in trust for any recoveries.
This means “there is a material reliance on reinsurers’ ongoing financial stability and the Financial Strength Ratings and assessments issued by rating agencies,” the PRA explained.