Relying on the cheapest available source of reinsurance capacity is not advisable, according to rating agency Standard & Poor’s. Insurers seen to use cheap reinsurance capital in an undisciplined manner, could face rating downgrades the rating agency warned.
In the current softened reinsurance market environment, reinsurance capital and capacity is almost as cheap as it has ever been.
With more capital than ever before in the sector, thanks to well-capitalised traditional reinsurers who have not faced major catastrophic losses for a few years, as well as the growing pool of alternative capital augmenting capacity and availability of risk transfer, the temptation to leverage cheaper reinsurance for growth or arbitrage is great.
However the rating agency feels that this would be inadvisable.
“We could take rating actions if we start to see insurers rely on cheaper forms of reinsurance to support excessive growth, poor underwriting standards, or insufficient risk management,” said Standard & Poor’s credit analyst Tracy Dolin.
S&P has noticed that ceding insurance companies are adopting different strategies towards their protection, resulting in a “bifurcation of reinsurance optimization strategies” which highlights different levels of strategic risk management sophistication and also risk tolerances.
While S&P does not believe that “insurers are changing their risk tolerances and/or underwriting guidelines just because cheaper forms of reinsurance are available,” the rating agency does warn that any signs that companies begin to base key decisions on the availability of lower cost reinsurance capacity could result in a rating downgrade.
So S&P is warning insurance and reinsurance ceding companies not to become complacent just because market conditions for buyers of reinsurance or retrocession are favourable, but to ensure that reinsurance purchases are undertaken with similar levels of discipline to insurance underwriting.
S&P notes that the trickle down effect of cheaper reinsurance pricing is unevenly seen and most evident in larger commercial property insurance accounts. S&P also notes that although there is evidence of reinsurance arbitrage, it is not yet apparent that large cedants are setting their risk tolerances based on the availability or price of reinsurance capacity.
S&P notes that while the benefits of cheaper reinsurance are being felt by ceding companies, these benefits are not always being passed on to the insurance consumer, which creates an opportunity for arbitrage. However it doesn’t feel that primary companies are “compromising their underwriting standards” yet.
Despite the arbitrage opportunity, S&P has not yet “seen a trend by cedants to increase their top line through reinsurance leverage.”
However, with profitability less certain for primary companies, as softening begins to impact some of their lines of business as well, the temptation to loosen discipline and take advantage of the reinsurance arbitrage opportunity may grow.
So while, at the moment, price alone is not driving reinsurance purchasing, there is a risk that if the soft market continues and affects primary lines, primary insurance companies may be tempted into leveraging the cheaper reinsurance capital for growth opportunities.
It’s another factor to watch, as the structural change in the reinsurance market plays out. Sometimes its tempting to buy the cheapest product on offer, but when it comes to the protection that your business relies on it could prove not to be the most prudent of decisions.