Insuring the Insurer

Reinsurance has long been an effective means of diversifying risk for property and casualty (P&C) insurance companies in Canada, particularly the risk of large-claim events. Nevertheless, reinsurance risk does exist and it can have important implications in determining the ultimate cost of an insolvency for member insurers.

REINSURANCE IN CANADA

The Canadian P&C industry is a heavy consumer of reinsurance products. Reinsurance, a highly complex global business, accounts for about 24% of the Canadian P&C insurance industry’s direct written premiums. In comparison, reinsurance accounts for about 6% and 17.1% respectively of U.S. and Organization for Economic Co-operation and Development direct written premiums.

Reinsurance allows insurers to transfer risks that exceed their underwriting capacity or to share risks they choose not to bear alone. The principal value of reinsurance to a primary insurance company is recognition in the financial statement of a reduction in its liabilities (in its unearned premium reserve and its unpaid claims loss reserve). The reduction in these two accounts is commensurate with the payments that can be recovered from reinsurers.

The purchase of reinsurance can reduce the volatility of insurer underwriting results, provide capital relief and also provide specific expertise and services for an insurer. Acting as a risk transfer mechanism for large losses, reinsurance has been an important part of the insurance industry for nearly 160 years, contributing directly to the stability of the Canadian insurance markets.

Highlighting the value of reinsurance to primary companies, the global reinsurance market in 1998 and 2005 bore about two-thirds of the Canadian P&C industry’s combined Cdn$3.9 billion in catastrophe losses. In the United States, the reinsurance industry absorbed half of the Cdn$68.2 billion in recent hurricane-related insured losses.

Were there ever to be a loss of reinsurance support, the implications for a primary insurer would be extensive and could potentially result in the financial impairment of the primary insurance company.

REINSURANCE AND SOLVENCY

In Canada, reinsurance has not been a major source of in surance company insolvency, but it has been a contributing factor in a quarter of all failures over the past 50 years. In the majority of insolvencies in which reinsurance was a contributing factor, the issue appears to have been the failed insurer’s reinsurance management, and not any failure on the part of the reinsurer. In some cases, there were complex inter-group arrangements; in others, there was an over-reliance on reinsurance assets that became more difficult to obtain when the reinsurance market hardened.

REINSURANCE RISK

Although the overall risk is low, reinsurance companies do fail. Since 1990, an estimated 82 reinsurance writers in Canada, the United States and the United Kingdom have exited the market involuntarily through a winding-up or liquidation order. All were relatively small players in the reinsurance market; the majority were reinsurers affiliated with insurance groups. Three departures had a direct impact, albeit a small one, on the Canadian market. Reinsurers have also involuntarily exited the market in other jurisdictions, but we have insufficient information on these exits.

While reinsurance has a long history of working successfully with insurers, reinsurance recoverables may be a potentially risky asset on an insurer’s balance sheet. The key risk is that the reinsurance party in an agreement will default. During 2006, Property and Casualty Insurance Compensation Corporation (PACICC) member insurers ceded one-quarter of their premiums to reinsurers and booked Cdn$15.8 billion in reinsurance recoverables as assets on their balance sheets.

The financial strength of reinsurance companies, while still strong, has weakened over the past several years. The number of financial strength rating downgrades of reinsurance companies has exceeded upgrades in recent years. Reinsurance has been an important risk management tool for the insurance industry, but reinsurance assets nevertheless contain some risk: they can deteriorate quickly, cannot be readily sold and must be actively managed.

(UN) REGISTERED REINSURERS

High levels of reinsurance recoverables ceded to unregistered (those not chartered in Canada) and unaffiliated reinsurers might be a risky strategy for insurers that make extensive use of reinsurance. Unregistered reinsurance is generally believed to be a higher risk than reinsurance placed with registered reinsurers. Reflecting this, the MCT and BAAT capital tests have a risk factor for unregistered recoverables built into them. Using a sample of member companies, PACICC estimates the average financial strength rating of an unregistered reinsurer is approximately two rating grades below that of large registered reinsurers.

Unregistered reinsurers, companies that are largely domiciled outside Canada, had a 26.7% share of Canadian “unaffiliated” premiums on average since in 2003, according to data from MSA Research. The term “unaffiliated” refers to the relationship between companies. A primary insurer may cede business to a reinsurer affiliated with it or one that is unaffiliated. Insurance premiums ceded to such reinsurers totalled Cdn$760 million in 2006, a 3.5% decrease from 2005. More than 54 offshore, unregistered reinsurers assumed Canadian premiums.

For PACICC, as well as regulators, insurance companies, brokers and consumers, reinsurance risk is important because it is one of many factors that can directly affect the solvency of an institution. It may also affect the level of assets ultimately available in the event of a liquidation. For example, since 2001 there have been five insolvencies of P&C insurers in Canada; in three cases, reinsurance recoverables were between 45% and 55% of the total assets available to run-off the insolvent operation. This is three to four times the industry average.

REINSURANCE AND THE LIQUIDATION PROCESS

In assessing the collectibility of reinsurance, there are two key issues to consider: the solvency of a reinsurer, and its willingness to pay. Solvency is tied to a reinsurer’s ability to discharge obligations as they become due. Willingness to pay can be measured by the degree of friction encountered when collecting recoverables from solvent reinsurers — from differences in understanding contractual arrangements and other sources. The first can be readily assessed; the second is more challenging to measure.

In a solvent circumstance, the reinsured must first pay the loss and then seek reimbursement for that loss from its reinsurer. The situation is somewhat different in an insolvency. Where claims are fully covered by PACICC, the liquidator will pay claims and follow up with the reinsurer in the normal fashion. For non-covered claims or claims that exceed PACICC’s Cdn$250,000 limit, however, the insolvent insurance company does not pay claims. Rather, it allows claims against the assets of the estate for future distribution to policyholders and creditors of the estate.

Reinsurance policies are contracts of indemnity. But most reinsurance treaties in Canada using the recommended wordings of the Reinsurance Research Council (RRC) have an insolvency clause. This clause provides that, should the reinsured become insolvent, reinsurance amounts will be paid to the liquidator and will become assets of the estate.

For those not using the RRC wordings, reinsurance treaties may not have such an insolvency clause — increasing the need for dialogue between the liquidator and reinsurer. An insolvency clause also generally allows the reinsurer to offset its obligations to the insolvent insurer against any amounts owed by the insurer. In some cases, this offset may be substantial.

In evaluating the reinsurance experience among liquidations, PACICC found a strong negative correl ation between the proportion of total assets represented by reinsurance recoverables and the level of recoveries expected from a liquidation. In fact, the correlation coefficient (a statistical function used to determine the degree of relationship between two variables) is -67%. This suggests that as reinsurance recoverables increase as a proportion of total assets, the cost of insolvency to PACICC member insurers also increases. This is not in all cases due to the reinsurance recoverables, per se, but likely reflects deeper capital management issues.