Uncollectibles – Fact or Fiction?

I was taught that doing business with companies with names such as “As-honest-as-the-day-is-long Re” is generally not a good idea as they are unlikely to live up to their standing. I was also warned to be wary of companies with glittering new headquarters, as the argument ran that the management of said companies would more than likely have spent more time thinking about curtain colors than the business on hand. Two frivolous items of criteria perhaps, but finding companies that can be trusted is a critical consideration in the insurance industry.

To build up belief in a reinsurance partner is to do more than look at financials. The infrastructure of a company gives a clue to its ability to deliver a quality product. Can it price business correctly? As a senior reinsurance broker recently pointed out, “if you buy from markets that consistently under-price, they will sooner or later disappear”. And, the buyer needs to ask, does the reinsurer in question have superior actuarial capabilities, a willing and professional claims department, and a wordings department that can deliver certainty of contract in a timely manner?

I recently spoke to a member of a major London broker’s security committee, and he surprisingly told me that the firm had included on their security list a company which had no rating agency ranking! The ultimate aim of any sort of reinsurance analysis is to achieve a partner who can deliver on the promise to pay. The health of the insurance market is certainly bound up with the ability of reinsurers to honor their commitments. Notably, a recent analysis suggests that reinsurance collectibles for the U.S. property and casualty primary insurance industry now represents a figure equivalent to 80% of total surplus.

REINSURANCE RISK

Reinsurers themselves have “collectibles”, and their proportion of shareholders funds/surplus is a key measure for rating agencies. So how robust is the reinsurance industry? Clearly reinsurance capital is a fraction of that in the overall insurance industry, but in recent events the sector has responded well. The appalling events of 9/11 represented a “worst case scenario” loss for reinsurers. Yet, their timely and complete response was a ringing endorsement to the credibility of the sector. And, the fact that reinsurers were able to rebuild capital after the terrorist attacks is another reason why buyers should have confidence in the sector.

However, the issue of collectibility regarding long-tail claims is more difficult. The establishment of Equitas at Lloyds represented the culmination of a huge study into the likely ultimate cost of various categories of long-tail claims to the primary companies reinsured at Lloyds. It was the first comprehensive study into this area, although the ultimate costs identified were not reflected by a commensurate increase in the primary companies’ reserves.

But, the last couple of years did see primary insurers carry out extensive studies to reassess their old year liabilities. A recent Morgan Stanley report shows that the shortfall in U.S. p&c insurance reserves has improved to $80 billion from the $120 billion estimated from two years previously. The suspicion is that this increase has not yet flowed through reinsurers’ balance-sheets. Notably, there will not be a straight pass through due to the effect of deductibles and limited coverage offered by reinsurers.

COLLECTIBLE DOUBT

Furthermore, a 2004 National Underwriter report into future asbestos claims observes that “the nature of emerging asbestos losses indicates that a greater proportion of future asbestos losses will remain on the books of primary companies as the percentages of losses recovered from reinsurers dips below historical levels”. It is interesting to note that an A.M. Best report published in March 2003, which analyzed 218 U.S. non-life insurers that failed between 1993 and 2002, found that none of the failures resulted from a reinsurance default.

It is also observable that the volume of reinsurance collectables is rising. Benfields recently analyzed 2600 U.S. non-life insurers who expected to collect $188 billion based on their 2002 returns – which reflects a 57% increase in value since 1996. When measured against the 2002 surplus of the companies in question, this produced a ratio of 79% – a significant rise on the 54% ratio recorded for 1996.

Does this equate to a greater risk of the primary companies not being able to collect? Rating agency Standard & Poor’s (S&P) uses standard bond default rates as a proxy for reinsurance failure. In contrast, A.M Best prefers the concept of impairment, as it recognizes trading conditions of a reinsurer before it is formally declared insolvent. Following the 9/11 tragedy, there was a general downgrading of reinsurance security, but subsequently the marketplace saw increased prices, tightened terms/conditions which aided in the rebuilding of reinsurer balance-sheets – yet again showing the resilience of the reinsurance sector.

It is important to note that there will always be a lag between such actions taking place and their recognition by the rating agencies. Returning to the S&P default rates, it appears that the collectibility risk is relatively small because they equate figures of 1.9% or less for “A” or better rated paper, with “AAA” paper attracting a default rate of 0.5%.

INSURER PRECAUTIONS

There have been a couple of practical steps which insurers have tried to take to ensure the rating integrity of their panel of reinsurers. Firstly, insurers have sought to collateralize as much as they can on reinsurers obligations. In its extreme form, this has led to requests to collateralize their lines of cover!

The practice of establishing letters of credit for outstanding losses is long established, but asking a reinsurer to collateralize its line before any loss has occurred simply on the basis that a company may suffer a rating downgrade, is too extreme. The wider concerns about collateralization are centered on liquidity issues and the ability of the banking industry to provide letter of credit capacity. Demands for collateralization in the event of reinsurer downgrades can therefore cause instability in the reinsurance marketplace. As such, “runs on the bank” can occur which might push a reinsurer, who could otherwise trade out of difficulty, into a more serious financial crisis.

The second step which insurers have taken to preserve the strength of their reinsurance panel is to introduce special “termination clauses” into contracts. These seek to give the insurer the ability to replace a reinsurer, should it be downgraded, at pre-agreed terms.

Again this can be counterproductive. Had these clauses been in widespread use prior to 2001/2002, then severe instability could have resulted in the reinsurance sector. Notably, there were a number of reinsurers downgraded to “B” financial strength rating after 9/11, and activation of special termination clauses would have prevented the companies in question from rebuilding their balance-sheets.

It is interesting that so much time has been spent on the issues surrounding reinsurance security and collectibility – particularly since recent years have seen few reinsurance failures. The exception to this would be Australia’s ill-timed foray into the reinsurance market. However, I would suggest that the demise of that market was well known to most observers long before it occurred.

Another issue that has been thrown up by this whole debate is that of the optimum number to constitute a panel of reinsurers. Twenty years ago the placements were heavily syndicated to as many as 50 reinsurers. Recent years have seen a significant move toward having “bigger relationships” with fewer reinsurers. It now appears that the pendulum may be swinging back the other way as insurers seek to minimize the impact of a reinsurer default.

CANADIAN CAPACITY

The Canadian market has a number of well capitalized reinsurers to partner. The barrier to entry created by the Office of the Superintendent of Financial Institutions (OSFI) should give comfort to cedants that only the finest security is allowed to become licensed. Many of these licensed reinsurers are also locally regulated by such bodies as the Financial Services Authority (FSA) in London as well as European Union (EU) regulators. As public-traded companies, they are also subject to investor scrutiny.

I believe that Canadian brokers are more than able to pick a panel of reinsurers for their clients which will give them good security from companies they can trust. Many of the devices designed to deal with security issues are destabilizing to an industry that is seeking underwriting success with the same fervor of its insurance counterparts.

Stories of “reinsurance uncollectibles” have become almost legendary in today’s volatile insurance marketplace. In this respect, buyers of reinsurance face a difficult task in assembling credible, long term reinsurance partnerships. Relationship building is therefore crucial in achieving a stable operating environment, and it can even be argued that the quality of such relations creates a competitive advantage for primary clients. To this end, there are a myriad of tools available to help today’s buyer in making an informed decision.