ANALYSIS
How robust are your reinsurance recoverables ?
For cedants previously relaxed about the structure of their reinsurance programme, a new report by Litmus Analysis has unveiled an often overlooked challenging reality about the reinsurer credit risk a cedant is really taking.
Cedants’ reinsurance recovery risk can dramatically increase at exactly the worst moment—and just when they need their recoverables most. But many cedants may be unaware of this and therefore not factoring it into their strategy and calculations when buying reinsurance.
That is the conclusion of “Hiding in Plain Sight”, a new study published by Litmus Analysis, an advisory firm specialising in ratings and credit risk. The report sought to better understand the impact of severe underwriting-related stress events on reinsurance programmes and the reinsurer credit risk a cedant is taking.
Stuart Shipperlee, managing director of Litmus Analysis, said: “For many cedants, a well-structured reinsurance programme with well-rated reinsurers is both economically rational and central to their ability to focus on business-as-usual.
“Unfortunately, this world view can mean missing a much more challenging reality about the reinsurer credit risk a cedant is taking. That reality comes from what can happen to both cedant and reinsurer balance sheets if and when severe underwriting related stress events occur.”
The report detailed three crucial consequences that occur in the event of a reserve shock—and examined how they can combine to create a scenario far worse than many insurers will have imagined.
One, the cedant’s own net retention of the shock reduces its own risk absorbing capital. Two, the cedant’s reinsurers’ share of the shock increases its exposure to the ‘reinsurance asset’ or recoverables—the amount owed to it by reinsurers. Finally, each of those reinsurers has its own risk-absorbing capital reduced (depending on the number of cedants with exposure) by its share of that, while its own exposure to its retro capacity increases.
“Individual reinsurer credit profiles can be impacted very differently by the same market-wide shock.”
Stuart Shipperlee, Litmus Analysis
Thus, the Litmus report reveals, cedants facing this type of stress event can have a much higher exposure to their reinsurers than they might like at exactly the moment when their own ability to absorb the cost of any unrecoverable reinsurance is reduced, and the risk of non-recovery due to reinsurer financial duress is increased.
Shipperlee said: “In many ways, traditional reinsurance has been and remains an ideal solution to the insured risk mitigation needs of cedants. But understanding and analysing the credit risk implications during severe insurance loss events seems to us a fundamental consideration in effective risk management by cedants of their reinsurance programme.
“Individual reinsurer credit profiles can be impacted very differently by the same market-wide shock. In a previous paper, we analysed a test sample of 35 leading reinsurance carriers. We believe the results will surprise many cedants who may not previously have considered the true implications and sequence of events when a severe underwriting-related stress event occurs.
“Cedants often seem to think of reinsurance asset risk as similar to their bond portfolio exposure, with both being rated. Unfortunately, in a shock scenario, that is not remotely the case. Bond portfolio shock risk is mitigated by those portfolios being highly diversified and liquid. The reinsurance asset is neither.
“Moreover, the scale of the bond portfolio exposure cannot grow as a result of a shock, whereas the reinsurance asset does exactly that.”
“The scale of the bond portfolio exposure cannot grow as a result of a shock, whereas the reinsurance asset does exactly that.”
Case study
In the simplified balance sheets we see how a 25 percent whole account reserve shock greatly increases ABC Insurance’s reinsurer credit risk exposure. Before the stress (Figure 1) ABC Insurance’s balance sheet looks like this: total assets of 300m with liabilities (gross technical reserves) of 200m and reported surplus (also referred to as shareholders’ funds [equity], or capital & surplus) of 100m.
Total assets include the reinsurers’ share of gross reserves of 50m—an amount that also therefore makes up half of ABC’s reported surplus.
Figure 2 shows that after the stress the reserve shock of 50m has increased gross technical reserves to 250m and the reinsurers’ share of those technical reserves to 60m (a net impact of 40m for ABC) with a resulting impact of minus 40m on reported surplus.
Reinsurance recoverables now represent 100 percent of ABC’s reduced reported surplus (both at 60m) and those reinsurers may now themselves be weakened due to the impact of the shock on their own balance sheets.
Stuart Shipperlee is managing director of Litmus Analysis. He can be contacted at: stuartshipperlee@litmusanalysis.com
Figure 1: Pre-stress balance sheet
Figure 2: Post-stress balance sheet
Main image: Shutterstock / ALDECA Studio
