Reinsurer security is paramount for any reinsurance buyer, but, asks Neil Bennett, do they receive sufficient information to allow them to adequately assess this?

This is the time of year when reinsurance managers of cedants bask in the warm glow of satisfaction generated by completing their 1 January reinsurance placements - hopefully on time and within budget. As each layer reaches the magic 100% mark, the sense of well-being increases.

But are we fooling ourselves with a false sense of security? The real test of these reinsurance programmes is yet to come, and security is a key component of that test. How will reinsurers fare in the coming years, and will they be there if and when required to pay claims?

If there is one key issue for reinsurance buyers it is surely the security of reinsurers - and it is the security at the time the claim is paid that really matters, rather than the security at the time of purchase.

Information rich

Reinsurance purchase may be described as the exchange of insurance risk for credit risk and this trade is driven by a number of key factors. Risk data is an obvious one. Transparency in the insurance risk is vital. It is in the interests of the cedant to ensure that reinsurers fully understand the risk being ceded. Failure to achieve full transparency will almost certainly result in problems at a later date.

To this end, reinsurers require significant amounts of information: risk profiles, catastrophe modelling results, breakdown of the account and an understanding of the underwriter's philosophy, as well as information regarding the effectiveness of internal controls, and risk identification and mitigation mechanisms. Today, insurance companies record more risk information than ever before. The value of this information in risk assessment and the purchase of reinsurance is undisputed. Reinsurers and reinsurance brokers contend that reinsurance capacity is more readily available to those insurers with comprehensive information while those with less robust, poor, or incomplete data, pay more for the same capacity or cannot find any capacity at all.

Let us not forget, however, that risk is passing in both directions and both sides need to demonstrate their willingness to provide the data required to fairly assess that risk.

Facts, not fiction

To achieve the best spread of secure reinsurers, insurers are looking to make specific assessment of the credit risk they face. But there are a fairly limited set of tools available to do this. No doubt, there is scope for the insurance sector to improve its assessment of the credit risk of reinsurers and the exchange of information is very important.

Comparing the wealth of data, financial information, statistics and modelling available to reinsurers with the limited data available to insurers, the credit risk assessment appears almost arbitrary. Insurers mitigate the potential credit exposure by establishing minimum ratings, minimum levels of surplus / shareholders funds, and minimum standards for other key financial measures, such as solvency ratios. Insurers have made a significant investment to establish their own research facilities to analyse publicly available financial information - although this data may be considerably out of date at the time of purchasing a reinsurance programme. Furthermore, a major component of any reinsurer's balance sheet is the level of reserving.

Despite the advancement of the actuarial profession this appears to remain a less that exact science and barely a quarter passes without a reinsurer (or insurer) announcing a strengthening of reserves for prior years underwriting.

Insurers will of course consider 'soft' information, such as underwriter's market intelligence and feedback, when making a decision on acceptable security.

Assessing credit risk

Where there is an interactive financial strength rating, the rating agencies have access to more detailed and more contemporary financial information, and to the reinsurer's management team, and so should be able to provide a timely and independent view of the financial strength, or otherwise, of the reinsurer. These agencies are in a strong position to provide insurers with the information they need but have been accused of being reactive rather than proactive. Although the rating agencies point out that the ratings are a continuum, for a reinsurer the consequences of being 'BBB' rather than 'A' can be severe. Perhaps this acts as a constraint - the danger of self-fulfilling prophecies - but the rating agencies should be looking at how they can offer more early warnings on potential issues.

Of course, publicly quoted companies need to be aware of potentially price-sensitive issues and this could be seen as a barrier to greater openness, but it should not be used as an excuse in halting the progress towards transparency.

Large multi-national reinsurers, operating across many countries and jurisdictions with numerous accounting and reporting standards, complicate the task of assessment. The introduction of International Accounting Standards (IAS), whilst a significant challenge for the industry, would at least facilitate the relative assessment of reinsurers and possibly the absolute assessment.

Can pay, won't pay

Insurers face the twin spectres of the reinsurer's ability and willingness to pay claims. The tools available to assess the reinsurer's financial ability to pay have already been discussed. However, their willingness is equally important. Transparent and complete information of the insurance risk being traded should ensure that insurers and reinsurers have similar expectations of what could give rise to a claim. No matter how diligent insurers are in the provision of information, there will always be disputes between insurers and reinsurers, but experience shows that there the general attitude towards claims varies from one reinsurer to the next. Claims payment is an important factor to consider when selecting reinsurers.

The reinsurer pool is shrinking

Concentration of risk is another area creating issues for insurers. In long-tail risks, in particular, the bar is set higher by cedants and so there are fewer acceptable reinsurers. If we were to experience another major risk event of the magnitude of, say, asbestosis many insurers would be chasing the same balance sheets for their reinsurance recoveries. The implications for the market are self-evident.

Since 2001, reinsurers, in the main, have performed well. The relatively low level of claims has enabled many to enhance their balance sheets.

This performance is seen as a testament to the reinsurers' boards and managements focusing on sustained profit growth and the delivery of shareholder value. But is this a reality or a fallacy? The real strength of the Bermudan 'Class of 2001' has yet to be tested. They have benefited from the market's relative stability, enabling them to build up their financial strength, but how will they fare in the face of substantial claims? 2004 may have been a near record year for catastrophe losses, but this was mainly driven by the frequency of events and so the reinsurance market was not fully tested. How would the reinsurance market have fared had the Indian Ocean tsunami occurred in an area where more insurance is bought?

The newer players have made hay whilst the sun shone over the last few years. The traditional companies have done the same but continue to face the possibility of deterioration in their reserves, resulting from issues such as the ongoing impact of US casualty claims. The future balance sheet performance of all reinsurers is difficult to judge, especially as there remains an imbalance between the depth and breadth of information available to insurers and that required by reinsurers.

Paying for the privilege

Some of the 'well-rated' players are indicating that insurers should be paying higher premiums in recognition of the benefits this better rating represents. The counter to that argument is that those insurers who place a particular emphasis on limiting the number of reinsurers they use are already paying a higher price. The law of supply and demand applies. The stronger reinsurers already have advantages over less well-rated players, in terms of the spread of risk and line sizes that insurers are prepared to cede, and the advantage of not being required to post collateral. Meanwhile, what happens if a reinsurer is downgraded? Will they rebate the additional premium paid for their superior credit rating?

Perhaps reinsurers could offer cedants a credit wrapped policy guaranteeing that the security available at the time of claims payment would be rated, say, 'AA', with the cost of the credit wrap being borne by the reinsurers and the price of providing that guarantee for an 'AA' rated company included in the premium paid by the cedant. This would give the insurer the required comfort level and create a differential in return between differently rated reinsurers.

Appetite for change

Reinsurance has long operated on the basis of continuity and, in an ideal world, insurers would have stable panels of reinsurers. But we also need to maintain the credit quality of our market. The impact of changes, and the growing importance of contract certainty, is another factor which reinforces the need for transparency. Initiatives such as the London insurance market's adoption of process reforms can only help in this process. Insurers and reinsurers alike see the value and commercial sense in delivering both clarity and certainty in contractual terms, and the creation of an efficient and streamlined business process. The processes the London market will adopt over the coming years will make it easier to share more information.

It is in all our interests for there to be a strong reinsurance market and there must be a fair price paid for this. But the price needs to reflect all aspects of the insurance and credit risk and this will only really come from greater collaboration between insurer and reinsurer.

Neil Bennett is Reinsurance Officer of ACE European Group.