Expect rating triggers to feature strongly in 2006 renewal
negotiations, says Chris Waterman.

The losses that the reinsurance industry is expected to sustain in 2005 from Hurricane Katrina and other natural catastrophes will reignite negotiations during the January 2006 renewal season for the incorporation of rating triggers into reinsurance contracts.

During the period 2001 to 2005 the credit quality of the reinsurance industry declined significantly with Fitch's average reinsurer insurer financial strength (IFS) rating falling from “AA-” to “A”. As a result of this credit shift, cedants are taking the financial security of their counterparties ever more seriously.

As cedants want to maintain diversification among reinsurers that participate on their reinsurance programmes, and at the same time only a limited number of reinsurers operate with very strong IFS ratings, we have seen an increase in demand for some form of protection against reinsurer failure. This has led to the introduction of rating triggers within reinsurance contracts and this will be further fuelled as a result of Katrina.

Rating triggers are contract provisions that require a reinsurer to post collateral or cancel a contract when its IFS rating falls below a pre-determined level. This rating level can vary from policy to policy, but inevitably exposes reinsurers to an unforeseen cash-flow deterioration or liquidity squeeze immediately after a rating downgrade. Thus the imposition of rating triggers can effectively create a rating cliff for those reinsurers whose current IFS rating is close to the trigger.

Fitch believes the use of rating triggers contributes to the “flight to quality” that is currently taking place in the reinsurance sector. While highly rated reinsurers often have the strength to negotiate the removal of rating triggers, lower rated reinsures do not have the same bargaining power. The loss of business by Converium in the second half of 2004 following its downgrade from the single “A” range to the ‘BBB' range is a good example of how rating triggers can exacerbate existing financial difficulties.

Fitch believes that the reinsurance market should employ a more efficient system in which the benefits of a strong rating are reflected in price. Until this is the case, some reinsurers will inevitably remain exposed to the compounding financial stress that results from the breach of a contractual rating trigger.