Scrutinising the financial stability of reinsurers has become an important task for primary insurers. And some reinsurers fall short, says Herbert Fromme.

Consider this: you run a medium-sized continental European primary insurer. So far, your organisation has survived the current crisis moderately well, write-downs on investments are manageable. You burned your fingers in the equity crisis seven years ago and since have kept the volume of shares in your investment bouquet low. You also have managed your counter-party risk well. You and your finance chief introduced an upper limit for any counter-party – no investment with a bank, a hedge fund or a private equity operation may exceed 1% of your total investments.

In this comfortable situation you realise one very uncomfortable truth: when buying reinsurance, one of the key instruments for securing your company’s future, you don’t have that option. There are simply not enough reinsurers around with the rating you require or the know-how you want. You worry deeply and have some explaining to do to your supervisory board.

This is not a theoretical scenario. Many chief executives of primary insurers face the problem. For them, scrutinising the financial stability of reinsurers has become an important task. And this goes far beyond looking at annual reports and ratings.

In the next round of redistributing market shares, reinsurers with a very conservative investment strategy are set to win. Others will have problems.

One key example is Swiss Re. Technically excellent and well-loved by customers for know-how and research, it mistook the investment side of its operation for a separate business, similar to that of an investment bank, whose main purpose was to speculate on behalf of customers.

The company’s losses on subprime-related deals sent a shockwave through the industry. The fact that Warren Buffett had to come in with financial help, another. The company saw the signs very late, and new chief executive Stefan Lippe, who in February replaced Jacques Aigrain, is facing a large task to bring the company back to financial stability – without handing it over to Buffett.

The time when cedants did not care what reinsurers did on the investment side is long over, if they were ever there. Cedants consider some of that money indirectly theirs – and the fact that reinsurers carry a large part of the primary insurers’ long-term reserves justifies this view. All they want is a reinsurer that is able to pay even during a major financial upheaval.

This view is not limited to cedants. Investors too understand what they want when investing in reinsurers: they want to participate in the business of making money on proper underwriting and risk-taking. If they wanted to invest in fancy and risky papers and models, they would have done so through other means, not the asset side of the reinsurer they buy shares in. This is one of the reasons many reinsurers have fared so badly in recent months. This experience is not limited to this crisis or to Swiss Re or XL where there have been sharp falls in share prices. In the crisis of seven years ago, overexposure to shares meant Munich Re’s balance sheet was severely dented; it was also foolish enough to seek a fight with the rating agencies – which it promptly lost – with the negative consequence of a downgrading. Reinsurers are the fire brigade of the insurance industry and so need fast and powerful vehicles. But they haven’t been equipped with these vehicles to make a bit of extra cash by taking part in stock car racing championships.

Herbert Fromme is a Cologne-based insurance journalist.