Sally Bramall looks at the importance of proactive credit risk management and corporate governance for today's reinsurance buyer

Reinsurance buyers have learnt some harsh lessons about their reinsurers' security - lessons from successive reinsurer failures in the 1990s and lessons therefore taught through the appearance of gaps in the balance sheet. The world is now demanding business transparency and minimal risk. In this climate, today's buyer is arguably as much driven by the need to demonstrate active credit risk management and attention to corporate governance as by potential reinsurer failure.

The quantity of market security information available is huge, and effective analysis a specialised task. A necessary one, however, to ensure managers make informed and effective decisions when managing their risks.

There are three main issues that any reinsurance buyer needs to consider. First, the minimisation of bad debt exposure from the failure of a reinsurance partner - a partner who, after all, was chosen as a vehicle to reduce and spread risk from the cedant's balance sheet. Even the largest scale failure will nearly always produce a percentage return, but the timing of often substantial reinsurance recoverables can be extended over many years. This will potentially cause the cedant itself considerable cash-flow strains.

Second, the importance of long-term relationships with their reinsurance partners should not be underestimated. Confidence that informed decisions about long-term reinsurer relationships are being made is clearly critical.

Third, buyers should be aware not only of credit risk exposure to individual carriers, but also to accumulation risks, which can come from both the use of multiple reinsurers within one group, and geographical accumulation.

Informed decision-making

At the heart of best practice, for both cedants and brokers alike, is informed decision-making - in both choice of current reinsurance partners, as well as those with whom the cedant has legacy issues. The most effective way of achieving this is through a balance of formal and informal techniques. This should be centred around a security committee that can monitor, research and make decisions on the credit quality of past and present reinsurers.

To give sufficient attention (both in practical and best-timing terms) to reinsurers considered for participation most security committees must sit throughout the year and not just during the renewal season. The practicalities of how this research is carried out are dictated by the complexity of the business and the volume of reinsurers being considered for both treaty and facultative programmes. Basic information, covering not only the financial status of the carrier, but factual knowledge on ownership, management, ratings etc, can be sourced widely. The skill is in the analysis and interpretation of such information to ensure balanced and prudent decision-making. Over the past 15 years, a specialist profession of security analysts has grown up with this specific challenge.

As important as facts and figures, the best decision-making comes from the qualitative knowledge that can be tapped by a cedant. Within their organisation, there is a vast array of experts who should be integrated - formally or informally - into the process. This includes not only underwriters and reinsurance buyers, but also senior management with high level relationships, plus claims managers and brokers, accounting and technical representatives. All have vital knowledge about the reputation, expertise and efficiency of the reinsurance partners under consideration.

This jigsaw of information segments can be enhanced with knowledge from outside the cedant's own organisation. Sources here include the opinions and comments of brokers, rating agencies, and other market commentators such as stock analysts, as well as shared knowledge from market associations.

Much of the factual information (including financial reports) represents a snapshot in time, produced to the accounting and regulatory standards of the day. These reports are in themselves only a single view of a reinsurer's position, and even then show historical information. Thus the feel from the market - which is particularly strong in the reinsurance world - is more critical than ever.

Ratings: bane or blessing?

Setting standards and guidelines as criteria for the approval of reinsurers can sometimes seem daunting. This is why many reinsurance buyers utilise guidelines based on the opinions of rating agencies, notably Standard and Poor's, AM Best, Fitch and Moody's (the four largest global agencies) in particular. Even these can be intimidating in their complexity, as they seek to guide reinsurance buyers and other interested parties with their opinions on the prospective merits of individual carriers.

There is no doubt that ratings can be extremely helpful. They remove much of the research burden, apply consistency in approach (within each agency), and provide an easy way to understand alphabetic formula for the buying public. But cedants must employ caution when assessing this information. In particular they must sufficiently understand the premise behind the rating opinions. It is important, for example, to have a clear understanding of the basic principles which govern the rating process, as they vary significantly from agency to agency. The application of sovereign rating ceilings by some agencies, for example, can impact the financial strength ratings assigned to reinsurers in certain territories, particularly in Asia and developing markets. The difference between an interactive rating, and one based purely on public domain or quantitative information only, is another subtlety, which needs appreciation if a cedant intends to rely significantly on the rating assigned to a reinsurer.

When one rating agency issues an opinion that is substantially different to that of another, based on theoretically identical information, our clients are often left bewildered. The best advice we as a broker can give in helping them understand is to look beyond the rating letter to the carefully prepared commentary that accompanies any rating action. Read carefully, these commentaries can be enlightening, as the analysts will always carefully construct the wording to provide guidance into the background surrounding the rating movement and indicators. Interactive ratings are intended to be prospective views on a reinsurer's financial strength. The commentaries should, therefore, provide a leading indication of their expectations on how a rating may progress, at least in the short to medium term.

The most common question we receive is, "How do the rating scales of the different agencies compare?" Unfortunately, there is no easy answer. Whilst the Standard & Poor's and Fitch scales are identical, those of AM Best's and Moody's are significantly different. Much difference of opinion surrounds the comparability, arguably encouraged by some to maintain tactical differentiation.

Clearly the relative strength and position of individual agencies often falls to their historic impact on the region and their coverage in particular sectors. Some clearly have more comprehensive coverage and influence than others in the reinsurance sector - preference often therefore comes down to the personal choice of the reinsurance buyers.

Rating agencies are often accused of excessive influence on the success, or more critically failure, of carriers. They vehemently deny the creation of "credit cliffs" - the fine line between the "A" and "B" range ratings - justifying the "secure" or "good" definitions of "BBB"/"B " range ratings from their default statistics.

Power with responsibility

Leading reinsurance brokers worldwide believe they can provide a valuable role in supporting their clients in this tricky field. A broker's role is to act in the best interests of its clients, and giving the best advice on market security is taken seriously amongst major brokers.

Brokers undertake research to ensure that the best reinsurance partners are offered for consideration to their clients. In many instances, sizeable teams exist to compile the necessary research and to conduct the analysis to make these recommendations. They will use every opinion to hand, and will be particularly aware of the impact that rating agency opinions will have on the market. Many cedants look implicitly to the broker to drive this.

Run-off

While most of the comments in this article focus on pre-placement reinsurer selection, the impact which cedants may still be experiencing from reinsurers utilised on placements made years ago has been noted. This is not a short-term industry and many reinsurance recoverables of substantial volume can sit on a cedant's balance sheet for many years, if not decades. Awareness of long-standing recoverables, and the credit risk associated with these, is sensible.

This may relate to reinsurers that are still actively trading, but perhaps no longer operating in the same field, where the practices relating to current credit risk analysis can be engaged. At the other end of the spectrum, a number of carriers have become insolvent, and in many cases therefore are subject to schemes of arrangement. It is impossible to influence the level of return that can be attained by the time the carrier is in this position. It is therefore important that clients remain alert to liquidators' deadlines for documentation and claims.

However, those reinsurers in orderly run-off (of which there are a significant number in various parts of the world) require a more active management policy. Many reinsurers run-off successfully for many years, and while there will inevitably be a slowdown in settlement speed this should not necessarily impact their ability to meet their liabilities in due course. However, business can deteriorate, and therefore with an eye to both the certainty and timing issues, an increasing number of cedants are appreciating the benefits of resolution, via either commutation or consolidation of recoverables. Reinsurers too value closure, and are often keen to commute, or increasingly look to a complete resolution via solvent schemes of arrangement.

Reinsurance security assessment remains critical to the good management of professional insurance and reinsurance organisations around the world. Information is available in abundance to inform buyers of what they need to know. This, when enhanced by analysis and assessment techniques, will ensure cedants make informed decisions to best match their risk management needs.

Sally Bramall is executive director of market security at Willis.