Reinsurers and GSII: Global, certainly; important, for sure; but ‘systemically’ risky?

The IAIS, with its proposal for additional risk-adjusted capital rules for major re/insurers, seems to be joining the regulatory bandwagon for seeing these as a potential source of threat to to the global financial system.

However, other than when they choose to act as ‘shadow banks’, the exact basis for why even the largest re/insurers should be considered to represent a systemic source of risk is debateable to say the least, particularly if that leads to a requirement for additional capital levels over and above those already considered prudent within existing and proposed insurance regulatory regimes such as Solvency II.  Extra capital can mean only one of two things; less re/insurance or more expensive re/insurance.

The concept makes little sense in general, and particularly so for reinsurers.

Systemic risk derives from the ‘contagion’ (domino) effect when the failure of one organisation triggers that of others.  This may be caused either by the consequences of ‘fear’ –  leading to creditors demanding their money back and asset prices plunging; or by the knock on impact of bad-debts on the failed organisation’s creditors.

The former is the classical ‘run on a bank’ problem.

But there is no routine concept of a ‘run’ on an insurer.  Some savings or investment related life insurance products can contain an option for policyholders to demand an immediate pay-out; but that ‘liquidity and ALM’ risk would be specific to the insurer.  A systemic problem would only result if a significant number of life insurers had this as a major exposure and policyholders lost confidence in them collectively.  Even that is a lot more manageable than controlling the nature and consequences of a banking crisis.

The ‘bad debt’ (unrecoverable reinsurance) problem would be the impact of the failure of a major reinsurer.  Theoretically in extremis this could cause a systemic problem within the industry but the nature and scale of the failure would need to be so profound as to really be outside of the scope of capital rules (given the reinsurer would not only need to go bust but be capable of paying so little of any given claim that the loss to other re/insurers from unrecoverable reinsurance is sufficient to create further failures).

A more probable (though hopefully still extraordinarily remote!) risk would simply be the systemic nature of a huge catastrophic event wiping out much of the reinsurance industry in one fell swoop. But, again, that is a risk that really falls outside any reasonable application of regulatory capital rules.

A sounder prudential regulatory approach might be to simply prevent regular re/insurers trading credit protection products (shadow banking).

Better still would be thinking again about whether a ‘mark to market’ approach to valuing re/insurers’ invested assets (the near universal direction of travel in accounting and regulation) really adds stability to the system; restricting, as it does, the ability of these otherwise natural ‘buy and hold’ investors to provide a rationale ‘pricing floor’ in traded financial assets during a crisis (which is when it actually matters) this could simply make things a great deal worse  (to wit preventing those financially capable of ‘catching the falling knife’ from actually doing so).

Indeed, were that to be addressed then, far from being a source of systemic risk, re/insurers could be a source of systemic risk mitigation.

Stuart Shipperlee, Analytical Partner, Litmus Analysis

Ratings of Catlin, Lancashire, Partner Re and Platinum Underwriters highlight the fundamental impact of ERM vs. capital on S&P’s reinsurer ratings

This is a technical article reviewing recent actions by S&P in implementing their new criteria on the reinsurance sector.  If you are interested in understanding this further, would like further clarification or would like to comment please feel free to mail us at info@litmusanalysis.com.

(*/** indicate references to ‘technical notes’ at the end of the note)

The recent S&P rating updates of the core operations of Catlin, Lancashire, Partner Re and Platinum Re highlight the profound impact of truly qualitative factors (and especially ERM) in S&P’s reinsurer ratings. 

For Catlin and Lancashire this was of critical importance as the rating implications of not scoring highly in S&P’s ERM analysis were stark. 

The financial strength rating anchor* for both groups is ‘bbb+’, which is below what is often perceived as a key threshold of market acceptance. However, each achieved a ‘strong’ score for ERM. The ERM analysis acts as a modifier to the initial rating anchor and was enough to push the indicative rating up one notch to the crucial ‘A-‘ level. 

In Catlin’s case a further notch uplift to ‘A’ was achieved through S&P’s ‘holistic’ analysis whereby the agency may add or subtract a rating notch based on a final view of particularly strong or weak credit factors not already sufficiently captured by its analysis. For Catlin this reflected in particular S&P’s view of the strength of its competitive position and the relative quality of its earnings versus its peer group.

The S&P ratings anchor combines the “Business Risk Profile” and “Financial Risk Profile” assessments of each company. For Catlin a key constraining factor for the rating anchor is having only a ‘moderately strong’ Capital & Earnings score within its Financial Risk Profile despite S&P’s assumption of strong prospective earnings. By contrast Lancashire achieved a ‘very strong’ result for Capital & Earnings but this was offset by its Risk Position being scored as ‘very high’ and its Business Risk Profile score being reduced to ‘satisfactory’, despite receiving a ‘strong’ for its Competitive Position.  Both constraints on the rating derive from its concentration in severity lines with large limits.

For both organisations the ERM score is clearly a powerful affirmation of management quality, however we would presume they would be far more comfortable being able to achieve the ‘A-‘ rating level via the Business Risk and Financial Risk profiles that drive the initial rating anchor, not least given that what constitutes high quality ERM is a bar that is consistently being raised. Moreover for Lancashire achieving an ‘a-‘ rating anchor from S&P might be difficult as the key drivers of this are heavily influenced by S&P’s interpretation of its high risk lines business model.

A.M. Best assigns ‘A’ financial strength ratings to both Catlin and Lancashire. Best does not publish the equivalent of a rating anchor but the positive deviation in its view from that of S&P on Lancashire’s strength can be further seen in the  positive outlook Best’s assigns to its ‘Issuer Credit Rating’ (ICR) of the group’s underwriting operations. The ICR  ‘translates’ the AM Best scale to the S&P scale and basically means Lancashire has a reasonable future chance of achieving an FSR  rating  from Best equivalent to ‘A+’** on the S&P scale.  In rating terms that’s a long way from the ‘A-‘ S&P rating.

By contrast, Partner Re was assessed with a ‘aa-‘ level rating anchor from S&P but the final financial strength  rating is reduced to the ‘A+’ level. Again Best is more positive with an ‘A+’ rating on its own scale that maps** to ‘AA-‘ on the S&P scale.

Within the S&P analysis of Partner Re the fundamental components of its rating anchor are almost as strong as they can be for a reinsurer.  Only risks intrinsic to the reinsurance industry  drag this down from the highest possible ‘anchor’ level of ‘aa+‘.  However, given their size and sophistication, we assume they will be disappointed with S&P’s assessments of their Management & Governance being only ‘fair’ whilst their ERM is assessed as being ‘adequate with strong risk controls’. Both judgments on the key qualitative factors are below most of the group’s peers.

Platinum Underwriters was however assessed below Partner Re on these combined factors; also receiving ‘fair’ for Management & Governance, but a lower assessment of ‘adequate’ for ‘ERM’.  This would have had the effect of pushing the indicative rating down to the ‘BBB+’ level. However in a further indication of the fundamental role of qualitative factors in their analysis, S&P’s final ‘holistic’ review  raised it back to the ‘A-‘ level.  Again AM Best is more bullish, rating Platinum ‘A’ on its own financial strength scale with a mapping to ‘A’** on the S&P scale.

Technical notes

*The ‘ratings anchor’ is not a rating (hence the use by S&P of the lower case symbols) but rather is the initial outcome of S&P’s rating review of a re/insurer. It addresses the core elements of financial and business risk analysis but is prior to S&P’s review of the key qualitative aspects of the re/insurer’s management profile; namely the quality of management, governance and its ERM. These may modify the rating anchor outcome positively or negatively. A further ‘holistic’ review is then applied which may adjust the rating up or down by one notch. S&P then may apply a ‘cap’ to the rating based on concerns around either liquidity or sovereign risk. Finally the rating may be adjusted due to wider group or government support. 

** AM Best’s rating scale for financial strength ratings (FSRs) has fewer gradations than that used by S&P and some of the symbols common to both stand at different points in their respective scales. However Best also publishes ‘issuer credit ratings’ (ICRs) on rated re/insurers. Since the ICR for an operating re/insurer is the same as it’s FSR, for those carrying a financial strength rating the ICR effectively acts as a mapping of the AM Best scale to the S&P scale. Thus a Best’s ‘A+’ maps to an ‘AA-‘ or ‘AA’ on the S&P scale and a Best’s ‘A’ maps to an S&P ‘A’ or ‘A+’. It should be noted that typically for both S&P and Best’s the ICR of holding companies is below that of a given group’s core operating re/insurers.