AASCIF - july-august-september03 Terrorism Risk Insurance Act

Reinsurance is one of the most significant discretionary expenditures an insurance company makes and also one of the most risky. As such, the issues associated with reinsurance warrant attention at the highest levels of an organization.

Reinsurance in its simplest form is a straightforward concept: You pay a reinsurer a discounted sum now so that you won’t have to pay for certain losses in the future. Reinsurance, when properly administered, can increase the financial strength of an insurance company by reducing its exposure—especially in areas of high claim volatility.

However, additional exposures are inherent with reinsurance. Chief among these is credit risk. Because insurance companies are counting on reinsurers to pay claims in the future, every effort must be taken to ensure that reinsurance partners will be able to fulfill their obligations. The longer the reinsurance obligations last, the greater the risk.

State of the reinsurance industry
Unfortunately, the strength of the reinsurance industry overall has eroded in recent years. Three significant circumstances contributed to poor health of reinsurers.

First, and probably most significant, is the prolonged environment of anemic investment returns. The price of the reinsurance, or in other words, the magnitude of the present value discount the reinsurer is applying to the claims value they assume, is a derivative of the investment returns they expect to achieve on the premium.

The second affliction of reinsurers is inadequate reserves. A.M. Best estimates the insurance industry was under-reserved by $15 billion in 2001. General Re, the only remaining major reinsurer to currently maintain the highest rating across all major rating agencies, recorded a $1.31 billion charge in 2002 to shore up reserves for prior years. Charges of this sort will almost certainly be incorporated into the premium formulas for future years.

The third factor impacting the reinsurance environment was September 11. The tragedy likely slowed any economic recovery and contributed significantly to the underwriting losses of the industry overall and reinsurers in particular. It identified risks covered by various lines of insurance—property, life, business interruption, workers’ compensation, etc.—for which no premium had been collected. Insurers moved quickly to incorporate exclusions for terrorist acts and also raised premiums to compensate for the historical error. It is important to note that while primary insurers cannot exclude terrorist acts from workers’ compensation coverages, reinsurers do so as a matter of course.

All these factors weighed down the financial health of reinsurers, increasing the pressure for rating downgrades. Rating downgrades can result in losses of premium reinsurers desperately need to improve financial health. In extreme cases, reinsurers could sink into a death spiral of insolvency. A key responsibility for primary insurers is to minimize and diversify their reinsurance exposure to avoid being dragged into the same economic whirlpool.

In his annual report to shareholders of Berkshire Hathaway, owner of General Re, Warren Buffett, stated: “Recently . . . one of the world’s largest reinsurers—a company regularly recommended to primary insurers by leading brokers—has all but ceased paying claims, including those both valid and due. This company owes many billions of dollars to hundreds of primary insurers who now face massive write-offs. ‘Cheap’ reinsurance is a fool’s bargain: When an insurer lays out money today in exchange for a reinsurer’s promise to pay a decade or two later, it’s dangerous—and possibly life-threatening—for the insurer to deal with any but the strongest reinsurer around.”

Industry analysts feel with some certainty that Mr. Buffett was referring to Gerling Global Reinsurance Corporation of America. Gerling denies the allegation that they are not paying claims.

Impact of reinsurer deterioration on direct writers
The Employers Insurance Company of Nevada illustrates the impact of reinsurance on a company. On July 1, 1999, the Nevada State Industrial Insurance System, a former AASCIF member, was transitioned to a mutual insurance company. In connection with the transition, EICON entered into a retroactive 100 percent quota share reinsurance agreement (a loss portfolio transfer), ceding $1.525 billion in loss reserves. The reinsurers accepted this liability in consideration for $775 million in cash.

The Nevada Legislature created a permitted statutory accounting practice that enabled EICON to take credit for the reinsurance on its financial statements based on security equal to the discounted value of the reserves.

To its credit, EICON incorporated protections and remedies into the reinsurance treaty. Among these was a requirement that if a reinsurer’s A.M. Best ratio fell below A-, that additional security would need to be deposited. This requirement was enforceable upon the parent of the reinsurer via a cut-through guaranty.

Gerling holds a 55 percent participation in the EICON treaty. On Oct. 18, 2002, Gerling was downgraded by A.M. Best to B+. EICON demanded the additional collateral required per the reinsurance contract and Gerling, and the parent, failed to comply. EICON has initiated litigation to enforce the agreement.

Should a reinsurer fail to perform, a primary reinsurer may have recourse against a security or statutory deposit. However, due to exemptions for authorized reinsurers or limitations through state permitted or prescribed practices, there is less aggregate collateral for reinsurance than there is aggregate exposure. Direct writers should consider the risk of reinsurer failure and the impact such failure could have on their surpluses. The greater the amount of reinsurance recoverable relative to surplus, the greater the risk to a direct writer.

A high ratio of reinsurance recoverable to surplus is not unusual. The Dec. 31, 2002, workers’ compensation industry composite ratio of reinsurance recoverable to surplus, as published by A. M. Best, was 190.7 percent.

Evaluating reinsurance needs
Because of the risks associated with reinsurance, insurers should carefully evaluate how much reinsurance they need. Key considerations include concentrations of risk, surplus and capital requirements and state-specific mitigating factors.

Because state fund insurance companies typically must accept all risks, management must be cognizant of concentrations of risk. Such concentrations will significantly impact reinsurance decisions. If an insurer has a high concentration of insureds in a single building or even zip code, there is greater exposure to a catastrophic loss than if the same number of insureds were spread out over several counties.

Similarly, an insurer of industries exposed to high severity risks such as mining, trucking or explosive manufacturing will have a greater need for reinsurance than an insurer who doesn’t write coverage in such industries. Reinsurance contracts typically contain numerous exclusions, and careful review is needed to make sure the key exposures for which your company needs protection aren’t excluded.

Maintaining appropriate risk-based capital ratios is critical to most insurers, although some state-fund companies may be exempt from risk-based capital requirements. For companies operating close to regulatory action thresholds, reinsurance may be an important strategic option, enabling the insurer to continue to operate without contracting premium writings, obtaining surplus notes or engaging in other short-term and frequently shortsighted maneuvers.

Many states have second-injury funds or other statutory reinsurance mechanisms which spread the risk for certain—typically more severe—claims among all the insurers in the state and frequently over several years. Some states by statute are responsible for any deficits generated by state-fund insurers. Such factors affect the overall risk.

By design, state funds are more focused on long-term solvency than short-term financial performance. Typically, they can experience more volatility in losses than stock companies because they do not need to report quarterly earnings to stockholders. A healthy surplus relative to premium greatly reduces the need for reinsurance.

Impact of commutation clauses
When establishing the criteria for reinsurers, consideration should be given to the length of time recoverables will be outstanding. The longer the period, the greater the risk of financial deterioration of the reinsurer.

Commutation clauses may mitigate the credit risk by accelerating the financial settlement. However, such clauses increase underwriting risk as the burden of future adverse development transfers back to the primary reinsurer upon commutation. Also, commutation clauses allow for disparate opinions on the present value of the loss. Different opinions on life expectancy or medical inflation can result in the reinsurer offering a less than satisfactory settlement.

Even if commutation clauses are present, the recovery period will still cover several years. Thus, the quality of the reinsurers is always a key consideration. Due diligence should be commensurate with the scope of the arrangement. Industry rating agency reports should be carefully reviewed, but it is also appropriate to check customer references, particularly if there is an area of special concern, such as commutations, claim payment turnaround, etc.

Oversight of reinsurance programs
After the contract is executed, performance should be monitored carefully. Failure to comply with claim reporting obligations to the reinsurer will likely absolve them of liability.

Also, reinsurer ratings should be monitored continually. Quick response to a downgrade may provide an opportunity to commute and obtain a recovery that otherwise would be lost.

In summary, reinsurance can be a valuable, prudent and necessary component of a company’s operating strategy. However, it is a complex product with peculiar risks. In an era of heightened attention on management decisions, reinsurance oversight demands critical, competent and constant attention.

Contact Scott Westra at swestra@wcf-utah.com or (801) 288-8003.

Additional insight on reinsurance by James Marr, managing director, Guy Carpenter & Company Inc., an associate AASCIF member, can be found in the research paper “Returning to traditional reinsurance buying decisions” in the Library section of AASCIF’s website www.aascif.org.

Reinsurance oversight Beware the risks of reinsurance; here's what to look for

Reinsurance oversight
Beware the risks of reinsurance; here's what to look for