Cedants warned on hidden counterparty risk
Insurers and reinsurers have been warned to delve deeper into both the credit quality of their own reinsurance counterparties, and their own financial resilience when analysing the potential impact of market-wide stress events, whether in the form of losses or economic upheaval.
That is the warning from Litmus Analysis, in a new report published ahead of Baden-Baden titled “Stress Testing and Reinsurer Resilience”. The report, building on previous work done by Litmus in this sphere, argues that European insurers and reinsurers are significantly more exposed to reinsurance recoverable credit risk after the 2022 capital squeeze—and that such findings should play a part in how they consider such risk in the future.
Author Paul Galpin (pictured), senior consultant at Litmus Analysis, said some of the findings were profound.
“Given the potential for events such as the 2022 capital reduction to shift an insurer’s financial strength to such a degree, we strongly believe that insurers and reinsurers should look more closely at the credit quality of their own reinsurance counterparties, and their own financial resilience, when analysing the potential impact of idiosyncratic and market-wide stress events,” Galpin said.
“While the scale of some stresses that we can test may be considered relatively unlikely, the decline in capital from financial year end 2021 to financial year end 2022 was a real-world event. Any deterioration of that magnitude in an insurer’s financial strength will not only have a material impact on an insurer’s future resilience (and that of its reinsurers), but will also most likely have material consequences for its competitive position.”
Survey results
This research by Litmus is the latest piece on the theme of insurer and reinsurer stress-testing and how a material stress event might adversely impact financial strength and resilience. In earlier studies, the firm used LitmusQ, its proprietary financial scoring model, to assess the impact on the financial strength of a cohort of insurers and reinsurers in response to varying levels of reserve shock.
The results of the initial survey were released in May 2022, when the LitmusQ financial scores of a cohort of 35 leading reinsurers before and after a series of increasingly severe reserve shocks were published. Although the overall resilience of the cohort was found to be quite high, the results highlighted a considerable gap between the best and the worst performers.
Its next work looked at the theoretical consequences for cedants subjected to material adverse underwriting stress at the same time as their reinsurers. It examined how a cedant’s net retention following a market-wide event would reduce its own loss-absorbing capital, while the quality of that capital might be simultaneously undermined by a deterioration in the credit quality of its own reinsurers.
“In other words, cedants facing a material stress event could have a higher—potentially much higher—exposure to their reinsurers at exactly the moment when their own ability to absorb the cost of any unrecoverable reinsurance is reduced and the risk of non-recovery due to reinsurer financial duress is increased,” Galpin explained.
This time around, Litmus evaluated the resilience of a group of European cedants to a claims-driven increase in reinsurance counterparty risk exposures and what this might mean for their financial strength.
Having initially analysed its European cohort based on financial year end 2021 financials, repeating the exercise based on the financial year end 2022 data provided a real-world example of a financial market stress as global financial markets responded to rising geopolitical tensions and macroeconomic turmoil.
The report found that rising interest rates and a slowdown of global economic activity caused the capital & surplus of its European cohort to decline in most cases by 20 percent or more between financial year end 2021 and financial year end 2022, leaving them significantly more exposed, and much less resilient in the face of any deterioration in claims experience or adverse reserve shock.
Galpin said: “In 2022 there was a material decline in capital & surplus across the cohort, as the world’s economies and financial markets struggled in the face of rising geopolitical tensions, inflation and interest rate rises—hitting investor confidence and lifting bond yields and credit spreads.
“In addition to the adverse impact on all capital metrics, this materially increased the cohort’s vulnerability to any deterioration in the credit quality of its reinsurers. Indeed, the majority of the cohort experienced falls in capital & surplus of 20 percent or more from financial year end 2021, the most extreme being a fall of over 50 percent.”
In conclusion, Galpin said, this is simply a risk and an exposure that cedants must be more aware of. The report can be viewed online at: www.litmusanalysis.com
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