Credit Risk And Reinsurers - Institute And Faculty Of Actuaries

abcdCredit Risk and ReinsurersPaul BrettDarshan SinghQuiz How many of these reinsurers were rated AA orabove just before 9/11? How many of these Reinsurers are now rated AA- orabove?Why is it of interest? Downgrades Reinsurance Recoverables increasing Regulators and Rating Agencies Price of Security1

Moody’s on reinsurance recoverables“In the face of these emerging concerns overreinsurance exposure, Moody’s is increasinganalytic attention on reinsurance risk in ourevaluation of ceding insurance firms, mostnotably in the context of assessing capitaladequacy.”Source: Moody’s Special Comment, Growing Reinsurance Risk Weighs on P&C InsuranceMarket Recovering, August 2003Warren Buffet Quote“Cheap” reinsurance is afool’s bargain: When aninsurer lays out moneytoday in exchange for areinsurer’s promise to paya decade or two later, it’sdangerous – and possiblylife-threatening – for theinsurer to deal with any butthe strongest reinsureraround.What we’ll talk about Nature of Reinsurance Credit RiskPosition in the UKTools of the TradePlacing a value on securityStrategies for mitigation2

What we’ll talk about Nature of Reinsurance Credit RiskPosition in the UKTools of the TradePlacing a value on securityStrategies for mitigationCredit riskFSA Definition:Credit risk is incurred whenever a firm isexposed to loss if a counterparty fails toperform its contractual obligations includingfailure to perform them in a timely manner.Reinsurance collectabilityMoody’s definition:the reinsurer’s ability and willingness to paywhat the ceding insurer claims is owed underthe terms of the contract.3

Reinsurance credit riskInvestment Credit Risk Lots of data Diversification possible No business relationship Traded Exposure known RegulatedReinsurance Credit Risk Not much data Correlation Business partner Non-traded Exposure unknown Regulated?How does it arise? Reserves Guarantees CatastrophesWhat we’ll talk about Nature of Reinsurance Credit RiskPosition in the UKTools of the TradePlacing a value on securityStrategies for mitigation4

Reinsurance recoverables increasing ’mReserves for Reinsurance Ceded20012003Abbey National423935Aegon106372Aviva9852,356Axa Sun Life59128Canada Life76230HBOS108147HSBC252323Legal & General7362,948Prudential18318775240114207Royal Bank of ScotlandStandard LifeNon profit business in the L&GA and PHI fundsSource: ThesysA large proportion of resources ’mReserves for ReinsuranceCededAbbey National20012003% of LTBA4239355.3%% of a Sun Life591280.6%4%Canada %Legal & 8.3%67%1142070.4%4%Royal Bank of ScotlandStandard LifeRegulation PS04/16 The rules and guidance. seek to protect against creditrisk by requiring a firm to limit and diversify its exposureand to hold sufficient financial resources to withstand creditloss insofar as such loss is reasonably possible.Dear Chief Executive letter August 2004 “it is perhaps surprising that life insurers do not givereinsurance credit risk a higher profile”.Identifying good practice with regard to credit risk.5

PS04/16 Exposure limits 100% capital resources 20% of gross earned premium Capital requirement Margin for credit default Stress capitalSpread factor * Bond spread * ExposureWhat we’ll talk about Nature of Reinsurance Credit RiskPosition in the UKTools of the TradePlacing a value on securityStrategies for mitigationTools of the Trade Agency ratings Individual research Capital markets and default statistics6

Tools of the Trade Agency ratings Individual research Capital markets and default statisticsS&P Financial Strength RatingA Standard & Poor’s Insurer Financial Strength Ratingis a current opinion of the financial securitycharacteristics of an insurance organisation withrespect to its ability to pay under its insurance policiesand contracts in accordance with their terms.Insurer Financial Strength Ratings are based oninformation furnished by rated organisations orobtained by Standard & Poor’s from other sources itconsiders reliable.Insurer Financial Strength Ratings do not refer to anorganisation’s ability to meet non-policy (ie debt)obligations.The Rating Process?7

Financial Strength Ratings AAAAn insurer rated “AAA” has EXTREMELY STRONGfinancial security characteristics. “AAA” is the highestInsurer Financial Strength Rating assigned byStandard & Poor’s. BBBAn insurer rated “BBB” has GOOD financial securitycharacteristics, but is more likely to be affected byadverse business conditions than the higher ratedinsurers.The different ratingsS&P / Fitch Moody’s AM BestAAAAaaA AA Aa1A AAAa2AA-Aa3AA AA1A2A-A-A3B BBB Baa1Extremely StrongVery StrongStrongGoodS&P Rating ChangesAAAGen ReSwiss ReMunich ReGE Frankona ReHannover RePartner ReRGAXL ReSCORGerlingReviosConverium ReScottish ReAA AAX AA-A AA- BBB Indicates year in which rating changedX2001XX 20022003XXXX 2004 XXX XXRatings as of November 4, 2004. Changes since September 11, 2001.8

Gerling Global Re12 months8 notchesAAAAAAAA AA AAAAAA-AA-A A AAA-A-BBB BBB BBBBBBBBB-BBB-BB BB Non-Investment GradeBBBBBB-BB-B B Q2'04Q3'04Munich Re9 months4 notchesAAAAAAAA AA AAAAAA-AA-A A AAA-A-BBB BBB BBBBBBBBB-BBBBB BB Non-InvestmentGradeGradeNon-InvestmentBBBBBB-BBB Q2'04Q3'04B GE Frankona15 months4 notchesAAAAAAAA AA AAAAAA-AA-A A AAA-A-BBB BBB BBBBBBBBB-BBB-BB BB Non-Investment GradeBBBBBB-BB-B B Q1'04Q2'04Q3'049

Reasons for the downgrades 9/11MistakesReserve strengtheningWeak pricingCatastrophesWeak investment marketsMoody’s current view“After numerous ratingdowngrades over the pastfew years, Moody’sconsiders the rating outlookfor the reinsurance industryto be stable, reflecting aview that, over the next 1218 months, the number ofrating actions is likely to bemoderate and driven moreby specific characteristics ofindividual firms thanindustry-wide conditions.”S&P and Moody’s ableAaaNegativeSwiss ReAANegativeAa2StableGE FrankonaA NegativeAa2StableMunich ReA StableAa3NegativeHannover ReAA-StableBaa1PositiveXL ReAA-StableAa3StablePartner ReAA-StableAa3StableRGA ReAA-StableA1StableScor ReBBBStableBaa3DevelopingGen ReReviosConverium ReScottish ReA-StableNo ratingBBBWatchBaa1StableA-StableA3Negative10

Tools of the Trade Agency ratings Individual research Capital markets & default statisticsIndividual research Larger exposure Sources of data: Report and accountsRating agency reportsReinsurer questionnaireSearch the webSome questions to ask What are the key risks to your financialstrength? Do you stress certain scenarios? What is your exposure to Mortality, CI, IP,Longevity, financial reinsurance, GI risks .? How often are exposures measured andupdated?11

Tools of the Trade Agency ratings Individual research Capital markets & default statisticsDefault Statistics44Cumulative default 98301991121.5198919 9 41 99 31 9 9219 9119 9 01 98 91 98 81 9 8719 8 61 98 51 98 41 9 8319 8219 8 1032.519870.53.51993C u m u la tiv e d e fa u lt (% )3.5S&P Rated "AAA" in CalendarYearS&P Rated "A" in Calendar YearMarket 0Jul-00150Jan-00Spread over gilts (bps)250Jan-00Spread over gilts (bps)Industrials250ASource: JP Morgan FI Research, 10 yr Sterling12

The Credit Spread PuzzleRatingSpreads over Gilts bpsHistoric defaults per 10000(10yr Financials as at 29 Oct 2004)(S&P 10th Root of 10 year default rate 19812003)AAA42.45AA71.310A88.120Some pieces of the puzzle Spreads over gilts built up from: Real-world expectations of Default X Recoveries Liquidity Risk premium Correlation with market risk Non-diversifiable credit risk including contagion Downgrade risk¾ Market spreads can’t be ignoredReinsurance spread might be higher Default/recovery could be higher or lower Liquidity low Downgrade risk higher Credit Risk Correlations Insurance riskInsurance businessEquity risk, other investment riskLeverage/reinsurance Greater interaction with operational risk13

What we’ll talk about Nature of Reinsurance Credit RiskPosition in the UKTools of the TradePlacing a value on securityStrategies for mitigationPretend that there’s a perfect reinsurer Will pay claims The regulator won’t require capital to be heldagainst default Has unlimited capacity¾This reinsurer sets the arbitrage freeprice of risk transferHow do other reinsurers compare? Modelled how much the credit risk costs Used spreads based on previous slides And credit risk capital requirements inPS04/16 Under both realistic and statutory regimes Essentially arbitrage-free adjusted for capitalrequirements14

Price of security 20-year term, level premium reinsurance No correlations, not very risky linesRatingPriceAAAAAA10098.496.9Difficult to model ula!copOther reinsurersyehtMortalityPopulationn – trendse fu environmentIPorEconomicmSocial environmenteCIavhNon-life businessSavings businessFOSAggregate with DependenciesSensitivityRatingAAAAAAPrice100 98.4 96.9Increasing spread by20%100 98.2 96.515

Risky lines of businessRatingRisky line with morecorrelation and moreinsurance riskAAAAAA100 97.9 96.1 More insurance risk results in relatively higherreserves More risk increases the dependency betweencredit and insurance riskWhat about the things you can’t putnumbers on?¾ Reinsurer are intimate business partners Impact on customers Attention of the regulator Management time and effort wasted Interaction with operational riskWhat we’ll talk about Nature of Reinsurance Credit RiskPosition in the UKTools of the TradePlacing a value on securityStrategies for mitigation16

Management of the riskDiversify reinsurersDeposit backsCredit triggersThird party supportSecuritisationStructuringDiversification - The Mantra of Finance Reduces extreme outcomesfrom localised or idiosyncraticevents Does not reduce macro risksor risks in extremisRegulationInvestmentsOther reinsurersPopulation trendsEconomic environmentSocial environmentNon-life businessSavings businessFOS Risks affecting the wholereinsurance sector Measurement is difficult Model/parameter errors arelargeA Simple Example Generalised Modelσ {(N (N²-N)ρ}σ St Dev of Individual Credit LossN Number of Creditsρ Correlation of Counterparties Observed Defaults from Moodys 1980 to2003 Binomial Model Capital 2 X St Deviations/Exposure Observations from Nil CorrelationScenario Diversification brings benefits Diversification can reduce capital The weaker the credit quality, themore value diversification seems tohave1 Year HorizonCorrelation 0%Capital Charge 10%8%6%Aa/AAA/A4%Baa/BBB2%0%1251050100Number of Counterparties17

Impact of correlation1 Year HorizonCorrelation 50%Capital Charge Impact of partial correlation Reduces the value ofdiversification Ranking of RelativeImportance Individual CounterpartyRisk Correlation ofcounterparties Number of counterparties10%8%6%Aa/AAA/ A4%Baa/ BBB2%0%1251050100Number of CounterpartiesCredit triggersReinsurer’s view: Exacerbates any decline Rating agencies don’t like themInsurer’s view: Good protection but what if queue is not valid scope for disagreement in deciding on amount of recaptureor commutation If he’s got it I want it!Deposit backs, Third Party, Securitisation Deposit backs Good for managing credit risk Regulatory arbitrage diminished Letters of credit, guarantees Usually short term only Securitisation Size of deals Could grow in importance18

Structuring Risk premiums Credit risk builds up if insurance risk deteriorates Also can lose valuable risk mitigation Capital efficiency Reviewable ratesFinancing with the same reinsurerReduced Premium PeriodsBuy less, buy smarterConclusion Reinsurance credit risk more complicatedReinsurance credit risk is increasingRegulators are driving changesQuality of reinsurance credit risk has deterioratedThorough research is neededA price for security is emergingDiversification may not helpOther mitigants may not helpConclusion “A reinsurance company is like a tea bag .you don’t know how strong it is until you put inthe hot water.” – James Bryce, CEO, IPC Holdings as quoted in Reactions The most expensive reinsurance isuncollectable reinsurance. – Moody’s Industry OutlookSeptember 2003.19