REINSURANCE SYSTEMIC IMPORTANCE


Natural Catastrophes Are Unlikely To Trigger Systemic Failures In Insurance


By Miroslav Petkov and Rob Jones


Systemic risk to the reinsurance sector is limited because two factors—the industry’s robust capitalization and increasing use of collateralized reinsurance—help mitigate the risk of insolvency in the event of extreme losses.


In November 2014, reinsurers will find out whether the Financial Stability Board (FSB) has chosen to designate the industry’s major players as global systemically important insurers (G-SIIs). The designation would do more than identify the largest players, it would involve more oversight, new capital requirements and resolution plans. Standard & Poor’s Ratings Services recognizes that there is interconnectedness of insurers and reinsurers arising through reinsurance. This interconnectedness (as well as interconnectedness with financial markets) could add systemic risk in the insurance industry in the eyes of the FSB. In theory, the failure of one or a few names that act as a backstop to the industry could result in a chain of reinsurance or insurance company defaults. However, in our view, catastrophe risk exposure is not a source of systemic risk for the insurance industry. Our analysis of the catastrophe exposure of reinsurers and the interconnectedness of their retrocession coverage indicates that high levels of capital adequacy are protecting the sector from systemic risk.


Could Natural Catastrophe Risk Threaten The System?


We anticipate that the FSB could see exposure to natural catastrophe risk as a potential source of systemic risk because reinsurers accumulate this risk for the insurance industry.


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The timing and size of catastrophe losses are, by nature, unpredictable and could cause balance-sheet shocks for both insurers and reinsurers. A major catastrophe can decimate the capital base of a reinsurer, and could lead to default. This is a particular risk for companies that have a large exposure to catastrophe risk relative to their capital bases. Most reinsurers purchase retrocession protection (retro) and view it as a key line of defence in limiting the amount they would have to pay out after a major catastrophe event.


Retrocession introduces credit risk— the risk that their retrocessionaire could default—into the buyer’s equation. We estimate that about 30% of rated reinsurers’ protection is collateralized. This insulates the reinsurer from the credit risk as claim payments are made from the collateral account, even if the provider is in default. For example, claims payment from an insurance-linked securitization comes from a ring-fenced pool of assets.


That said, most retrocession protection is uncollateralized. Whether a reinsurer is fully indemnified for their retrocession claims in the event of a major catastrophe therefore depends on whether their retrocessionaires have defaulted or not. Even though a reinsurer may have enough capital to withstand catastrophe losses after allowing for its retrocession protection, it could experience financial distress if it


suffers a material nonpayment of its retro claims. While reinsurers would prefer that their retrocessionaires not share their risk profile, in many cases, retrocessionaires are exposed to the same catastrophe loss events as their cedents.


How Interdependent Are Reinsurers? In theory, the failure of one or a few names that act as a backstop to the industry could result in a chain of reinsurer and insurer defaults. However, we do not see this scenario as likely to occur.


We assessed the existence of such a systemic risk by analyzing reinsurers’ catastrophe risk exposure using data from our annual catastrophe risk surveys. We investigated the effect of very extreme catastrophe events on rated global reinsurers’ balance sheets and the extent to which we believed reinsurers would rely on their uncollateralized retrocession protection to avoid bankruptcy. Specifically, we assessed the impact of losses as a result of extreme events modeled to occur less frequently than once every 500 years; and three extreme events occurring in the same year. For the latter, we combined realistic disaster scenarios, as defined by Lloyd’s, covering U.S. hurricane, U.S. earthquake, and Japanese typhoon (see http://www. lloyds.com/the-market/tools-and-resources/ research/exposure-management/realistic- disaster-scenarios).


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