Strong capital adequacy insulates against systemic risk
We found no evidence of the existence of systemic risk based on an aggregation of catastrophe risk. Primarily, this is due to the strong capital adequacy of rated reinsurers. Our analysis indicates that almost all reinsurers would survive these stress scenarios, even if uncollateralized protection providers failed to pay out. Those reinsurers that would become insolvent as a result of these stresses (that is, those that would not have sufficient assets to cover their losses) would do so even if they receive their full retro claims. In other words, their weaker capitalization—not their credit risk exposure to retrocessionaires—is likely to cause their default in the event of a large catastrophe loss. (The ratings on these reinsurers reflect their higher risk of default due to weaker capitalization.)
In addition, we observed that the major retrocessionaires (including large reinsurers that offer retro protection to other reinsurers) are among the best capitalized. This indicates that it is likely that these retrocessionaires would remain solvent and able to meet their retrocession obligations to reinsurers. Therefore, we expect that most retro payments would be made, except in scenarios more extreme than those we tested. Even if a reinsurer defaults and cannot pay its full claims, it could still pay a substantial proportion of the claims, limiting the impact of a default of a provider of uncollateralized protection.
We found no evidence that retrocession protection provision is concentrated in a few names. In our opinion, the industry has no material credit risk to one or a few reinsurers. The scenarios that we considered are extreme. If they occurred, ratings on some reinsurers could be lowered sharply. Under the scenarios, although we assume some reinsurers may be unable to meet their regulatory capital requirements, we still expect them to be able to meet their liabilities. Furthermore, we expect many of the reinsurers would be able to raise capital and so continue to operate. Shareholders are likely to support reinsurers—they expect profitability to increase following these major losses because premiums typically increase sharply.
Could A Catastrophe’s Knock-On Effects Increase Systemic Risk?
A very severe catastrophe could have a wide-ranging impact and may indirectly
Global Reinsurance Highlights 2014
“We found no evidence of the existence of systemic risk based on an aggregation of catastrophe risk.”
Systemic impact on insurers is also limited
lead to financial or operational losses. These spill-over effects could exacerbate losses directly caused by the natural catastrophe and further weaken reinsurers’ balance sheets.
We consider that the risk of equity market disruption related to a major catastrophe would have the most material impact on reinsurers’ capital and therefore included it in our stress scenario analysis. Opinions differ on whether a major natural catastrophe could have a material medium-term effect on the equity markets. Evidence from historical catastrophe events supports arguments against such an effect—to date, catastrophe events have had limited and short-lived negative effects on the equity markets. However, in our view, the global impact of those catastrophe events was far less severe than those we considered in our analysis. We consider that the more-severe scenarios we considered might have a very broad and lasting negative impact on the world economy. To account for the potential impact of catastrophe events on the equity markets, we added to the natural catastrophe losses the impact on the reinsurers’ equity portfolio of our ‘BBB’ equity stress test (see “Refined Methodology And Assumptions For Analyzing Insurer Capital Adequacy Using The Risk-Based Insurance Capital Model,” published on June 7, 2010). However, because most rated global reinsurers have a low exposure to equities, this additional stress did not change the conclusions of our analysis.
Systemic risk of failure from catastrophe losses in the wider insurance industry is currently limited, in our view. As described above, we expect the largest reinsurers to survive extreme stress scenarios. Furthermore, natural catastrophe risk exposure is a major risk for only a few insurers, and our analysis indicates that primary insurers can absorb any shortfall from unpaid reinsurance claims. Allowing for corresponding equity losses does not change our conclusion. Insurers may have larger equity portfolios, but these are mainly for their life businesses. We anticipate that, even in these high-stress scenarios, the capital covering the life business should be sufficient to absorb such equity losses. Like the reinsurers, primary insurers could experience downgrades under our extreme scenarios. Insurers with large exposures to catastrophe risk, especially those exposed to weaker reinsurers, could even default on their obligations, either because of their own direct losses or because their reinsurance has failed. However, our analysis suggests that only a few insurers are likely to be affected. Therefore, we do not consider that natural catastrophe risk presents a systemic risk for the insurance industry.
Could Systemic Risk Increase In Future? Systemic risk is currently limited because of two factors—the industry’s robust capitalization and increasing use of collateralized reinsurance—that help mitigate the risk of insolvency in the event of extreme losses.
However, systemic risk could arise in the future if the role of any of above mitigating factors is reduced or not present. This could occur if there is a significant reduction in reinsurers’ capital positions—in particular if the major retrocession players reduce their capitalization—and reinsurers do not compensate by increasing their use of collateralized retrocession. We will monitor the sector for indications that systemic risk has started to emerge.
Miroslav Petkov London, (44) 20-7176-7043
miroslav.petkov@
standardandpoors.com Rob C Jones
London, (44) 20-7176-7041
rob.jones@
standardandpoors.com
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