Reinsurance counterparty concerns to rise, collateralized looks appealing

Counterparty risks are back on the agenda in the insurance and reinsurance market, as part of carriers and regulators heightened concerns over credit risks and creditworthiness, which could serve to make fully-collateralized reinsurance through insurance-linked securities (ILS) even more appealing to ceding companies.

Regulators are increasingly raised counterparty credit risks as an issue that insurance and reinsurance market participants need to be aware and wary of.

From exposures on the asset side that can make a counterparty vulnerable to financial market shocks, to other systemic risks such as climate and cyber, the focus on creditworthiness of reinsurance counterparties and their ability to weather shocks to the global system has only been heightened since the pandemic broke out.

COVID-19 has sharpened the pencils of those analysing credit risk in the insurance and reinsurance industry, as well as other systemic type risk exposures.

The UK’s Prudential Regulatory Authority (PRA) warned re/insurers in its 2021 outlook back in December that, on credit risks, “The outlook for credit risk remains highly uncertain due to the factors noted above,and insurers are exposed to downgrades and defaults that would accompany any deterioration in credit fundamentals. In view of the illiquid nature of much of the sector’s credit exposure, both through direct investments and counterparty risks in, for example, reinsurance contracts, we expect your board to satisfy itself that the firm is resilient to a wide range of potential adverse credit scenarios in the short and medium term.”

It’s a sign of the heightened nervousness over the potential for counterparty credit to become an issue in re/insurance, should shocks of similar magnitude to the pandemic occur.

Regulators are increasingly honing their stress testing regimes to try to identify stress events that could cause market volatility, disruption, or a breakdown of creditworthiness in the sector.

On this, the PRA says that it wants to build on previous rounds of stress testing, “to develop stress testing as a supervisory tool for measuring sector resilience to specific shocks and to explore its use to provide a top-down assessment of individual firms’ capital adequacy.”

Essentially, this boils down to heightened scrutiny of insurance and reinsurance firms’ ability to make good on their obligations and how various stresses could impact that.

When it comes to reinsurance and retrocessional protection, it is just a promise to pay supported by a companies financial and credit worthiness. If major systemic type events hit the industry, how quickly does that break down and become an inability to pay?

As these issues come under greater scrutiny it does highlight one of the key benefits of insurance-linked securities (ILS) and catastrophe bonds, their fully-collateralized nature.

The majority of ILS transactions and collateralized reinsurance arrangements see the full obligations for the limit transferred placed in trust and the cash invested in extremely low-risk assets, such as treasuries, or even held in a cash equivalent.

What that means is, that no matter the stress event, or the systemic nature of a credit type crisis, the ILS collateral is almost certainly going to be there to make good on any reinsurance and retrocession recoveries and claims.

In speaking with one major corporate that accesses risk transfer using ILS, we learned that this matters just as much for those accessing the capital markets for insurance risk transfer capacity.

Corporate risk transfer buyers also have a heightened focus on credit worthiness and solvency of their counterparties right now, in insurance as much as in their trade and business.

That makes ILS look attractive right now, as a source of risk transfer capacity with extremely low to zero counterparty credit risk attached.

As stress testing regimes are toughened and increasingly climate exposures, including weather and catastrophe, are measured and credit metrics linked to those risks, the counterparty stability of an ILS or catastrophe bond transaction is going to look like a very viable option and one that looks particularly good in front of shareholders and other stakeholders.

These trends could accelerate now, as the pandemic increasingly looks set to come under some control but leaves a nervousness and heightened risk aversion behind it.

The ILS market should drive home the quality of protection and capacity it provides, as well as just how remote the risk of non-payment is, even in the face of major systemic world events.

Of course, the larger reinsurers and insurers are unlikely to face any concerns on counterparty credit, but it is possible some smaller to mid-sized players may not perform as well under stress scenarios and buyers of risk transfer could begin to shy away from them as a result.