The ability of insurers and reinsurers to meet their policyholder obligations has always been a major concern for their clients. This is why so many buyers use ratings as a central plank of their insurer and reinsurer selection process.
However, the early days of the Covid-19 pandemic brought into sharp focus the idea that counterparty credit risk management involves thinking about this in a more sophisticated way than simply ‘business as usual’. As the extent of the crisis became apparent there were dramatic falls in investment values, accompanied by growing uncertainty as to the social and financial costs of the pandemic, the extent to which the financial costs would be picked up by the insurance industry, and about how the industry’s risk appetite would be managed going forward.
The ability of insurers and reinsurers to pay their claims is ultimately a function of each insurer’s resilience to adverse events, not least their exposure to their own reinsurers and the future availability of the reinsurance capacity that their business model requires.
As the UK Prudential Regulatory Authority highlights in its annual UK CEO letter for 2021:
“The outlook for credit risk remains highly uncertain…., 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.”
“In 2020, we expected firms to use a number of approaches and analyses, such as stress and scenario testing, to assess risks and consider the increased risk of losses from multiple sources and the increased uncertainty due to Covid-19 and the wider economic outlook. We want to see firms continue to improve the stress and scenario testing they undertake….”
When it comes to (re)insurance counterparty risk, resilience means knowing the answer to questions such as:
How well would our (re)insurers withstand one or more stress scenarios?
What might this mean for their ability to pay future claims?
Will they still be able to offer acceptable capacity next year?
This implies that buyers will need to look beyond a static assessment of the security of their insurers and reinsurers to include more dynamic analysis, such as stress testing.
The rating agencies themselves undertake this kind of review as part of the rating process. But fundamentally they are not issuing ratings as if the “reasonable worst case” stress has actually already happened.
Some insurers and reinsurers are already looking at stress testing counterparties within their risk management functions. But, for many, this will be a new challenge starting with a blank sheet of paper.
There are solutions out there – here at Litmus we are currently working with two top 20 global reinsurers on their reinsurer/retro counterparty stress testing – with a particular focus on the individual or collective impact of stress level catastrophe losses, reserving shocks and investment market write-downs. For (re)insurance claim-related stresses this analysis includes the “multiplier” effect on various different key risk metrics.
This is not a molehill, but neither does it have to be a mountain, and we applaud the PRA’s focus on this important area that will fundamentally enhance the resilience of insurers and reinsurers in the UK and potentially elsewhere over what could prove to be a highly stressed period in the industry’s history.