As regulators take a close look at counterparty risk, Bermuda:Re+ILS examines the part convergence capital can play in this area.
Counterparty risk is at the forefront of regulators’ minds in a number of jurisdictions around the world. This is particularly the case in Europe where re/insurers are facing a more complex regulatory environment from national and super-regional authorities.
The approaching date for implementation of Solvency II (January 1, 2016) will demand a higher level of awareness of stress situations on the part of risk managers when they select their reinsurance partners. This is of crucial importance to Bermuda-based re/insurance entities as the Island’s move to equivalence with the directive’s requirements seems set to be approved very soon.
The defining feature of the problem affecting re/insurers is that any transaction takes in numerous counterparties. These include policyholders and agents, corporate bond issuers and asset managers, reinsurers and reinsurance intermediaries—any one of which could throw up a counterparty risk issue where a default could potentially subject the
re/insurance company to significant financial loss.
This could be further exacerbated after a merger, where business lines and contacts become even more concentrated with the result that a failure in one area could have an enhanced effect on the newly created larger entity—which in turn, increases the possibility of a systemic knock-on effect on the wider re/insurance sector.
In Europe, Solvency II will introduce strict capital requirements for reinsurers; the costs of compliance are higher for smaller players and this may also result in a further wave of consolidation.
Smaller or unrated reinsurers assessed under the standard model will see capital requirements increase, which could trigger the withdrawal of niche reinsurers from the market or further consolidation as they seek to combine with larger companies. One effect of this would be to eliminate some of the risk transfer options available to cedants.
Concentration of sourcing is always a risk concern. In the context of reinsurance, the over-reliance on rated capacity (unsecured promises to pay) can become a capital sufficiency problem in a catastrophic event scenario.
Diversification is often propounded as the safeguard to the adverse consequences of increased size. While diversification across several counterparties with largely uncorrelated results will limit the risk of a domino effect in the event of a large systemic loss event, this risk itself cannot be entirely eliminated.
Under Solvency II, counterparty default risk is one of the core components of the Solvency Capital Requirement (SCR). This module has undergone substantial change over the several quantitative impact studies (QIS) carried out by the European Insurance and Occupational Pensions Authority (EIOPA) as the supervisors attempted to find an appropriate measure of the risk.
The Solvency II approach to measuring counterparty risk on reinsurance contracts is described in articles 189 to 202 of the Solvency II Delegated Act and is based on two key parameters, namely the probability of default and the loss given default.
“Lloyd’s historically has been represented by numerous smaller individual syndicates, each of whom took a piece of a risk thereby spreading the counterparty exposure." Don Kramer, ILS Capital
For every reinsurance counterparty, the probability of default is assigned based on either 1) the credit quality of the reinsurer (ie, its credit rating); or 2) the solvency ratio of the reinsurer.
“Overall we agree with the need to take reinsurance counterparty default risk into account and we do not have major concerns over the level of calibrations. However, there are concerns over some limitations of the current approach,” says Cristina Mihai, the head of international affairs and reinsurance at the Brussels-based re/insurance trade federation, Insurance Europe.
“There is a clear disparity between the probability of default to be used on the basis of an External Credit Assessment Institution (ECAI) rating versus on the basis of the solvency ratio (see article 199).
“More specifically, the probability of default is floored at 0.002 percent on the basis of the credit quality and floored at 0.01 percent on the basis of the solvency ratio. So a counterparty with a very high solvency ratio, but which doesn’t have a credit rating, would never achieve a probability of default below 0.01 percent. This approach can generate higher than justified capital requirements for counterparties with high solvency ratios, but no external credit rating,” she says.
Executive directors will have increased responsibility for risk management under Solvency II and will have to develop a strategy defining their risk appetite and receive regular updates on the development of risks.
The basic premise is that the risk management framework of an institution must be capable of identifying, mitigating and measuring credit risk, according to internally defined limits. Credit ratings should be monitored and probabilities of default evaluated, including for unrated exposures.
Exposure to speculative assets should be limited, and syndicates with significant exposure to assets bearing credit risk should be capable of hedging that exposure.
Solvency II guidelines also warn that with the current low interest rate environment possibly generating a “search for yield” through a variety of mechanisms, supervisors need to be “cognisant of the growth of such risk-taking behaviours and the resulting need for firms to have appropriate risk management processes”.
In this way a lot of responsibility is placed in the hands of supervisors who need to be aware whether firms are accurately capturing central counterparty exposures as part of their credit risk management.
Third party capital
There appears no end in sight to the development of the convergence market as evidenced by the record-breaking amount of cat bond issuance and the increase of insurance-linked securities (ILS) funds under management. This was perhaps to be expected given the continued low interest rate environment and the benign insured loss sector.
However, one consequence of the introduction of third party capital into the marketplace is its effect of mitigating counterparty risk through the transference of insurance risks from re/insurers to the capital market.
The received wisdom is that the ILS market helps reduce counterparty risk as collateral is invested in highly rated investment-grade securities where the creditworthiness of the collateral and the ability of the special purpose vehicle to meet payment obligations are largely uncorrelated with the occurrence of a large natural catastrophe.
ILS structures also, typically, have unambiguous payment terms. Whereas traditional reinsurance contracts can give rise to coverage and payment disputes, cat bonds are structured to avoid such disputes and to pay out promptly.
It’s also thought that reinsurance mergers and acquisitions (M&A) could benefit ILS funds as larger carriers will be keen to reduce counterparty credit risk.
“As the number of reinsurance counterparties declines, customers are turning more and more to ILS players, and given our enhanced credit associated with collateralised reinsurance, the opportunity for ILS funds continues to grow,” says ILS Capital chief risk officer Paul Nealon.
ILS Capital founder Don Kramer says consolidation could be a “big boon” to ILS funds as no cedant would want to have too much exposure to a newly amalgamated counterparty. This, he believes, could leave room for new counterparties. He cites the changing dynamic of the Lloyd’s insurance market as an example.
“Historically purchasers of reinsurance liked to spread their reinsurance agreements over several counterparties so that the decision of one company or another to leave the market would not hurt them,” he says.
“Lloyd’s historically has been represented by numerous smaller individual syndicates, each of whom took a piece of a risk thereby spreading the counterparty exposure. Lloyd’s today is represented by several larger members as well as numerous smaller ones.
“For example one of its members, following a merger, now accounts for 9 percent of the entire market. This wave of consolidations has led to greater opportunities for smaller non-Lloyd’s companies to take pieces of the reinsurance business and spread the counterparty risk.”
As the understanding of ILS products, including collateralised reinsurance, industry loss warranties, catastrophe bonds and sidecars continues to increase, coupled with advances in risk modelling platforms resulting in a growing acceptance of such risk transfer through these structures, so too will potential risks and regulatory/rating concerns.
“A whole host of concerns and emerging risks may manifest and impact the convergence market as it grows,” notes insurance and reinsurance ratings agency, AM Best.
In a recent publication It’s not Your Father’s Reinsurance Market Anymore—The New Reality, it highlights the risks it believes pose a threat to the expansion and evolution of the convergence market.
These include basis and tail risks; collateral/counterparty risks; legal risks associated with the formation/legitimacy of special purpose vehicles and segregated cell structure; and the true potential value of the notional balances of parental guarantees by insurance and non-insurance entities acting as counterparties.
The basis risk, defined as the risk that a re/insurer won’t receive adequate recoveries from a product in relation to its actual loss from an associated event, “is one of the key regulatory and rating concerns as the number and amount of ILS transactions continue to increase”, AM Best notes.
Another concern for the growth of the convergence market is with collateral and counterparty risks, highlighted by the default of four cat bonds in 2008 owing to missed repayments.
Since the use of fronting arrangements and guarantees by re/insurers is not unusual in the convergence market “these activities make it impossible to access the true notional value balances of parental guarantees in cases where guarantees are involved and may even pose a hidden systemic risk for reinsurers in case of catastrophic events of monumental importance”, AM Best notes.
So clearly there are risks to the expansion and continued development of the convergence market to the extent that the rating agencies are increasingly looking at how insurance-linked securitisation can affect the ratings of the insurance companies they evaluate.
Standard & Poor’s (S&P) notes: “In recent years a lot of focus within the catastrophe bond area of securitisation has been on collateral risk, but often the real risk to collateral is actually the risks associated with the counterparty who could be providing that collateral.”
S&P says that the financial disruptions of the last few years have reinforced that this is a risk that cannot be ignored, and adds that counterparty risk should not be overlooked.
“Under stressed conditions there is a risk that a counterparty might not perform its duties, which, in some cases, could lead to a payment default on the securities,” says credit analyst Andrew South.
“Even as the securitisation market recovers, and structures begin to evolve to reflect lessons learned, we believe that counterparty risk is likely to remain an important consideration in determining the creditworthiness of structured finance securities,” he adds.
The newly merged XL Catlin operation believes that its approach, where cedants access it at one point but place risk into several of its markets, acts as a barrier to counterparty risks.
Jonathan Gale, chief executive of XL Catlin’s London operations, says: “They can access us wherever they want—London or Bermuda, for example—and they will find that both those hubs will have the same risk appetite and the same view on pricing. It is a question of diversification of placement but commonality of approach.
“That gives them immediate diversification in terms of counterparty risk and access to two different markets while dealing with the same group.”
Mitch Blaser is the CEO of the Bermuda-based Iron-Starr agency which was established in 2009 as a direct response to the changing buying behaviour of clients following the credit crisis when worries surrounding counterparty risk and capacity concentration with a single carrier were to the fore.
His firm operates as a ‘one-stop shop’, underwriting casualty and financial lines business on behalf of several partners.
“Every risk that is placed with us is supported but there is no concentration with one carrier,” he says. “That gives additional comfort in terms of allaying counterparty risk fears.”
The issue of counterparty risk has been to the fore ever since the credit crisis hit in 2008 with regulators keen to devise a protocol that prevents systemic risk to the financial system. It seems that the influx of third party capital and the popularity of ILS may provide one method of transferring risk in the system.
But clearly there are risks to the expansion and continued development of the convergence market itself, so much so that AM Best “is increasingly looking at how insurance-linked securitisation can affect the ratings of the insurance companies it evaluates”.
Any counterparty default can subject the re/insurance company to potentially significant financial loss. Whatever the final method for assessing counterparty default risks under Solvency II, this is an opportune time for all companies to revisit credit risk management to ensure not only compliance with regulations but also to limit this non-core risk.
Bermuda:Re+ILS, Solvency II, EIOPA, S&P, Don Kramer, ILS Capital, Bermuda, Europe