Ratings agency warns against counterparty risk from offshore reinsurance

The continued growth of offshore life reinsurance, in which Bermuda leads the way, increases counterparty risk, a ratings agency has warned.

Moody’s said in a report that it viewed “the continued trend offshore mostly from the US to Bermuda and Cayman Islands with caution”.

It added in a report entitled Offshore reinsurance goes mainstream, raising counterparty risk: “The overall movement of business offshore is a net credit negative for the life insurance sector because of increased counterparty risk, less transparent financial regulation compared with businesses that reside in the US, as well as a lack of transparency around financial assumptions and disclosure on the reinsured business.”

The report said the movement offshore to affiliated and non-affiliated reinsurers and sidecars was driven by life insurers’ desire to manage capital, and support risk management.

“Use of offshore reinsurance and sidecars will continue to grow as life insurers aim to improve capital efficiency, distributable earnings, and attract capital,” the report said.

It added: “Insurance regulators are increasingly concerned about life insurers’ reliance on offshore reinsurance, and have emphasized a need for improved governance and transparency in these transactions.

The report said the increase in counterparty risk was caused the arrangements allowed insurers to exchange the risk related to direct investments, which support their liabilities, for the risk related to the reinsurers' performance in the transaction.

The report said the shift raised other concerns about the use of mergers and acquisitions to expand products and services.

“The growing influence of private capital, which includes alternative asset managers, continues to reshape the landscape of the life insurance sector,” the report said. “As private capital’s consolidation of life and annuities liabilities has expanded, these organisations have also moved into new business sales, largely in annuities, while seeking fresh capital.”

Moody’s said it viewed US regulators evaluating regulation that would develop guidelines to enhance asset adequacy testing for life and annuity reinsurance transactions as a credit positive.

The report did not take into account regulatory changes being effected by the Bermuda Monetary Authority to improve transparency and disclosures on investments or the BMA’s requirement that block reinsurance transfers must be approved by both the BMA and the life insurer’s home regulator.

The report differs from a recent report ratings agency Fitch Ratings which said it viewed the BMA’s changes as a credit positive.

The report acknowledged that the current US economic outlook and the stable outlook on the US life insurance sector was increasing demand for life and annuity products.

“New and existing strategic partnerships between private capital – including alternative asset managers – and life insurers have also grown substantially,” it said. “Business strategies that combine the interests and expertise of life insurers and alternative asset managers are expanding life insurance companies' balance sheets and increasing assets under management, supporting merger and acquisition (M&A) and divestiture activity.

“These factors will continue to drive growth in reinsurance activity and the shift to reinsuring US life insurance business offshore, mostly from the US to Bermuda, through 2025.”

Since 2017, the amount of US life insurance and annuity reserves ceded offshore has surged to almost $0.8 trillion, over 40% of the $2.3 trillion of total reserves ceded, with Bermuda the common destination for the offshore reinsured business.

“These arrangements let insurers exchange the risk related to direct investments, which support their liabilities, for the risk related to the reinsurers' performance in the transaction,” Moody’s said. “If the credit quality of the reinsurers, as counterparties, is strong, this second type of risk can be lower.

“Although reinsurance transactions moved offshore to Bermuda have been significant, cross-border transactions in recent years — around 9% — have also been reinsured from the US to Cayman Islands. We believe that the reinsurance cession activities into these two international jurisdictions will continue after year-end 2024 results are compiled, but also into 2025.

“As more assets backing insurance liabilities are managed by private capital firms, an increasing amount of business – mostly annuities, including contracts supporting pension risk transfer liabilities – is being reinsured into offshore international markets to reinsurers that are affiliate or non-affiliated companies with a significant investment stake from private capital investors. These arrangements or structures support annuity sales, and the acquisition of in-force blocks, providing private equity insurers a key source of funds for their asset management businesses.

“Life insurance reserves reinsured or ceded offshore as of end 2023 totalled approximately $1 trillion or around twice the industry's total capital and surplus. This marks the fourth year in a row that total reserve credit was equal to or greater than the industry's capital position, and the trend is likely to continue in 2024 and into 2025 driven by cessions to affiliates.

“The increasing amount of business moving offshore could heighten the counterparty risk to the insurance group or cedent, and could add to industry concerns around the role of private capital-owned or private capital-controlled insurers in offshore reinsurance.

“Counterparty exposure is one of the most significant risks for insurers ceding business offshore, and as reinsurance activity has grown, the risks have increased.

“This leaves the cedents exposed to the quality of the subject business, the capital level of the offshore entity, the governing accounting consolidation standards, and the offshore entity's risk management capabilities. Financial difficulties or worse than expected performance on the business acquired by the reinsurer could lead to a recapture by the cedent resulting in an increase in capital at an inconvenient time.”

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