Rating Collateralized Reinsurers
With $55 billion in capacity, collateralized reinsurance is the fastest-growing form of insurance-linked securities.
- John Weber
- August 2019
WEBINAR REVIEW: Dr. Wai Tang, left, director, AM Best and Emmanuel (Manny) Modu, managing director, AM Best, discuss how insurance-linked securities-affiliated collateralized reinsurers are rated.
The Reinsurance Special Section is sponsored by Munich Re. Click on the microphone icon to listen to the Munich Re podcast or go to www.ambest.com/ambradio.
Insurance linked securities-affiliated collateralized reinsurers are relatively new, but are expected to become a larger share of the reinsurance sector as they seek greater operational efficiency, elimination of fronting fees, and more flexibility in tailoring their offerings to cedents.
In the webinar “Rating ILS Affiliated Collateralized Reinsurers,” AM Best analysts examined how they rate ILS affiliated collateralized reinsurers.
Taking part in the webinar were Emmanuel (Manny) Modu, managing director of AM Best, and Dr. Wai Tang, director at AM Best.
Following is an excerpt from the webinar.
The ILS Universe
Modu: The capacity provided by the ILS market is currently at about $98 billion, which consists of four components. The fastest-growing component is collateralized reinsurers, which is approximately $55 billion worth of capacity.
The next biggest is the cat bonds, which offer about $30 billion worth of capacity, and sidecars and ILWs round it out with $13 billion worth of capacity.
If you compare the numbers in July 2018 and March 2019, there's a diminution in AUM [assets under management] of about $2 billion or so. That's an indication that some investments have pulled out of the market due to a cat event over the past couple of years.
Strengths and Weaknesses of the ILS Market Post Catastrophes
Modu: On the strength side, you had orderly payments of losses by the ILS market and without any hitches because the collateral, obviously, is there to make the payments.
The events also exposed loss creep issues and exposed the fact that CRs, collateralized reinsurers, are not exactly equivalent to traditional reinsurers from a cedent's perspective. That's because of a limited claims development period for CRs versus traditional reinsurers. So what you have is tail risk that goes back to the cedents based on the limited claims development period.
Collateralized Reinsurer Ratings
Modu: We call the rated CR a Newco Re. There are several motivating factors for a rated CR. The first factor is the elimination of fronting costs. Fronting fees can range from between five and 15% of premiums, depending on how much leverage the investment manager is seeking in the transactions.
The rating can also eliminate dependence on fronting companies, and thereby avoiding some of the fronting dislocations in the fronting market at this point. Right now, there are three major fronting companies. You have Hannover Re, Allianz, and TMR. TMR has announced recently that it will no longer be in the fronting business due to its acquisition by RenRe.
Therefore, you've got elimination of one of the major fronters, which is a problem for some of the investment managers in the ILS space. Therefore, they want to eliminate that dislocation. Starting their own Newco Re, which is effectively a fronter, is their solution.
The ILS managers want to reduce inefficiencies associated with having many trusts and letters of credit (LOCs). You could have scores of trust and many LOCs, and it's an operation nightmare for these investment managers.
In addition, a rated entity helps create some leverage because with a rated entity, you don't need to hold 100% collateral. Most of the risk will be ceded to the transformer. The risk that's retained by the Newco Re is now fully collateralized. That provides some leverage.
Also, what we have with a rated CR, Newco Re, is increased flexibility to provide reinsurance solutions. These solutions could be solutions related to reinstatements, aggregate transactions, and other forms of reinsurance that are not readily available through the unrated CRs.
Another motivation is that some cedents can only transact with rated entities. Having a rated entity opens up the collateral manager to soliciting business from cedents that will not otherwise be interested in their business.
ILS-Affiliated Collateralized Reinsurers
Modu: AM Best classifies three companies as ILS affiliated collateralized reinsurers. The first one is Kelvin Re Limited. We rated Kelvin Re September 2014. The capital for Kelvin Re was provided by Middle Eastern Sovereign Wealth Fund. The source of the business is primarily through Credit Suisse Insurance Linked Strategies.
Kelvin Re has alternative asset investment strategy and its leverage as measured by net written premiums over surplus is moderate.
The second reinsurer in this space that we rated was Humboldt Re in October 2015. The capital for Humboldt Re was provided by a Swiss pension fund. Once again, the business here is sourced through Credit Suisse Insurance Linked Strategies.
Humboldt Re has a low risk investment asset strategy and its leverage is also quite low as measured by NWP over surplus.
Lumen Re was first rated in December 2017. The capital was provided by one of the LGT funds. The source of business is LGT ILS Partners. Lumen Re has a low risk asset investment strategy and extremely low leverage whether measured by NWP over surplus or limit over surplus.
Kelvin, Humboldt, and Lumen are rated A, A and A respectively.
Tang: First, as usual, the main methodology for rating our reinsurance companies is the Best's Credit Rating Methodology, BCRM. Other than that, there are several very important criteria that actually have to be included in this rating process.
The first two criteria listed here discuss BCAR, that is, the Best's Capital Adequacy Ratio, which is a quantitative measuring of the risk of the company relative to its available capital.
The third criteria here talks about cat stress, which is second event cat stress where the loss is applied directly to the capital rather than appear in the net required capital formula. The fourth criteria is the calculation of equity credit for different types of capitals, such as common stock or hybrid like preferred stocks.
The fifth criteria, rating new company formation, here we are basing on this criteria to classify if the entity seeking rating is a new company or not. If the company is classified as a new company, there are certain constraints on some of the building block assessment.
The last two criteria discuss tail risk back to the Newco from the transformer and the treatment of that.
Differences Between Rating Collateralized Reinsurers and Rating Insurers
Tang: Our approach for rating an insurance company is building block approach. Total, there are six blocks. In general, only the first four blocks are applicable to CR. The last two blocks usually are not applicable.
Balance sheet strength is the first block. It usually is viewed as the foundation of the financial security. One of the components of balance sheet strength is BCAR. Other than BCAR, there are other quantitative and qualitative factors in the assessment of the balance sheet strength of the entity.
The second and third blocks, operating performance and business profile, concern the well being of the balance sheet strength of the entity in the future. Without solid operating performance and business profile, a company's balance sheet strength will erode over time. Operating performance is a leading indicator of future balance sheet strength and long-term financial stability. After the operating performance review, we will assess the company's business profile, like the nature of the business itself, the market position, the distribution channels. Favorable business profile will typically translate into defensible competitive advantages. Enterprise risk management, ERM, is the fourth block. We will want to understand the development and the implementation of the insurer's risk management framework and understanding of the insurer's risk management capability relative to its own risk profile.
Important Rating Considerations
Modu: The concept of permanent capital is absolutely important at AM Best. For us, the most permanent capital is common equity, and that receives full equity credit in our analysis.
When we are presented with hybrid capital such as preferred stock or trust preferred, we do apply haircuts based on certain features. Maturity features, of course, the longer the maturity, the less the haircut. Call features, debt service features such as mandatory payments. If the payments are mandatory, it probably gets more of a haircut. Subordination level to policyholders, treatment by regulators, and management intent. If we substantially haircut or cap our capital, it can affect greatly available capital, and then affect greatly the BCAR scores, which ultimately would make balance sheet strength somewhat inadequate. So the idea of permanent capital is of absolute importance on rating analysis. We don't have any guideline as to what kind of capital you ought to have, but just know that any hybrid capital would suffer severe haircuts.