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Survival of the fittest

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Despite recent downgrades, German reinsurance buyers are willing to trust their traditional suppliers, at least for the time being

By Knut Schaefer.

For people outside Germany it is hard to appreciate quite what an impact the current row over reinsurance ratings is having on its insurance industry. To say that it is the big talking point in the country would be an understatement.

Germany has the oldest reinsurance industry in the world and, of course, many of the biggest reinsurers. In stark contrast, the German insurance industry is highly fragmented and has largely resisted the recent trend towards consolidation. There are more than 300 non-life insurers, most of them mutuals. Many of them are highly localised or specialist. Although they often provide an excellent service to their customers, they do not have the resources - either financial or human - that you would find in an international or large national company.

Valuable relationships

Most of these smaller insurers place tremendous value on their relationships with reinsurers - not just for capital purposes, but because of the expertise and continuity that they offer. Reinsurance is something the Germans think they do better than anyone else, and they have come to take it for granted that their companies provide the best service and security around.

This faith in their reinsurers is part of the industry's psyche. Anyone who has spent their working life as a German insurer has grown up to accept their reinsurers as ever-present and a bedrock of stability in turbulent times.

Stability under attack

It has, therefore, come as quite a shock to find this fundamental assumption under assault - and from a highly respected source. The rating agencies are also important and well-regarded, and once again the size of most German insurers provides part of the explanation. As a rough rule, the smaller the company the more attention they pay to what the rating agencies have to say. Indeed, many German insurers use the Standard & Poor's (S&P) capital adequacy models as the basis for their own internal financial models.

So, to find S&P involved in an increasingly public battle with part of the German reinsurance industry is causing a lot of heartache. This is reminiscent of the old school physics question: "What happens when an irresistible force meets an immovable object?" We are still waiting to learn the answer.

First, however, let's put the current row into context. Not all German reinsurers are involved. GeneralCologne Re retains its 'AAA' rating, while Hannover Re is also relatively unscathed. ERC Frankona and Swiss Re (heavily represented in Germany in its own right and through the acquisition of Bavarian Re) are hurting. Although privately critical of their recent ratings downgrades, they have decided to bite their lips and say little in public.

The centre of the storm, as anyone knows, involves Munich Re. As the world's largest reinsurer and traditionally among the 'AAA' elite, its position is unique. A few years ago they would have regarded an S&P single 'A' rating, admittedly an 'A+', as totally unthinkable. Now they see it as an affront, evidence that the rating agencies are out of date and out of touch. Far from taking it lying down, they are publicly challenging the rating agencies in what appears, at least to German insurers, as something of a power struggle.

So, how have their customers responded to these unfolding events? In Germany at least, the reaction has been one of amazement more than anything else. To the best of my knowledge no reinsurance buyer has deserted any of the downgraded companies.

Germans in all industries value long-term relationships; it is a national characteristic. To break up a long-standing business arrangement when one or the other party is experiencing a short-term difficulty would be regarded as 'un-German'.

Core arguments

Above all, though, the rating agencies' decisions are simply not believed. Munich Re's core argument is that its own models are more dependable than those of the rating agencies. For the time being Munich Re appears to be winning the debate.

The fact that the company has decided to raise EUR3-4bn in order to regain at least a 'double A' status indicates that they recognise the commercial value of a high rating. In Germany, though, buyers and brokers have been willing to give Munich Re and other downgraded reinsurers the benefit of any doubt that may exist.

Indeed some German insurers are positively annoyed by the downgrades. Any pressure on their reinsurers' security affects them too, especially in their relations with commercial buyers, and there is an often-expressed view that the agencies have too much power. This sentiment is shared by many mutual insurers, even though they are not so dependant on the ratings system, especially those with their own publicly-quoted subsidiaries.

Looking to the future

It can be difficult to make predictions, but it seems that the downward ratings trend has bottomed out. Of course there could be another enormous loss of 11 September 2001 proportions or a series of big reinsurance disasters and there may even be another global equity crisis - any of these scenarios might put a strain on ratings. However, unless something of this nature happens we will see ratings rise again.

They will not return to the levels seen before 11 September, where 'AAA' security was relatively commonplace, for the foreseeable future. Indeed, this may never happen as most shareholders consider the amount of capital required to achieve this as an inefficient use of resources.

As for the rating agencies, they will remain powerful. If the atmosphere in Germany is any guide, however, uncritical acceptance of their decisions is a thing of the past.

- Knut Schaefer is a director of EMB Deutschland, the German branch of the actuaries EMB.

Lifting the lid on ratings

The debate about the methods used by rating agencies is a global one, with companies like French reinsurer Scor publicly taking issue with the analysts, and many others doing so privately. The main allegation is that they use yesterday's criteria and methodologies.

Before criticising the rating agencies, it is only right to acknowledge the service they have provided to cedants. It is a matter of historical record that 'triple-A' reinsurers have been significantly less likely to default than 'double-A' reinsurers, who in turn have been more dependable than 'single-A' reinsurers, and so on. For the customer, especially the less sophisticated reinsurance buyer, this type of guidance has therefore been of tremendous value.

The important question now, though, is whether they are as relevant today at a time when financial modelling has moved on and large (re)insurers are far more sophisticated in the way they calculate capital adequacy.

The rating agencies create models by using a methodology to assess financial stability that was commonly used until recently by (re)insurers and regulators - and to some extent still is. They are based on a series of risk charges applied to various different risk types based on market average data.

The simplicity of this approach is both a great strength and a weakness. It is fast and cheap in terms of man-hours, but by no means does it provide a complete or thorough assessment of the entity being investigated. It is general by its very nature, and does not apply to the particular characteristics of each company.

Other more detailed criticisms include the weighting that some analysts give to quota share reinsurance as opposed to top-layer reinsurance. A company that buys excess of loss is treated, for the purposes of security ratings, in exactly the same way as if it were buying a quota treaty. In practice, of course, it is targeting the very layers that might otherwise bring about default. Yet this is not acknowledged when assessing their financial security. The way they use reserves to calculate capital requirements has also been questioned.

Many people argue that the rating agencies' models are no longer the best way to measure risk, thanks to the latest generation of techniques and software that make more sophisticated analysis a more practical option. That is why the trend in the EU and in some other countries, most notably Australia, is towards risk-based assessment of (re)insurer security and achieving that assessment through simulation techniques.

Modern financial modelling involves a detailed analysis of a (re)insurer's own data, most notably its exposures and reinsurance programmes. By feeding in thousands of simulated scenarios designed to replicate the financial consequences of a range of feasible events, a company can measure what effect those events would have on its security. In that way it can test its robustness with an accuracy that was previously not possible, including the measurement of the chances that a particular entity might default.

The main drawback with this methodology is that it is complex and time-consuming. You would not expect the rating agencies to create their own sophisticated risk-based models each time they assess a (re)insurer; that would make the whole exercise slow and prohibitively expensive. It is also prohibitive for smaller insurers who may not have the expertise or resources to justify such an intensive approach.

There is, however, an obvious way around this drawback - for agencies to make companies' financial models a central part of the rating process. Although they currently do take them into account, the agencies' own (often less appropriate models) take precedence.

It is also true that, as the rating agencies themselves stress, there is much more to assessing the strength of a reinsurer than creating a financial model. Nonetheless, it is a pretty fundamental part of the exercise, and it is very much open to debate whether they get it right.


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