SUNDAY
15.10.17
Opinion
Hurricanes and the importance of
ERM to ratings
The fact that the recent hurricane losses are unlikely to become a capital event for
reinsurers owes much to the industry’s greater sophistication in its use of enterprise
risk management, writes Stuart Shipperlee, managing director of Litmus Analysis.
At the time of writing S&P has begun to
Stuart Shipperlee
“If the ERM system is seen
to have performed well under
this degree of stress then that
should reinforce an agency’s
faith in it.”
negatively adjust a few reinsurer rating outlooks
due to the impact of expected losses from hurricanes
Harvey, Irma and Maria (HIM). There remains
a very wide range of possible loss outcomes, and
whether HIM (and the rest of 2017) will develop
collectively as a major ‘capital event’ for any rated
reinsurer is very hard to second-guess at this point.
Most forecasts have industry losses exceeding
those of 2005, which was most certainly a capital
event for some. But that was a different world
for the management of reinsurer capital. Since
then a lot of work has been done on reinsurer
enterprise risk management (ERM).
ERM quality has also become fundamental to
reinsurer ratings.
Of the four main agencies globally active
in rating reinsurers, only S&P has made the
impact of ERM explicit in individual rating
reports, although AM Best is about to start
doing so with the launch of its updated rating
methodology. But both Fitch and Moody’s also
make it clear that they have ERM quality as a
fundamental rating factor.
S&P published its initial ERM assessment
criteria in 2005 so, like the industry itself, the
agency has had more than a decade to develop
and refine its approach.
While the 2011 and 2012 cat years provided
some evidence of how well reinsurer ERM was
working they did not provide the degree of
‘stress’ 2017 will probably deliver.
This matters because ERM is not only
fundamental to reinsurer ratings, it has also been
a major supporting plank of these through the
soft market.
From 2014 the agencies have been trying
to rationalise two opposing and pivotal rating
factors: inadequate risk-adjusted pricing versus
very robust capitalisation. This has led to a range
of different, and changing, sector level opinions
from the agencies.
Normal credit-analytic logic is that future
profitability drives future capital adequacy. Since
ratings are prospective, the pricing environment
has the potential to trump the current capital
position—that is why AM Best maintains a
negative rating outlook on the sector. Moody’s,
however, has just restored its sector outlook to
stable from negative. Fitch and S&P both have
stable ratings outlooks for the sector while flagging
the concern that returns on capital are trending
below the cost of capital.
This is all in a context where—pre-HIM—
nobody saw pricing getting any better (for ‘sellers’).
Yet, other than the case-specific consequences
of M&A, reinsurer ratings have hardly seen
downgrades.
A reason underpinning this is perceived
ERM quality. For individual reinsurers this has
helped provide a floor to the rating agencies’
pricing concerns. These persist of course, but if
a reinsurer’s risk appetite and tolerances are welldefined,
risk controls and governance look robust
and risk modelling is high quality and well tested
then that downside concern is mitigated.
Which leads us back to how 2017’s cat events
may impact things, even if it is not a full blown
‘capital event’ for a rated reinsurer. If the ERM
system is seen to have performed well under this
degree of stress then that should reinforce an
agency’s faith in it.
Conversely, if key expectations around maximum
exposures by return period are not met, this
supporting plank of a reinsurer’s rating may come
under pressure. Not only might the ERM assessment
in isolation be impacted, but positive assessments
across the ratings process could be challenged (such
as confidence in prospective operating performance
and the effectiveness of board oversight).
The challenges of ‘loss assessment’ could add
to the complexity of agency communications
for reinsurers. A conservative approach to yearend
2017 event reserving will make the headline
accident year number and event loss scale versus
stated risk tolerances look worse.
It could also weaken apparent risk-adjusted
capital by increasing the ‘required capital’ for
reserves.
Any rated reinsurer believing it is following an
appropriately cautious path with its catastrophe
reserving numbers should make very sure it
explains that to the rating agencies, for example,
by explicitly showing the outcomes ‘with and
without’ that additional prudence. n
10 | PCI TODAY | DAY 1: Sunday October 15 2017 www.intelligentinsurer.com | www.bermudareinsurancemagazine.com