A full understanding of the political risk insurance market requires an understanding of the reinsurance that underpins it. For an explanation, we turned to Ben Love, Vice President of The Benfield Group, a global reinsurance intermediary and leader in reinsurance solutions for insurers of credit and political risks worldwide.
As much as a third of political risk insurance premium and exposure is assumed by the reinsurance market, making reinsurers a significant partner if not always a silent one. Though the interests and motivations of the two are largely consistent, reinsurers can at times curb the strategies of the direct writer, impacting the insurance product made available to customers. In recent years this has affected basic parameters such as tenor (policy duration) – notably for Lloyd’s, which is generally restricted to competing on transactions below thirty six months; coverage – reinsurer preference for “trade-related” business and limited, defined perils; and capacity—per risk or otherwise—for example, in respect of regulations under which certain reinsurers “pass on” their inability to cover US embargoed territories.
Prudent Risk Management
Despite the potential for such restrictions, reinsurance does play a significant and often critical role in insurer business strategy. In most instances, the ultimate level of political risk losses has been relatively low in volume and magnitude. As a result, historical experience is often not the principal driver for buying external capacity; rather, it is a function of corporate governance and prudent risk management. The nature of the class is such that significant exposures, concentrated in a limited number of countries and often representing multi-year commitments, steadily combine to represent a potentially catastrophic level of loss—if business assumptions and practiced techniques for risk selection and mitigation fail.
Capacity, With Limitations
Reinsurance is the traditional way by which an insurer achieves external support and protects itself against the unforeseen. For buyers of political risk reinsurance, there are two dominant structure types:
- Excess of Loss – per risk “XOL” provides a fixed limit per risk above a fixed retention for a fixed premium. Limited reinstatements (i.e. coverage for a second, possibly third loss) are generally provided, at a predetermined price.
- Quota Share – under a “QS” arrangement, reinsurers share proportionately in every risk for a proportionate share of premium, less a ceding commission to cover insurer expenses.
Both have limitations for writers of political risk. Per risk XOL does not provide significant protection against “country loss,” i.e. the true catastrophic loss, being a series of losses in one country, and XOL has not generally been available in respect of policies with a period beyond 36 months. QS addresses both these limitations, but at a cost, being both the volume of premium and profit potential assumed by reinsurers, and the level at which it is ceded, being from the “ground-up,” as a fixed percentage of every premium dollar is passed on.
Whilst these basic structures have remained largely the same, far greater change has been seen in the volume of reinsurance capacity available to insurers. A significant milestone in the expansion of capacity was the privatization of the short term book of the UK’s Export Credit Guarantee Department in 1992—the subsequent private market reinsurance placement being the first time many reinsurers provided cover for political risks, albeit as an adjunct to their core export credit business.
Throughout the 1990’s, the increasing confidence in and understanding of political risk among both insurers and reinsurers supported the formation of several significant direct writers in Lloyd’s and company market. Similarly, the growth in full/partial privatizations of public entities, resulting in a quasi-commercial/political risk, served to encourage the blending of political and commercial credit writers as each expanded its product offering. In a benign marketplace, such trends were (relatively) smoothly embraced by reinsurers.
Towards the end of the 1990’s, specific loss activity (notably in Argentina, Cuba, Russia and SE Asia) undoubtedly tempered capacity and renewal terms, though the reinsurance market for these risks remained largely intact until the events of 9/11.
The Perfect Storm
Whilst the tragedy of 9/11 did not result in any political risk losses, a number of factors combined simultaneously to significantly reduce the capacity available to political risk insurers. These included the recognition of reserving inadequacy (notably, relating to US casualty), the fallout from the collapse of ENRON and a far more challenging investment climate which would no longer compensate for poor underwriting results. Writers such as GE Frankona, General & Cologne Re, Gerling Globale Re, RSA and St Paul Re withdrew from the market entirely, some lost credibility as their credit ratings reduced, whilst others elected to reduce or cut back capacity as opportunities to deploy capital for higher and more immediate returns presented in other classes, such as property, terrorism and aviation.
The significant contraction of capacity impacted buyers of political risk reinsurance in terms of increased price, tighter conditions and far greater scrutiny of coverage/defined perils. Together, these challenged the marketability of a product that was suffering already from a general slowdown in trade and investment.
Since the end of 2001, the arrival of fresh capital, unencumbered by past issues, has served to once again ease buying conditions. Adding to the renewed interest from incumbent reinsurers, new entrants such as Arch, Endurance and Platinum have contributed to the development of available reinsurance capacity.
The significant hurricane activity of 2004 and 2005 clearly presented a major challenge to the wider reinsurance market. However, the speed with which the reinsurance market recapitalized meant anything near sustainable rate/condition hardening has been limited to business exposed to natural perils. Political risk insurers with an established track record and strong reputation have not been significantly challenged in achieving their desired reinsurance. Indeed, just two years on, most renewals at 1 January 2007 were over-placed, meaning supply is outstripping demand.
Notwithstanding potential losses and a complex underwriting environment, interest in political risk continues undiminished, driven even further now by the anticipated ratings weakness in mainstream insurance lines and the tacit encouragement of rating agencies to diversify by product line and geography. The market for buyers of political risk reinsurance is in good shape—with as many as twenty-five reinsurers participating from the US, Bermuda, London and Europe. A further indication of this robustness is the recent re-emergence of political risk facultative (case-by-case) reinsurance—largely unavailable since 2001.
Maximizing the Benefit
If the market for political risk insurance is to really benefit from the greater attention of reinsurers, per the limitations outlined previously, this interest must propel the innovation needed to better address the needs of buyers. To do this, we will have to successfully tackle a number of the idiosyncrasies that distinguish the direct political risk product:
- Policy tenor – the requirement for multi-year coverage is a challenge for much of the reinsurance market, whose focus is “shorter tail” business and potentially faster reporting of final results and commensurate returns on capital.
- Limited Quantitative Analysis – for most lines of insurance, underwriting and risk are increasingly evaluated using objective, actuarially based techniques. Absent a significant body of relevant loss information, it is not practical to deliver the same analytics for political risk, frustrating reinsurer attempts to analyze the class on a comparable basis.
- Capacity Usage – political risk differs from most insurance classes in that the underwriter can often manage and mitigate exposures before, during and after a claim. The result can either obviate the need for a claim payment or achieve meaningful recoveries. The recognition of this is of central importance to the political risk insurer, though the actual value, as assessed at policy inception, is highly subjective and challenging for reinsurers to correctly reflect in the terms they offer.
- Concentrated Country Exposures – the purchase of political risk insurance is largely discretionary, resulting in an exposure profile for insurers that is concentrated among a limited number of countries. The management of country exposures is a critical factor for reinsurers who must contemplate exposures aggregating across multiple reinsureds. For many reinsurers, limited diversity within the class is a natural brake to their greater involvement.
These factors challenge the emergence of more efficient and effective reinsurance for insurers of political risk. To harness current product interest will require the commitment of participants to step beyond the routine reinsurance renewal discussion and engage in a more protracted period of collaborative discussion. By ensuring a high level of product understanding among reinsurers, through open and interactive dialogue and the provision of good information, structure innovation and greater flexibility are achievable. Assuming, of course, there is no “perfect storm” which derails. ■