Guy Carpenter helps our clients manage the specific counterparty risk elements associated with collateralized markets. The credit analysis of collateralized markets is different than the analysis of a traditional reinsurer.
The issue of counterparty risk has several components: ability to pay, willingness to pay and concentration of source.
The ability to pay is typically attempted to be captured by ratings methodology and protocols. This focuses primarily on financial condition of the other party. In normal market conditions a snapshot of financial condition is useful. However, in distressed market conditions ratings tend not to capture rapid deterioration in a timely fashion, as evidenced by the 2008 financial crisis. The snapshot approach is not well suited to cover the “cliff risk” of a highly rated entity dropping below investment grade in a single step.
The willingness to pay is a more difficult challenge, whereby the party may have the financial ability to perform but chooses not to fulfill obligations and/or challenges contract terms. This is an aspect of reinsurance recoverables that can often increase upon severe loss events. Due to the often short form nature of reinsurance documentation, these challenges are subject to market standards, the courts or relationships to remediate.
Concentration of sourcing is always a concern for enterprise risk. In the context of reinsurance, the over reliance on rated capacity (unsecured promises to pay) can become a capital sufficiency problem in a catastrophic event scenario.
How then do we mitigate these risks? We use ratings to assess ability to pay. Market conditions and convention often determine if we price differentially for ratings strength. The capital markets use collateral/security to mitigate willingness to pay, by gaining a priority claim on a source of repayment instead of joining the pool of all payees.
Controlling concentrations of counterparty types is critical to managing enterprise risk.
In the context of reinsurance programs, introducing collateralized capacity in the form of collateralized reinsurance or catastrophe bonds is a sound plan to balance the inherent risks of a program comprised solely of unsecured promises to pay from rated entities.
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