Watch out for 'weasel' words!

Risk & Insurance, March, 2004 by Joseph F. Mangan

Do your lenders impose security requirements for property insurers? Do they demand a minimum rating from A.M. Best or Standard & Poor's before they will accept a policy from an insurance company? That's probably a silly question. Most loan officers consider that a basic part of their job and risk managers accept it as one of the conditions they have to deal with. A better question is whether you're encountering some difficulty finding insurance companies that satisfy those security requirements. A lot of risk managers are wrestling with flat problem for two reasons. Insurer financial stability ratings are down almost across the board, so there are fewer insurers who meet security requirements. The wave of consolidation that has swept the insurance industry has had the same effect because there are fewer insurance companies to begin with.

That can leave risk managers facing a tough decision at renewal, or even midterm if you or your lenders keep an eye on rating changes. You may have worked hard to build a strong relationship with a particular insurer, and a policyholder often enjoys positive benefits from renewing with the same carrier. Rating slippage can put that hard work and those benefits in jeopardy, but reinsurance can sometimes provide an answer.

Solutions that Don't Always Work

One way that reinsurers frequently help out when a primary insurer's rating slips below the standards that lenders apply is to issue something called a cut-through endorsement. That usually satisfies the lender, but there's considerable doubt whether it changes anything in the event of a loss.

On its face a cut-through endorsement appears to give the policyholder the right to collect the reinsured portion of any loss directly from the reinsurer if the primary insurer becomes insolvent or is placed trader the supervision of a state regulator. Many experts, however, doubt that any reinsured will issue a cut-through endorsement that will actually allow that to happen, much less make it happen. For one thing, cut-through endorsements are so full of weasel words that a lot of reinsurance specialists just can't foresee a situation that will actually meet all the criteria for giving the policyholder direct access to the reinsurer. State insurance laws and insurance department regulations are another impediment to direct access because they often require reinsurers to pay the proceeds of reinsurance to the conservator or liquidator of a troubled insurer. That makes a cut-through endorsement that does give the policyholder direct access to the reinsurer unenforceable because it violates public policy.

Getting a Helping Hand

Reinsurance can, on the other hand, offer an effective solution to the closely related problem of insurer capacity.

When the trend in financial stability ratings is down, lenders sometimes look beyond a simple rating and consider the insurer's capacity to write policy limits. A bare-bones analysis compares an insurer's surplus to policy limits. A lender may also step things up a notch and compare the highest value at risk to the insurer's surplus, and the most sophisticated comparison matches the highest value at risk to the insurer's surplus plus available reinsurance. That's a situation that reinsurance can address effectively, and the questions some risk managers have started asking suggest that it's actually happening.

The reinsurance technique that has generated the most questions from risk managers is something called quota share reinsurance. That's a kind of participating reinsurance in which the reinsurer assumes a share of each loss within the reinsured layer. Let's take the simplest form of quota share agreement which starts at first dollar and runs to the limit of the reinsurance agreement. Quota share refers to a reinsurance treaty, an agreement that applies to a defined book of business, but an insurance company can derive the same benefits from participating facultative reinsurance agreements that cover only an individual risk.

It's been suggested that what risk managers don't know about reinsurance could fill several volumes. Perhaps that's because risk management so rarely demands any knowledge of the subject. When the need does arise, however, knowing the ins and outs of "insurance of insurance" can sometimes pay big dividends.

Joseph F. Mangan is a consultant in Scotch Plains, N.J. He can be reached at riskletters@lrp.com.