Lessons from Unicover.

The collapse of a controversial system for reinsuring workers' compensation risks spotlights the need to rethink the role of reinsurance brokers and to assess the risk that reinsurers won't honor their contracts.

The Unicover controversy has generated a string of losses, complaints and legal threats over the last year, with a number of reinsurers claiming to have been treated unfairly. In particular, some reinsurers have claimed that they did not receive shares of the premium proportional to the risks that they accepted from the workers' compensation pool.

The high-profile players in this controversy have tried to put their mistakes behind them. Aon Corp. and Reliance General Holdings organized an industrywide settlement, under which insurers and reinsurers have redistributed losses among various participants in the deal.

But concerns remain that go beyond Unicover and the companies that were involved. The Unicover incident revealed more than the mistakes of a few companies. It shined a spotlight on deficiencies in the current reinsurance system in two key areas: the way reinsurance intermediaries work and the failure of ceding insurers and their brokers to assess and control counter-party performance risk.

This is basically what happened in the Unicover case:

* Primary insurers originated and underwrote workers' compensation business.

* Unicover Managers Inc., renamed Cragwood Managers LLC, was the managing general underwriter in reinsuring the business on behalf of several reinsurers in a pool.

* Reinsurance brokers helped to arrange the transfer of risk from the pool to other reinsurers.

* The reinsurance brokers stepped in again, this time to arrange the transfer of risk to still more reinsurers--some of whom were the same insurers who transferred the risk in the first place.

A premium is paid each time the risk is transferred from one reinsurer to another, with the broker who arranges the transfer taking a significant fraction (reported to be as high as 30% of the ceded premium in some cases).

It was arguably the reinsurers at the end of the chain who retained most of the risk, had the least sophisticated understanding of it and were paid the least for it. Players higher up in the chain, on the other hand, took premium but bore little risk. In essence, they were paid primarily for passing the risk on to players lower in the chain.

Focus on the Brokers

The collapse of reinsurance broker E.W. Blanch's first-quarter earnings was attributed by many to its involvement in Unicover's controversial system for sharing premiums and risks in underwriting reinsurance for the workers' compensation pool. Blanch's earnings were 77% lower than a year earlier, and when the company warned of the shortfall in March, its share price plummeted 63% in one day from $55.38 to what was then a three-year low of $20.75.

The scale of the punishment doled out to Blanch could be due to a dramatic failure of confidence in the firm and perhaps dismissed as an overreaction. But Blanch is not alone. Though the market also severely punished other companies caught up in Unicover's troubles, the harshest punishments were doled out to the reinsurance brokers.Aon Corp., for example, lost $3.3 billion in market capitalization following a Jan. 10 warning that it would take charges of up to $150 million, which ended up including $72 million related to Unicover and other litigation. For Blanch and Aon, the primary brokers involved with the case, the Unicover incident is seen as an indicator of fundamental weakness in the way they presently conduct business.

The brokers' key failing was that they did not communicate the risks clearly to the reinsurers on the receiving end. Avoiding such failures in the future requires that the role of the reinsurers change or that a new type of reinsurance intermediary be introduced.

This new intermediary would:

* take fees for evaluating reinsurance transaction risk, rather than a commission on the transaction;

* employ an easily understood system for identifying which transactions require a more sophisticated understanding of risk; and

* articulate clearly the underlying risk of the deal and the pieces of the risk borne by each participant.

Risk Transfer: A Two-Way Street

The poor communication of the ceded risk to the receiving counter-parties is clearly the most important issue for the reinsurers to whom the risk was transferred. The Unicover situation also raises an important issue for the ceding parties: assessing the risk that the reinsurer will not honor the contract.

As the Unicover case has demonstrated clearly, this is not simply a matter of the reinsurer's ability to perform--its solvency--but also of its willingness to perform, which is less tangible. That implies the need for two related, but distinct, risk-management practices. The first is quantification of the risk of counterparty nonperformance. The second is an assessment of the "suitability" of reinsurance counterparties. How might these risk-management objectives be achieved? The market in financial derivatives offers a model.

When an insurer "cedes" risk to a reinsurer, there are two changes to its overall risk position:

* Risk is decreased by the amount specified in the reinsurance agreement.

* Risk is increased due to the chance that the reinsurer cannot, or will not, honor the contract.

The ceding counterparty is not completely eliminating risk, or transferring it all away, but is trading one form of risk for another. This has strong parallels in the financial markets with the credit risks incurred by the parties of a derivative contract. In fact, the language of financial derivatives recognizes that risks are exchanged, rather than simply transferred: The two parties to a financial derivative usually are referred to as "counterparties," rather than as cedent and receiver.

Lessons from Derivatives

Under a financial-derivative contract, a counterparty's credit exposure is a function of the change in the market-to-market value of the derivative. That is, if the derivative increases in value in such a way that it is now worth more to Party A (that is, Party B "owes" Party A), then Party A has a counterparty credit exposure equal to the contract's positive value. This gives rise to an "expected credit exposure" and "maximum likely credit exposure" that the counterparties should calculate and factor into the pricing of the contract.

In the early days of the over-the-counter derivatives markets, this risk was not factored into the pricing. To participate, a company's credit simply had to be of sufficiently high quality (typically double-A rated or better) that the counterparty credit risk did not amount to much and, therefore, could be ignored with reasonable safety. Over time, however, dealers began offering swaps and other over-the-counter derivatives to their lower-rated customers. When they did, they began to charge these clients for the counterparty credit risk.

The analytics involved in quantifying credit risk for derivatives involved simulating the following:

* the volatility of the exposure amount (driven by potential changes in value of the derivative);

* the volatility of the counterparty's default probability; and

* the (typically low) correlation between these two factors.

A Model for Insurers

Insurers can use a similar approach, with one major difference: The expected exposure is equal to the expected loss ceded to the reinsurer. The "maximum likely exposure" can be quantified by knowing the distribution of claims ceded. The big difference between a derivative contract and a reinsurance contract is that the correlation between exposure and nonperformance is likely to be high in the case of reinsurance, whereas it is low with derivatives.That is, there is a much greater chance that the event that causes a large exposure to the ceding insurer--a large catastrophe or workers' comp claim, for example--is the same event that will result in either insolvency or nonpayment.

The answer to this issue is to have an explicit model that quantifies reinsurance counterparty performance risk. The simplest and most common version of this is to estimate the amount of reinsurance recoverable that is likely to be uncollectible in the event of a large claim and reduce the amount of risk reduction by this amount.

A better method, however, would be to estimate the average probability of nonperformance and the correlation between nonperformance and exposure for reinsurance counterparties. This could be tackled by developing a scorecard that predicts nonperformance on the basis of historical data (for example, timeliness in paying claims, propensity to litigate) and use this to differentiate the probability of nonperformance across reinsurers.

Once the counterparty performance risk has been evaluated, it should be factored into the pricing of reinsurance. A reinsurer with the highest solvency rating that pays on time and is not prone to litigation should be able to claim higher rates than a lower-rated reinsurer that is chronically late with payments and spends a large proportion of its time in court.

This pricing adjustment can be calculated via a risk/return framework such as risk-adjusted return on capital, which is known by the acronym RAROC. In this framework, the expected loss ceded is reduced by the expected loss from counterparty nonperformance, and the capital liberated is reduced by the amount of capital required to cover nonperformance risk. The net "cost" of counterparty performance risk is therefore equal to the expected loss plus the cost of the capital to support this risk.

Know Your Counterparty

Another lesson to be learned from the derivatives markets is the importance of the broker's role in ensuring that the counterparties to a deal are "suitable." In the Unicover case, the brokers were supposedly responsible for ensuring that all counterparties received adequate information on the risks that they were taking and were sophisticated enough to understand this information. It appears that one, or both, of these conditions were not met.

The derivatives market learned the importance of suitability the hard way. Its collective experience was exemplified by Bankers Trust, then one of the world's top derivatives houses, between 1994 and 1996. During those years, Bankers Trust was sued by four of its major clients--Federal Paper Board Co., Gibson Greetings, Air Products & Chemical and Procter & Gamble--who asserted that Bankers Trust had misled them with respect to the riskiness, complexity and value of derivatives that they had purchased from the bank.

The first three cases were settled out of court at a total cost of $93 million. The $195 million Procter & Gamble suit was settled at a net gain to P&G of $78 million. The most lasting damage, however, was to Bankers Trust's reputation. Regardless of the actual rights and wrongs of the four cases, the bank struggled to recover from the perception that it had in some cases taken advantage of its clients' na[ddot{i}]vet[acute{e}] to sell them profitable, but spectacularly inappropriate, derivative products. The derivatives industry generally suffered, too, as clients became suspicious, and complex but useful products fell into disuse.

Bankers Trust's public humiliation did not go unnoticed. Most derivatives dealers have since instituted strict suitability guidelines to ensure that clients understand the risks of the transactions. As a result, suitability has only infrequently been a serious issue in derivatives-related disputes since.

The Unicover incident has highlighted the deficiencies of the current reinsurance system in this respect. The derivatives industry learned from its mistakes. Now is the time for those involved in the reinsurance business--most immediately, the brokers--to prove that they can do likewise.

Peter Nakada is acting president of eRisks.com, New York.