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Are you diverse or perverse?

Dear friend,

It’s great to see a ratings agency tackle an issue head-on and try and engage the industry in a debate. Often ratings agencies give the impression of being preoccupied more with the recent past than what the future holds. How often have we seen (re)insurers affirmed only to be downgraded immediately as soon as new information comes to light in the very next quarterly results?

And since our industry is all about buying bits of paper that hold the promise of cover for 12 months into the future, not the past, this is rather an important perceived failing on the agencies’ parts.

So hats off to Fitch for launching into an open letter on the vexed subject of (re)insurer diversification.

This week it released a very frank commentary entitled In Pursuit of Diversification: Treatment in Economic Capital Models and Prism. To paraphrase and summarise Fitch’s point, the moan from the industry is that in the light of last year’s massive catastrophe losses and model tweaks, it feels it is somehow being bullied into diversifying to avoid being loaded with hefty extra capital charges.

So far so good. Here is Fitch’s key response:

“All else equal, an insurer that is diversified will require less capital than one that is concentrated. This is logical because non-correlated risks within risk types, across risk types, across entities within one jurisdiction and across jurisdictions can be offsetting, lowering the variability of a more diversified company’s performance. In fact, one of the historical criticisms of rating agency capital models was failure to reflect such diversification benefits.”

Quite right, Munich Re has been arguing this for as long as anyone can remember. But now for the killer blow from Fitch:

“The key is that “all else equal” is never true in the real world.”

Bravo! How refreshing!

Fitch goes on to warn of the dangers of ill-conceived diversification, (with which anyone who lived through the late 1990s is no doubt painfully familiar).

Why should someone who is second-rate at lots of different skills have a rating that is better than someone who is top of the tree at just one speciality?

Over to Fitch again:

“To some extent, a well-run yet concentrated insurance company simply needs to accept the fact that its capital requirement will be higher than that of a well run diversified company. But a well-run concentrated company should take comfort from the additional fact that its capital requirement (and rating) should be more favourable than that of a company that has embarked upon an ill-advised diversification strategy.”

Hooray! Well-run companies get better ratings.

And if you’re a mono-liner there are lots of other ways of combating the age-old problems of frequency and severity:- get yourself a Cat bond or two, stop worrying and concentrate on charging the right price for the job.

Fitch’s Prism model represents a change in thinking:- rating agencies are now starting to try to get under the industry’s skin and make much more qualitative judgements about who is good at what they do.

This will cause a lot of fireworks — but it is healthy for the industry.

It will also make things more fun!

PS. There is still just time to help us reward the best in our industry by giving them a gong with our 2006 readers’ awards. The awards nominations are closing next week, so get your skates on:

Reader awards 2006

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