Diversification May Reduce Capital Requirements

Changes to rating agencies' risk capital models could result in lower capital requirements for insurers and reinsurers that diversify their business, say analysts from rating agenciesFitchandAM Best.

"On a standalone basis, firms will need to hold more capital against catastrophes," saysJeff Mohrenweiser, analyst at Fitch. "But some companies, especially reinsurers, will gain increased benefits from diversification. This is an incentive for companies to broaden their product lines and reduce geographical clustering."

Fellow rating agency AM Best also says it would take a positive view of companies with more diverse business lines. "Firms with a greater level of diversification will, generally speaking, not have as high a capital requirement as those without," saysJohn Andre, analyst at AM Best.

Rating agencyStandard and Poor'ssaid in a recent report that under its updated risk capital model, which will be introduced during 2006, capital charges for some insurers will change dependent on their business mix.

"We give credit to insurers with a good level of diversification," saysDavid Anthony, director at S&P. "Although this is not entered explicitly into our risk capital model, we account for it subjectively."

Some companies have welcomed the news.Elke König, CFO atHannover Re, believes that in the past, rating agencies have not given enough credit for diversification.

"Rating agencies must put more focus on diversification when rating a company," says König. "For a long time, the industry has been asking for greater credit to be given to firms with more diversified business portfolios. The new capital requirements will make accounting for diversification all the more important."

However, not all are positive about rating agencies rewarding diversification.Alan Rees, executive director at brokerAon, believes it could prompt companies to branch out into unfamiliar areas.

"If you get the correct specialists in when you are starting something up, then that is fine," says Rees. "But some firms may be encouraged to do so without the correct expertise on board. This is tantamount to asking for problems in the future."