Best Downgrades Hannover Re, HDI

October 31, 2003

A.M. Best Co. announced that it has downgraded the financial strength rating of Hannover Rueckversicherung AG (Hannover Re) and its core subsidiaries to A (excellent) from A+ (superior). It also downgraded the financial strength rating of HDI Haftpflichtverband der Deutschen Industrie V.a.G. (HDI) (Germany), which owns 71.8 percent of Hannover Re, to A (excellent) from A+ (superior).

The ratings on both companies have been removed from under review with negative implications, but the rating outlook remains negative.

Best said that in its view “further improvement in earnings is unlikely to be sufficient to maintain a consolidated risk-adjusted capitalization supportive of an A+ financial strength rating throughout the underwriting cycle.”

Best said it had also “downgraded the ratings to “bbb+” from “a” on the USD 400 million subordinated debt issued by Hannover Finance Inc. due March 2029, and the EUR 350 million [$407 million] subordinated debt issued by Hannover Finance S.A due March 2031 (both issues guaranteed by Hannover Re).”

Best also downgraded the financial strength rating of HDI Reinsurance Ireland Ltd. to A (excellent) from A+ (Superior), but said that they would remain “under review with negative implications while A.M. Best further evaluates the company’s strategic position within the Hannover Re group.”

Best explained the negative outlook as reflecting its “concerns about a potential deterioration of risk-adjusted capital adequacy as a result of the planned increased retention and uncertainties surrounding HDI’s plans to reduce its stake in Hannover Re.”

Concerning Hannover Re, Best’s bulletin noted the following:

Prospective risk-adjusted capitalization–Despite a successful EUR 530 million (USD 624 million) rights issue in June 2003–thereof EUR 220 million (USD 259) cash component placed with institutional investors and EUR 310 million (USD 356 million) contribution in kind from the parent company, HDI–and half-year improved consolidated earnings, A.M. Best believes that Hannover Re is unlikely to maintain a risk-based capital level commensurate with a superior rating throughout the underwriting cycle, particularly as the company intends to increase its net retention. Hannover Re’s financial flexibility remains highly dependent on its ultimate parent, HDI, which in turn is limited due to its mutual status. HDI plans to further increase Hannover Re’s free float, although HDI will remain main shareholder, but the time-frame remains uncertain given the volatility in the equity markets.

Increased risk to reinsurance recoverables–Hannover Re’s reinsurance leverage–reinsurer’s share of technical reserves to shareholder’s funds–remains high at 313.6%, despite a reduction of 8% percentage points in 2002. Although a further reduction is foreseen in 2003 and 2004, A.M. Best believes that the general deterioration in credit quality amongst reinsurers leaves Hannover Re exposed to higher default and liquidity risks. In A.M. Best’s view the overall recovery risk is also increasing as a result of heightened scrutiny by reinsurers of reinsurance contracts, a greater tendency to dispute claims and a stronger demand for settlements through arbitration or court decisions. However, the credit risk exposure is somewhat mitigated by the significant proportion of Hannover Re’s reinsurance recoverables that are collateralized or protected by strong security of Letters of Credit (LOCs).

Improving Operating Performance–As anticipated, Hannover Re’s consolidated earnings in the first 6 months of 2003 improved substantially with a net profit of EUR 162 million (USD 191 million)–EUR 146 million (USD 172 million) in half-year 2002–largely due to a 27% increase in investment income. Property/casualty results benefited from a high rate environment, although the half-year consolidated combined ratio increased by 2.3% compared to year-end 2003 due to the shift from property into casualty business with an inherently higher reserve level. In the life and health and financial reinsurance lines, results were satisfactory. A.M. Best believes that further improvements in earnings in the present environment are unlikely to enable Hannover Re to maintain a superior consolidated risk-adjusted capital base through the underwriting cycle.

Excellent business profile–Hannover Re’s business profile in the property/casualty reinsurance market remains excellent where it ranks amongst the four largest players. Half-year consolidated gross written premiums declined slightly to EUR 5.9 billion (USD 6.7 billion), due to exchange rate movements. A.M. Best expects consolidated gross premiums to remain flat for the full year 2003.

Best said it believes that due to its heavy involvement with Hannover Re HDI is “exposed to the higher risk associated with the weakened credit quality across the reinsurance sector and the increasing industry-wide tendency to dispute reinsurance claims.” Best also said it “recognizes HDI’s excellent consolidated underwriting performance in non-life and its leading domestic business profile in industrial insurance lines.

The negative outlook reflects the potential impact of a planned increase in retention levels over time and the uncertainties about the execution of HDI’s strategic plans to enhance its financial flexibility, i.e. further reducing the stake in Hannover Re and floating of Talanx AG, although HDI will remain majority shareholder.”

Best further explained its concerns over the “increased risk to reinsurance recoverables, as affecting HDI’s reinsurance leverage–reinsurer’s share of technical reserves to shareholder’s funds. Indicating that is exposure “remains high at 298% due to the reliance on retrocession protection at Hannover Re’s US-based subsidiary Clarendon and in HDI’s primary industrial business.

“The company has successfully begun to reduce this exposure–by 8 percentage points in 2002–and expects to achieve a further reduction via a higher net retention of approximately 8% over the next two years and the collection of its reinsurance recoverables.

“However, the general deterioration in credit quality amongst reinsurers leaves the group exposed to an increased default and liquidity risk. In addition, the size of recoverables leads to a potential exposure of the growing industry-wide trend of disputed reinsurance claims.

“However, the credit risk exposure is somewhat mitigated by the significant proportion of HDI’s reinsurance recoverables that are protected by strong security of Letters of Credit (LOCs) and cash funds withheld. The planned increase in retention levels, even at higher premium rates and better underwriting terms, could lead to reduced risk-adjusted capital adequacy, given the increases in premium and reserve risk.”

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