Ratings of Catlin, Lancashire, Partner Re and Platinum Underwriters highlight the fundamental impact of ERM vs. capital on S&P’s reinsurer ratings

This is a technical article reviewing recent actions by S&P in implementing their new criteria on the reinsurance sector.  If you are interested in understanding this further, would like further clarification or would like to comment please feel free to mail us at info@litmusanalysis.com.

(*/** indicate references to ‘technical notes’ at the end of the note)

The recent S&P rating updates of the core operations of Catlin, Lancashire, Partner Re and Platinum Re highlight the profound impact of truly qualitative factors (and especially ERM) in S&P’s reinsurer ratings. 

For Catlin and Lancashire this was of critical importance as the rating implications of not scoring highly in S&P’s ERM analysis were stark. 

The financial strength rating anchor* for both groups is ‘bbb+’, which is below what is often perceived as a key threshold of market acceptance. However, each achieved a ‘strong’ score for ERM. The ERM analysis acts as a modifier to the initial rating anchor and was enough to push the indicative rating up one notch to the crucial ‘A-‘ level. 

In Catlin’s case a further notch uplift to ‘A’ was achieved through S&P’s ‘holistic’ analysis whereby the agency may add or subtract a rating notch based on a final view of particularly strong or weak credit factors not already sufficiently captured by its analysis. For Catlin this reflected in particular S&P’s view of the strength of its competitive position and the relative quality of its earnings versus its peer group.

The S&P ratings anchor combines the “Business Risk Profile” and “Financial Risk Profile” assessments of each company. For Catlin a key constraining factor for the rating anchor is having only a ‘moderately strong’ Capital & Earnings score within its Financial Risk Profile despite S&P’s assumption of strong prospective earnings. By contrast Lancashire achieved a ‘very strong’ result for Capital & Earnings but this was offset by its Risk Position being scored as ‘very high’ and its Business Risk Profile score being reduced to ‘satisfactory’, despite receiving a ‘strong’ for its Competitive Position.  Both constraints on the rating derive from its concentration in severity lines with large limits.

For both organisations the ERM score is clearly a powerful affirmation of management quality, however we would presume they would be far more comfortable being able to achieve the ‘A-‘ rating level via the Business Risk and Financial Risk profiles that drive the initial rating anchor, not least given that what constitutes high quality ERM is a bar that is consistently being raised. Moreover for Lancashire achieving an ‘a-‘ rating anchor from S&P might be difficult as the key drivers of this are heavily influenced by S&P’s interpretation of its high risk lines business model.

A.M. Best assigns ‘A’ financial strength ratings to both Catlin and Lancashire. Best does not publish the equivalent of a rating anchor but the positive deviation in its view from that of S&P on Lancashire’s strength can be further seen in the  positive outlook Best’s assigns to its ‘Issuer Credit Rating’ (ICR) of the group’s underwriting operations. The ICR  ‘translates’ the AM Best scale to the S&P scale and basically means Lancashire has a reasonable future chance of achieving an FSR  rating  from Best equivalent to ‘A+’** on the S&P scale.  In rating terms that’s a long way from the ‘A-‘ S&P rating.

By contrast, Partner Re was assessed with a ‘aa-‘ level rating anchor from S&P but the final financial strength  rating is reduced to the ‘A+’ level. Again Best is more positive with an ‘A+’ rating on its own scale that maps** to ‘AA-‘ on the S&P scale.

Within the S&P analysis of Partner Re the fundamental components of its rating anchor are almost as strong as they can be for a reinsurer.  Only risks intrinsic to the reinsurance industry  drag this down from the highest possible ‘anchor’ level of ‘aa+‘.  However, given their size and sophistication, we assume they will be disappointed with S&P’s assessments of their Management & Governance being only ‘fair’ whilst their ERM is assessed as being ‘adequate with strong risk controls’. Both judgments on the key qualitative factors are below most of the group’s peers.

Platinum Underwriters was however assessed below Partner Re on these combined factors; also receiving ‘fair’ for Management & Governance, but a lower assessment of ‘adequate’ for ‘ERM’.  This would have had the effect of pushing the indicative rating down to the ‘BBB+’ level. However in a further indication of the fundamental role of qualitative factors in their analysis, S&P’s final ‘holistic’ review  raised it back to the ‘A-‘ level.  Again AM Best is more bullish, rating Platinum ‘A’ on its own financial strength scale with a mapping to ‘A’** on the S&P scale.

Technical notes

*The ‘ratings anchor’ is not a rating (hence the use by S&P of the lower case symbols) but rather is the initial outcome of S&P’s rating review of a re/insurer. It addresses the core elements of financial and business risk analysis but is prior to S&P’s review of the key qualitative aspects of the re/insurer’s management profile; namely the quality of management, governance and its ERM. These may modify the rating anchor outcome positively or negatively. A further ‘holistic’ review is then applied which may adjust the rating up or down by one notch. S&P then may apply a ‘cap’ to the rating based on concerns around either liquidity or sovereign risk. Finally the rating may be adjusted due to wider group or government support. 

** AM Best’s rating scale for financial strength ratings (FSRs) has fewer gradations than that used by S&P and some of the symbols common to both stand at different points in their respective scales. However Best also publishes ‘issuer credit ratings’ (ICRs) on rated re/insurers. Since the ICR for an operating re/insurer is the same as it’s FSR, for those carrying a financial strength rating the ICR effectively acts as a mapping of the AM Best scale to the S&P scale. Thus a Best’s ‘A+’ maps to an ‘AA-‘ or ‘AA’ on the S&P scale and a Best’s ‘A’ maps to an S&P ‘A’ or ‘A+’. It should be noted that typically for both S&P and Best’s the ICR of holding companies is below that of a given group’s core operating re/insurers.

 

Spanish reinsurer rating updates highlight sovereign rating impact and differences between S&P and AM Best

As S&P continues to roll out ratings reflecting its new insurance criteria, those of Spanish reinsurers Nacional Re and Mapfre Re give a specific illustration of the impact of the sovereign rating.

Many market participants have viewed the two reinsurers as fundamentally ‘A’ range security prior to the application of the sovereign impact and the new S&P release reinforces this.

Nacional Re has a final financial strength rating of ‘BBB- ‘ with a negative outlook. But its ‘rating anchor*’ is disclosed as being ‘a-‘; the three notch reduction from the anchor being explicitly driven by the sovereign rating (along with the negative outlook).

Mapfre Re (rated as a core subsidiary of the Mapfre group) has a rating anchor of ‘a’ but a final financial strength rating of ‘BBB+’ with a negative outlook. The two-notch reduction (as opposed to the three applied to Nacional Re) reflects the degree of the Mapfre group’s non-Spanish global exposure.

What is particularly telling about these ratings is that the rating anchors should already include most of the impact of the companies’ credit risk exposure to Spanish sovereign and other debt as well as their exposure to the systemic risk drivers within the Spanish insurance market.

The ratings anchor is made up by combining the ‘Financial Risk Profile’ of the reinsurer with its ‘Business Risk Profile’.  The former includes Capital Adequacy and Risk Position, therefore covering investment risk, while the latter includes the IICRA**.  Therefore In both cases S&P appears to be adding a very material extra degree of sovereign impact. This would include the concentration risk the reinsurers have with Spanish government bonds but, nonetheless, it’s a severe outcome relative to the rating anchors.

By contrast, AM Best’s rating on Nacional Re is A- (stable outlook), the same as the S&P rating anchor but with a stable rather than negative outlook and for Mapfre Re it is A (negative outlook) exactly the same as the S&P rating anchor***.

Given that Best also has country risk and sovereign debt exposure explicitly addressed within its ratings this represents one of the largest differences of rating opinion that we are aware of between the two agencies.

Stuart Shipperlee, Analytical Partner, Litmus Analysis

Technical notes

*The ‘ratings anchor’ is the initial outcome of S&P’s rating review of a re/insurer. It addresses the core elements of financial and business risk analysis but is prior to S&P’s review of the key qualitative aspects of the re/insurer’s management profile; namely the quality of management, governance and its ERM.  These may modify the rating anchor outcome positively or negatively. S&P then may apply a ‘cap’ to the rating based on concerns around either liquidity or sovereign risk. Finally the rating may be adjusted due to group or government support.

**An IICRA (Insurance Industry and Country Risk Assessment) addresses the risks typically faced by insurers operating in specific industries and countries. It covers macro issues from the degree of economic and political risk to the payment culture and rule of law to more micro factors such as barriers to entry.

*** AM Best maps its ‘A’ grade financial strength rating to the level of ‘A+’ or ‘A’ on the capital markets scale used by S&P. However the Issuer Credit Rating (ICR) it also issues on Mapfre confirms that the mapping in this case is to the ‘A’ level.

Behind the veil – just how transparent can the new Standard & Poor’s criteria be?

The article below refers to Standard & Poor’s (S&P) new criteria document ‘Criteria | Insurance | General: Insurers: Rating Methodology’, dated 7 May 2013.

 In changing its criteria, S&P’s three stated goals have been to increase transparency, to make the ratings more prospective and to enhance consistency. 

Transparency is the biggest challenge.  Moves towards transparency invariably seem to increase the ‘rules-based’ and ‘model-based’ aspects of any analysis. However, rules and models inevitably have arbitrary aspects to their implementation.   Hence, while increased transparency (in the sense of exactly how the rating is arrived at) had been a market demand, responses to S&P’s Request for Comment (RFC) have led to a move back towards more subjective judgement, correctly in the view of Litmus.

So, while the criteria may still seem on the face of it mechanistic, qualitative input is allowed at many levels. The revised document post-RFC is less quantitative than before and some of the more stringent caps on scoring have been removed.  In an effort to cover all eventualities, even where it appears that there is a direct ‘read across’ from a table, the small print often allows for plenty of flexibility.  The criteria are by no means a straightjacket.

A good demonstration of the type of judgements allowed in the interpretation of the published methodology can be found in the newly issued Research Update on Allianz SE (23 May 2013).  Although the insurer financial strength rating (FSR) of the group and its core entities has not changed, the rationale for the rating has been amended in line with the new criteria.  The rationale reveals that, along with all the other designated ‘global multi-line insurance groups,’ Allianz’s “Insurance Industry and Country Risk Assessment” (IICRA) is deemed ‘Intermediate’.  An IICRA is pretty much set in stone for global sectors and for single market insurers.  Even where the IICRA is blended for multi-market companies, it should not prove too controversial.  The combination of the IICRA score plus S&P’s view of the Competitive Position leads directly to the “Business Risk Profile” (BRP) score, one of the two building blocks needed to get to the “Anchor”, a new stepping stone in the ratings process that is designated in lower-case rating letters.

Allianz’s Competitive Position is judged ‘Extremely Strong’.  According to Table 2 (Business Risk Profile Assessment) of the criteria, the product of this score and the ‘Intermediate’ IICRA should be a BRP of ‘Very Strong’.    Surprisingly, Allianz has a published BRP of ’Excellent’.  The explanation for this lies in the footnotes to the table, specifically the reference to paragraph 27.  This states that another category can be added to the ‘unadjusted BRP score’ if ‘the insurer has large and predictable non-insurance sources of earnings with low balance sheet risk’.  Since Allianz benefits from PIMCO contributing 28% to group operating profit, this was deemed by S&P to merit the maximum BRP score.

Analytically, Litmus does not disagree with the outcome of the BRP scoring for Allianz, nor are we contending that S&P has not followed its own criteria.  Furthermore, we agree that the Research Update explains how S&P came to its ultimate conclusion on the BRP score.  However, underlying the final score are a number of factors and sub-factors, which are all separately subject to qualitative interpretation.  For instance, the scoring for Competitive Position is based on six individually scored sub-factors and relies on a committee decision to decide the final outcome.  Despite the emphasis of Table 6 of the criteria (Competitive Position Assessment) on counting the number of positive versus negative scores, S&P has given the impression that Operating Performance, partially based on peer reviews, is the most important sub-factor and so is likely to be given more weight in the committee.  Consequently, the Competitive Position score, despite the rules-based way in which the criteria are couched, still seems as qualitative as it always was.

Moving on to the “Financial Risk Profile” (FRP), which forms the second stepping-stone to the Anchor, we see a similar level of flexibility.  In particular, there is a new emphasis on forward-looking, ie inherently subjective analysis typically based on confidential information.  S&P has said that it will disclose its earnings assumptions, but it may be difficult to understand how these have been derived.  The S&P Capital Model is central to the Capital and Earnings score, which itself is central to the FRP.  The final capital model analysis is likely to be less transparent and even harder for an outsider to replicate than previously, as the historic ‘as is’ position will only act as a starting point for a ‘forward looking analysis’.  This will take the form of adjustments for future premium growth, earnings, dividends etc, though the article is surprisingly light on detail here.  It is unlikely that rating users would be able to build a credible and detailed capital model that replicates S&P’s result without confidential knowledge of the company involved.

Using examples of what has been published so far, the Research Updates for Allianz SE and Zurich Insurance Co Ltd disclose the ‘current’ capital adequacy range as previously.  They also disclose S&P’s ‘base case’ for earnings from 2013-15 and the impact of those on prospective capital adequacy.  The base case earnings are in the same sort of detail as might previously have been found in the Outlook, so again do not add much that is new, except perhaps a longer timeframe.  For large, diversified, listed groups like Allianz and Zurich it is likely that earnings will remain relatively stable from year to year, but it will be more problematic to calculate future earnings for smaller or more volatile companies.  It also begs the question whether prospective earnings for catastrophe-exposed reinsurers will be ‘normalised’ (as in results expected from ‘normal’ cat losses).

The second element of the FRP is Risk Position, which includes amongst other things the concentration risk charge and the size factor, both now removed from the capital model.  The Risk Position is somewhat of a ‘catch-all’, which allows for the identification of risks not covered by the capital model but which have the potential to rapidly impact its outcome and hence require fast (probably downward) transition of ratings.   While the sources of such risks may be disclosed their potential impact, by their nature, is hard to predict.

The final element of the FRP is Financial Flexibility, a familiar category from the previous criteria, but now theoretically to be more transparently analysed, particularly regarding levels of financial leverage and fixed-charge coverage.

The Anchor is then assigned by means of a matrix of BRP versus FRP scores (Table 1 of the criteria), which allows a choice of outcomes in some cells plus further flexibility in certain circumstances.

Having created the rating anchor the ERM and Management Assessment “Modifiers” have been added. A new “Holistic Analysis” then replaces the original separate peer comparison element from the RFC, which proved too difficult to implement (although it remains intrinsic to the Operating Performance sub-factor within Competitive Position).  Not much has been published on the Holistic Analysis, giving it the appearance of another source of ratings flexibility, allowing S&P to step back and ask whether the analysis so far properly reflects its view of the company.  S&P does say that ‘comparative analysis’ will be slightly more significant than under the old criteria (again particularly in informing the Competitive Position analysis), but no peer groups are likely to be published, and companies can be in multiple, evolving groups.

On the basis of all of the above, we don’t believe that it is going to be any easier for a third party analyst or other rating user to sit down with S&P’s new criteria and be prescriptive as to what an S&P FSR for a company ought to be, than it would have been using the old criteria.  And we’re not therefore sure that the new criteria do bring with them a new level of transparency in that respect. This is not a criticism of the new process but rather the inevitable consequence of preventing the analysis from becoming overly mechanistic and arbitrary.

Where there will be more transparency will be in the publication of “Rating Score Snapshots”, comprising the Anchor; BRP and FRP scores; scores for IICRA, Competitive Position, Capital & Earnings, Risk Position, Financial Flexibility, ERM, Management & Governance, and Liquidity; quantification of the impact, if any, of the two Modifiers and the Holistic Analysis plus Group and Government Support.  This will allow for easier and more detailed comparisons between companies, and insight into the ‘dna’ of ratings.  In particular publication of the Anchor allows a user to see the influence, if any, of the modifiers and holistic analysis.

In summary, Litmus’ view is that the publishing around ratings has become more transparent, but the underlying analytical judgements leading to the published ratings will remain as shrouded in subjectivity as they ever were.

Rowena Potter