Why is the current pricing pain not yet impacting reinsurer ratings?

Since the disappointing pricing at the 1.1. renewal the bad news on reinsurance pricing has kept on coming. April, June and July renewals were all reported as materially down by the major brokers.

S&P adopted a ‘negative trend’ in its reinsurer ratings in direct response to the January outcome, Moody’s followed with a ‘negative outlook’ for the sector last month.  Best and Fitch by contrast maintain ‘stable’ outlooks but both are flagging the potential impact on sector ratings if the current environment persists.

However since the start of the year we have seen no reinsurer downgrades (using S&P’s ‘Top 23 Global Reinsurers’ as our peer group) or even negative changes to individual rating outlooks by any of the agencies.  Indeed, while most ratings assessed this year so far have simply been affirmed a few have even seen upgrades or positive outlook changes.

In no small part that’s explained by much of the cause of the pricing problem; excess capital, combined with a generally positive view from the agencies about the robustness of the sector’s risk management capabilities.

But all agencies routinely stress that their ratings are prospective and that forecast earnings quality (profitability and volatility) are central to that.

S&P’s detailed rating criteria highlights the point. Its capital adequacy model reflects a two-year forward view (currently the base case model is for 2016 in a reinsurer’s S&P rating), therefore critically including forecasted retained earnings. In addition its analysis of a rated reinsurer’s ‘operating performance’ reflects the current and subsequent year forecasts, ‘ERM’ focusses heavily on risk adjusted pricing controls and its ‘management & governance’ analysis hinges in no small part on a reinsurer’s ability to effectively set and deliver on financial targets. Added to this is the need for Cat exposed firms to ensure they do no stray outside of their ‘risk tolerance’.

Best’s too uses forward looking capital models and prospective earnings as a central part of the ratings process.

However, among S&P’s list of 23 all but 2 have already had their ratings at least affirmed by either S&P or Best’s since January. The 2 are Lloyd’s (currently a positive outlook from both agencies) and SCOR (currently a positive outlook from S&P and stable from Best). Individually S&P has yet to report on only 7 of the 23 so far this year, and Best on 10.

So, why is more rating pain not being felt?

The answer may come from how much actual earnings deterioration the agencies are so far forecasting. Again these days S&P is the most explicit about that.

Other than for the short-tail Cat specialists, in its recent rating updates the agency is typically forecasting ‘95% or better’ combined ratios this year and next.  Generally that’s only a few points worse than 2013 and similar to (and sometimes better than) 2012.  These forecasts assume a normal Cat year for any given reinsurer’s portfolio. (The Cat specialists of course generally operate with much lower combined ratios in a non-Cat heavy year).

Of course not all of the 23 are ‘pure play’ non-life reinsurers. Nonetheless this seems a tough circle to square with the headline pricing noise. Of course rate reductions can take a while to work through into quarterly or annual results but – given normal loss experience, and absent substantial further reserve releases – numbers reported by at least early 2015 should be expected to reflect the current pricing environment.

So either the headlines overstate the problem,  or key metrics such as loss and combined ratios, return on revenue and return on equity may start struggling to hit the ‘base case’ assumptions the agencies have in their current ratings.

Some reinsurers are more exposed to this than others in rating terms, particularly those where the current rating ‘bakes in’ a strong prospective operating performance and even more so if current capital is seen as marginal for the rating level but is supported by assumed positive future earnings.

So far the agencies have kept their powder dry.  As we’ve noted a before, it’s a tough call to take a negative rating action on a concern that future performance will worsen before seeing actual evidence that it has; but that, unavoidably, is what ‘prospectiveness’ in ratings requires.

The critical thing for reinsurers defending their rating in this context is to explain the defensive qualities of their competitive position (and the supporting ERM and other controls) to the agency in terms that reflect the agency’s criteria. When it comes to performance, credit rating analysts are ultimately interested in the ability to manage the down-cycle.

Rated companies do not always explain themselves to the agencies well. Some can rely too much on  unsupported assertions of strengths and their ‘persuasive powers’, while others may simply respond to the details of the agency questions without focussing enough on addressing the underlying issue (or even spotting it).

In this environment, to mitigate their future downgrade risk, reinsurers will need to focus clearly and coherently on how, and exactly why, they are able to manage the down-cycle.  A plea to the agency to ‘look at our capital and our track record’ may well not be enough.

Aspen & Endurance; Spot the performance difference?

Behind the ‘muck and bullets’ of the Aspen and Endurance battle is the background noise of relative performance.

Endurance assert Aspen’s has been poor and that Endurance is the answer. Aspen question the leadership style and culture at Endurance and its ability, therefore, to deliver sustainable performance in a risk driven business.

Both claims are partly about an unknowable future.  However, ignoring the convention of ‘not letting the facts get in the way of a good story’ we wondered what their respective performance histories actually looked like.

We wanted an objective source and so turned to A.M. Best’s latest reports on the financials of the respective holding companies (which cover the period 2009 – 2013).

The results below across 4 key performance metrics are striking! These are two peas from the same performance pod. Even the volatility profiles are remarkably alike.

Indeed given the inherent variances in exposures between any two organisations in their sectors the numbers are almost spookily similar.

Of course, both organisations are really trying to tell a story about the future. Aspen’s being that it has built a business platform and culture that it can now leverage to drive up sustainable profitability; Endurance’s that dynamic new leadership will do the same. And, to be frank, neither group’s last 5 years have been stellar. OK, but not great (2011, of course, had a big impact on that).

Of the metrics below RoE and Combined Ratios get the most coverage. We tend to see Loss Ratios and Return on Revenues (RoR) as at least as important if not more so. We are not persuaded that competition based on keeping the expense ratio down really makes sense for these kinds of businesses – fundamentally performance must come down to underwriting quality (observed in the Loss Ratios) unless a higher risk investment strategy is followed which is a whole other story (see our recent blog on this here – http://bit.ly/1pIM6SD). In addition, RoE reflects underwriting and debt leverage (hence RoR gives us a ‘purer’ view of overall operating performance). We are keen on Operating Ratios too but Best does not publish these in its holding company reports and RoR anyway does a similar job.

Inevitably, there’s lots of key background not shown here. These are calendar year numbers and hence reflect the recent history of prior year reserve releases. The Loss Ratios are net (gross results can give a key perspective of the fundamental quality of the book). There will be differences in the duration of the claims tails.

But, it’s hard to look past the story of the data below. For the last 5 years these have been two very, very similarly performing businesses.

 

RSA’s S&P rating remains seriously at risk even after second downgrade

Following S&P’s initial downgrade last month we noted that RSA faced a further risk to its rating without fresh equity.  This reflected the fact that even prior to its recent problems RSA’s prospective capital was only consistent with an S&P ‘BBB’ range financial strength rating.

At that time however the agency was stressing a downside limit to the rating of ‘A-‘. RSA was duly downgraded to that level yesterday evening but S&P now indicates up to two further notches of ratings downside, which would lead to a ‘BBB’ financial strength rating for the group’s core carriers.

That’s well below the rating level frequently required by brokers and larger commercial insurance buyers (operations S&P deems strategically important but not core to RSA, including Ireland, are already now in the BBB range). S&P’s ratings are particularly high profile among brokers and buyers in many of RSA’s core markets and RSA dropped its rating from the second most commonly followed agency in these markets, A.M. Best, last year.

In essence the problems remain those we highlighted last month; the need for management actions to shore up current and prospective capital (the latter being in part predicated on both improved earnings and a dividend policy that retains these as capital) and S&P’s reduced confidence in both RSA’s ‘Management & Governance’ and its ERM (Enterprise Risk Management) system.

Following the recent losses and reserve hikes RSA’s prospective capital is now viewed by the agency as below even the ‘BBB’ level.  We continue to believe that to address that RSA will need fresh equity.

The specific trigger for yesterday’s downgrade was a reduction in the ‘Management & Governance’ assessment from “satisfactory” to “fair” (S&P reviews 17 sub-factors for this, several of which would be impacted by the issues behind the profit warnings and management changes at the group).

However, two currently still positive features of RSA’s credit profile are also under review by S&P and a worsening of the agency’s view of either could push the rating below ‘A-‘.

Firstly RSA’s rating is substantially higher than that implied by its capital score due to its “very strong” Business Risk Profile; that in turn is highly impacted by its performance relative to peers which clearly S&P will be reviewing in the light of recent losses. Secondly RSA also still carries the highest S&P assessment for its ERM; that looks inconsistent with the recent losses (the “very strong” ERM assessment is supposed to indicate a robust ability to avoid surprise losses) and S&P has noted that it is reviewing this.

The agency does, however, also note some upside to the potential rating (i.e. moving back to ‘A’ for the group’s core carriers). Basically this requires a positive out-turn of the Business Risk Profile and ERM reviews AND an increase in prospective capital adequacy.

Raising capital however is never easy when shareholders are nursing unexpected losses, and in this case especially so since it is difficult to see how this could be done without further pressurising the group’s expected ‘return on equity’.  RSA might convince S&P that its actions now will generate sufficiently strong retained capital from future earnings to avoid the need for equity raising but that would require a considerable leap of faith by the agency given recent events.

All of which may well make a trade sale or substantial disposals that much more attractive for shareholders. That though requires that the buyer has a lot of confidence that there are no further skeletons in the cupboard.

Stuart Shipperlee, Analytical Partner, Litmus Analysis.

Lloyd’s on the cusp of ‘AA’ range ratings; this could be a game-changer

During the summer both A.M. Best and Fitch assigned ‘positive’ outlooks to their current Lloyd’s market ratings. S&P did so last year.

Translating the A.M. Best rating scale to the one used by S&P and Fitch this means that Lloyd’s is rated ‘A+’ with a positive outlook by all three agencies.

While a subsequent upgrade from any one agency is not a given this suggests (absent a – truly – major loss) that a ‘AA’ range rating from one or more of the agencies is very likely in the not too distant future.

This would be both a notable step in the long-run post R&R transformation of Lloyd’s and also a profound event for the global reinsurance and specialty lines sector.

If the latter point seems like hype, consider this; only eight of the largest 40 reinsurance groups in the world have a major reinsurance carrier rated in the ‘AA’ range by S&P*. Lloyd’s paper would be rated equivalent, or close, to the strongest globally available from professional reinsurers. Yet organisations can transact business via Lloyd’s who could never begin to achieve that rating level independently.

Writing at Lloyd’s for any re/insurance group with an ability to also write via its own carriers is often seen as a ‘trade-off’. The market costs and Franchise Board oversight are seen (by some at least) as negatives, while the licences, (potential) capital efficiencies, distribution and brand are positives. The current rating is an important positive for many – but not all – and not so much that it is the overwhelming factor for much of the market’s capacity.

BUT, if the decision to trade at Lloyd’s also means the ability  to offer ‘AA-‘ paper then it becomes a whole new ball game.

Even very well known ‘A’ or ‘A+’ rated groups (for their non-Lloyd’s carriers) that are active at the market might now say “of-course we can offer you ‘AA-‘ paper via our Lloyd’s platform if you prefer”. We could even finally see some true ‘credit risk’ based pricing spreads emerge. And those not active at the market would be faced with a very different ‘cost/benefit’ scenario about whether to pursue participation.

Of course, we should not confuse this with the idea that a rating is, per se, the only way re/insurers, brokers, or buyers should communicate or evaluate financial strength. At Litmus we have long argued that a balanced set of inputs should be considered. Nonetheless, there’s no avoiding the fact that a ‘AA-‘ rating in the reinsurance market is a very powerful card.

How Lloyd’s might react to any flood of participation interest is itself an issue. The rating agencies have heavily bought into the ‘selectivity’ and oversight of the Franchise Board in getting to the current rating levels (along with the demonstrated robustness of the ‘market level’ capital model). So, from both a ‘market’ and a ‘ratings protection’ perspective the Franchise Board is likely to be very cautious about any ‘upgrade driven’ participation interest.

Nonetheless the market wants risk spread in the world’s growth economies and what better way to get it than by being able to say ‘if you meet our standards you can offer ‘AA-‘ paper to your clients’; a rating level higher than that of the sovereign in most of those markets.

* Source: S&P’s Global Reinsurance Highlights 2013

Stuart Shipperlee, Analytical Partner

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.