Reinsurer downgrades on the cards for 2014; these may be very controversial

On the 20^th January, S&P announced that – for the first time since 2006 – it expects a negative trend in reinsurer ratings in 2014. Of the 23 groups (including ‘Lloyd’s) it defines as ‘global reinsurers’ it notes that ‘nearly half’ are materially exposed to the competition driven risks it sees as the likely primary cause of rating downgrades.

Anybody who has even casually scanned the industry media recently will not be surprised at S&P’s rationale.  Namely that excess capital (traditional or otherwise) and reduced demand are driving out ‘technical pricing’ discipline (we would add adverse development risk to those issues but the agency seems more sanguine).

So, why might reinsurer downgrades prove especially controversial?

Well, firstly, they often are.  Even some of those driven by what have seemed to be an unavoidably clear weakening of a reinsurer’s credit profile have been so, at least at the time (Converium, Gerling).  But also this time S&P is indicating the risk of downgrades driven simply by its view of a reinsurer’s prospective earnings.  It is one thing to issue a downgrade based on a balance sheet event such as a severe cat. loss, asset write-down or reserve hike, quite another when it’s based on the agency’s judgement about weakening earnings potential.

S&P notes that its concerns are about further price/terms & conditions weakness during 2014 as well as the rate reductions seen at the Jan 1 renewal.  So any earnings driven downgrades in 2014 could well happen before any published figurers from the reinsurer actually confirm such weakening.

This ‘prospectiveness’ is, of course, a prime focus of the agency’s revised rating criteria launched last May.

A fundamental plank of that is how the relative strength of a reinsurer’s ‘competitive position’ supports sustainably strong earnings and it is this – directly or indirectly – that S&P highlights as the likely source of downgrades.

While we wouldn’t disagree with the premise, in our view there are some anomalies in S&P’s take on this for the reinsurance industry.

Firstly, as we have highlighted before, the agency has had a surprisingly positive view of ‘competitive position’ across the ‘global reinsurance’ cohort.  Only one reinsurer (Maiden Re) is currently assigned a score for this of less than ‘Strong’ (‘Adequate’ in Maiden Re’s case).

For a famously cyclical, highly competitive business where ‘product differentiation’ is challenging to say the least this has always struck us as odd (although we presume that at least in part it’s a judgement relative to industries seen as more competitive still).

Secondly ratings are intended as ‘through the cycle’ views (indeed the agency’s focus on the importance of ‘competitive position’ reflects that).  So, what is it seeing that is not part of expected cyclicality?

Our take on both points is that the agency is unnerved by how reports (and maybe the non-public information it gets from rated companies) suggest that the industry’s claimed degree of focus on maintaining technical pricing appears to be about as resilient as the archetypal military battle plan (in that it has survived only up to the moment the ‘enemy’ of price-based competition has been engaged).

Prior to its announcement only one of the 23 groups had its rating on ‘negative outlook’ (again this is Maiden Re whose rating is BBB+).  Outlooks are the mechanism by which S&P normally flags a negative ‘trend’ (rather than a negative ‘event’) that may lead to a downgrade. The agency we believe is therefore now anticipating a significantly worse pricing environment than it expected just weeks ago.

So, whose rating is at risk?

No names are named in the announcement although  ‘smaller catastrophe-heavy reinsurers’ are highlighted as being under most pressure.

Ordinarily we would look to the ‘oulooks’ as a guide but, as above, the agency appears to have had a negative ‘step-change’ in its view that is not yet reflected in the outlooks.

Beyond Maiden Re’s ‘Adequate’ 14 of the 23 groups have the ‘Strong’ assessment for ‘competitive position’, 6 are assessed as ‘Very Strong’ and two as ‘Extremely Strong’.  A reduced assessment in  most of these cases could in theory trigger a downgrade, but the logic of S&P’s position is that it is those it views to have the least easily defended ‘competitive position’ whose rating is at most risk . Counter-intuitive though it might seem at first sight, those therefore with ‘only’ a strong ‘competitive position’ assessment seem most exposed.

Moreover the assessments for the capital adequacy part of the analysis (known as the ‘financial risk profile’ score) also reflect prospective earnings so a more bearish view of ‘competitive position’ leading to worsening prospective earnings can impact this part of the analysis too, magnifying  the ratings impact.

It should be noted however that S&P also stresses a general concern about pricing discipline and, ultimately, a general willingness to under-price by any of the 23 groups undermines perceived competitive strength in a rating analysis.  And since it is not 2013 and prior performance that S&P is concerned about, up-coming releases of 2013 numbers may not provide much of a guide either (though any performance that is  materially ‘below peers’ would certainly not help a group’s case).

For S&P rated reinsurers now more than ever defending their rating will require effectively communicating both exactly what their competitive advantages are (the ‘why’ not just the ‘what’), persuasively arguing that they will not be market share focussed, and that their risk and pricing controls are robust across all operations .  And then hope it’s a reasonably benign cat. year and that their prior year reserves are adequate!

Stuart Shipperlee, Analytical Partner, Litmus Analysis

How should brokers react to downgrades to BBB?

Recent rating downgrades and the risk of this continuing have focussed the attention of many brokers on an old problem; how, if they use ‘A-‘ as a minimum level of automatic acceptability, should they react to a downgrade of a former ‘A range’ carrier to the ‘BBB range’?

One response is that they should form their own conclusions on security anyway; but for most brokers that is a big ask, especially in terms of analysing a larger or more complex group.

While broker approaches to market security vary, for many relying on a ‘rating floor’ (typically ‘A-‘) OR requesting specific client approval for carriers rated below this (or not rated at all) is the norm.

But what if the carrier was previously ‘A range’ but drops below this?  In most cases requesting client approval is really only tenable from sophisticated buyers and, if there is higher rated alternative capacity available at an affordable cost, it is easy to imagine how the reaction can be instinctively risk adverse (‘move my business’). That is to say that if the broker, as the ‘expert in the chain’, is unwilling to continue to recommend the security, a natural consequence is for the policyholder to be concerned.

A broker could, of course, substitute the role of the rating with the fact that a carrier is regulated and licenced to trade.  However, neither the PRA in the UK or any regulator throughout the EU runs a ‘zero failure’ regime; they set prudential rules that accept the premise that regulated insurers may fail and that the regulatory process is designed to limit this risk but not completely preclude it.

In that context a broker’s duty of care to policyholders may make them feel that they need more than simply the fact of a carrier being regulated for them to continue to propose it (indeed that is why ratings are used by brokers in the first place).

The uncertainty around how to deal with downgrades in part derives from a limited understanding of what ratings actually are.  They are opinions about the future; in other words forecasts.

Expert forecasts are important contributors to economic and business decisions but they should never be treated as ‘facts’.  So, the binary use of ratings (above a certain level, fine; below that level, a problem) is conceptually flawed (as the confusion caused by ‘A-‘ ratings on negative or developing creditwatch highlights).

Moreover, like most forecasts, ratings are really expressing a view of probabilities. Indeed the rating agencies publish data on exactly this. For example S&P’s data tells us that the historically observed probability of an ‘A-‘ defaulting over a one-year period is 0.07%, whereas for a ‘BBB+’ the historical  probability is 0.14% (see below *).

Whether that extra degree of implied credit risk is reasonable for any given policyholder is something the broker should consider (and perhaps discuss with the policyholder). But, it seems to us, providing such advice is no different from considering the risk to the policyholder of different types of cover, exclusions, limits or other terms and conditions, as are related ratings issues such as where a given carrier is rated below the level of other members of the group OR where one rating agency has a significantly higher or lower rating on a carrier than another OR whether different views of desired rating should exist for different lines of business.

So, while it may be impractical for most brokers to have the internal resources to do their own full security analyses, it seems entirely reasonable to expect brokers to have a good understanding of what ratings mean in practice and, hence, how they can constructively advise their clients as to what they imply.

*Source: Standard & Poor’s. Litmus Comment; the application of generic bond default data to the risk of rated insurers not being able to pay claims is challenging in that the point at which an insurer is in default in terms of claims payment is hard to define. Moreover ‘financial strength’ ratings address the ability to pay valid insurance claims, not willingness to pay. Nonetheless the data is generally seen as being a good proxy for insurer default risk. 

Stuart Shipperlee, Analytical Partner, Litmus Analysis

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.

Is your rating at risk?

Controversial though they can be, financial strength ratings, and particularly those from S&P and AM Best, continue to be central to the transaction process in reinsurance globally and in many primary markets.

The confirmation this week of fundamental changes in S&P’s ratings process is therefore, to borrow a phrase beloved of financial markets mathematicians, a ‘non-trivial’ event.

S&P’s new criteria for rating re/insurers will result in ratings changes – including downgrades. It’s not yet clear how many insurers will be impacted. However, even if a relatively small percentage of ratings change, this could still mean dozens of re/insurers being affected.

In July last year S&P published a ‘request for comment’ (RFC) on the proposed criteria changes. At their seminar later in the year, they reinforced the concepts behind the changes and confirmed that ratings actions, including some downgrades, are highly likely. Shortly afterwards we published a commentary (“S&P insurance rating criteria change means downgrades – and upgrades – are on the way”) noting that “What S&P are saying is that an insurer or reinsurer with exactly the same profile as it has today could have a lower – or higher – rating by the middle of next year”.

This week, having taken on board feedback to the RFC , S&P published the new criteria. They have stressed that they “expect that a significant majority of our ratings will not change as a result of the publication of these criteria”. Which therefore means a minority will change; although there is a somewhat more upbeat note than previously stressing that “preliminary results suggest that positive rating actions will likely slightly outweigh negative rating actions”.

Our initial observations and conclusions are:

• Whilst there are likely to be more positive than negative actions, and the ‘significant majority’ will not change, given the breadth of S&P’s coverage of insurers we could still see a meaningful number of downgrades.

• Ratings on over 2000 insurers have been put ‘under observation’ following the introduction of the new criteria, but this does not mean most ratings will change. Indeed, S&P has stressed that only a minority will. (The ’under observation’ status is a regulatory requirement when introducing new criteria – so no need for panic!)

• S&P’s language does allow for some two notch (or more) rating changes although the implication is that this will be unusual.

• For the minority of  re/insurers downgraded a one or even two notch downgrade may not have a great impact on their daily operations. But given the extensive use of ratings triggers and the binary usage of ratings in insurance markets, those on the cusp of ‘ratings cliffs’ could see a major impact.

• Our experience and S&P’s comments suggests they have been testing the criteria thoroughly since the RFC  via running it in parallel to the existing criteria in order to ascertain the impact.

• Their target is likely to have been to minimise the impact of the criteria change. However the process will have identified ‘outliers’- insurers who appear to be either better or worse under the new criteria.

• Some, though not necessarily all, of these ‘outliers’ are likely to have seen an increase in the depth of the analytical interest they have received from S&P over the past 9 months. Anyone who has seen such an increase should be particularly alert to the fact that either an upgrade or a downgrade could be on the horizon and consider giving very detailed attention to the questions they are being asked.

Among the key technical aspects of the changes taking place we would highlight that –

• There is some additional flexibility to assign ratings higher than the sovereign given a tightly defined set of circumstances.

• The new ‘Insurance Industry and Country Risk Assessments’ (“IICRA”) could prove to be an important driver of ratings changes in the future – a change to one IICRA could impact numerous insurers at once.

• Nevertheless the IICRA’s show a positive endorsement of certain sectors – for example the P&I Sector, where reading the historical rationales it wouldn’t be difficult to conclude that the S&P view of the industry might have been worse than the ‘Intermediate Risk’ now assigned by S&P. This puts the sector on a par with the UK, Belgium or Global P&C reinsurance.

• Full IICRA reports will be published after revised ratings.

• Public Information based ratings (‘pi’s’) will also be impacted, although they will be reviewed at a later stage.

• All research updates will be re-worded based on new criteria – this increased transparency should help insurers determine where to focus discussions with S&P.

Among the more detailed amendments following the RFC are; the elimination of the controversial fixed charge cover test and more emphasis on analytical judgement/prudential assessment versus strict reliance on mechanical cut-offs.

S&P have also removed the prescriptive approach to assessment of operating underperformance & outperformance; this perhaps implies that they have found it too challenging to identify truly coherent peer groups. In addition some other tables containing scoring metrics for geographical diversification, financial flexibility and liquidity have also not made it into the final criteria. S&P have thus avoided tying themselves into the straitjacket that the original proposal could have lead to.

Even if it does appear that S&P may have achieved its goal of ensuring that the new criteria enhance the transparency of its ratings, this new criteria is one of the most important changes to the approach a rating agency has taken to the insurance industry.

Links –

Standard & Poor’s –

Insurers: Rating Methodology–Shows how eight rating factors determine the stand-alone credit profile (SACP) or group credit profile (GCP).

Group Rating Methodology–Discusses external support from a subsidiary’s parent group, depending on how we classify the subsidiary within five specified “group status” categories, and how ICRs and FSRs are assigned to operating and holding companies within a group.

Criteria | Insurance | General: Enterprise Risk Management–Examines how enterprise risk management (ERM)is scored using five subfactors.

Methodology For Linking Short-Term And Long-Term Ratings For Corporate, Insurance, And Sovereign Issuers–Looks at how the descriptor for the insurer’s liquidity determined in the rating methodology combines with its long-term rating to determine its short-term rating.

An accompanying list of IICRA scores has also been published.

List Of Issuers With Ratings Under Criteria Observation

Litmus Analysis –

S&P insurance rating criteria change means downgrades – and upgrades – are on the way

S&P insurance rating criteria change means downgrades – and upgrades – are on the way

This is an article written by Stuart Shipperlee in November 2012, before this blog existed.  Nevertheless the content is still relevant and presages potential important news later this year.

At its latest seminar this week, S&P confirmed again that rating changes, including some downgrades, are highly likely as a result of its current review of insurance rating criteria.  Yet, despite the central role ratings play in the reinsurance, commercial and specialty lines markets globally, this continues to receive little general market attention.

For most insurance market participants rating criteria is a subject as gripping as watching paint dry, especially in the middle of the renewal season. And the markets have grown used to downgrades over the past decade. But this is very different. S&P is not highlighting the fact that the usual suspects of severe cat losses, adverse development on casualty business or drastic reductions in asset values can lead to rating downgrades; that is business as usual. What they are saying is that an insurer or reinsurer with exactly the same profile as it has today could have a lower – or higher – rating by the middle of next year.

While that might be of little practical consequence if a AA rated carrier were to move to AA-, it would be a very different story if the change was from A- to BBB+. Yet both, in rating terms, are simply ‘one notch’ downgrades.  On the other side of the coin, there could be some who benefit with an upgrade.

Of course the agency is conscious that some rating changes are a lot more significant than others. But it has very little room to recognise that in its actions; if the new criteria suggests a downgrade is needed then that is the path it will have to follow. The ‘A-/BBB+’ rating cliff is a market convention, not something introduced by the rating agencies, and they have no real flexibility to accommodate the consequences of it when making rating decisions.

The criteria review was announced in July when S&P published its initial proposals and a ‘request for comment’ (RfC).  They have received over 100 responses and yet there is no avoiding the impression that the market in general is oblivious to the process.

In part this is due to the agency trying not to sound alarmist. They stress that they do not see a need to adjust re/insurer rating levels overall. In fact they highlight that much of the process has been around mapping the new criteria to the existing rated universe in order to minimise rating changes. But there is an inevitable limit to that. While the goal of the exercise is partly to enhance transparency, it is also to make insurance ratings more ‘forward looking’ and ‘comparable’.  The latter, by definition, imply rating changes. While average rating levels will not move, there will clearly be winners and losers.

S&P’s seemingly benign comment on this highlights the point. They stress that ‘the significant majority of ratings is expected to remain the same or move by no more than one notch’. So, whatever minority that leaves are expected to move by two notches (or more).  And enough one notch changes are envisaged to mean their comment was not ‘a significant majority of ratings will not move’.  As the process is not finished, and the agency therefore cannot yet know exactly what specific rating actions it will take, perhaps this will change.  But it is clear that rating changes are very much on the cards.

Indeed, while S&P stresses that a rating remains fundamentally an opinion and therefore that it retains flexibility in how it ultimately decides these, the new rating factors being taken into account make changes seemingly inevitable. These include:

• Use of industry/country risk assessments as a central part of the initial (internal) rating view
• Peer comparisons as explicit positive or negative modifiers to the initial rating
• The inclusion of ‘risk position’ as part of the financial risk profile
• The linking of capital analysis to forward looking earnings projections
• Additional elements to their analysis of competitive position, financial flexibility and liquidity.

In fact S&P veteran Rob Jones commented that in his 17 years at the firm this is by far the most substantive change to insurance rating criteria he had seen (and he should know; he previously led the development and introduction of S&P’s European capital model and ERM analysis).

You can’t do that and keep every rating the same. So, if the average is not going to move, some ratings must go up and some must go down.

None of this should come as a surprise. The agency is making a very major effort to proactively communicate what it is doing and solicit feedback. Nor, in our opinion at Litmus, is there anything fundamentally wrong with the analytical logic behind the changes (although we wonder if the ‘peer comparisons’ are possible or necessary in the way seemingly intended).  Timing of the expected roll-out of the new methodology, and of ratings updated to reflect it, is also something S&P is being very transparent about.  Publication of the final criteria is due in the first half of 2013, with updated ratings being published in tranches thereafter, starting with global multiline insurers and reinsurers.

So, whether you are a re/insurer, broker or buyer, come late next summer you may be looking at rating changes that materially impact your day despite the rated company’s profile not having changed.  Just in time for conference season, including, interestingly, the big reinsurance meeting in Monte Carlo!

Stuart Shipperlee, 28 November 2012