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.

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.

SCOR joins exclusive club with highest S&P ERM score; but what do ERM assessments actually mean?

On the 21st November S&P moved its ‘A+’ rating for SCOR’s core carriers to a positive outlook.  A return to the ‘AA’ range would highlight the remarkable transformation of the group’s profile from the difficult position it found itself in a decade ago.

SCOR’s path to recovery is well documented but the assignment of the highest Enterprise Risk Management (ERM) assessment from S&P (‘very strong’) is a rare accolade.

Only 5 other reinsurance groups achieve this (Aspen, Hannover Re, Munich Re, Renaissance Re and Swiss Re).  Moreover only two European primary groups also achieve this, Allianz and RSA, and RSA’s assessment is under some pressure following recent surprise losses at the group.

S&P’s ERM assessment scale has 5 categories and we summarise the potential ratings impact below –

(For a high resolution of this chart, email us – info@litmusanalysis.com).

While analysis of ERM is a detailed and jargon filled subject (S&P maintains a specialist team to support its work in this area) the principles behind the assessments are actually straightforward.

The first step is an evaluation as to whether the organisation has the systems in place to avoid nasty surprises relative to its Risk Appetite (hence the pressure on the RSA assessment).  The important point here is that it is not a judgement of how ‘risky’ the Risk Appetite actually is; simply whether, having defined it, the re/insurer can manage according to that appetite.  ‘High risk’ re/insurers can have a ‘very strong’ ERM assessment and ‘low risk’ re/ insurers can have a ‘weak’ ERM assessment.

A ‘weak’ assessment derives from either a lack of a properly defined Risk Appetite or S&P’s belief that the systems in place are insufficiently strong to reliably operate within that appetite.  We will not dwell on the details of the analysis here but issues looked at include the controls in place, the quality and usage of models and the overall ‘risk culture’ of the organisation.

In theory, without external support, a reinsurer assessed as ‘weak’ for ERM could achieve only a BBB+ rating at best even if the rest of its profile was extremely strong (without external support).

The ‘adequate’ and ‘adequate with strong risk controls’ assessments both indicate S&P’s belief that the Risk Appetite should be achievable (the latter usually reflecting sectors, such as reinsurance, where the risk control environment is more challenging, thereby requiring more robust systems).  However, given the importance the agency places on ERM within the reinsurance sector, a reinsurer achieving just the ‘adequate’ assessment needs to do well in the wider ‘management & governance’ part of the analysis not to risk having its rating lowered due to ERM.

The two highest assessments by contrast relate to how a rated group’s ERM will positively enhance its risk-adjusted performance.  In essence this means how the systems in place AND the strategic use of ERM allow the maximisation of return for any defined Risk Appetite. Part of this is a rare example of a rating agency embracing the idea of opportunistic behaviour; albeit in the context of highly sophisticated systems allowing this to be done optimally.

To achieve either of the two top categories the rated  group first needs to demonstrate it has an effective process in place for evaluating and then managing ‘emerging risks’.  Thereafter the ‘strong’ category reflects a holistic approach to risk/return optimisation.  Leadership decisions across issues such as line of business prioritisation, investment policies, diversification strategies and other areas, along with successful execution, are at the heart of this.

Finally to achieve the ‘very strong’ category, the group’s internal economic capital model needs to score highly as the underlying management tool for the above (this in itself requires a separate analysis by the agency).

The direct and indirect impact of a ‘strong’ or ‘very strong’ ERM assessment on a reinsurer’s rating can be very significant.  Catlin’s ‘A’ rating is fundamentally driven by both its ‘strong’ ERM score and its risk-adjusted out-performance (seen as derived from its strong ERM).  Partner Re by contrast, with an otherwise ‘AA-‘ profile, is actually rated lower than this implies at A+; were its ERM assessment to be ‘strong’ rather than ‘adequate with strong risk controls’ the rating would very probably be ‘AA-‘.

For SCOR the move to ‘very strong’ for its ERM does not in itself increase its A+ rating.  However, S&P’s faith in the quality of SCOR’s ERM is reflected in the agency’s belief that the consequent earnings performance will bolster and sustain capital adequacy such that a ‘AA-‘ rating becomes merited.

Stuart Shipperlee, Analytical Partner, Litmus Analysis

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.