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

International Group of P&I Club Ratings Updated on S&P New Criteria: At Last, Sense has Prevailed.

Standard & Poor’s (S&P) recent release of the details of its review of the ratings of the 11 out of 13 members of the International Group (IG), which are interactively rated, brought with it a number of changes. The arrival of the new criteria has given S&P the opportunity to adjust its ratings to result in what we regard as  a more analytically robust and less dispersed distribution of grades.  

The biggest change was the dawning of a new era where all IG members now have investment grade (BBB- or above) ratings.  This state of affairs seems eminently sensible, but has been a long time coming.  Despite the poor performance of some clubs over the past few years, there are a number of reasons why it seemed hard to justify any of the clubs having a sub-investment grade (BB+ or below) rating.  Paramount amongst these is the legal right and demonstrated ability of the clubs to make additional calls on members in the event of a shortfall in funds, usually caused by a catastrophic year for losses.  The near-monopoly of the IG in providing third party liability cover for the global shipping industry, the shared reinsurance cover, the pooling of some risks and the barriers to entry to the market are other reasons for the compression of the spread of ratings around a higher mean rating.

The American Club, the last club to have its rating languishing in the “non-secure” range has finally been upgraded.  To us the previous BB+ rating made little sense, given S&P’s overwhelmingly positive public comments about the strength of the IG.  The club is still deemed to have a “less than adequate” Financial Risk Profile (FRP), with modest earnings and capital adequacy that has a “modest deficiency at the BBB level”, but S&P has recognized that the club’s future is looking brighter.  It even says that it could raise the rating further within two years if capital and earnings improve.  Such a rapid transition up the rating scale would certainly signal a more realistic view for this member of the IG in our opinion.

Both Japan Club (to BBB+ from BBB) and the West of England Club (to BBB from BBB-) have received one-notch upgrades, in a tacit recognition that their previous ratings were also too low.  The ratings had both suffered from the implicit drag caused by their relatively recent move to interactive ratings from “public information” (pi) ratings, where the methodology logically demands a greater degree of conservatism on the part of S&P.  This can lead to a lower pi rating than might reasonably be expected as S&P has to assume that the non-public information that it does not have access to may be negative. Since, inevitably, the published pi rating sets an implicit base case context, the rated entity can initially struggle to make the case for a significantly higher interactive rating. This is compounded by the fact that the agency is only likely to get comfortable with management forecasts of operating performance (even more important under the new criteria) after some years of dealing with the club on an interactive rating basis. Unfortunately therefore , it is a fact of life that the more tardy an insurer is in coming forward for an interactive S&P rating, the lower down the scale it is likely to be compared with its longtime–rated peers.  It takes a while to move up the S&P rating scale.

The only club to be on the end of a negative action by S&P was Standard Club, which saw the Outlook on its rating move to Negative.   This reflected a below-par underwriting performance, and seems fair enough given that the combined ratio was above 120% for the last two years. The challenge will now be to persuade S&P that it has the strengths in its Competitive Position to bring its combined ratio down materially since both prospective absolute performance, which is fundamentally informed by historic performance, and relative performance versus peers resonate through the new criteria, impacting both the financial risk profile and business risk profile.

Rowena Potter, Consultant Analyst, Litmus Analysis

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

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