Down, Down, Down – Ratings Trigger Clauses and the Spiral of Descent

With the backdrop of the approaching New Year and many insurance and reinsurance policies being renewed at 1.1., it seems that we will no doubt see the use of “ratings downgrade trigger clauses” reach another high.

The ability of individual re/insurance buyers to cancel a policy ab-initio following a downgrade from one or other of the main rating agencies might seem prudent but can become self-fulfilling and counter-productive. The problem is that whilst the act of cancelling the business is fairly harmless when it involves just two parties, there is a very real possibility that a herd mentality takes over; that is when the transition from a ‘BBB+’ ‘live’ insurer to a ‘BB’ or ‘BBB’ range run-off becomes more likely. So, while neither a ratings downgrade nor the loss of business make the insurer any less solvent than it already was, the market reaction to a downgrade can lead to the loss of business viability.

The market starts with ratings – a graded scale representing the notion of varying degrees of probability of failure to meet obligations (of an insurer paying claims) – a ‘staircase’ of differing levels, if you like, and turns that staircase into a cliff, then pushes the insurer over the cliff if it simply moves down one small step. How big is that step? A quick look at S&P’s detailed study of ratings performance (source http://bit.ly/1fDNqO0) tells us that the historical difference in the one-year default expectation of an ‘A-‘ rated entity compared to a ‘BBB+’ is less than 0.10%. That’s a pretty small step.

The other surprising thing about the insurance markets is that they generally ignore the ‘Outlook’ that is published by the rating agencies. We at Litmus have often asked whether it is better to deal with an ‘A-‘ with a negative outlook or a ‘BBB+/Positive’. Given S&P’s definition of an outlook (“Standard & Poor’s assigns positive or negative outlooks to issuer ratings when we believe that an event or trend has at least a one-in-three likelihood of resulting in a rating action over the intermediate term for investment-grade credits, generally up to two years” – source http://bit.ly/19xjqSV), it would seem that the ‘small step’ is even smaller in this case.

But the ratings cliff in the insurance industry of ‘A-‘ very often removes an insurer from the list of acceptable security from the lists of buyers and brokers alike, who collectively line up to push the insurer over the business viability cliff. They then leave themselves with a ‘legacy’ headache.

Much is made of the ‘power of the rating agencies’ by market commentators, but it’s not the agencies who distribute the business or make the decisions with regard to which re/insurer to use (or indeed how ratings are used) – it’s the buyer and/or the broker. The power lies with them with regard to the role that ratings play in the market, and the default position is perhaps down to human nature; protecting yourself against criticism should the re/insurer you choose fail.

At Litmus we make a big noise about the importance of understanding ratings and using them carefully for a reason – like any forecast or tool, understanding what lies behind it and using it sensibly is vital.

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

Litmus Analysis Quick Reference Guide – to non-life re/insurer key metrics and ratios

Analysing a non-life re/insurer can be a complicated process; however some of the most important information is the data in the public accounts.

This quick reference guide gives an overview of the more commonly used metrics and ratios. by its nature the guide summarises the descriptions provided.

Litmus Quick Reference Guide_2013

For a complimentary copy of the full Litmus Ratio Guide please contact: info@litmusanalysis.com

 

 

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

Lloyd’s, Aon, the Berkshire ‘side car’ and the history of the London Market; what really is the strategic concern?

The late ‘80’s was a very particular time and place in the City of London. ‘Big Bang’ and the Lawson boom set the tone for the UK’s financial centre’s own version of American Yuppiedom.  Mobile phones the size of bricks, red braces, big hair, cocktails of dubious provenance, ‘Swing Out Sister’ (that’s a band!) and in the London insurance market the LMX spiral; in all its self-regarding and self-indulgent pomp.

The brief period of the highs then lows of the LMX market sometimes detracts from the recollection of a wider truth; that London had long been a ‘subscription’ market before ‘excess of loss’ reinsurance came to the fore. Indeed co-insurance meaningfully existed in London well before reinsurance really did anywhere. One could argue that London exists as an insurance centre in no small part because of its history as a subscription market with its ‘lead and follow’ underwriting culture.

At the time of LMX’s late ‘80’s hay-day your correspondent was a 20-something analyst at a small insurance data and ratings business called ISI (then owned by the stockbrokers FPK). It’s impossible not to recall that much of what I was analysing did seem to be a bizarre blend of ‘churn’ and hubris. No doubt that was, at least in part, the arrogance of (my) youth but, as we got into the ‘90’s and things started to unravel, my prejudices were, if anything, reinforced.

I therefore always enjoyed meeting intelligent and informed cynics of that world. One was an American working in London at Bankers Trust. I recall he saw the opportunities for how capital could be successfully deployed through London’s ability to attract risk and profitably distribute it via the syndication of capital, but was just perplexed by the way the market actually worked. 

His name was Tom Bolt.

At that point Tom was looking to develop BT’s insurance derivatives business but if we recall that the young (or youngish) talent in the ‘traditional’ market at that time included (to name just a few) Stephen Catlin, John Charman, Tony Taylor, and Chris O’Kane (founding CEO’s of four of today’s top 40 global reinsurers) the reality of the market’s intellectual bedrock is clear.

The problems were partly the frictional cost of the then LMX spiral in general and the tiny percentages on line slips in the following market (all seemingly requiring a lot of ‘lunching’ by brokers), and the equally miniscule capital bases of many of them. But especially the lack of discrimination in risk pricing that came along with the following market. ‘What if the “lead” was wrong?’ was not a high priority question for a lot of that ‘innocent’ capacity?

Fast forward to 2013. Tom is, of course, Performance Director of the Lloyd’s Franchise Board (LFB); a  body whose basic raison d’etre derives from the lessons learned in requiring that the ‘lead’ does indeed need to know what he or she is doing. The competitive advantage of London’s insurance market remains its unique collective intellectual property, innovation and global connectivity (we might call it a ‘cluster’) and the ability to syndicate capital.

So, Messrs Buffet and Jain decide they would now like to be part of London’s 2013 ‘following’ market. In stark contrast to the history above they offer very large scale capacity and the highest levels of security available.  They are anything other than innocent capacity.  Any incremental frictional cost appears tiny (at least as far as we can see) and the ‘lead’ is controlled by the discipline of the LFB.

That is simply a massive endorsement of what Lloyd’s has become. This seems a strategic threat only if you believe that London’s strengths actually don’t matter. And, if you do believe that, the game’s up anyway. Capital is a very fluid commodity; it has no need to be ‘located’ in London. So, if a large and very highly informed slug of it chooses to endorse underwriting decisions made at Lloyd’s, then that’s great, surely?

Naturally there is the concern that some market participants get ‘written down’ to accommodate the Berkshire behemoth, but ultimately Lloyd’s wants underwriting led market participants offering a globally diverse risk exposure in speciality lines, and especially more exposure to the world’s growth economies. If some market capacity in the existing business gets freed up by Berkshire’s supporting balance sheet then, fundamentally, that helps Lloyd’s and its underwriting leaders and innovators drive the market forward doesn’t it?

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.

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

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

Why Insurers should sponsor fire stations, the police and A&E

Amidst all the furore in the UK around the closures of fire stations and hospital accident and emergency departments (‘A&E’) I remembered a pet theory of mine, which came upon me once in the CII halls in Aldermanbury.  If you’ve ever been there you will know that the walls display many ‘fire marks’ – metal plaques which used to be attached to the walls of buildings around the UK.

These marks told you who insured the buildings and in the event of fire, which fire brigade to send.  So bystanders would see the ‘Royal’ fire engine speeding through the streets to put out the fire of the building insured by the Royal.   I’m sure that this gave them a good feeling about the insurer – on their way to stop the next Great Fire of London.

The problem with the image of insurance these days, notwithstanding some atrocious service and fighting over claims, is the simple fact that it’s so intangible.  We receive our pieces of paper with the contract terms, stick them in a file until either renewal arrives or we need to make a claim.  And both of these actions are with a degree of trepidation – am I going to have to argue about the premium?  Is the insurer going to fight the claim?

In the meantime our insurers have been sponsoring all sorts of things – from cricket stadiums to rugby tournaments in the sporting world, to adverts about how much better they are at paying their claims and how much cheaper their insurance is.

I think they’ve been missing a glorious opportunity to give insurance another image – one that cares about our property, our safety and our health at the very least.  An opportunity to make insurance more tangible, more valuable. Perhaps not loved, but at least appreciated more than today.

So this is my call to insurers – give up the silly adverts and unnecessary sponsorships and get behind the services that help your customers and help you – the police forces that stop burglaries and help keep the streets and roads safe, the hospitals that help keep us well and the fire stations that reduce the impact of fires – all of the things that help you keep your claims costs down.

Get your names on the sides of fire engines and the public might just learn to love you again.

Peter