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.

Will ratings hinder reinsurer M&A and the hedge fund ‘play’?

In the investment banker ‘101’ playbook for cyclical industries the reinsurance industry has arrived at the page marked ‘weak pricing due to too much competition; sell M&A services to our clients’.

This, if you are a banker, can be a very nice place to be.  Less so of course for those clients that are the potential targets given that the ‘M’ in ‘M&A’ is rarely more than a fig leaf, but still there’s good money to be made advising the defenders.

Of course, an industry whose productive capacity is capital itself shouldn’t really be cyclical at all. There are no multi-year product development cycles, or billions locked up in factories, plant and machinery that have to be either ‘sweated’ or written-off.  A ‘rational’ reinsurance player can reduce volumes in a poorly priced market with an ease unheard of in most of business life.

Nonetheless cyclicality seems to prevail.

One could argue that since the current excess capacity is in part driven by the influx of ‘alternative capital’ what we are actually seeing is this driving a disruptive industry change to reduced pricing through a lower cost of capital rather than simply cyclical behaviour.

More generally, as Aon recently reported, there are ways for the traditional market to access that cheaper capital too.  If everybody’s capital gets cheaper then RoE targets should reduce (again meaning part of the pricing reductions could be structural not cyclical).

That said, few seem to actually believe that current pricing is sufficient.

So, for now at least, the mantra for many is ‘find more return’; either by consolidation, or pursuing more aggressive ‘hedge fund type’ investment strategies. Neither will be easily sold to the rating agencies.  Reinsurer M&A in a softening market has not always been a runaway success to put it mildly; the business case will not be easily made to the agency.

Increased market power can be a plus but it takes real scale in the reinsurance market for this to be much better than a neutral factor for a rating.

Cost efficiencies, if that’s the plan, are a positive of course but few reinsurer ratings are heavily influenced by this for the simple reason that – in a volatility based business – it’s management of that volatility (i.e. capital, underwriting and ERM) that drives the credit risk profile, not whether a reinsurer has rather overdone it in staffing up the marketing department.

Capital (rather than cost) efficiencies can work in the diversification sense; buying a well-established book is generally seen as less risky – reserve adequacy permitting – than organic diversification thanks to the avoidance of the anti-selection risk faced by new market entrants.

But if, one way or another, the plan involves a more aggressive use of the post-acquisition combined capital than that of the pre-acquisition acquirer, the conversation with the agency may not be straightforward.

Add to that the agencies’ inevitable concerns about execution risk and whether the acquired reserves are indeed adequate, and acquisitions at this point of the cycle (that are anything much more than ’bolt –ons’), can need some very persuasive logic to support the acquirer’s rating.

But what about ignoring the Banker’s siren calls and instead enhance returns via a hedge fund type investment strategy? Indeed this appears to being talked up as the industry trend ‘du jour’.

The logic is straightforward; while current reinsurance pricing limits healthy RoE’s the business still has the happy outcome of generating investable premiums up-front.  So, find a friendly hedge fund to spice up the investment strategy, focus on longer tail lines, and watch those enhanced returns roll-in.

Simple!

We are reminded of the 1980’s rhetoric of some Lloyd’s members’ agencies to prospective individual Names; “support your underwriting at Lloyd’s via a bank LOC based on your assets and  – shazaam – you magically get to use your capital twice!”.  The accompanying reality that, by doing so, the Name also had the privilege of risking their capital twice somehow seemed to get lost.

Not only was this ‘implied financial alchemy’ message successfully sold to non-experts, many industry participants fervently saw it that way themselves.

That seems bizarre with hindsight, but these things always do.

Yet a reinsurer actively pursuing a more aggressive investment strategy is doing exactly this; using and risking its capital twice.  And that is how the rating agencies will look at it.

More investment risk may or may not make sense in any given case but it is no generic solution to the problem of under-priced reinsurance.

To be fair, the expert asset management professionals involved will stress that it’s a lot, lot cleverer than that.  Asset/liability portfolio management can optimise the risk/return trade off and that’s the name of the game, but that’s a very hard trick to pull off in practice when a large part of that risk is derived from a soft reinsurance market.

Not that a case to the agency cannot be made, but demonstrating control of underwriting risk and pricing will, as ever, be crucial.  Writing for volume becomes a lot more enticing when the expected investment return goes up, and the agencies know that.

We recently read of one asset manager from a leading global firm who believes this trend will mean the agencies will have to adapt how they look at asset and liability risk when running their capital models on reinsurers.  Since the agency models have long factored investment exposures into their risk adjusted capital adequacy calculations we assume he means model changes would be needed to reflect the enhanced portfolio effect of ALM driven reinsurer investment strategies.

We suspect he will be disappointed. The last time the agencies allowed clever portfolio model analysis to mitigate the volatility of what were otherwise clearly high risk assets they ended up giving AAA ratings to pools of mortgages taken out by unemployed Americans.

And that, it seems reasonable to say, did not end well.

 

Stuart Shipperlee, Analytical Partner

 

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

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

Reinsurers and GSII: Global, certainly; important, for sure; but ‘systemically’ risky?

The IAIS, with its proposal for additional risk-adjusted capital rules for major re/insurers, seems to be joining the regulatory bandwagon for seeing these as a potential source of threat to to the global financial system.

However, other than when they choose to act as ‘shadow banks’, the exact basis for why even the largest re/insurers should be considered to represent a systemic source of risk is debateable to say the least, particularly if that leads to a requirement for additional capital levels over and above those already considered prudent within existing and proposed insurance regulatory regimes such as Solvency II.  Extra capital can mean only one of two things; less re/insurance or more expensive re/insurance.

The concept makes little sense in general, and particularly so for reinsurers.

Systemic risk derives from the ‘contagion’ (domino) effect when the failure of one organisation triggers that of others.  This may be caused either by the consequences of ‘fear’ –  leading to creditors demanding their money back and asset prices plunging; or by the knock on impact of bad-debts on the failed organisation’s creditors.

The former is the classical ‘run on a bank’ problem.

But there is no routine concept of a ‘run’ on an insurer.  Some savings or investment related life insurance products can contain an option for policyholders to demand an immediate pay-out; but that ‘liquidity and ALM’ risk would be specific to the insurer.  A systemic problem would only result if a significant number of life insurers had this as a major exposure and policyholders lost confidence in them collectively.  Even that is a lot more manageable than controlling the nature and consequences of a banking crisis.

The ‘bad debt’ (unrecoverable reinsurance) problem would be the impact of the failure of a major reinsurer.  Theoretically in extremis this could cause a systemic problem within the industry but the nature and scale of the failure would need to be so profound as to really be outside of the scope of capital rules (given the reinsurer would not only need to go bust but be capable of paying so little of any given claim that the loss to other re/insurers from unrecoverable reinsurance is sufficient to create further failures).

A more probable (though hopefully still extraordinarily remote!) risk would simply be the systemic nature of a huge catastrophic event wiping out much of the reinsurance industry in one fell swoop. But, again, that is a risk that really falls outside any reasonable application of regulatory capital rules.

A sounder prudential regulatory approach might be to simply prevent regular re/insurers trading credit protection products (shadow banking).

Better still would be thinking again about whether a ‘mark to market’ approach to valuing re/insurers’ invested assets (the near universal direction of travel in accounting and regulation) really adds stability to the system; restricting, as it does, the ability of these otherwise natural ‘buy and hold’ investors to provide a rationale ‘pricing floor’ in traded financial assets during a crisis (which is when it actually matters) this could simply make things a great deal worse  (to wit preventing those financially capable of ‘catching the falling knife’ from actually doing so).

Indeed, were that to be addressed then, far from being a source of systemic risk, re/insurers could be a source of systemic risk mitigation.

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

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.