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.

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

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

 

 

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

Ratings of Catlin, Lancashire, Partner Re and Platinum Underwriters highlight the fundamental impact of ERM vs. capital on S&P’s reinsurer ratings

This is a technical article reviewing recent actions by S&P in implementing their new criteria on the reinsurance sector.  If you are interested in understanding this further, would like further clarification or would like to comment please feel free to mail us at info@litmusanalysis.com.

(*/** indicate references to ‘technical notes’ at the end of the note)

The recent S&P rating updates of the core operations of Catlin, Lancashire, Partner Re and Platinum Re highlight the profound impact of truly qualitative factors (and especially ERM) in S&P’s reinsurer ratings. 

For Catlin and Lancashire this was of critical importance as the rating implications of not scoring highly in S&P’s ERM analysis were stark. 

The financial strength rating anchor* for both groups is ‘bbb+’, which is below what is often perceived as a key threshold of market acceptance. However, each achieved a ‘strong’ score for ERM. The ERM analysis acts as a modifier to the initial rating anchor and was enough to push the indicative rating up one notch to the crucial ‘A-‘ level. 

In Catlin’s case a further notch uplift to ‘A’ was achieved through S&P’s ‘holistic’ analysis whereby the agency may add or subtract a rating notch based on a final view of particularly strong or weak credit factors not already sufficiently captured by its analysis. For Catlin this reflected in particular S&P’s view of the strength of its competitive position and the relative quality of its earnings versus its peer group.

The S&P ratings anchor combines the “Business Risk Profile” and “Financial Risk Profile” assessments of each company. For Catlin a key constraining factor for the rating anchor is having only a ‘moderately strong’ Capital & Earnings score within its Financial Risk Profile despite S&P’s assumption of strong prospective earnings. By contrast Lancashire achieved a ‘very strong’ result for Capital & Earnings but this was offset by its Risk Position being scored as ‘very high’ and its Business Risk Profile score being reduced to ‘satisfactory’, despite receiving a ‘strong’ for its Competitive Position.  Both constraints on the rating derive from its concentration in severity lines with large limits.

For both organisations the ERM score is clearly a powerful affirmation of management quality, however we would presume they would be far more comfortable being able to achieve the ‘A-‘ rating level via the Business Risk and Financial Risk profiles that drive the initial rating anchor, not least given that what constitutes high quality ERM is a bar that is consistently being raised. Moreover for Lancashire achieving an ‘a-‘ rating anchor from S&P might be difficult as the key drivers of this are heavily influenced by S&P’s interpretation of its high risk lines business model.

A.M. Best assigns ‘A’ financial strength ratings to both Catlin and Lancashire. Best does not publish the equivalent of a rating anchor but the positive deviation in its view from that of S&P on Lancashire’s strength can be further seen in the  positive outlook Best’s assigns to its ‘Issuer Credit Rating’ (ICR) of the group’s underwriting operations. The ICR  ‘translates’ the AM Best scale to the S&P scale and basically means Lancashire has a reasonable future chance of achieving an FSR  rating  from Best equivalent to ‘A+’** on the S&P scale.  In rating terms that’s a long way from the ‘A-‘ S&P rating.

By contrast, Partner Re was assessed with a ‘aa-‘ level rating anchor from S&P but the final financial strength  rating is reduced to the ‘A+’ level. Again Best is more positive with an ‘A+’ rating on its own scale that maps** to ‘AA-‘ on the S&P scale.

Within the S&P analysis of Partner Re the fundamental components of its rating anchor are almost as strong as they can be for a reinsurer.  Only risks intrinsic to the reinsurance industry  drag this down from the highest possible ‘anchor’ level of ‘aa+‘.  However, given their size and sophistication, we assume they will be disappointed with S&P’s assessments of their Management & Governance being only ‘fair’ whilst their ERM is assessed as being ‘adequate with strong risk controls’. Both judgments on the key qualitative factors are below most of the group’s peers.

Platinum Underwriters was however assessed below Partner Re on these combined factors; also receiving ‘fair’ for Management & Governance, but a lower assessment of ‘adequate’ for ‘ERM’.  This would have had the effect of pushing the indicative rating down to the ‘BBB+’ level. However in a further indication of the fundamental role of qualitative factors in their analysis, S&P’s final ‘holistic’ review  raised it back to the ‘A-‘ level.  Again AM Best is more bullish, rating Platinum ‘A’ on its own financial strength scale with a mapping to ‘A’** on the S&P scale.

Technical notes

*The ‘ratings anchor’ is not a rating (hence the use by S&P of the lower case symbols) but rather is the initial outcome of S&P’s rating review of a re/insurer. It addresses the core elements of financial and business risk analysis but is prior to S&P’s review of the key qualitative aspects of the re/insurer’s management profile; namely the quality of management, governance and its ERM. These may modify the rating anchor outcome positively or negatively. A further ‘holistic’ review is then applied which may adjust the rating up or down by one notch. S&P then may apply a ‘cap’ to the rating based on concerns around either liquidity or sovereign risk. Finally the rating may be adjusted due to wider group or government support. 

** AM Best’s rating scale for financial strength ratings (FSRs) has fewer gradations than that used by S&P and some of the symbols common to both stand at different points in their respective scales. However Best also publishes ‘issuer credit ratings’ (ICRs) on rated re/insurers. Since the ICR for an operating re/insurer is the same as it’s FSR, for those carrying a financial strength rating the ICR effectively acts as a mapping of the AM Best scale to the S&P scale. Thus a Best’s ‘A+’ maps to an ‘AA-‘ or ‘AA’ on the S&P scale and a Best’s ‘A’ maps to an S&P ‘A’ or ‘A+’. It should be noted that typically for both S&P and Best’s the ICR of holding companies is below that of a given group’s core operating re/insurers.

 

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

Reinsurer profitability and the interest rate myth

The challenge that low interest rates pose to the insurance industry seems to be considered as axiomatic. Company leaders, equity analyst and rating agencies all routinely highlight the challenges this causes.

For investment related life insurance products; fair enough. Indeed for those life companies that have offered long-term guaranteed returns, low rates can become an existential threat.

However, what, exactly, is the issue for non-life reinsurers?  Of course, investment income is a fundamental part of a reinsurer’s earnings, and, since prudence drives asset allocation to be dominated by high grade fixed income investments, very low interest rates lead to very low investment income.  But to suggest this is a major problem for the profitability of reinsurers is to invert ‘cause’ and ‘effect’ in reinsurance pricing.

The impact of high expected investment returns on the reinsurance industry is that it drives down premium rates. Indeed, high interest rate environments are notorious for causing carnage in the industry as carriers lose sight of the need for any form of pricing discipline and write simply for volume.

To be fair, fundamental profitability on long-tail business written several years ago with a – then- reasonable expectation of a higher interest rate environment will be impacted while it runs off. But, for short tail lines and, indeed, anything written since 2008, the only reason investment income can be held out as a problem is if the reinsurer chose to make a bet on rising future interest rates.  If they think they are good enough at predicting that to make such a bet they should become bond traders.

The reality is that it is competition within the industry that is the driver of profitability, not investment income.  This, though, does allow the fact of globally low investment yields to play a role, albeit indirectly.  Rate pressure comes from too much capital chasing finite amounts of business. Some of that capital is in the industry because it cannot find somewhere else attractive to go. We would argue that greater innovation by the industry would increase demand but, absent that, the global investment environment is a problem. But not via reduced investment income in reinsurer P&L’s.

Stuart Shipperlee