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.