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

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

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

S&P insurance rating criteria change means downgrades – and upgrades – are on the way

This is an article written by Stuart Shipperlee in November 2012, before this blog existed.  Nevertheless the content is still relevant and presages potential important news later this year.

At its latest seminar this week, S&P confirmed again that rating changes, including some downgrades, are highly likely as a result of its current review of insurance rating criteria.  Yet, despite the central role ratings play in the reinsurance, commercial and specialty lines markets globally, this continues to receive little general market attention.

For most insurance market participants rating criteria is a subject as gripping as watching paint dry, especially in the middle of the renewal season. And the markets have grown used to downgrades over the past decade. But this is very different. S&P is not highlighting the fact that the usual suspects of severe cat losses, adverse development on casualty business or drastic reductions in asset values can lead to rating downgrades; that is business as usual. What they are saying is that an insurer or reinsurer with exactly the same profile as it has today could have a lower – or higher – rating by the middle of next year.

While that might be of little practical consequence if a AA rated carrier were to move to AA-, it would be a very different story if the change was from A- to BBB+. Yet both, in rating terms, are simply ‘one notch’ downgrades.  On the other side of the coin, there could be some who benefit with an upgrade.

Of course the agency is conscious that some rating changes are a lot more significant than others. But it has very little room to recognise that in its actions; if the new criteria suggests a downgrade is needed then that is the path it will have to follow. The ‘A-/BBB+’ rating cliff is a market convention, not something introduced by the rating agencies, and they have no real flexibility to accommodate the consequences of it when making rating decisions.

The criteria review was announced in July when S&P published its initial proposals and a ‘request for comment’ (RfC).  They have received over 100 responses and yet there is no avoiding the impression that the market in general is oblivious to the process.

In part this is due to the agency trying not to sound alarmist. They stress that they do not see a need to adjust re/insurer rating levels overall. In fact they highlight that much of the process has been around mapping the new criteria to the existing rated universe in order to minimise rating changes. But there is an inevitable limit to that. While the goal of the exercise is partly to enhance transparency, it is also to make insurance ratings more ‘forward looking’ and ‘comparable’.  The latter, by definition, imply rating changes. While average rating levels will not move, there will clearly be winners and losers.

S&P’s seemingly benign comment on this highlights the point. They stress that ‘the significant majority of ratings is expected to remain the same or move by no more than one notch’. So, whatever minority that leaves are expected to move by two notches (or more).  And enough one notch changes are envisaged to mean their comment was not ‘a significant majority of ratings will not move’.  As the process is not finished, and the agency therefore cannot yet know exactly what specific rating actions it will take, perhaps this will change.  But it is clear that rating changes are very much on the cards.

Indeed, while S&P stresses that a rating remains fundamentally an opinion and therefore that it retains flexibility in how it ultimately decides these, the new rating factors being taken into account make changes seemingly inevitable. These include:

• Use of industry/country risk assessments as a central part of the initial (internal) rating view
• Peer comparisons as explicit positive or negative modifiers to the initial rating
• The inclusion of ‘risk position’ as part of the financial risk profile
• The linking of capital analysis to forward looking earnings projections
• Additional elements to their analysis of competitive position, financial flexibility and liquidity.

In fact S&P veteran Rob Jones commented that in his 17 years at the firm this is by far the most substantive change to insurance rating criteria he had seen (and he should know; he previously led the development and introduction of S&P’s European capital model and ERM analysis).

You can’t do that and keep every rating the same. So, if the average is not going to move, some ratings must go up and some must go down.

None of this should come as a surprise. The agency is making a very major effort to proactively communicate what it is doing and solicit feedback. Nor, in our opinion at Litmus, is there anything fundamentally wrong with the analytical logic behind the changes (although we wonder if the ‘peer comparisons’ are possible or necessary in the way seemingly intended).  Timing of the expected roll-out of the new methodology, and of ratings updated to reflect it, is also something S&P is being very transparent about.  Publication of the final criteria is due in the first half of 2013, with updated ratings being published in tranches thereafter, starting with global multiline insurers and reinsurers.

So, whether you are a re/insurer, broker or buyer, come late next summer you may be looking at rating changes that materially impact your day despite the rated company’s profile not having changed.  Just in time for conference season, including, interestingly, the big reinsurance meeting in Monte Carlo!

Stuart Shipperlee, 28 November 2012