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.

Aspen & Endurance; Spot the performance difference?

Behind the ‘muck and bullets’ of the Aspen and Endurance battle is the background noise of relative performance.

Endurance assert Aspen’s has been poor and that Endurance is the answer. Aspen question the leadership style and culture at Endurance and its ability, therefore, to deliver sustainable performance in a risk driven business.

Both claims are partly about an unknowable future.  However, ignoring the convention of ‘not letting the facts get in the way of a good story’ we wondered what their respective performance histories actually looked like.

We wanted an objective source and so turned to A.M. Best’s latest reports on the financials of the respective holding companies (which cover the period 2009 – 2013).

The results below across 4 key performance metrics are striking! These are two peas from the same performance pod. Even the volatility profiles are remarkably alike.

Indeed given the inherent variances in exposures between any two organisations in their sectors the numbers are almost spookily similar.

Of course, both organisations are really trying to tell a story about the future. Aspen’s being that it has built a business platform and culture that it can now leverage to drive up sustainable profitability; Endurance’s that dynamic new leadership will do the same. And, to be frank, neither group’s last 5 years have been stellar. OK, but not great (2011, of course, had a big impact on that).

Of the metrics below RoE and Combined Ratios get the most coverage. We tend to see Loss Ratios and Return on Revenues (RoR) as at least as important if not more so. We are not persuaded that competition based on keeping the expense ratio down really makes sense for these kinds of businesses – fundamentally performance must come down to underwriting quality (observed in the Loss Ratios) unless a higher risk investment strategy is followed which is a whole other story (see our recent blog on this here – http://bit.ly/1pIM6SD). In addition, RoE reflects underwriting and debt leverage (hence RoR gives us a ‘purer’ view of overall operating performance). We are keen on Operating Ratios too but Best does not publish these in its holding company reports and RoR anyway does a similar job.

Inevitably, there’s lots of key background not shown here. These are calendar year numbers and hence reflect the recent history of prior year reserve releases. The Loss Ratios are net (gross results can give a key perspective of the fundamental quality of the book). There will be differences in the duration of the claims tails.

But, it’s hard to look past the story of the data below. For the last 5 years these have been two very, very similarly performing businesses.

 

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

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

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

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

Nonetheless cyclicality seems to prevail.

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

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

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

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

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

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

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

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

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

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

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

Simple!

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

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

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

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

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

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

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

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

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

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

 

Stuart Shipperlee, Analytical Partner

 

Reinsurer downgrades on the cards for 2014; these may be very controversial

On the 20^th January, S&P announced that – for the first time since 2006 – it expects a negative trend in reinsurer ratings in 2014. Of the 23 groups (including ‘Lloyd’s) it defines as ‘global reinsurers’ it notes that ‘nearly half’ are materially exposed to the competition driven risks it sees as the likely primary cause of rating downgrades.

Anybody who has even casually scanned the industry media recently will not be surprised at S&P’s rationale.  Namely that excess capital (traditional or otherwise) and reduced demand are driving out ‘technical pricing’ discipline (we would add adverse development risk to those issues but the agency seems more sanguine).

So, why might reinsurer downgrades prove especially controversial?

Well, firstly, they often are.  Even some of those driven by what have seemed to be an unavoidably clear weakening of a reinsurer’s credit profile have been so, at least at the time (Converium, Gerling).  But also this time S&P is indicating the risk of downgrades driven simply by its view of a reinsurer’s prospective earnings.  It is one thing to issue a downgrade based on a balance sheet event such as a severe cat. loss, asset write-down or reserve hike, quite another when it’s based on the agency’s judgement about weakening earnings potential.

S&P notes that its concerns are about further price/terms & conditions weakness during 2014 as well as the rate reductions seen at the Jan 1 renewal.  So any earnings driven downgrades in 2014 could well happen before any published figurers from the reinsurer actually confirm such weakening.

This ‘prospectiveness’ is, of course, a prime focus of the agency’s revised rating criteria launched last May.

A fundamental plank of that is how the relative strength of a reinsurer’s ‘competitive position’ supports sustainably strong earnings and it is this – directly or indirectly – that S&P highlights as the likely source of downgrades.

While we wouldn’t disagree with the premise, in our view there are some anomalies in S&P’s take on this for the reinsurance industry.

Firstly, as we have highlighted before, the agency has had a surprisingly positive view of ‘competitive position’ across the ‘global reinsurance’ cohort.  Only one reinsurer (Maiden Re) is currently assigned a score for this of less than ‘Strong’ (‘Adequate’ in Maiden Re’s case).

For a famously cyclical, highly competitive business where ‘product differentiation’ is challenging to say the least this has always struck us as odd (although we presume that at least in part it’s a judgement relative to industries seen as more competitive still).

Secondly ratings are intended as ‘through the cycle’ views (indeed the agency’s focus on the importance of ‘competitive position’ reflects that).  So, what is it seeing that is not part of expected cyclicality?

Our take on both points is that the agency is unnerved by how reports (and maybe the non-public information it gets from rated companies) suggest that the industry’s claimed degree of focus on maintaining technical pricing appears to be about as resilient as the archetypal military battle plan (in that it has survived only up to the moment the ‘enemy’ of price-based competition has been engaged).

Prior to its announcement only one of the 23 groups had its rating on ‘negative outlook’ (again this is Maiden Re whose rating is BBB+).  Outlooks are the mechanism by which S&P normally flags a negative ‘trend’ (rather than a negative ‘event’) that may lead to a downgrade. The agency we believe is therefore now anticipating a significantly worse pricing environment than it expected just weeks ago.

So, whose rating is at risk?

No names are named in the announcement although  ‘smaller catastrophe-heavy reinsurers’ are highlighted as being under most pressure.

Ordinarily we would look to the ‘oulooks’ as a guide but, as above, the agency appears to have had a negative ‘step-change’ in its view that is not yet reflected in the outlooks.

Beyond Maiden Re’s ‘Adequate’ 14 of the 23 groups have the ‘Strong’ assessment for ‘competitive position’, 6 are assessed as ‘Very Strong’ and two as ‘Extremely Strong’.  A reduced assessment in  most of these cases could in theory trigger a downgrade, but the logic of S&P’s position is that it is those it views to have the least easily defended ‘competitive position’ whose rating is at most risk . Counter-intuitive though it might seem at first sight, those therefore with ‘only’ a strong ‘competitive position’ assessment seem most exposed.

Moreover the assessments for the capital adequacy part of the analysis (known as the ‘financial risk profile’ score) also reflect prospective earnings so a more bearish view of ‘competitive position’ leading to worsening prospective earnings can impact this part of the analysis too, magnifying  the ratings impact.

It should be noted however that S&P also stresses a general concern about pricing discipline and, ultimately, a general willingness to under-price by any of the 23 groups undermines perceived competitive strength in a rating analysis.  And since it is not 2013 and prior performance that S&P is concerned about, up-coming releases of 2013 numbers may not provide much of a guide either (though any performance that is  materially ‘below peers’ would certainly not help a group’s case).

For S&P rated reinsurers now more than ever defending their rating will require effectively communicating both exactly what their competitive advantages are (the ‘why’ not just the ‘what’), persuasively arguing that they will not be market share focussed, and that their risk and pricing controls are robust across all operations .  And then hope it’s a reasonably benign cat. year and that their prior year reserves are adequate!

Stuart Shipperlee, Analytical Partner, Litmus Analysis

How should brokers react to downgrades to BBB?

Recent rating downgrades and the risk of this continuing have focussed the attention of many brokers on an old problem; how, if they use ‘A-‘ as a minimum level of automatic acceptability, should they react to a downgrade of a former ‘A range’ carrier to the ‘BBB range’?

One response is that they should form their own conclusions on security anyway; but for most brokers that is a big ask, especially in terms of analysing a larger or more complex group.

While broker approaches to market security vary, for many relying on a ‘rating floor’ (typically ‘A-‘) OR requesting specific client approval for carriers rated below this (or not rated at all) is the norm.

But what if the carrier was previously ‘A range’ but drops below this?  In most cases requesting client approval is really only tenable from sophisticated buyers and, if there is higher rated alternative capacity available at an affordable cost, it is easy to imagine how the reaction can be instinctively risk adverse (‘move my business’). That is to say that if the broker, as the ‘expert in the chain’, is unwilling to continue to recommend the security, a natural consequence is for the policyholder to be concerned.

A broker could, of course, substitute the role of the rating with the fact that a carrier is regulated and licenced to trade.  However, neither the PRA in the UK or any regulator throughout the EU runs a ‘zero failure’ regime; they set prudential rules that accept the premise that regulated insurers may fail and that the regulatory process is designed to limit this risk but not completely preclude it.

In that context a broker’s duty of care to policyholders may make them feel that they need more than simply the fact of a carrier being regulated for them to continue to propose it (indeed that is why ratings are used by brokers in the first place).

The uncertainty around how to deal with downgrades in part derives from a limited understanding of what ratings actually are.  They are opinions about the future; in other words forecasts.

Expert forecasts are important contributors to economic and business decisions but they should never be treated as ‘facts’.  So, the binary use of ratings (above a certain level, fine; below that level, a problem) is conceptually flawed (as the confusion caused by ‘A-‘ ratings on negative or developing creditwatch highlights).

Moreover, like most forecasts, ratings are really expressing a view of probabilities. Indeed the rating agencies publish data on exactly this. For example S&P’s data tells us that the historically observed probability of an ‘A-‘ defaulting over a one-year period is 0.07%, whereas for a ‘BBB+’ the historical  probability is 0.14% (see below *).

Whether that extra degree of implied credit risk is reasonable for any given policyholder is something the broker should consider (and perhaps discuss with the policyholder). But, it seems to us, providing such advice is no different from considering the risk to the policyholder of different types of cover, exclusions, limits or other terms and conditions, as are related ratings issues such as where a given carrier is rated below the level of other members of the group OR where one rating agency has a significantly higher or lower rating on a carrier than another OR whether different views of desired rating should exist for different lines of business.

So, while it may be impractical for most brokers to have the internal resources to do their own full security analyses, it seems entirely reasonable to expect brokers to have a good understanding of what ratings mean in practice and, hence, how they can constructively advise their clients as to what they imply.

*Source: Standard & Poor’s. Litmus Comment; the application of generic bond default data to the risk of rated insurers not being able to pay claims is challenging in that the point at which an insurer is in default in terms of claims payment is hard to define. Moreover ‘financial strength’ ratings address the ability to pay valid insurance claims, not willingness to pay. Nonetheless the data is generally seen as being a good proxy for insurer default risk. 

Stuart Shipperlee, Analytical Partner, Litmus Analysis

RSA’s S&P rating remains seriously at risk even after second downgrade

Following S&P’s initial downgrade last month we noted that RSA faced a further risk to its rating without fresh equity.  This reflected the fact that even prior to its recent problems RSA’s prospective capital was only consistent with an S&P ‘BBB’ range financial strength rating.

At that time however the agency was stressing a downside limit to the rating of ‘A-‘. RSA was duly downgraded to that level yesterday evening but S&P now indicates up to two further notches of ratings downside, which would lead to a ‘BBB’ financial strength rating for the group’s core carriers.

That’s well below the rating level frequently required by brokers and larger commercial insurance buyers (operations S&P deems strategically important but not core to RSA, including Ireland, are already now in the BBB range). S&P’s ratings are particularly high profile among brokers and buyers in many of RSA’s core markets and RSA dropped its rating from the second most commonly followed agency in these markets, A.M. Best, last year.

In essence the problems remain those we highlighted last month; the need for management actions to shore up current and prospective capital (the latter being in part predicated on both improved earnings and a dividend policy that retains these as capital) and S&P’s reduced confidence in both RSA’s ‘Management & Governance’ and its ERM (Enterprise Risk Management) system.

Following the recent losses and reserve hikes RSA’s prospective capital is now viewed by the agency as below even the ‘BBB’ level.  We continue to believe that to address that RSA will need fresh equity.

The specific trigger for yesterday’s downgrade was a reduction in the ‘Management & Governance’ assessment from “satisfactory” to “fair” (S&P reviews 17 sub-factors for this, several of which would be impacted by the issues behind the profit warnings and management changes at the group).

However, two currently still positive features of RSA’s credit profile are also under review by S&P and a worsening of the agency’s view of either could push the rating below ‘A-‘.

Firstly RSA’s rating is substantially higher than that implied by its capital score due to its “very strong” Business Risk Profile; that in turn is highly impacted by its performance relative to peers which clearly S&P will be reviewing in the light of recent losses. Secondly RSA also still carries the highest S&P assessment for its ERM; that looks inconsistent with the recent losses (the “very strong” ERM assessment is supposed to indicate a robust ability to avoid surprise losses) and S&P has noted that it is reviewing this.

The agency does, however, also note some upside to the potential rating (i.e. moving back to ‘A’ for the group’s core carriers). Basically this requires a positive out-turn of the Business Risk Profile and ERM reviews AND an increase in prospective capital adequacy.

Raising capital however is never easy when shareholders are nursing unexpected losses, and in this case especially so since it is difficult to see how this could be done without further pressurising the group’s expected ‘return on equity’.  RSA might convince S&P that its actions now will generate sufficiently strong retained capital from future earnings to avoid the need for equity raising but that would require a considerable leap of faith by the agency given recent events.

All of which may well make a trade sale or substantial disposals that much more attractive for shareholders. That though requires that the buyer has a lot of confidence that there are no further skeletons in the cupboard.

Stuart Shipperlee, Analytical Partner, Litmus Analysis.

SCOR joins exclusive club with highest S&P ERM score; but what do ERM assessments actually mean?

On the 21st November S&P moved its ‘A+’ rating for SCOR’s core carriers to a positive outlook.  A return to the ‘AA’ range would highlight the remarkable transformation of the group’s profile from the difficult position it found itself in a decade ago.

SCOR’s path to recovery is well documented but the assignment of the highest Enterprise Risk Management (ERM) assessment from S&P (‘very strong’) is a rare accolade.

Only 5 other reinsurance groups achieve this (Aspen, Hannover Re, Munich Re, Renaissance Re and Swiss Re).  Moreover only two European primary groups also achieve this, Allianz and RSA, and RSA’s assessment is under some pressure following recent surprise losses at the group.

S&P’s ERM assessment scale has 5 categories and we summarise the potential ratings impact below –

(For a high resolution of this chart, email us – info@litmusanalysis.com).

While analysis of ERM is a detailed and jargon filled subject (S&P maintains a specialist team to support its work in this area) the principles behind the assessments are actually straightforward.

The first step is an evaluation as to whether the organisation has the systems in place to avoid nasty surprises relative to its Risk Appetite (hence the pressure on the RSA assessment).  The important point here is that it is not a judgement of how ‘risky’ the Risk Appetite actually is; simply whether, having defined it, the re/insurer can manage according to that appetite.  ‘High risk’ re/insurers can have a ‘very strong’ ERM assessment and ‘low risk’ re/ insurers can have a ‘weak’ ERM assessment.

A ‘weak’ assessment derives from either a lack of a properly defined Risk Appetite or S&P’s belief that the systems in place are insufficiently strong to reliably operate within that appetite.  We will not dwell on the details of the analysis here but issues looked at include the controls in place, the quality and usage of models and the overall ‘risk culture’ of the organisation.

In theory, without external support, a reinsurer assessed as ‘weak’ for ERM could achieve only a BBB+ rating at best even if the rest of its profile was extremely strong (without external support).

The ‘adequate’ and ‘adequate with strong risk controls’ assessments both indicate S&P’s belief that the Risk Appetite should be achievable (the latter usually reflecting sectors, such as reinsurance, where the risk control environment is more challenging, thereby requiring more robust systems).  However, given the importance the agency places on ERM within the reinsurance sector, a reinsurer achieving just the ‘adequate’ assessment needs to do well in the wider ‘management & governance’ part of the analysis not to risk having its rating lowered due to ERM.

The two highest assessments by contrast relate to how a rated group’s ERM will positively enhance its risk-adjusted performance.  In essence this means how the systems in place AND the strategic use of ERM allow the maximisation of return for any defined Risk Appetite. Part of this is a rare example of a rating agency embracing the idea of opportunistic behaviour; albeit in the context of highly sophisticated systems allowing this to be done optimally.

To achieve either of the two top categories the rated  group first needs to demonstrate it has an effective process in place for evaluating and then managing ‘emerging risks’.  Thereafter the ‘strong’ category reflects a holistic approach to risk/return optimisation.  Leadership decisions across issues such as line of business prioritisation, investment policies, diversification strategies and other areas, along with successful execution, are at the heart of this.

Finally to achieve the ‘very strong’ category, the group’s internal economic capital model needs to score highly as the underlying management tool for the above (this in itself requires a separate analysis by the agency).

The direct and indirect impact of a ‘strong’ or ‘very strong’ ERM assessment on a reinsurer’s rating can be very significant.  Catlin’s ‘A’ rating is fundamentally driven by both its ‘strong’ ERM score and its risk-adjusted out-performance (seen as derived from its strong ERM).  Partner Re by contrast, with an otherwise ‘AA-‘ profile, is actually rated lower than this implies at A+; were its ERM assessment to be ‘strong’ rather than ‘adequate with strong risk controls’ the rating would very probably be ‘AA-‘.

For SCOR the move to ‘very strong’ for its ERM does not in itself increase its A+ rating.  However, S&P’s faith in the quality of SCOR’s ERM is reflected in the agency’s belief that the consequent earnings performance will bolster and sustain capital adequacy such that a ‘AA-‘ rating becomes merited.

Stuart Shipperlee, Analytical Partner, Litmus Analysis

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

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

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

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

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

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

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

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

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

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

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

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

Stuart Shipperlee, Analytical Partner, Litmus Analysis

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.

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