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