International Reinsurance, Commercial and Specialty Lines Edition
Issue 11, 9th April 2015
Find below our ‘Overview’ and ‘Commentary’ followed by news of individual rating agency activity.
Overview – M&A Drives Rating Activity
It was beginning to look like the rating agencies were crying wolf with their negative outlooks on the reinsurance sector. Robust capitalisation and, actually, results that were not that bad, had supported individual credit profiles despite the ongoing soft market, largely leading to rating affirmations through 2014.
But the flurry of M&A activity (in part a function of the soft market) has now led to various applications of ‘CreditWatch’ (S&P’s term). These indicate the potential for near term downgrades (or upgrades).
As we saw with Ren Re/Platinum (see LRR10) there are some divergent initial views among the agencies about whether individual transactions are likely to be credit positive, neutral or negative. We cover the more high profile of these under ‘Individual Agency Activity’ on page 6.
Typically the agencies buy into the ‘consolidation logic’, but, where they are negative, have concerns about either the execution risk or how well the acquired entity fits the acquirer’s strategy or core market position.
The latter relates to an often over-looked aspect of ratings analysis; namely that the ‘business profile’ (the future ability to create quality earnings) can be as significant to the rating outcome as the current capital position. We cover the background to that in Litmus Commentary on page 6.
Meanwhile February saw a rare ratings event; a major European commercial lines player withdrew its S&P rating. Generali did so stressing its concern around S&P’s perceived inflexibility in how it treats the firm’s exposure to ‘Italy risk’.
As we discussed in LRR10, S&P’s approach is not simply about assessing the exposure to Italian government debt and it led to S&P downgrading Generali to ‘BBB+’ despite the firm’s own rating profile being assessed by S&P at the ‘a’ level (the disclosure of this distinction – and the explicit criteria for how S&P assesses this – reflect S&P’s enhanced ratings transparency initiative introduced in May 2013).
Interestingly Generali has nonetheless maintained its Moody’s rating even though it is at the same level (‘Baa1’), and despite S&P’s generally higher profile among European insurance market participants. Best and Fitch both continue to have ‘A range’ ratings on the firm.
The Litmus Commentary
Reinsurer M&A and how expected performance drives reinsurer ratings
The current spate of M&A in the reinsurance and specialty sectors is fundamentally being driven by pricing competition. Faced with an over-supply of capital the soft market persists across much of the reinsurance sector. Moreover a move to centralised buying by larger cedants means having the scale to be their ‘global partner’ is increasingly seen by many as fundamental (although the desire for a diversified panel may mitigate that).
Enhanced market position, increased diversification and some cost savings are therefore the M&A rationale.
Rating agencies generally buy that argument, albeit often with concerns about execution risk and – sometimes –strategic fit.
But what they really care about is the ‘quality’ of future operating performance (the degree of future profitability, its sustainability and volatility).
This is the source of an enduring ratings myth; that the agencies encourage companies to diversify. They don’t. But they do penalise concentration risk. Despite appearances, that does not amount to the same thing as they will also penalise diversification if they perceive the reinsurer is moving into areas it doesn’t understand well.
Buying an established book can therefore be seen as ‘safer’ diversification than organic growth in a new market.
The near to medium term outlook for reinsurance profitability is what leads all 4 main agencies to have a negative outlook on the industry (in essence meaning an expectation of more downgrades than upgrades). That’s despite high levels of industry capitalisation (which in turn influences the pricing pressure).
So defending ratings in this environment means demonstrating a strong ability to deliver profitability.
The degree of importance this has on rating outcomes can be seen in the table below from S&P.
Source: Standard & Poor’s
The columns in the table above reflect the capital driven part of the analysis, the rows the ‘business’ element. The latter is all about both how the operating environment in the sector overall, and a reinsurer’s specific business attributes within that, combine to drive future performance.
The outcome is the ‘ratings anchor’. While this may then be changed somewhat to reflect issues such as the perceived quality of management, it fundamentally drives the final rating outcome.
The upper left quartile of the table highlights the point. The first column headed ‘extremely strong’ represents a capital adequacy outcome at a ‘better than AAA’ level. Yet when combined with a ‘business risk profile’ of ‘satisfactory’, the final rating anchor outcome is only ‘a’ or ‘a-‘.
Yet the capital adequacy could drop all the way to ‘upper adequate’ (roughly the ‘BBB+’ level) and yet still generate a rating anchor of ‘a‘ if the ‘business risk profile’ score were ‘very strong’. Indeed even a ‘lower adequate’ (at or below ‘BBB’) capital outcome can lead to an ‘a-‘ anchor with this ‘business risk profile’.
Geographic and line of business diversification play a role in S&P’s firm specific part of the analysis, as does market share, brand/franchise and distribution mix. But the expected relative operating performance (i.e. vs peers) is fundamental (highly but not completely influenced by relative historic performance). So, scale helps but is not the be all and end all. 15 months into the soft market S&P last week upgraded niche reinsurer IGI to ‘A-‘ on the back of the quality of its operating performance.
Individual Agency Activity
Unless otherwise stated ratings and outlooks refer to the financial strength ratings (or issuer credit ratings for A.M. Best) of the named group’s ‘core’ carriers (see our Ratings Guide for a fuller description). Reasons given for agency actions are our interpretation of the agencies’ comments and criteria, not our own analytical views.
Rating activity from 18/12/2014 to 06/04/2015 (see LRR10 for Renaissance Re/Platinum)
Best continues to keep the ‘aa-‘ ratings of both Partner Re and Axis ‘under review, negative’ due to concerns around the complexity and scale of the merger and potential near-term problems with key staff retention. It stresses though that it agrees with the longer term business logic.
XL’s ‘a+’ is also ‘under review, negative’ following the Catlin acquisition, in part due to execution risk but also reflecting increased debt leverage. Again, though, Best highlights the positive longer term potential of the deal. Catlin’s ‘a’ is ‘under review, positive’ due to the potential for enhanced risk adjusted capital.
The agency has moved QBE’s outlook on its ‘a’ rating from ‘negative’ to ‘stable’ following enhancements to its capital position.
Fitch takes essentially the same view as Best (above) on Partner Re’s rating with its ‘AA-‘ being on ‘negative’ watch, but the opposite view on Axis whose ‘A+’ is now on positive ‘watch’.
Fitch has moved AIG’s ‘A’ to a ‘positive’ outlook following enhancements to its capital position, improved insurance earnings and reduced interest payment costs.
The existing ‘negative’ outlook of Montpelier’s ‘A’ was moved to negative ‘watch’ following the acquisition announcement. Fitch does not rate Endurance and its Montpelier rating is ‘unsolicited’.
Moody’s affirmed Partner Re’s ‘A1/Stable’ and moved Axis’s ‘A2’ to ‘positive’ watch.
The agency also moved Tokio Marine’s outlook on its ‘Aa3’ to ‘stable’ from ‘negative’.
S&P initially had Partner Re’s ‘AA-‘ on ‘negative’ watch over a raft of potential concerns related to the merger but rapidly affirmed the rating and restored the ‘stable’ outlook.
The outlook on Montpelier’s ‘A-’ was moved to positive based on the expectation of rapid integration into Endurance (probably implying the rating would then reflect ‘core’ status under S&P’s group rating criteria).
Odyssey Re’s outlook on its ‘A-‘ was moved to ‘negative’ reflecting concerns around parent group Fairfax’s capital adequacy levels (a function of perceived increased risk levels and of how the agency treats the increased level of ‘goodwill’ within its capital model). However S&P stresses that the competitive position has improved and that the group is looking at capital enhancement measures.
The capital plans are presumably why the agency has taken the unusual step of suggesting the outlook has a 6 to 12 month timeframe (rather than the typical 12 to 24 months).