ANALYSIS AND KNOWLEDGE FOR THE WORLD OF INSURANCE

The slippery slope – Ratings downgrades and capital

Re/Insurers rating downgrades: it’s not just about the capital!

For almost all cedants and brokers the “financial strength” rating of their reinsurers remains a fundamental part of their selection process. For reinsurers, achieving and maintaining a rating at the desired level is mission critical. Many cedants themselves also operate in markets where their own rating is central to their business profile. Understanding how the rating agency decides their rating, and, therefore what it takes to maintain that required level, would seem a crucial requirement. Yet all too often companies are surprised, shocked and often genuinely angry when faced with the risk of a rating downgrade. There can be many causes of that disconnect between the agencies and rated companies but one big one is the tendency of rated companies to assume the rating process is dominated by the capital analysis.

It is not.

Capital is crucial of course; weak capital is a fundamental limiting factor whatever the other qualities of a rated re/insurer’s profile. But even the strongest capital position does not inherently lead to a high rating.  Nor does it eradicate rating downgrade risk.

S&P’s rating criteria, and the new rating methodology A.M. Best is about to formally adopt, both make this explicit. Even excluding any impact from factors that can be absolute rating constraints (such as lack of liquidity, sovereign risk and any concern about corporate governance), ratings from either agency can be profoundly lower than the capital analysis, in isolation, might suggest.

In S&P’s case a capital model outcome above the “aaa” level can still lead to a “rating anchor” of “bb-“.  Similarly, the strongest category of outcome in A.M. Best’s new BCAR can, by the time Operating Performance and Business Profile have been considered, lead to an indicative rating level of “bb+”, with considerable further downside if ERM is viewed negatively.

Of course, the kind of profile that would see this happen would be unusual. But that’s not really the point. Most internationally active reinsurers still feel the need for a rating of at least “A-“. (By the way, we would argue that the market’s tendency to apply ratings in that binary way is overly-simplistic but that’s a different article).  It doesn’t take too much negativity in the non-capital part of a rating analysis to start putting an “A range” rating at risk.

The reason for that is straightforward: ratings are prospective; it is future capital adequacy that really matters. And that, the agencies consider, is materially a function of future retained earnings. Hence, everything that can be considered to drive the level and volatility of those is fundamental to ratings.

Numerous things come into that but the mind-set of the rating committees at the agencies when considering these is also crucial. For the reinsurance industry that can be summed up as “it’s a difficult business with a high tendency to irrational price-based competition. So exactly how and why will this reinsurer succeed?”.  If that’s not clear, then they presume that, one way or another, even a strong current capital position will be eroded. The agencies can look through short-term pain as long as the medium to long-term outlook is positive, but that requires a compelling rationale for that positive future.

In our experience, rated insurers and reinsurers often have a much better story to tell than they currently make to the agencies. In part because, until a problem with their rating occurs, they simply don’t realise how important it is. Yet changing a negative mind-set at a rating agency is much harder than avoiding it in the first place. The “how and why” of their business strengths should be an absolute focus of any rated re/insurer’s agency communications.

Stuart Shipperlee
Head of Analytics
September 2017

Optimising your financial strength rating

Leave a Reply

Litmus Analysis

LITMUS ANALYSIS is a team of analysts offering a broad range of products and services designed to create increased transparency, clarity and knowledge in the insurance and reinsurance markets.

We bring the skills and experience of a team of top analysts to the insurance world.