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.