Standard & Poor’s (S&P) recent release of the details of its review of the ratings of the 11 out of 13 members of the International Group (IG), which are interactively rated, brought with it a number of changes. The arrival of the new criteria has given S&P the opportunity to adjust its ratings to result in what we regard as a more analytically robust and less dispersed distribution of grades.
The biggest change was the dawning of a new era where all IG members now have investment grade (BBB- or above) ratings. This state of affairs seems eminently sensible, but has been a long time coming. Despite the poor performance of some clubs over the past few years, there are a number of reasons why it seemed hard to justify any of the clubs having a sub-investment grade (BB+ or below) rating. Paramount amongst these is the legal right and demonstrated ability of the clubs to make additional calls on members in the event of a shortfall in funds, usually caused by a catastrophic year for losses. The near-monopoly of the IG in providing third party liability cover for the global shipping industry, the shared reinsurance cover, the pooling of some risks and the barriers to entry to the market are other reasons for the compression of the spread of ratings around a higher mean rating.
The American Club, the last club to have its rating languishing in the “non-secure” range has finally been upgraded. To us the previous BB+ rating made little sense, given S&P’s overwhelmingly positive public comments about the strength of the IG. The club is still deemed to have a “less than adequate” Financial Risk Profile (FRP), with modest earnings and capital adequacy that has a “modest deficiency at the BBB level”, but S&P has recognized that the club’s future is looking brighter. It even says that it could raise the rating further within two years if capital and earnings improve. Such a rapid transition up the rating scale would certainly signal a more realistic view for this member of the IG in our opinion.
Both Japan Club (to BBB+ from BBB) and the West of England Club (to BBB from BBB-) have received one-notch upgrades, in a tacit recognition that their previous ratings were also too low. The ratings had both suffered from the implicit drag caused by their relatively recent move to interactive ratings from “public information” (pi) ratings, where the methodology logically demands a greater degree of conservatism on the part of S&P. This can lead to a lower pi rating than might reasonably be expected as S&P has to assume that the non-public information that it does not have access to may be negative. Since, inevitably, the published pi rating sets an implicit base case context, the rated entity can initially struggle to make the case for a significantly higher interactive rating. This is compounded by the fact that the agency is only likely to get comfortable with management forecasts of operating performance (even more important under the new criteria) after some years of dealing with the club on an interactive rating basis. Unfortunately therefore , it is a fact of life that the more tardy an insurer is in coming forward for an interactive S&P rating, the lower down the scale it is likely to be compared with its longtime–rated peers. It takes a while to move up the S&P rating scale.
The only club to be on the end of a negative action by S&P was Standard Club, which saw the Outlook on its rating move to Negative. This reflected a below-par underwriting performance, and seems fair enough given that the combined ratio was above 120% for the last two years. The challenge will now be to persuade S&P that it has the strengths in its Competitive Position to bring its combined ratio down materially since both prospective absolute performance, which is fundamentally informed by historic performance, and relative performance versus peers resonate through the new criteria, impacting both the financial risk profile and business risk profile.
Rowena Potter, Consultant Analyst, Litmus Analysis
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