On the 20th January, S&P announced that – for the first time since 2006 – it expects a negative trend in reinsurer ratings in 2014. Of the 23 groups (including ‘Lloyd’s) it defines as ‘global reinsurers’ it notes that ‘nearly half’ are materially exposed to the competition driven risks it sees as the likely primary cause of rating downgrades.
Anybody who has even casually scanned the industry media recently will not be surprised at S&P’s rationale. Namely that excess capital (traditional or otherwise) and reduced demand are driving out ‘technical pricing’ discipline (we would add adverse development risk to those issues but the agency seems more sanguine).
So, why might reinsurer downgrades prove especially controversial?
Well, firstly, they often are. Even some of those driven by what have seemed to be an unavoidably clear weakening of a reinsurer’s credit profile have been so, at least at the time (Converium, Gerling). But also this time S&P is indicating the risk of downgrades driven simply by its view of a reinsurer’s prospective earnings. It is one thing to issue a downgrade based on a balance sheet event such as a severe cat. loss, asset write-down or reserve hike, quite another when it’s based on the agency’s judgement about weakening earnings potential.
S&P notes that its concerns are about further price/terms & conditions weakness during 2014 as well as the rate reductions seen at the Jan 1 renewal. So any earnings driven downgrades in 2014 could well happen before any published figurers from the reinsurer actually confirm such weakening.
This ‘prospectiveness’ is, of course, a prime focus of the agency’s revised rating criteria launched last May.
A fundamental plank of that is how the relative strength of a reinsurer’s ‘competitive position’ supports sustainably strong earnings and it is this – directly or indirectly – that S&P highlights as the likely source of downgrades.
While we wouldn’t disagree with the premise, in our view there are some anomalies in S&P’s take on this for the reinsurance industry.
Firstly, as we have highlighted before, the agency has had a surprisingly positive view of ‘competitive position’ across the ‘global reinsurance’ cohort. Only one reinsurer (Maiden Re) is currently assigned a score for this of less than ‘Strong’ (‘Adequate’ in Maiden Re’s case).
For a famously cyclical, highly competitive business where ‘product differentiation’ is challenging to say the least this has always struck us as odd (although we presume that at least in part it’s a judgement relative to industries seen as more competitive still).
Secondly ratings are intended as ‘through the cycle’ views (indeed the agency’s focus on the importance of ‘competitive position’ reflects that). So, what is it seeing that is not part of expected cyclicality?
Our take on both points is that the agency is unnerved by how reports (and maybe the non-public information it gets from rated companies) suggest that the industry’s claimed degree of focus on maintaining technical pricing appears to be about as resilient as the archetypal military battle plan (in that it has survived only up to the moment the ‘enemy’ of price-based competition has been engaged).
Prior to its announcement only one of the 23 groups had its rating on ‘negative outlook’ (again this is Maiden Re whose rating is BBB+). Outlooks are the mechanism by which S&P normally flags a negative ‘trend’ (rather than a negative ‘event’) that may lead to a downgrade. The agency we believe is therefore now anticipating a significantly worse pricing environment than it expected just weeks ago.
So, whose rating is at risk?
No names are named in the announcement although ‘smaller catastrophe-heavy reinsurers’ are highlighted as being under most pressure.
Ordinarily we would look to the ‘oulooks’ as a guide but, as above, the agency appears to have had a negative ‘step-change’ in its view that is not yet reflected in the outlooks.
Beyond Maiden Re’s ‘Adequate’ 14 of the 23 groups have the ‘Strong’ assessment for ‘competitive position’, 6 are assessed as ‘Very Strong’ and two as ‘Extremely Strong’. A reduced assessment in most of these cases could in theory trigger a downgrade, but the logic of S&P’s position is that it is those it views to have the least easily defended ‘competitive position’ whose rating is at most risk . Counter-intuitive though it might seem at first sight, those therefore with ‘only’ a strong ‘competitive position’ assessment seem most exposed.
Moreover the assessments for the capital adequacy part of the analysis (known as the ‘financial risk profile’ score) also reflect prospective earnings so a more bearish view of ‘competitive position’ leading to worsening prospective earnings can impact this part of the analysis too, magnifying the ratings impact.
It should be noted however that S&P also stresses a general concern about pricing discipline and, ultimately, a general willingness to under-price by any of the 23 groups undermines perceived competitive strength in a rating analysis. And since it is not 2013 and prior performance that S&P is concerned about, up-coming releases of 2013 numbers may not provide much of a guide either (though any performance that is materially ‘below peers’ would certainly not help a group’s case).
For S&P rated reinsurers now more than ever defending their rating will require effectively communicating both exactly what their competitive advantages are (the ‘why’ not just the ‘what’), persuasively arguing that they will not be market share focussed, and that their risk and pricing controls are robust across all operations . And then hope it’s a reasonably benign cat. year and that their prior year reserves are adequate!
Stuart Shipperlee, Analytical MD, Litmus Analysis