How getting it right is crucial to ratings
- Comparisons to peers play a fundamental role in how major rating agencies assess insurers and reinsurers
- Rated carriers are both often unclear as to the analytical basis for this and even how and why a peer group is selected
- Peer selection is a function of a rating agency’s methodology and will be central to core aspects of its analysis. Any insurer that is unaware of this background is “flying blind” in crucial aspects of its communications with the agency
- Here we demonstrate how published rating agency reports, when viewed from the perspective of their rating methodologies, provide a rich source of insight into this aspect of their analysis
Peer analysis and comparisons are extremely important considerations in rating agency methodologies and are often key drivers in ratings differentiation between insurers.
For an insurer’s leadership, knowing which peers the agency is using, and how the agency assesses those peers, can be fundamental to making, or defending, the case on comparative and competitive differences. This, in turn, can be vital to optimising the rating outcome.
This article demonstrates what can be determined by reading between the lines of a rating agency report without access to any non-public information on an insurer or its peers, but through a fundamental knowledge of the agency’s methodology.
Seen through this prism there is a considerable degree of information and insight in agency rating reports that can help a rated company determine what to focus on in their communications with the agency, and crucially, how to best position the messaging in a way that fits an agency’s mindset. This insight can often be a valuable perspective for internal management use as well.
In order to illustrate this, we have taken what we view as three natural peers with S&P ratings and applied our knowledge of S&P’s methodology to their rating reports.
The following is an overview of what we discovered. It is entirely based on the rating agency reports published on each insurer’s own website.
S&P Rating Comparison
Table 1 below shows the assessment level for each of the three insurers of the key “heads of analysis” within the S&P methodology. This summary “snapshot” is typically provided within S&P rating reports and relates to the structure and execution of its rating methodology.
The “anchor” is the combined outcome of the “Business Risk Profile” and “Financial Risk Profile” sections of the analysis. It is before consideration of governance, liquidity, external support, or the impact of the sovereign rating of an insurer’s domicile. None of these “post-anchor” factors have any impact on the ratings of these insurers, hence the anchor is the same as the final rating though, importantly, Insurer B’s rating has been assigned a negative outlook.
Table 1 – Rating Factor Assessment Snapshots
*Insurance Industry and Country Risk Assessment
The gap between the Capital Adequacy assessment and final ratings
A general observation is that, as is common, the anchor and the final ratings are materially lower than the Capital Adequacy assessment (which for insurers B and C above is “AAA”). The Capital Adequacy assessment basically reflects the “two years forward” result of the S&P capital model. Despite that view being prospective, the capital model is just one component of S&P’s forward-looking analysis of capital strength and resilience captured within the overall Financial Risk Profile assessment.
In addition, the Business Risk Profile addresses the business factors that the agency considers drive the sustainable ability to generate healthy risk-adjusted returns. The agency considers that ability (or lack of it) to be central to financial strength in the medium to long term.
The crucial role of the Competitive Position assessment
The Competitive Position assessment plays a fundamental role in S&P rating decisions and is commonly the area with which, as rating advisors, we find ourselves providing the most help to clients when they are developing presentations for their meetings with the agency. This is true not only in terms of understanding the meaning of the details of S&P’s methodology but also, crucially, the agency’s mindset and analytical thinking.
A simple thought experiment on Insurers A and B (illustrated in Table 2 below) highlights quite how significant the Competitive Position assessment is. If we hold all other assessment factors (as shown in Table 1) constant for both insurers, but raise the Competitive Position assessment to the highest level of “Excellent”, each insurer’s anchor and rating become “aa-“ and “AA-“ respectively. If we reduce the assessment level by just one category (from “Strong” to “Satisfactory”) the anchors/ratings drop to either “a-“/“A-“ or “bbb+”/“BBB+”.
The Competitive Position assessment plays a fundamental role in S&P rating decisions and is commonly the area with which, as rating advisors, we find ourselves providing the most help to clients when they are developing presentations for their meetings with the agency. This is true not only in terms of understanding the meaning of the details of S&P’s methodology but also, crucially, the agency’s mindset and analytical thinking.
A simple thought experiment on Insurers A and B (illustrated in Table 2 below) highlights quite how significant the Competitive Position assessment is. If we hold all other assessment factors (as shown in Table 1) constant for both insurers, but raise the Competitive Position assessment to the highest level of “Excellent”, each insurer’s anchor and rating become “aa-“ and “AA-“ respectively. If we reduce the assessment level by just one category (from “Strong” to “Satisfactory”) the anchors/ratings drop to either “a-“/“A-“ or “bbb+”/“BBB+”.
Table source: S&P Global Ratings
Insurer B’s negative outlook
Insurer B has a negative rating outlook despite its current and prospective AAA capital adequacy.
A deeper look into S&P’s report reveals that they view recent technical losses for Insurer B as being a threat to its Competitive Position assessment.
While Table 1 features the standard published snapshot of the rating factor assessment levels S&P provides in the rating report, it is not directly clear from its contents that either Competitive Position is the issue or that, within that assessment, technical losses are the proximate cause.
However, we were able to conclude this by combining the commentary within the S&P report, the methodology S&P deploys when assessing Competitive Position and the agency’s analytical mindset with regard to the role technical performance plays within the Competitive Position assessment.
What guidance would Litmus offer Insurer B given the above?
If we were Insurer B’s rating advisors, we would be focusing ondetermining whether the agency’s negative view of technical performance is justified. For example, are results reflecting a real trend or are they more a function of ad-hoc occurrences (such as a greater than normal set of large losses)?
Has the agency fully taken into account the nature of Insurer B’s business, (as in the case of a mutual for example), or the strength of its position in the specific market where it operates?
Who is the agency comparing their performance with and is that justified (either in terms of peer selection or the nature of the comparison being made)?
If the Insurer itself considers its results are unsatisfactory, what actions is it now taking and how are these best explained to the agency in a way that allows them to buy into an expectation of consequent enhanced performance?
This can include description of the analysis of the book, pricing actions, evidence of the willingness to not renew loss producing clients, changes in the business mix, enhancements to underwriting controls and/or data and more.
If action has already been taken, how has that been presented to the agency and what is holding it back on giving credit for that?
How does A achieve the same rating and outlook as C?
Despite a lower Capital Adequacy outcome, Insurer A has achieved the same rating as B and C, and unlike B, retains a “stable” outlook. And this is not due to having a better Competitive Position assessment.
Moreover, Insurer C has achieved an ‘Excellent’ designation for Capital & Earnings (the outcome of Capital Adequacy after S&P adjusts for various factors not captured within its capital model), even though this is rare for its size, whereas A has the two category lower assessment of “strong”.
In order to preserve its A/Stable rating Insurer A must at least maintain its AA capital adequacy, whereas Insurer C may have some leeway within its AAA capital adequacy based on its Excellent Capital & Earnings score. Having said this, Insurer C will no doubt be very keen to hold on to this key differentiating factor, and would benefit from discussing the parameters with S&P.
But, given the above, how is Insurer A achieving the same rating as Insurer C?
The crucial factor is that it has a better Risk Exposure assessment than either Insurer B or C (“moderately low” vs “moderately high”). This relates to a combination of the perceived degree of risk within its overall business profile (most commonly the underwriting portfolio) but also S&P’s judgement as to the efficacy of its risk controls.
In peer comparison terms this is a significant call. If Insurer A’s Risk Exposure assessment was at the same level as B and C, its Financial Risk Profile assessment would automatically drop to “Satisfactory”. Then, all else being equal, the anchor for Insurer A would drop to ‘a-‘ or ‘bbb+’, and its final rating outcome to “A-“ or ‘BBB+’.
Selecting the right peers
The rating agencies’ approach to peer selection can seem to be an opaque process. We often see the agencies select peers that are quite different from the panel of competitors our clients think about. Understanding why they have selected these peers is important, and occasionally challenging the peers they have selected can be fruitful. Understanding an agency’s selection process and using their language is important in effectively making that argument.
In summary, for rated insurers and reinsurers, understanding the true drivers of their rating in comparison with others can seem difficult at best. Getting to the heart of what needs to be done in order to defend or improve the rating can feel like peeling the layers of an onion. Yet we have never seen a case where developing a full understanding of all the rating drivers, and how they interact with each other, cannot be achieved.
Leave a Reply