Winners and losers are inevitable from S&P’s capital model proposals

10 December 2021

S&P flagged the impending arrival of an RfC1 on changes to its capital model 9 weeks ago, and the details of those changes hit the desks of rated insurers and reinsurers on Tuesday this week.

“S&P’s testing suggests up to 10% of ratings across insurers of all types may change if the proposals are implemented as is.

The devil will be in the detail of both how the model changes for any given rated group (or stand-alone rated carrier) impact its model outcome and, crucially, how the rest of their credit profile interacts with that outcome.

The key themes below highlight the potential drivers of rating changes for non-life insurers and reinsurers, the role of the capital model in S&P’s ratings, the next steps in the RfC process and our initial thoughts on what insurers and reinsurers should be thinking about.”

Stuart Shipperlee, Litmus Analysis

Key themes

  1. On the current proposal basis 10% of ratings may change, with somewhat more upgrades than downgrades.
  2. The changes are merely “proposed” (via an RfC) at this point but Litmus’ experience suggests further changes to the proposals from here may not be that profound.
  3. A fundamental conceptual shift is at the core. A significant part of the current “implied” diversification credit is moved out of the individual risk capital charges (via increases to these) and into an explicit separate calculation.
  4. In particular, risk capital charges for premiums and reserves are going to show material increases for many insurers and reinsurers.
  5. The impact of the specific degree of diversification within and across lines of business and asset types becomes more significant as this will be a prime source for offsetting the higher risk capital charges.
  6. Geographic diversification is reflected elsewhere in S&P’s ratings methodology (under “competitive position”) and does not directly impact the current or proposed capital model. Although, as is currently the case, the risk capital charges themselves can vary by region or country.
  7. There is a toughening of the definition for when debt funded equity is credited in risk capital. This is potentially a challenge for some Bermuda-based groups as an example.
  8. Other changes also have the potential to be positive or negative, though, as with the above, the quantum and relevance of that will be case specific:

  • Changes in the treatment of redundancy in loss reserves (positive).
  • Recognition for available risk capital purposes of the deferred acquisition cost asset (positive).
  • Move to whole account PMLs for natural catastrophe exposures (negative).
  • Introduction of a range of return periods for the AEL Net PML factor and from a post-tax to a pre-tax amount (negative).
  • Inclusion of natural catastrophe exposures as part of the diversification calculation (positive).
  • Inclusion of risk capital charges for reinsurance recoverables derived from the different Net AEL PML return periods (negative).
  • Switch to bond and loan portfolio risk capital charges that only reflect unexpected losses (positive).

The role the capital model plays in S&P’s financial strength ratings for insurers and reinsurers

S&P, (along with A.M. Best and Fitch, the other main insurer rating agencies that use their own capital models2) spends a material amount of time explaining that their model does not define rating outcomes.

They are right. Among S&P’s global reinsurance cohort for example, most reinsurers get a rating lower than that implied purely by the model outcome, sometimes materially lower. Among that cohort the agency’s assessment of “competitive position” has relatively more explanatory power in terms of the final rating.

Yet, in one context, the extent to which rated insurers and reinsurers and other stakeholders can seem to focus more on the model result when considering ratings outcomes – compared to consideration of the other crucial rating drivers – is also understandable. While the model result does not define the rating outcome it is often central to maintaining, and (though significantly less often), to improving it.

This is why, while S&P is on record as officially describing an undue focus on the details of the model in terms of rating outcomes as “spurious accuracy”, many of its analytical reports on rated insurers and reinsurers nonetheless flag one of the “downgrade risks” as a sustained drop in the model outcome (known by the agency as “capital adequacy”).

This need for a given amount of “S&P capital”3 to support the desired rating also leads to a second crucial issue for rated (re)insurer leaderships, namely the impact that can have on their RoE.

What happens now and what could, or should, a rated insurer or reinsurer be doing?

The RfC process is about insurers and reinsurers (or other stakeholders) providing feedback to the agency on conceptual or technical aspects they agree or disagree with, including the option to offer alternative suggestions.

Crucially though, that does not mean rated insurers can run the implied new model, check if they like the outcome and comment accordingly. There will not be a new model available from S&P until the new model criteria is formally adopted and published. That will come after the RfC process (which ends on February 18th , 2022) and S&P’s finalisation of its review of the comments it has received (that review may be complete fairly shortly after February 18th, or take some time). At which point it will become “live”.

Some very large and/or highly sophisticated insurers and reinsurers will try and create their own pro-forma version now. This could help inform them in giving S&P feedback, though the simple fact of the changes being negative will not, in itself, be that relevant. There has to be a robust, technical rationale for any concern expressed for it to have a potential impact.  Also building a pro-forma model in the timeframe will be a very difficult thing to do well given the changes proposed (such as the introduction of the correlation matrixes to calculate the explicit diversification credit).

All insurers and reinsurers whose ratings may be impacted (positively or negatively) will be publicly identified at the point of the new model release (known as being “under criteria observation”)– with reviews of the impact then being executed by the agency in the following months. In theory those potentially impacted will have been contacted on this by their S&P analysts ahead of the “under criteria observation” announcement.

There are a lot of details in this RfC, but here are a few initial thoughts on what (re)insurers could start considering now:

  • Make sure you understand the exact role the capital model outcome is currently playing in your S&P rating in the context of all the other elements of S&P’s rating methodology. How much of a model change would be needed to impact you?
  • Consider your profile from the point of view of the thematic changes proposed (such as your degree of product line and investment risk diversification, or whether your AEL PML position may increase in significance).
  • Be aware that both S&P’s “capital and earnings” and “risk exposure” assessments can modify the impact of the capital model result. The former via S&P concluding the model is not sufficiently representative, and the latter by factoring in capital adequacy issues not fully captured in the model and how the efficacy of risk controls supports the maintenance of capital adequacy (or not).
  • If your operating insurer or reinsurer equity is a function of debt issuance higher in the organisation structure that may no longer be credited, begin to consider your alternatives now. That’s not just about other sources of equity capital (or things S&P will see as equivalent); risk mitigation and changes to areas of your risk appetite can be other things to consider.
  • Once you feel you are ready to do so, proactively engage with your S&P analyst(s) to get their feedback on how they see the changes potentially impacting you.

1“Request for Comment”

2The fourth, Moody’s, does not have its own insurance capital model.

3The amount of capital S&P calculates as available for risk taking. “Total Available Capital” (TAC)

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