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

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

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

• 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.