Keeping a Lookout for Outlooks

Looking beneath the rating agency reinsurance sector announcements

On 17 July 2018, Aon published an article remarking on the divergent outlooks the rating agencies have on the reinsurance sector, with Moody’s and S&P having a ‘stable’ outlook, while Fitch and A.M. Best retain their ‘negative’ outlooks.

How did they get there, and why the divergence?

A deeper look suggests that it’s important to understand both what is meant by a rating agency ‘outlook’ and, probably, what they’re indicating.

A good example is S&P’s report prior to Monte Carlo last year, in which they looked at 3 different indicators –

  • The business conditions, which they described as being ‘weak’;
  • The business outlook, which they viewed as being ‘somewhat weaker’,
  • And the sector outlook, which they had as ‘stable’.

That might sound a bit odd – how can the sector outlook be stable when the current and future business conditions are weak?

It’s all a question of definition. Essentially, the first two looked specifically at market conditions: what was going on, and what S&P viewed as likely to happen going forward. Pretty straightforward, although the likely impact of HIM was yet to be seen and some hoped this could be market changing.

But if the business conditions and outlook were weak, how does the sector outlook end up stable?

The sector outlook refers to S&P’s view on the likely direction of ratings in the sector. It’s quite simple really – a stable outlook means that their view is that, on average, ratings will be at the same level in the medium term as they are now. In other words, if there are downgrades, there’s likely to be a roughly equal number of upgrades.

Therefore they are suggesting that regardless of the weak market they see either very little change in ratings, or an equal number of winners and losers.

Reading their detailed reports from last year, a lot of the messages centred on market resilience, resulting from what they called ‘robust capital levels’ and ‘sophisticated ERM processes’. To quote –

‘‘…capital strength and ERM have proven to be the sector’s saving grace from weak business conditions’’.

Meanwhile, following on from their own report at Monte Carlo, A.M. Best reported on the U.S. reinsurance market in January this year, reiterating their negative outlook on the Global Reinsurance Market. Prior to that, in a video on 18 December last year they stressed solid balance sheets, but highlighted the need for sustained pricing pressure through June and July renewals, as well as concerns about potential adverse HIM loss development and excess capacity, stressing likely low RoE’s going forward.

Fitch commented earlier this year, stating a broadly similar position to A.M. Best, with a bit more negativity around rating levels –

“The majority of reinsurer rating outlooks remain stable. However, the ratings of XL Group Ltd and AXIS Capital Holdings Limited have recently been revised to Negative, while Lloyd’s was maintained on Negative Outlook and Fitch believes that the 3Q17 catastrophe losses have placed further pressure on the Negative Outlook.”

A key point made by Fitch was that just because declining rates seemed to have ended, it didn’t necessarily mean the end of the soft market.

Meanwhile Moody’s took what seemed to be, to the casual observer, the rather odd decision to shift their outlook to stable having been negative in the past; again it’s important to remember that this is an outlook on the likely direction of their ratings, so having believed there would be, on average, more downgrades than upgrades, they now believed that their ‘average’ rating on reinsurers would be stable.

It would seem that they drifted from A.M. Best’s concerns around the weaker performance of reinsurers to the S&P position that, at the end of the day, there’s still a lot of capital.
Crucially, sitting behind this, is the starting point of their ratings – if the rating agency is rating higher in the first place, then there is a greater likelihood of downgrades when a market turns. Our historical analysis has shown that S&P’s average rating of reinsurers has been very slightly lower than A.M. Best or Fitch, and that may go some way to explain their relative positions.

Now we’re approaching Monte Carlo again, and it’s going to be fascinating to see how the agencies’ positions shift now they have a better idea of the impact of HIM on results, reserving and pricing. As S&P said last year, reinsurers’ return on capital was getting perilously close to the cost of capital. If poor earnings persist for 2018 and reinsurers do not meet their cost of capital, S&P is likely to change its outlook to negative, with the prospect of ratings downgrades for the weaker players. Equally, AM Best and Fitch are unlikely to change their negative views.

Peter Hughes
8 August 2018

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