Why reinsurance practitioners should understand the drivers of cedant ratings
Even in those markets where ratings are fundamental to carrier selection, most practitioners tend not to dwell too much on the details of how ratings are decided.
Yet, for reinsurers and reinsurance brokers with rated cedant clients, this is a crucial piece of knowledge if they consider themselves to be providers of capital solutions and advice. From proportional and non-proportional reinsurance, to loss portfolio transfers, to insurance linked securities of various types, what is often being provided to the cedant is either capital support or a means of reducing the amount of capital they need.
This can enhance a cedant’s regulatory capital ratios. But, other than where a regulatory hurdle is in risk of breach, this is largely an issue of an often hazy sense of market perception (i.e. the extent to which the cedant’s own clients and distribution channels look at the degree of redundancy in its regulatory capital).
However, for rated cedants, there is a very different context. Rated cedants need to achieve and maintain the minimum rating level their clients/brokers demand or expect. Market practice means this can often be higher than the point at which the rating description sounds positive (an insurer rated BBB by S&P is defined as having “GOOD financial security characteristics”). Healthy looking regulatory capital ratios moving around from year to year (which, being an annual numerical calculation, they must do) are not usually an issue for a cedant. Rating changes, or even rating outlook changes, very much can be.
The role of reinsurance cover in ratings is often considered in the context of a major misunderstanding: that an agency’s capital model is the dominant factor in its rating decisions. First, the capital model outcome is just one input into the overall capital related part of the analysis. Second, non-capital factors are crucial to the final rating. Third, the nature and use of reinsurance cover by a cedant can materially impact the assessment of some of the non-capital factors.
Advising a cedant on the ratings-related value or impact of a reinsurance solution by focussing purely – or even largely – on the capital model can easily miss a lot of the point! Understanding the model impact is a crucial but not sufficient insight. Often not remotely sufficient.
All four agencies most active in reinsurance (A.M. Best, Fitch, Moody’s1 and S&P Global) have detailed rating criteria that makes this clear. A.M. Best and S&P also organise the logic of their criteria such that the interaction between capital model outcomes and the rest of their criteria is explicit. From that we can note the following.
An S&P rated cedant with better than “AAA” capital adequacy (current and prospective) coming out of the S&P model can in theory still receive a Financial Risk Profile2 assessment of “lower adequate”. Combine that with a “fair” assessment for the Business Risk Profile2, and a “less than adequate” assessment for ERM & Management, and the final rating level becomes “BB+” if all other factors are neutral.
The journey from the capital model outcome for A.M. Best (the “BCAR” score) differs in the detailed execution but essentially covers all the same elements in a similarly explicit way. Even the highest BCAR outcome can, when combined with the rest of the Balance Sheet Strength analysis, quite easily lead to an initial baseline assessment for the rating of “a-“3. Thereafter the Operating Performance and Business Profile could take the assessment down to “bb“3. The worst possible ERM assessment could reduce that by 4 notches more.
In both the S&P and A.M Best cases above we are not assuming material negative impacts from either country risk or weaknesses in a wider group that the cedant belongs to. All of these downward adjustments can happen based purely on the cedant’s own profile.
Of course, an insurer having a set of weaknesses required for the degree of rating impact described here would be very unusual. But then, their full impact would take a rating down way below what most ratings sensitive markets require. A more modest set of negatives can still crucially impact their ability to maintain the rating they need or want.
Which means that, when it comes to their ratings impact, traditional or alternative reinsurance solutions need to be considered in the light of all aspects of an agency’s rating criteria, not simply the observable impact to the agency capital model.
1Moody’s does not use its own capital model within its re/insurer ratings process. Rather the agency focusses on regulatory and internal model details and results, combined with consideration of individual capital ratios.
2The Financial Risk Profile is prospective, adding in forecast retained profits and business volumes. It also reflects capital adequacy related factors not covered within the S&P model (e.g. size, investment concentration risk, financial flexibility, potential volatility from catastrophe risk exposure). Business Risk Profile combines a view of the operating environment within the market(s) the insurer trades in with its own Competitive Position.
3A.M. Best produces its ratings using its (S&P and Fitch like) “Issuer Credit Rating, ICR” scale which it expresses in the lower case (it then maps this to the “Financial Strength Ratings” scale to translate that outcome to the rating scale most familiar to many US market participants).
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