Although effectively communicating the output is likely to be critical for European re/insurers
Periodically we hear the comment that the required publication by EU domiciled re/insurers of details on their financial health under Solvency II (SII) may remove market demand to see re/insurer ratings.
Here at Litmus, we seriously doubt that.
Fundamentally the information that will be disclosed under SII will have to be interpreted by the user in order to reach a view as to the re/insurer’s financial condition, whereas a rating is an explicit third-party opinion on exactly that.
A common belief is that public disclosure within SII is primarily about the calculation and publication of a key solvency metric: The Solvency Capital Requirement*(“SCR”), and that this would therefore simply and easily allow a market participant to see what the financial strength of a re/insurer is.
Both are misconceptions.
First, SII disclosure also includes the publication by the re/insurer of a wider Solvency and Financial Condition Report** (SFCR). This is intended by the regulators to set a fundamental context within which the SCR outcome is viewed.
Second, the only defined point on the SCR scale is the 100% level. At a 100% SCR the re/insurer holds sufficient capital such that – according to the SII model – they have a 1-in-200 risk of failure over a 1-year period. To our understanding any other SCR level is undefined (other than the extent to which the outcome is above or below 100%).
A 1-in-200 risk is roughly that indicated by a “BB+” S&P rating. So market practitioners who look for a higher rating than that will presumably look for a ‘greater than 100% SCR’. But how much greater? An S&P “BBB” has less than 1-in-400 expected annual default rate, an “A-“ has roughly a 1-in-1000 default rate.
For re/insurers the publication of their SFCR (which includes the SCR) will be very important. The impression these give of a re/insurer’s financial health is likely to become a fundamental and critical aspect of its market communications. And, indeed, rating agencies themselves are likely to study the SII related content of re/insurers they rate closely.
However, it’s the nature of how and why market participants use ratings that suggests to us that the availability of SII content will not replace them.
The misconceptions noted above around SII are at the heart of this:
How will market participants handle SCR changes?
While market participants might settle on a standard level of ‘desired’ SCR, how will they handle the annual changes to a given re/insurer’s outcome?
For example – if a 120% SCR become a standard – what if a re/insurer dropped from 121% to 119%? A tiny change; would that be OK but 110% not? Where’s the cut-off?
How will brokers and buyers address the issue of evaluating what the SCR, and the wider SFCR, mean?
While the overall SFCR provides market participants with a very important context for assessing the SCR specifically, this puts the responsibility onto the broker or buyer to then interpret what it means for the re/insurer’s financial profile, whereas when a broker or buyer looks at a rating they are reading a finalised opinion that reflects the agency’s view of all relevant aspects of the re/insurer’s current and prospective credit profile.
The most sophisticated market participants should be very capable of effectively using the rest of the SFCR content to refine what the SCR is telling them. But not all will want to,and many market participants will simply lack the resources to do so. For example, would most brokers really want to opine to a client on what the SFCR implies for a re/insurer’s solvency?
Whether a broker can rely on the fact that a subsequently failed carrier had a healthy rating, as a ‘defence’, is itself open to question. But with the SCR/SFCR on an unrated carrier there’s no public third party opinion to point at. A broker has to judge what SCR/SFCR profile is acceptable when acting within their required duty of care to buyers.
None of which is to suggest ratings are not going to continue to periodically appear to have been “wrong”. They are inherently forecasts (an imperfect science) and rating users should always keep that in mind when relying on them.Which is why we stress the importance of rating users understanding what goes into ratings (the rating criteria and process) and, hence, what their natural limitations are from a ratings users point of view.
But, for many market participants, ratings meet a need that SIIis not designed to address.
We conclude that market conventions on acceptable SCR levels are, if and when they emerge, likely to operate in parallel with, rather than instead of ratings. Some, but probably not most, market participants will effectively use the SCR and the wider SFCR information in combination: though those that do are likely to be disproportionately important to many carriers. Designing and effectively communicating the SFCR content will therefore be “mission critical” for many re/insurers. But availability of the SCR and wider SFCR content will not replace or reduce buyer and broker demand to see ratings.
*The SCR is one of two risk-adjusted capital ratios (expressed as percentages) required to be published under Solvency II. It is the more challenging of the two and the one most analysts believe will become the “de-facto” reference point for third parties.
**The SFCR is a set of quantitative and qualitative metrics and information an insurer is required to publish annually on its financial and risk profile. This SCR is part of that disclosure.
Stuart Shipperlee
Managing Director,
Litmus Analysis
11 September 2016
Note To The Above
Primer on use of bond default rates in this context
A financial strength rating of a re/insurer speaks to the ability to pay policyholder obligations. Since policyholders are viewed as the “most senior” unsecured creditor, this rating is usually assigned at the highest ‘generic’ rating level for the policy issuing entity (something S&P and Best both term the “Issuer Credit Rating”, or “ICR”).
Corporate bond default rates provide a rich source of data for quantifying the credit risk represented at any given point on the rating scale across multiple time periods. Since non-insurance corporates do not have policyholders as a special class of creditor, the ICR sets the level of their senior debt ratings.
From that point of view corporate bond default rates can be seen as applicable to financial strength ratings.
However, the fact and timing of ‘default’ by a re/insurer on policyholder obligations is far harder to objectively measure-than bond defaults.
Generally, the rating agencies see some form of mandatory regulator intervention in an insurer’s operations as analogous to a “default event” when adding insurer defaults to the rest of their default data (at Litmus we suspect that may overstate things a bit given mandatory intervention is usually intended to avoid policyholder default). In any event, bond default rates are a useful indicator but by no means a perfect guide to policyholder default risk by rating level.
A.M. Best publishes “impairment” data for US re/insurers by rating level but we believe Bests includes in that some insurers that were a long way from mandatory intervention (meaning the frequency of impairment as defined by Best at any given rating level would be higher than default, and potentially quite a lot higher.
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