13 September 2017 Insurance

How to avoid a rating downgrade

Despite the importance to reinsurers, and cedants in many cases, of achieving and maintaining a desirable financial strength rating, many companies still fail to grasp the complexity of rating agencies’ methodology—and some face downgrades as a result.

That is the view of Stuart Shipperlee, head of analytics at Litmus Analysis, speaking to Monte Carlo Today.

“All too often companies are surprised, shocked and angry when faced with the risk of a rating downgrade,” he said.

“There can be many causes of the disconnect between the agencies and rated companies but one big one is the tendency of rated companies to assume the rating process is dominated by the capital analysis. It is not.”

Shipperlee explained that capital is indeed crucial, and weak capital is a fundamental limiting factor—whatever the other qualities of a rated re/insurer’s profile.

“But even the strongest capital position does not inherently lead to a high rating. Nor does it eradicate rating downgrade risk,” he said.

S&P’s rating criteria and the new rating methodology AM Best is about to formally adopt both make this explicit, Shipperlee stressed. “Even excluding any impact from factors that can be absolute rating constraints (such as lack of liquidity, sovereign risk and any concern about corporate governance), ratings from either agency can be profoundly lower than the capital analysis, in isolation, might suggest.”

He noted that in S&P’s case a capital model outcome above the ‘aaa’ level can still lead to a ‘rating anchor’ of ‘bb-’. Similarly, the strongest category of outcome in AM Best’s new Best’s Capital Adequacy Ratio (BCAR) can, by the time operating performance and business profile have been considered, lead to an indicative rating level of ‘bb+’, with considerable further downside if enterprise risk management is viewed negatively.

“Of course, the kind of profile to which this would happen would be unusual. But that’s not really the point. Most internationally active reinsurers still feel the need for a rating of at least A-. It doesn’t take too much negativity in the non-capital part of a rating analysis to start putting an ‘A range’ rating at risk,” he said.

He argues that the reason for that is straightforward: ratings are prospective; it is future capital adequacy that really matters. And that, the agencies consider, is materially a function of future retained earnings.

“Hence, everything that can be considered to drive the level and volatility of those is fundamental to ratings,” he said.

“Numerous things come into that but the mindset of the rating committees at the agencies when considering these is also crucial. For the reinsurance industry that can be summed up as ‘it’s a difficult business with a high tendency to irrational price-based competition. So exactly how and why will this reinsurer succeed?’.”

If that’s not clear, then they presume that, one way or another, even a strong current capital position will be eroded.

“The agencies can look through short-term pain as long as the medium to long-term outlook is positive, but that requires a compelling rationale for that positive future,” Shipperlee added.

“In our experience, rated insurers and reinsurers often have a much better story to tell than they currently make to the agencies. In part this is because, until a problem with their rating occurs, they simply don’t realise how important it is.

“Changing a negative mindset at a rating agency is much harder than avoiding it in the first place. The ‘how and why’ of their business strengths should be an absolute focus of any rated re/insurer’s agency communications,” he concluded.

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