13 September 2016 Insurance

Differing outlooks not intuitive: Litmus

The differing outlooks of S&P Global Ratings and AM Best on the reinsurance industry are the opposite of what one might expect, given the basis of their criteria and methodology, said Stuart Shipperlee, head of analytics at Litmus Analysis.

S&P Global Ratings has the industry on a stable outlook at the moment, meaning any future positive and negative rating actions will likely balance each other out, while AM Best has the industry on negative outlook, meaning it expects more negative than positive actions. Shipperlee said that when their respective methodologies are considered, this is surprising.

He explained that the rating agencies are grappling at the moment with the paradox that exists in the industry: on the one hand, balance sheets are strong and most companies have surplus capital; on the other, profits are deteriorating due to the soft market.

Profits today will inform the strength of reinsurers’ balance sheets tomorrow so the rating agencies must interpret the situation with these two counteracting forces in mind.

“It depends on how much importance they attribute to future earnings and the long-term effect of that on balance sheets,” Shipperlee said.

This analysis ties in with a report published by Litmus Analysis comparing the criteria used by S&P Global Ratings and AM Best. Noting there are many common areas, the report said key differences still prevail, and summarised some of them.

One of the most notable is that for AM Best the ‘baseline’—the foundation and first step—is balance street strength, although the final rating can be very different from the balance sheet outcome.

In contrast, S&P Global Ratings starts with the ‘business risk profile’, with the ‘financial risk profile’ being the second ‘building block’, viewed as the prospective result of the business risk profile company has and the decisions it makes.

On this basis, given that balance sheet strength is not now a problem, but long-term business risk is, intuitively one might expect the rating agencies’ outlooks to have been the other way around.

“It is not what you might expect,” Shipperlee said. “Conceptually, AM Best starts with the balance sheet and works from there. S&P Global Ratings starts with the business risk profile. AM Best seems to believe that you cannot ignore the long-term impact of less profitable business now. S&P Global Ratings seems to see that as more of a concern, with the industry strong enough to absorb that challenge, it seems.”

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