Hurricanes and the importance of ERM to ratings
The fact that the recent hurricane losses are unlikely to become a capital event for reinsurers owes much to the industry’s greater sophistication in its use of enterprise risk management, writes Stuart Shipperlee, managing director of Litmus Analysis.
At the time of writing S&P has begun to negatively adjust a few reinsurer rating outlooks due to the impact of expected losses from hurricanes Harvey, Irma and Maria (HIM). There remains a very wide range of possible loss outcomes, and whether HIM (and the rest of 2017) will develop collectively as a major ‘capital event’ for any rated reinsurer is very hard to second-guess at this point.
Most forecasts have industry losses exceeding those of 2005, which was most certainly a capital event for some. But that was a different world for the management of reinsurer capital. Since then a lot of work has been done on reinsurer enterprise risk management (ERM).
ERM quality has also become fundamental to reinsurer ratings.
Of the four main agencies globally active in rating reinsurers, only S&P has made the impact of ERM explicit in individual rating reports, although AM Best is about to start doing so with the launch of its updated rating methodology. But both Fitch and Moody’s also make it clear that they have ERM quality as a fundamental rating factor.
S&P published its initial ERM assessment criteria in 2005 so, like the industry itself, the agency has had more than a decade to develop and refine its approach.
While the 2011 and 2012 cat years provided some evidence of how well reinsurer ERM was working they did not provide the degree of ‘stress’ 2017 will probably deliver.
This matters because ERM is not only fundamental to reinsurer ratings, it has also been a major supporting plank of these through the soft market.
From 2014 the agencies have been trying to rationalise two opposing and pivotal rating factors: inadequate risk-adjusted pricing versus very robust capitalisation. This has led to a range of different, and changing, sector level opinions from the agencies.
Normal credit-analytic logic is that future profitability drives future capital adequacy. Since ratings are prospective, the pricing environment has the potential to trump the current capital position—that is why AM Best maintains a negative rating outlook on the sector. Moody’s, however, has just restored its sector outlook to stable from negative. Fitch and S&P both have stable ratings outlooks for the sector while flagging the concern that returns on capital are trending below the cost of capital.
This is all in a context where—pre-HIM—nobody saw pricing getting any better (for ‘sellers’).
Yet, other than the case-specific consequences of M&A, reinsurer ratings have hardly seen downgrades.
A reason underpinning this is perceived ERM quality. For individual reinsurers this has helped provide a floor to the rating agencies’ pricing concerns. These persist of course, but if a reinsurer’s risk appetite and tolerances are well-defined, risk controls and governance look robust and risk modelling is high quality and well tested then that downside concern is mitigated.
Which leads us back to how 2017’s cat events may impact things, even if it is not a full blown ‘capital event’ for a rated reinsurer. If the ERM system is seen to have performed well under this degree of stress then that should reinforce an agency’s faith in it.
Conversely, if key expectations around maximum exposures by return period are not met, this supporting plank of a reinsurer’s rating may come under pressure. Not only might the ERM assessment in isolation be impacted, but positive assessments across the ratings process could be challenged (such as confidence in prospective operating performance and the effectiveness of board oversight).
The challenges of ‘loss assessment’ could add to the complexity of agency communications for reinsurers. A conservative approach to year-end 2017 event reserving will make the headline accident year number and event loss scale versus stated risk tolerances look worse.
It could also weaken apparent risk-adjusted capital by increasing the ‘required capital’ for reserves.
Any rated reinsurer believing it is following an appropriately cautious path with its catastrophe reserving numbers should make very sure it explains that to the rating agencies, for example, by explicitly showing the outcomes ‘with and without’ that additional prudence.
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