11 September 2016 Insurance

Who to blame? Why Solvency II won’t replace ratings

The idea that Solvency II will remove market demand to see ratings has been dismissed by Litmus Analysis, the consultancy that helps insurers and reinsurers better understand and manage their relationships with ratings agencies.

Stuart Shipperlee, managing director of Litmus Analysis, said that the information available under Solvency II has to be interpreted to reach a view on a reinsurer’s financial condition. A rating is an explicit third party opinion on exactly that, he says.

“A common misconception is that Solvency II disclosure is simply about the publication of a key solvency metric: the solvency capital requirement (SCR), which allows the market to clearly see the financial strength of a re/insurer,” Shipperlee said.

First, he noted, that disclosure includes a wider Solvency and Financial Condition Report (SFCR) that sets a fundamental context within which the SCR outcome should be viewed.

Second, the only defined point on the SCR scale is 100 percent.

“At 100 percent the re/insurer holds sufficient capital for a one-in-200 risk of failure over a one-year period. To our understanding, any other SCR level is undefined, other than the extent to which it is above or below 100 percent, he said.

He explained that a one-in-200 risk is roughly equivalent to a BB+ S&P rating.

“Practitioners who look for a higher rating than that will presumably look for a greater than 100 percent SCR. But how much greater? An S&P A- has a roughly one-in-1000 expected default rate, for example,” Shipperlee said. He also questioned how market participants might handle the annual changes to a given re/insurer’s numbers.

“For example, if a 120 percent SCR become a standard, what if a re/insurer dropped from 121 percent to 119 percent? A tiny change; would that be OK but 110 percent not? Where’s the cut-off?”

He stresses that the SFCR will be key to interpreting the SCR and the responsibility for that lies with the broker or buyer. On the other hand, a rating is an opinion intended to reflect all relevant aspects of the re/insurer’s profile.

“Some market participants should be capable of effectively using the SFCR to refine what the SCR tells them, but not all will want to and many lack the resources. Would most brokers opine on what the SFCR implies for a re/insurer’s solvency?” he asked.

The other advantage of a third party rating is just that—it represents the opinion of a neutral party.

“Whether reliance on the fact that a failed carrier had a healthy rating works as a ‘defence’ is open to question. But with the SCR/SFCR on an unrated carrier there’s no third party opinion to point to.

“None of which is to suggest ratings are not going to continue to periodically appear to have been ‘wrong’. They are forecasts (an imperfect science) and users should always keep that in mind.

“We often stress the importance of understanding what goes into ratings (criteria and process) and what their natural limitations are,” Shipperlee said.

Ratings meet a need that Solvency II was not designed to address, he added. “We conclude that conventions on acceptable SCR levels are likely to operate in parallel with, rather than instead of, ratings.”

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