Laura Bazer and Simon Harris explain Moody's rating methodology for life reinsurers
Over the years, the global market for life reinsurance has undergone significant change and rapid growth. Reinsurers have become increasingly international in scope, formidable in size and fewer in number. At the same time, transactions have grown larger, and the products reinsured have become increasingly complex, with a multitude of features, options and potential opportunities, as well as accompanying new risks. These risks must be identified, analysed and evaluated on an on-going basis, a task which falls primarily to the rating agencies.
Moody's rating system for insurers and reinsurers starts with the 'Insurance Financial Strength Rating' or 'IFSR'. This credit rating measures the ability of life insurance and reinsurance companies to repay senior policyholder claims and obligations in a timely manner, and it is the cornerstone of Moody's insurance rating system. Debt and other financial obligations are usually 'notched' down relative to the 'anchor' IFSR.
Moody's applies its rating methodology to all life insurers and reinsurers around the globe in an effort to achieve global rating consistency. Country and market-specific factors, including accounting and financial reporting regimes, are factored into Moody's analysis, as are issues specific to reinsurers.
Moody's analysis uses a 'top-down' approach to ratings, starting with the macroeconomic environment in which a company operates, and then drilling down, layer by layer, into the more specific details. Moody's rating approach is not model-driven; instead, both qualitative and quantitative factors play a key role in the analytic approach.
The assignment of a new insurance financial strength rating starts with an analysis of the qualitative, macroeconomic factors affecting a company.
This includes a review of the country, the market, and the political, regulatory and economic environments. It also includes a review of the accounting and reporting systems in use in that market, as well as the company's market share and relative competitive position.
The next step analyses company-specific issues including the quality of management, franchise strength, and distribution arrangements. Products and relative product risks are also key factors in the assessment. For example, a company that focuses predominately on credit-sensitive institutional investment contracts will have a higher risk profile than one with a large block of stable whole life insurance. The same can be said of a reinsurer of these two different types of insurance products, or of variable products, which offer the contract holder equity-market based guarantees, thereby exposing the insurer and reinsurer to potential low frequency, high severity risk.
In Moody's view, quantitative analysis - although essential to Moody's rating methodology - has some limitations. For example, financial ratios only reflect a single point in time, and therefore provide limited information.
An adequate amount of capital is essential to securing a strong rating, but a large amount of excess capital does not compensate for weaknesses in a company's franchise or competitive position. Inputs can be manipulated.
Models are only as good as their assumptions.
Nevertheless, quantitative factors are increasingly important to evaluate a company's financial health, providing information that supports, reconfirms and/or supplements qualitative factors. Key quantitative factors include capital adequacy, financial leverage and profitability. Asset-liability management (ALM) and liquidity and risk management are also essential.
In North America, some of the key ratios Moody's incorporates into its analysis are: consolidated statutory capitalisation; the NAIC Risk-Based Capital ratio (or the Minimum Continuing Capital and Surplus Ratio in Canada); growth of statutory surplus; financial leverage; pre-tax interest coverage; and statutory operating return on average capital.
In Europe, Moody's favourite measures are generally similar to those used in its analysis of US companies. One of the main differences, however, is the lack of any truly comparable cross-border accounting and regulatory framework, partly reflecting the variation in local products and taxation systems, as well as varying approaches to regulation across Europe. To account for these divergences, Moody's bases its analysis on the regulatory framework and capitalisation applicable at the local regulatory level.
Moody's may then make adjustments to this figure to allow for cross-border comparisons, depending on the regulatory and accounting specifics of a given country.
An example of such adjustments relates to asset valuation principles.
For instance, in Germany, life company solvency is assessed using the book value of assets, whereas assets are taken at market value in the UK. Consequently, in making international comparisons, Moody's would include some elements of unrealised capital gains on certain assets for German life insurers.
Additional credit factors
Moody's rating methodology for life reinsurers is essentially the same as its methodology for direct writers, since the macroeconomic factors, as well as the underlying insurance products and their risks, are the same for both.
However, because reinsurance contracts themselves have credit implications, Moody's methodology overlays additional areas of analysis. The additional areas of focus include the principal reinsurance treaties used, the types of coverage provided and the purpose of the reinsurance.
For instance, large facultative reinsurers tend to have higher expense profiles than automatic reinsurers, but better underwriting control. Reinsurers with large books of coinsurance are exposed to a variety of insurance risks (i.e. mortality, lapsation, investment risk), while YRT (yearly renewable term) insurers are exposed primarily to mortality risk.
Some arrangements have more complex and/or less transparent accounting implications (i.e. financial reinsurance), or are more capital-intensive than others (i.e. coinsurance). In addition, greater earnings volatility may be expected of large providers of financial or non-traditional reinsurance than from traditional reinsurers.
All of these factors - in the context of Moody's overall analysis - provide important information about a reinsurer's financial structure, its underwriting preferences and risk profile. This information is then used in translating the company's financial position into a Moody's rating.
Methodology over time
Moody's basic approach to rating an insurance company has not changed so much as evolved, in tandem with the evolving insurance and reinsurance markets. For example, in most major insurance markets, the most significant change of the last two decades has been the shift from protection to retirement savings products. Equity-based insurance products have proliferated, with the rise of variable life insurance and annuities in the US and segregated fund contracts in Canada, unit-linked/unitised with-profits products in the UK, and deferred and immediate annuities in Germany and other continental European markets. Moody's analysis now incorporates an evaluation of the risks and opportunities associated with these products, as well.
An additional force for change in the UK has been the ongoing regulatory reform being driven by the Financial Services Authority (FSA). At the primary company level, this may well lead to continued low levels of sales of with-profit products, and a renewed focus on protection sales. With reference to reinsurance, one key area of change has been the change in attitude towards acceptability (for regulatory purposes) of unfunded reinsurance contracts. Consequently, many of the financial reassurance contracts previously popular in the UK are no longer as marketable.
Guaranteed benefit features have accompanied many of the new products in the US, ranging from Guaranteed Minimum Death Benefits, to a variety of Guaranteed Living Benefits. These products expose both insurers and reinsurers to the catastrophic risk of a prolonged market downturn, with the potential need to pay policyholders at the worst possible time, at a loss to the company. Generous annuity options offered with UK pension contracts sold during the high interest rates of the 1980s provide a good example of what can happen to insurers and reinsurers when options are not adequately priced.
More generally, in a low interest rate environment with subdued rates of equity returns relative to the levels previously seen, many UK and continental European insurers are faced with fairly material levels of guaranteed returns on old books of business. Management of these guarantees, and in particular aligning asset strategies, is an increasingly key area of focus.
Because these product risks can have serious earnings, capital and, ultimately, ratings implications for insurers and reinsurers - as we have already witnessed - Moody's has expanded its analysis. New elements reviewed include a company's total variable product exposures, direct or assumed, relative to other businesses; the use of reinsurance, if any; reserving issues; accounting treatment of deferred acquisition costs, in the US, and suchlike.
ALM is an increasing area of focus in Europe, as is the valuation and costing of product guarantees, both retrospectively and prospectively.
Realistic capital assessments - whether they are devised using a new local regulatory framework (as in the UK under CP 195) or more internationally through the introduction in time of new solvency standards (Solvency II in Europe) or accounting approaches (IFRS) - are also playing a more important role in Moody's assessment of companies' capitalisation and risk profile.
In addition, because insurers and reinsurers have begun to use derivatives to hedge their equity market risk, Moody's has begun to analyse and evaluate hedging techniques and their overall effectiveness.
Other important developments in the reinsurance arena have included the growth offshore, in tax-favoured markets such as Bermuda, Barbados and the Cayman Islands in the North American sphere, and Ireland, the Isle of Man, the Channel Islands, Luxembourg and other sites in the British and European spheres. Given the generally less stringent insurance, accounting and regulatory regimes governing reinsurers in these locations, Moody's assesses the reinsurer's free cash and collateral, its bank letter of credit arrangements, its ownership structure and its access to alternative liquidity.
Similar to their onshore brethren, offshore reinsurers must have the ability to track and manage a number of different, and often rapidly evolving risks, including legal and regulatory changes, business and underwriting risks. Moody's analysis therefore includes a careful assessment of a company's reporting systems, its investment and risk management capabilities, and the experience and size of its staff. Often, de novo stand-alone offshore reinsurers will try to save on costs by keeping staffing and systems requirements at a minimum in the short-term, at expense of appropriate risk management in the long run.
The cornerstone of Moody's rating methodology for life insurers and reinsurers, wherever they operate, remains a rigorous fundamental analysis, supported and supplemented by a panoply of increasingly sophisticated quantitative tools. As the global insurance and reinsurance markets evolve - with new products, opportunities and risks - Moody's analytical focus and quantitative tools will evolve along with them. Moody's will continue to work closely with its rated life insurers and reinsurers in their global markets as the internal and regulatory assessment of their risks and capital becomes more complex and model-focused.
- Laura Bazer is VP-Senior Credit Officer at Moody's Investors Service In New York, and Simon Harris is VP-Senior Credit Officer at Moody's Investors Service in London.