Do all start-up reinsurers just get an “A-” rating by default? In the absence of a proven track record, Ronald Gift Mullins explores how the rating agencies judge the strength of the industry’s newcomers

Without at least a low “A” financial rating from one of the ratings agencies, the future of any start-up reinsurer can be challenging, risky even. Without an “A” start-ups are kept under heightened scrutiny by cedants and brokers, perhaps forced to offer bargain rates, more favourable terms and offer up excessive collateral. Fully aware of their “make-or-break” sway over start-ups, the rating agencies evaluate each entity using a complicated set of criteria to determine the purpose, management strength and wherewithal of the new reinsurer for the comfort and benefit of their customers, as well as the investment community.

In the US, the four agencies are AM Best, Standard & Poor’s, Moody’s and Fitch Ratings. Only these firms have been approved by the Securities and Exchange Commission (SEC) to issue credit and other financial ratings for specific regulatory purposes and are referred to as Nationally Recognized Statistical Rating Organizations (NRSRO). Essentially this designation eliminates any competition for the rating firms. But this cartel is likely to change when a US law becomes effective in June 2007 that allows other rating agencies to apply to the SEC for the NRSRO designation.

In addition to evaluating insurance and reinsurance companies’ financial strength, the agencies also evaluate the credit strength of hundreds of thousands of corporations, financial institutions and funds around the world. Standard & Poor’s and Moody’s control about 80% of all rating activity in the world.

Little historical data

Obviously, one of the prominent factors in rating the worth of any reinsurer is its historical financial data. Since by definition, start-ups have little or no historical data, rating analysts have created processes to evaluate various factors, including business plans, capitalisation and the credibility of management teams, which must demonstrate they have successful and relevant track records. This is in order to develop convincing opinions on the strength of start-up reinsurers. Uppermost in the minds of rating executives is that the users of their ratings, such as ceding companies and brokers, depend on them to make decisive security decisions as to how much liability to cede to a reinsurer. Thus the rating companies must be willing and able to support their rating opinions with valid and transparent research wherever possible.

Formations of reinsurers usually accelerate following a devastating catastrophe or natural disaster, such as Hurricane Andrew (1992), 9/11 (2001) and Hurricanes Katrina, Rita and Wilma (2005). Within the past few decades Bermuda, because of its compliant laws, favourable regulation and low taxation has been the locus for the greatest number of start-up reinsurers. Most rating agencies require start-up reinsurers to have at least $500m of equity capital to be a viable player in the global reinsurance market. This amount is viewed as the minimum threshold needed to convince cedants and brokers to view the start-up reinsurer as a going concern that will be willing and able to provide capacity on an ongoing basis. Typically, unless there are extreme positive factors – such as a gigantic initial capital investment, sterling management, a “can’t lose” business plan – a start-up reinsurer cannot reasonably expect to receive a rating higher than “A-”.

The reinsurance cycle is also important. Mark Rouck, senior director, Fitch Ratings, notes that after the 2005 hurricanes, Fitch had some concerns about whether the market environment would be conducive. It questioned the longevity of a hard market, the challenge of maintaining management talent and the immense investment by hedge funds. At the time, Fitch said it would be difficult for a majority of new insurers and reinsurers formed in Bermuda and the Caymans to achieve financial strength ratings as high as an “A”. “Thus, no start-ups came to us for a rating,” he says. “You can understand why.”

Only now has Fitch begun to assign ratings to the “Class of 2005”. It assigned an “A-” insurer financial strength rating to Flagstone Re’s now more established Bermuda and Swiss operations on 15 May, a move that was warmly welcomed by the company. “One of our key financial goals is to obtain and maintain multiple credit ratings at the ‘A’ level. These ratings from Fitch… represent significant progress towards that goal,” says Flagstone chairman Mark Byrne.

The value of an “A-”

After costly catastrophes, reinsurers are formed to meet specific needs that arise in the marketplace, explains John Andre, vice president at AM Best. “Investors see opportunities in the market and invest. We have a strong presence in Bermuda where a lot of start-ups begin. It’s pretty difficult for a new reinsurer to exist without a rating, the floor is “A-” or higher. Without a fairly high rating, cedants and brokers shy away from doing business with a new reinsurer.”

Damien Magarelli, director at S&P, says the process of rating a start-up reinsurer is about the same as for an existing company, “except there is a higher focus on areas of uncertainty, such as market presence, brand name recognition and management expertise.” Start-up companies are judged in terms of their merits and consistency with existing ratings of reinsurers as well, he explains. “For example, having no legacy reserves benefits a start-up, but on the other hand, the start-up may not have market penetration, scale or diversification that a long-established company has.”

To rate a start-up reinsurer, S&P requests a detailed, credible, five-year business plan that addresses the lines of business to be written and indicates revenue targets, income targets, and capitalisation plans for each year. The company’s management would have to have a track record of successfully managing and underwriting its chosen businesses. In the business plan, S&P wants to see a detailed programme from management as to how much business, and in what lines, it expects the company to produce in the next five years. It also wants the competitive advantages the start-up reinsurer has in each of its chosen lines of business to generate profitable growth. In addition, the agency’s rating analyst would have multiple discussions with the investors of the reinsurer concerning their expectations and long-term objectives.

“The users of their ratings, such as ceding companies and brokers, depend on them to make decisive security decisions

And that’s not enough. S&P also wants to know the make-up of the board of directors, to examine biographies of all senior managers describing their current functions and discussing in detail their prior work experience, as it relates to their ability to execute their new responsibilities successfully. Furthermore, the rating agency expects the company to demonstrate the ability to tap several sources of additional capital if needed. And if the start-up has aggressively tapped several sources already, the analyst would seriously question the company’s ability to maintain capital adequacy consistent with a high rating.

“We ask questions until we are satisfied with the answers,” says S&P’s Ron Joas, director of financial reporting. “We don’t focus on the accounting treatment alone, we focus on what is the actual underlying economic basis of the transactions.”

No hard and fast rules

Moody’s doesn’t have hard and fast rules on rating start-ups. “Our analysis covers a mix of quantitative and qualitative factors,” says Bruce Ballentine, vice president and senior credit officer at Moody’s. “This is true for a start-up or an existing primary insurer or reinsurer. Moody’s has a broad transparency initiative to be more open over time with issuers, investors and other constituents as to how we arrive at ratings. Published rating methodologies are part of that initiative.”

Ballentine explains that the information to rate either an existing company or a start-up is never perfect. “For a start-up, we give greater weight to a business plan, a risk management plan, background of the management team and so on. We usually have to make some considered assumptions from the information that we have available.” He notes that an unrated company can get an indicative rating which involves a full analysis but is not publicised. “Then,” Ballentine continues, “it is up to the company whether or not to have the rating published, or perhaps to modify its business plan.”

Depending on the complexity and structure of the reinsurer to be rated, its capital arrangements and business plan, the rating process may require a lot of financial modelling. “Sidecars, for example, are fairly structured entities where modelling plays a major part in the rating process,” explains Alan Murray, vice president and senior credit officer, Moody’s. “Timing of the process can range from a couple weeks to several weeks depending on the needs of the company, the information flow and other variables.”

Fitch’s Rouck said the time to produce a rating varies. “We typically start with a meeting with management of the start-up, then we begin the analytical process which can take from four to six weeks. The entire process can be done quicker, but generally four to six weeks is average.”

At AM Best, it can take two to three months for a rating to be completed, “sometimes less”, says Andre, “it depends on each company. Two months is about average.”

Sour grapes

If the management of a company doesn’t agree with a rating, it can appeal the rating within AM Best. “Sometimes it is just sour grapes,” says Andre. “Management disagrees with our approach or they produce information now that wasn’t offered previously. Appeals don’t happen often, but enough. Once a reinsurer receives the rating, it can decline it and not have it publicised. However, if a company accepts the rating, we are obligated to keep that rating current and appropriate. We look at every rating at least once during 12 months. And if we see or hear of a problem such as an investment situation, an event – like if the management team has resigned – we hone in on the company and watch developments very carefully and closely.”

Ronald Gift Mullins is an insurance journalist based in New York City.