How do reinsurers survive a "BBB" rating? Nick Thorpe explores the rocky road to recovery.
Every individual, company and industry has its trigger words that when heard, can signal anything from mild fear to knee-trembling dread: for politicians it's "sex scandal"; for industry it's "recession"; and for reinsurance companies it's "rating downgrade". Perhaps the only parallel that can be drawn is to the fickle world of celebrity, where magazines and the tabloid press have final say on careers and where once a star has fallen, there are five more eagerly waiting to take their place. But in no other industry do so many rely so much on the opinions and grading from another company, whose word is almost treated as gospel. And when this does happen how do reinsurers drag themselves out of the downward spiral that occurs when they lose their "A" rating?
Credit rating agencies measure the credit worthiness of an individual, corporation or country. In insurance and reinsurance, the rating is used as a financial indicator by investors, clients and industries alike and can heavily influence or limit the activities of organisations. A rating agency supplies a credit opinion on the companies they follow. They indicate their outlook on the ability of a reinsurance company to meet its future obligations by awarding a rating. Although slightly different for each agency, the ratings scale generally follows a similar pattern (see figure 1).
To arrive at a particular rating, agencies perform a detailed qualitative and quantitative analysis of a company. Chris Waterman, senior director at Fitch, explains: "We look at a range of financial indicators derived from the company. Indicators such as capital adequacy, underwriting profitability, investment returns and reserving adequacy are particularly important. We also meet with senior management to discuss and review the company's strategic direction."
The process, in theory, should not differ from country to country, effectively meaning an "A" rated company from Germany should offer the same financial strength as one from Japan. However, different accounting standards in each country are also taken into account, as is the regulatory environment.
Put simply, a company that is assigned an "AAA" rating is perceived to be in very stable and reliable financial health and should be seen as an attractive option by investors. Those that are assigned a "C" or "D" rating are either on the brink of liquidation or in actual default. Either way, there is no real way back from a low rating such as this.
The rating cliff
To be downgraded means different things for different companies, depending on which ratings you look at. For example, for a drop from "A" to "A-" the ramifications are much less than a drop from "A-" to "BBB", ie from an investment rating to a non-investment rating. This tipping point is an arbitrary trigger generated by the industry and, naturally, is not supported by the ratings agencies. It does, however, play a huge role in dictating the volume, and to some extent the quality, of business that a company will have access to.
Many in the insurance and reinsurance industry view an "A-" as the absolute minimum for contracts to be signed and indeed it has now become de rigeur for brokers to require a client to sign a waiver or acknowledgement if they are placing business with a company that is not in the "A" range. In some cases, this can deter a cedant, particularly if there is a lot of capacity in the market at that time and plenty of other "A" rated companies to do business with.
In Europe, a large proportion of reinsurance business is placed on a direct basis, where the relationship lies between the reinsurance company and the cedant, and there is no, or limited, broker involvement. This, coupled with long-standing relationships established between mature reinsurance companies in Europe and their cedants, has produced what Waterman refers to as "sticky" relationships: "The sticky or historic nature of the relationships between reinsurance companies and their cedants has meant that cedants have remained quite loyal even when their reinsurers have experienced a rating downgrade below the 'A' range. Conversely, broker-distributed business is typically much more rating sensitive."
In jurisdictions like Bermuda, which is much more broker-driven, organisations are more vulnerable following rating downgrades. This was witnessed recently with PXRE and Montpelier Re, which have had numerous problems since suffering massive losses following last year's hurricanes.
Part of the problem is that many brokers have decided they are only comfortable placing clients' business on an unrestricted basis with "A" rated reinsurers. This approach creates a rating cliff as those companies with a "BBB" rating or lower are effectively selected against and will see lower volumes of business than their "A" rated peers. "Fitch is not supportive of the arbitrary line of 'A-' that the industry has drawn," says Waterman. "We believe that 'BBB' rated companies offer good security ... in fact, the difference in the probability of default between 'BBB+' and an 'A-' is quite small."
Back from the brink
One of the best examples of the effect of a rating downgrade on a European reinsurer can be seen by examining SCOR and Converium, which both lost their "A" ratings. Both companies posted substantial losses in the run-up to the downgrades in 2003 and 2004. Yet two years on, Converium is still going strong at the "BBB" level while SCOR regained its hallowed "A" grade in 2005 (see box for details).
Converium was less than four years old when the rating agencies dealt the card that every organisation dreads receiving. After a disasterous second quarter in 2004, with the company reporting a shortfall in reserving of $384.7m in its North America operation, all three ratings agencies slashed their "A" ratings on the company. The resulting "BBB" rating "triggered substantial cancellations and share reductions" according to a statement released by the reinsurer at the time.
As the share price plummeted, swift action was taken. Cost cutting exercises reduced the company's workforce by almost 270 by the end of 2004 and the global strategy was adjusted, applying strict underwriting standards and focusing on profitablity, rather than chasing top-line results in property casualty and life and health reinsurance. Standard & Poor's was impressed enough with its recovery measures to upgrade its credit and financial strength rating to "BBB+". As recently as August 2006, S&P showed continued faith in its recovery by increasing its outlook on the organisation from stable to positive.
SCOR, the fourth largest life reinsurer in the world, which recently acquired German life reinsurer Revios, derives 70% of its income from Europe. Back in 2003, the company also suffered a rating downgrade to "BBB" after unexpected losses in the third quarter of 2002. Business was immediately affected in rating sensitive markets such as Australia and the US but elsewhere the solidity of SCOR's relationships meant many clients stayed with the reinsurer. Christian Mainguy, director for financial communication and ratings at SCOR, outlined the reinsurer's bespoke three-point plan for surviving a ratings downgrade - credibility, diversification and franchise.
In August 2005 SCOR was upgraded back to an "A" rating with a stable outlook. "The upgrade reflects SCOR's strong competitive position, which has proved resilient to past financial difficulties; appropriate corporate strategy; strong prospective capital adequacy; lower reserve risks; the expected maintenance of strongly improved aggregate operating performance; and strong financial flexibility," said S&P credit analyst Marcus Rivaldi at the time of the upgrade. The combination of sound recovery techniques and a clear goal meant business was flowing back towards the company almost instantly. "We got the news of the upgrade from S&P through on the 1 August and the effect on our facultative business was immediate," remembers Mainguy. "We immediately got phone calls from big corporations - motor, engineering etc - and their brokers who said they would send through their proposals for the next renewals at once."
Power of the rating
Rating agencies are a necessary and reliable force in a world that revolves around uncertain markets and volatile industries. But do they wield too much power? It is not just businesses that suffer at the hands of a ratings downgrade - countries are liable too and when a country is downgraded, it doesn't just mean a few hundred redundancies and loss of revenue, it can mean millions of job losses and nationwide recession. When Canada's debt was placed on review in 1995, the Canadian dollar instantly dropped half a cent against the dollar and interest rates on bonds shot up.
One issue is the barriers to entry for new ratings agencies. At the moment, most companies in the world have their fate decided by two or three agencies. For now, the best scenario is for organisations to perform well financially, plan for the future and put in place a definitive plan to cope with the decimating effects of a ratings downgrade.
- Nick Thorpe is senior reporter of Global Reinsurance.
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