One of the biggest announcements at this year’s ARC Congress in London came from Standard & Poor’s, which announced it would be offering a ratings service to the run-off industry. But what is the actual value of run-off ratings, asks Helen Yates, and will it be welcomed by the industry?
“Ordinarily, in the live market, you’d expect people to want better ratings, but you’d reasonably expect the opposite in the run-off market,” says Ipe Jacob, senior partner in Grant Thornton’s financial markets group. “Ratings can only usefully inform prospective counterparties. So what’s the point in having an “AA” rating for your hotel if you know no one is coming to stay?”
When S&P revealed at the annual congress of the Association of Run-off Companies (ARC) on 27 February this year that it was launching a new rating scale for companies in run-off, the main question on everyone’s lips was why on earth would run-off companies pay to get a rating, which could then prove detrimental to their exit strategies?
Since the ARC Congress, S&P has changed the name of its offering from “run-off recovery ratings” to “policyholder recovery ratings”, because the original description was too limiting. The intention is that the ratings “will indicate the expectation of likelihood of the ultimate recovery of principal from the reinsurer in run-off,” explains Peter Hughes, vice president of the corporate and governance practice at S&P. And that extends to portfolios within a company that may be in run-off, and any run-off subsidiaries within a live company or third party company.
The ratings are not intended to mirror the ratings of live insurers and reinsurers. Rather than the “ABC” rating scale, the recovery ratings range from “1+”, which represents that highest expectation of full recovery and 100% of principal, down to “5”, representing unlikely recovery, or 0%-25%, of principal. “We wouldn’t suggest everyone is going to get a public rating – we’re just offering the market a tool,” explains Hughes.
The ratings are based on an existing rating scale traditionally used in the loan sector, which again are intended to inform lenders as to what chance they have of getting their money back. “Without reinventing the wheel, we realised we could take that product and apply it to run-off,” explains Hughes. “We felt that we did need to make some revisions – so we’ve been looking at creating more granularity by using potentially different strengths of wording in the 100% range, as public users of this are likely to want to have something in the 100% range.”
Happy in the dark
The problem is that most companies in run-off don’t want their policyholders to know how likely they are to get their money back – particularly if there’s a 100% chance. How then could they be enticed to vote in favour of an early settlement? “For ongoing writers a strong rating is very important, whereas for companies in run-off this isn’t a motivation,” explains Lee Brandon, CEO of run-off service provider Pro Insurance Solutions. “A weak financial position can assist a company’s commutation and exit strategies. I can’t see the motivation for run-off companies to pay for these ratings.”
The other potential issue with ratings, according to Jacob, is that most run-off companies walk a fine line between solvency and insolvency, and recovery ratings could therefore draw undue attention to that delicate balancing act and cause panic. “Either run-off companies are solvent or they’re insolvent – it’s very binary,” explains Jacob. “They really want to walk along the edge.” He explains that Equitas managed this “brilliantly well” because it continued to have a very thin capital base and managed to stay in business despite having to deal with masses of asbestos liabilities. “People were whispering about the prospect of it going bust. When you look at what they did with their balance sheet – the asbestos liabilities grew terrifically and yet it maintained its capital base. And it did that through some superb commutation work. If it hadn’t done that it would have gone bust,” explains Jacob.
Given the importance of exit strategies like commutation, both Brandon and Jacob remain dubious as to whether the run-off sector will want to be rated. Ironically, despite Jacob’s reservations, Grant Thornton has in fact been publishing its own run-off ratings for several years. The Grant Thornton run-off ratings guide gives companies a star rating of between one and five, which takes into account the latest financial information available as well as risk management and regulatory criteria.
The main difference between this guide and what S&P is proposing is that it relies almost exclusively on historical data and almost certainly lacks S&P’s analytical expertise. “The reason we do it – and we don’t get paid to do it by any of these people – is that it’s a marketing exercise,” explains Jacob. “I don’t understand how they [S&P] expect to make money out of it.” But even as a marketing exercise Grant Thornton has many of the same issues as S&P. In its most recent ratings release, noting a dramatic improvement in the solvency of the run-off sector, Jacob conceded that the improvement in ratings would probably not be welcomed by everyone. “While the increase in five-star ratings will be welcomed by counterparties, it will point to bad news for those hoping to use a lack of stars as a negotiating point for deals,” he said at the time.
None of these concerns about the lack of popularity of run-off ratings comes as a surprise to Hughes. “We’re not staffing up with volumes of people,” he says candidly. “We’ll publish many run-off recovery ratings. We do, however, expect some confidential usage and have had a fair amount of interest in this area.” Where he currently sees most interest is in discrete deals, where potential run-off investors would want to use a rating as part of their due diligence. Crucially, the enquiries he’s received since the big announcement at the ARC Congress have come from hedge funds.
Hedge funds have become an increasing presence in the insurance world. These highly-liquid opportunistic investors, which are renowned for moving quickly in and out of investment opportunities, have been drawn to the industry. The fact insurance deals generally do not correlate with other investments in their portfolios is a big selling point. In 2006, over $12bn was raised to back a series of non-traditional reinsurance vehicles, including sidecars and industry loss warranties, with a significant chunk of the capital coming from the hedge fund community. Their appetite was such that some even directly backed Bermudian start-up reinsurance companies.
“The problem is that most companies in run-off don’t want their policyholders to know how likely they are to get their money back – particularly if there’s a 100% chance
That these innovative, but discrete, investors are now showing an interest in the run-off sector should come as no surprise. When legendary investor Warren Buffett announced last year that National Indemnity was taking on Equitas in a $7bn reinsurance deal after earlier buying up $1bn of Converium’s North American liabilities, the investment community finally sat up and took notice.
Run-off ratings are an obvious means by which prospective hedge fund investors might gauge the worth of a takeover bid. And they certainly have the means to pay for ratings (assets under management of the hedge fund industry totalled $1.225trn at the end of the second quarter of 2006, according to Chicago-based Hedge Fund Research).
Lee Brandon agrees this is one scenario where proper ratings for the sector might be valuable, but that they should not be used on their own. “There may well be a need for an independent review where a purchaser is conducting a due diligence of an acquisition target and requires a third-party view, such as S&P’s,” he explains. “That said, it should not be relied on as a sole indicator. PRO, for example, is regularly called in to provide a detailed understanding of the underlying liabilities and assets, operational risks and the likely support and exit costs as part of the wider due diligence process. An independent financial assessment complements this process, but others, notably the professional accounting firms, already provide this review.”
Brandon also believes ratings could be of use where an ongoing insurer would want to seek an independent assessment of its reinsurer’s true financial position. This could help it decide whether to continue with cover or consider a commutation solution at a realistic price, and/or establish suitable bad debt provisions. “The latter is the most likely use, in my view,” he says.
Hughes suggests yet another scenario – where a company has a subsidiary or portfolio in run-off and wants to reassure its investors that all is well. Before their groundbreaking deals with National Indemnity, both Converium and Lloyd’s found their discontinued liabilities to be something of a burden on the perceived health of the ongoing parts of their business. Independently-assessed ratings could provide a means by which companies can reassure their shareholders and policyholders.
The growing transparency in the run-off sector might also pave the way for ratings and more third-party assessment. Ratings in particular provide an independent assessment of the health of a run-off company. “Rating agencies and ratings are a very good way of improving transparency without the rated company giving anything away publicly,” explains Hughes. He says there are four key drivers of success for ratings in any market:
• Does it simplify something that’s very complex?
• Does it bring something into the market that will improve liquidity?
• Can the ratings improve transparency? and
• Is the market ready for it?
Three of Hughes four criteria certainly seem to ring true for the run-off sector, but whether the market is ready for it is where the question mark remains.
Helen Yates is editor of Global Reinsurance.