Sep 6, 2013 - Although A.M. Best does not have a formal ratings cap in ... importance of a company's decision making. ..
Europe, Middle East and Africa
Evolving Criteria September 2013
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Evolving Criteria
Europe, Middle East and Africa Perspectives Insurers throughout the EMEA region continue to face numerous and formidable challenges from external influences, placing additional scrutiny on internal decision making. In mid-August, the British Broadcasting Corporation reported that the Eurozone emerged from recession after 18 months, with Germany and France leading the way. However, with an overall growth of 0.3 percent in the second quarter and the economies of southern Europe shrinking, though at a slower pace, the recovery is fragile. Greece’s 10-year government bond yield remains above the theoretical unsustainable 7 percent mark at 10.3 percent, down from 25 percent a year ago, and the German Bundesbank believes that the country will need another bailout next year. As the Eurozone crisis continues in 2013, Fitch, Moody’s and S&P downgraded a number of sovereign ratings with many remaining on negative outlook. France, Italy, South Africa, Egypt, and Slovenia were all downgraded. As a result, insurers’ financial strength ratings remain strained, though as evidenced by 2013 S&P ratings momentum, a shift may be taking place.
Exhibit 1: S&P Non-Life and Composite EMEA Rating Changes 30
Upgrades
Downgrades
25 20 15 10 5 0
2009
Source: S&P
2010
2011
2012
2013 YTD
Although A.M. Best does not have a formal ratings cap in their methodology similar to S&P, Fitch or Moody’s, the rating agency performs a Country Risk Assessment as a step in their analysis. This assessment incorporates economic, political and financial system risk reviews, and countries are ranked in a tier between one and five, with five being the highest risk. As the country risk tier rises, the distribution of ratings clearly migrates down the rating scale. Apart from reacting to sovereign credit ratings, the rating agencies continue to refine their methodologies applicable to insurers. S&P’s new methodology, released in May, has made the rating process more transparent and the application more consistent globally. S&P also released an updated methodology to evaluate management strategic vision and execution, risk and financial management, and overall effectiveness of the management team to further highlight the importance of a company’s decision making. The continued low interest rate environment is now the number one risk per European Insurance and Occupational Pensions Authority’s (EIOPA) latest Financial Stability Report. For life insurers, guaranteed business is a concern and increases their vulnerability to insolvency if interest rates remain low; as was the case for many Japanese life insurers in the late 1990’s. For non-life insurers, this means profits must result from underwriting, perhaps at the cost of market share and through a change in the traditional business model.
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Despite its slow pace, Solvency II progresses towards implementation, which is now expected in 2016. The rating agencies have been particularly vocal in the past few months, with A.M. Best deeming the proposed long-term guarantee rules a critical step forward for implementation and that a “move toward a more coherent risk-based regulatory system under Pillar I is generally welcome.” In May, S&P stated that “though delayed, Solvency II is still needed. In our view, Solvency I is virtually devoid of incentives for good risk management and lacks capital requirements for asset risk.” S&P also believes that Solvency II may catalyze modernization of other geographies in terms of risk based regulation.
However, S&P also believes that the regulatory topics such as continued availability and affordability of insurance products containing long term guarantees and the future of investing behavior of insurers affecting the financing of infrastructure projects are deeply intertwined with the prospects for the European economy. Therefore, it is likely that significant changes in Solvency II will take place and “pragmatism is likely to prevail over principles.”
Exhibit 2: Eurozone Sovereign Ratings Landscape Fitch Country
Rating
Moody’s Outlook
Rating
S&P Outlook
Rating
Outlook
Austria
AAA
Stable
Aaa
Negative
AA+
Stable
Belgium
AA
Stable
Aa3
Negative
AA
Negative
Cyprus
B-
Negative
Caa3
Negative
CCC+
Stable
Estonia
A+
Stable
A1
Stable
AA-
Stable
Finland
AAA
Stable
Aaa
Stable
AAA
Stable
France
AA+
Stable
Aa1
Negative
AA+
Negative
Germany
AAA
Stable
Aaa
Negative
AAA
Stable
Greece
B-
Stable
C
N/A
B-
Stable
Ireland
BBB+
Stable
Ba1
Negative
BBB+
Positive
Italy
BBB+
Negative
Baa2
Negative
BBB
Negative
Luxembourg
AAA
Stable
Aaa
Negative
AAA
Stable
Malta
A+
Stable
A3
Negative
BBB+
Stable
Netherlands
AAA
Negative
Aaa
Negative
AAA
Negative
Portugal
BB+
Negative
Ba3
Negative
BB
Negative
Slovakia
A+
Stable
A2
Negative
A
Stable
Slovenia
BBB+
Negative
Ba1
Negative
A-
Stable
Spain
BBB
Negative
Baa3
Negative
BBB-
Negative
Note: As of August 20, 2013 Sources: Fitch, Moody’s and S&P
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Rating Agency and Regulatory Criteria Changes The four global rating agencies continued the trend of expanding, clarifying and fine-tuning their published rating methodology over the past 12 months. Numerous proposed and actual criteria updates, rating surveys and special reports were issued with none causing more stir than the release of S&P’s new methodology on rating insurers in early May. While the updates and refinements are being driven by various factors, the common theme is to ensure consistency and clarity in the application of rating agency methodology globally. This has required rated companies to disclose more non-public and granular data than ever before. This was best highlighted in the survey S&P sent out to insurers and reinsurers in late 2012 to enable them to assess the impact of their proposed new methodology for rating insurers. This paper provides more detail on the following notable items: ¡ S&P: Insurers Rating Methodology ¡ ERM in S&P’s New Rating Methodology ¡ S&P Revised Criteria: Management and Governance ¡ Various A.M. Best Updates ¡ IFRS 4: Insurance Contracts Exposure Draft
S&P: Insurers Rating Methodology On May 7, 2013, S&P released their new methodology on rating insurers. The reasons S&P cited for implementing the new criteria include a more transparent methodology, increased specificity of rating factors and sub-factors, a more forward looking approach that increases comparability, and consistency and centralizing insurance criteria framework in one single criteria document. S&P stated that only a few ratings would change, and the subsequent rating reviews under the new methodology confirmed this. Within the EMEA region, there have been seven upgrades and three downgrades (Generali and La CARTE, due to sovereign downgrade, and Salama, because of concerns at BEST Re) against more than 130 EMEA rating affirmations. For five of the seven upgrades, a more consistent evaluation and scoring of the Financial Risk Profile (FRP) and the Business Risk Profile (BRP), resulting in a higher anchor rating, was the main reason. More interestingly, three of the seven were adversely impacted by a weak ERM/Management and Governance score or holistic analysis. Globally 81 percent of companies were affirmed under the new criteria, and only 6 percent were either downgraded or had a negative outlook change.
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Exhibit 3: Rating Updates from New Criteria 8%
Rating Upgrade
3% 5% 3%
Rating Downgrade Affirmed—Outlook Improved Affirmed—Outlook Lowered Affirmed—No Change
81%
Source: S&P
Evolving Criteria
Exhibit 4 shows S&P’s Insurance Rating Framework. The BRP score is determined through an analysis of country and insurance industry related factors and the company’s competitive position within that country. Companies that operate in a country that is rated by S&P as Moderate Risk for insurance business have their Anchor rating capped at “a+.” For companies that operate in multiple countries, the rating is based on the premium weighted average of each country’s score. The FRP score is based on an analysis of Capital and Earnings, Risk Position and Financial Flexibility. Capital and Earnings includes a forward looking perspective of an insurer’s capital adequacy for the current year and two subsequent years. Risk Position is intended to capture material risks that the capital model does not incorporate and specific risks that could make an insurer’s capital significantly more volatile. Financial Flexibility incoporates qualitative and quantitative measures to estimate the balance between an insurer’s sources and uses of external capital. The Anchor rating can be modified through an evaluation of an insurer’s enterprise risk management (ERM) and management and governance and through a holistic analysis. It can also potentially be capped due to a low liquidity ratio or sovereign rating. S&P expects most insurers will not be rated higher than the sovereign, given their assets are predominantly domestic government debt and domestic bank deposits and thus sensitive to sovereign risk, changes to regulatory environment and potential direct government intervention. S&P issued a Request for Comment for its criteria on ratings above the sovereign in April 2013 and expects to finalize the criteria by the end of the third quarter. The criteria would allow some insurers to be rated up to four notches above the sovereign foreign currency rating and applies to companies globally; not just to those belonging to the European Monetary Union as is the case currently.
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Exhibit 4: S&P Insurance Ratings Framework Business Risk Profile
Financial Risk Profile
Insurance Industry Country Risk Assessment (IICRA)
Capital and Earnings Risk Position Financial Flexibility
Anchor Rating
Modifiers ERM
Management and Governance
Holistic Analysis Indicative Stand-alone Credit Profile
Rating Caps Liquidity Risk
Sovereign Risk
Stand-alone or Group Credit Profile
Group or Government Support Operating Company Issuer Credit Rating or Insurer Financial Strength Rating
5
Evolving Criteria
ERM in S&P’s New Rating Methodology
Various A.M. Best Updates
A company can be assigned one of five ERM assessments — very strong (formerly excellent), strong, adequate with strong risk controls, adequate and weak. In addition, the importance of ERM is evaluated as “high” or “low”, which determines the level of influence ERM has on the rating. As a modifier, especially for companies where the level of importance is high, S&P’s view of ERM can have a significant impact on the rating. The ERM assessment is coupled with an evaluation of management and corporate governance and combined they can influence the rating anchor. For example, an ERM and management and corporate strategy score of “very strong” can lift the Anchor rating by one notch if the Anchor rating is “a” or below, while a score of “weak” caps the rating at “bbb”, even if the Anchor rating is “aa+.” The importance of ERM increases, for most companies, under S&P’s methodology. Exhibit 5 shows the number of EMEA companies at each ERM rating. All companies rated Very Strong, Strong or Adequate with Strong Risk Controls (Adequate + SRC) are European domiciled.
A.M. Best released updates to 18 existing insurance criteria papers during the past 12 months, as part of their continual process of reviewing and refining their methodology. No ratings have changed as a result of these new or updated criteria. In the Universal BCAR model (used for GAAP or IFRS financials), risk adjusted asset risk factors have been included for individual countries. Country-specific risk charges are applied based on the origin of the asset to account for the liquidity and volatility within the capital markets of the country. Previously, this would have been manually applied by analysts so the change brings more consistency in BCAR modeling worldwide.
Exhibit 5: S&P ERM Ratings Distribution of Insurers in EMEA Region 150 117 100
50
0
A.M. Best is currently developing a stochastic version of the BCAR model but the expected implementation for EMEA companies is a couple years away.
31 7 Very Strong
34 Strong
6 Adequate + SRC
Adequate
Weak
Source: S&P
S&P Revised Criteria: Management and Governance S&P introduced revised criteria for evaluating management and corporate governance on November 13, 2012. The analysis of management and corporate governance is one of the most qualitative aspects of their rating methodology and the revised criteria brings further transparency to their process. Management is evaluated on nine sub-factors and corporate governance is rated on seven. Within their rating reports, S&P will publish only the overall score for management and corporate governance. Individual sub-factors will be discussed in the report if the company has a strong or weak overall score to give context on how S&P arrived at its assessment.
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Non-life insurers in Europe had a relatively good 2012 and were able to strengthen their balance sheets while maintaining solid reserves, despite the low interest rate environment and single digit returns. A.M. Best has concerns related to the peripheral Eurozone economies and life companies as the portfolio yields are moving closer to the highest of the rates on guaranteed products. In the Middle East, social unrest has continued but companies have adapted to the conditions and the market remains highly competitive and profitable. Africa is in the early stages of developing its insurance industry, and while products being offered are considered basic, companies are profitable. Overall, the EMEA rating environment is stable demonstrated by only two downgrades (Islamic Arab Ins. Co. (Salama) and Arabia Ins. Coop. Co.) and one upgrade (Assurances Mutuelles de France) in the first eight months of the year.
IFRS 4: Insurance Contracts Exposure Draft On June 20, 2013, the International Accounting Standards Boards (IASB) released a revision to the 2010 Exposure Draft of a standard that would replace the existing IFRS 4 and apply to all insurance and reinsurance contracts. The key change in the latest draft allows a company to recognize any change in future cash flows to be earned over the period in which they are earned instead of the period in which the change is made. Other proposed changes include a) an exception related to contracts having cash flows that are linked to returns on the underlying assets, b) presentation of contract revenue in the income statement (similar to how earned premiums are presented by non-life companies) and c) the presentation of interest expense from insurance contracts in profit or loss, such that it reflects a cost-based measurement and that the balance sheet carrying amount for contracts reflects a current-value-based measurement. Comments on this Draft are being accepted until October 25th and the effective date of the new Standard will be approximately three years after the final is published.
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Conclusion The Eurozone crisis clearly demonstrates the need for a more advanced and complex approach to risk and capital management. The interconnectivity between the insurance industry and macroeconomic factors is more pronounced than ever before and was especially highlighted by the recent naming of nine insurers, five from EMEA region, as global systemically important financial institutions. Risk management practices are now being executed in a more seamless and prudent way, which in turn, is influenced by external stakeholders such as regulators and rating agencies raising their bar of expectation. Signs of a Eurozone recovery may be fragile and the low interest rate environment will likely continue in the short-to-medium term placing stresses on insurers’ financials. Opportunities are available to address capital stresses that increased asset risk brings to insurers balance sheets, with reinsurance and alternative risk transfer solutions prominent in the marketplace. Solvency II, whenever implemented, will significantly increase the prominence of regulatory capital but, ultimately, companies that wish to maintain a strong rating and compete in the global marketplace will need to keep focus on ratings and the underlying capital considerations, beyond those of Solvency II.
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About Aon Benfield Aon Benfield, a division of Aon plc (NYSE: AON), is the world’s leading reinsurance intermediary and full-service capital advisor. We empower our clients to better understand, manage and transfer risk through innovative solutions and personalized access to all forms of global reinsurance capital across treaty, facultative and capital markets. As a trusted advocate, we deliver local reach to the world’s markets, an unparalleled investment in innovative analytics, including catastrophe management, actuarial and rating agency advisory. Through our professionals’ expertise and experience, we advise clients in making optimal capital choices that will empower results and improve operational effectiveness for their business. With more than 80 offices in 50 countries, our worldwide client base has access to the broadest portfolio of integrated capital solutions and services. To learn how Aon Benfield helps empower results, please visit aonbenfield.com. © Aon Benfield Inc. 2013 All rights reserved. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. This analysis is based upon information from sources we consider to be reliable, however Aon Benfield Inc. does not warrant the accuracy of the data or calculations herein. The content of this document is made available on an “as is” basis, without warranty of any kind. Aon Benfield Inc. disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Members of Aon Benfield Analytics will be pleased to consult on any specific situations and to provide further information regarding the matters. 7
Contact Information For additional information on this analysis or our analytical capabilities, please contact your local Aon Benfield Broker or a member of the Aon Benfield Analytics team, including:
Patrick Matthews
Marc Beckers
Ankit Desai
Head of Global Rating Agency Advisory +1 215 751 1591
[email protected]
Head of EMEA Analytics +44 (0)20 7086 0394
[email protected]
Head of EMEA Rating Agency Advisory
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