Europe: Berating the ratings

In an unusual step, Fitch issued a white paper saying IFS ratings are not comparable across the four main Credit Rating Agencies.

Specifically it said that the A- IFS ratings assigned to firms by AM Best should only be viewed as equivalent to the BBB ratings of the other three CRAs. It also warned these differences were not widely understood and may have negative repercussions for market participants.

Fitch's statement has caused a degree of surprise in the ratings industry, but also generated much debate about the value of IFS ratings.

The white paper assessed four situations where it says there is significant difference in the criteria application at the A- rating between AM Best and Fitch, including: newly formed insurers and reinsurers; companies with high country risks, in other words, low sovereign ratings; captives; and smaller-sized insurance companies.

"Under AM Best's criteria reinsurance companies in these categories are often rated A- or higher, whereas Fitch's criteria would typically limit ratings to the BBB IFS ratings category," it says.

Lack of comparability
Fitch says ratings are not comparable mainly because AM Best uses different criteria from the other three CRAs. Besides, AM Best ratings are displayed on a 13-category scale, whereas Fitch's are expressed on 19-category scale that is very similar to those used by Moody's Investor Services and Standard & Poor's.

"This lack of comparability could perpetuate less informed reinsurance selection decisions, higher risk of exposure to unexpected insolvencies and unpaid claims, as well as less information about creditworthiness in the marketplace," Fitch warns.

"We do not suggest that AM Best's approach is wrong. Rather, Fitch suggests that AM Best's approach is different, and that this difference, in turn, makes AM Best's ratings less comparable with those provided by Fitch and the other CRAs."

According to Fitch, anecdotal evidence also indicates the historical impairment rate for AM Best's A- IFS rating is significantly higher than the estimated historic default rate for its own A- ratings, and falls between Fitch's default rates at BBB and BBB-.

"IFS ratings are assigned to insurance and reinsurance companies, and speak to the likelihood that policyholder obligations will be paid in full and on a timely basis," Fitch says. "The focus of the IFS rating on policyholder obligations distinguishes it from credit ratings more broadly used by investors across the capital markets that are assigned to debt obligations."

In its response to Fitch's white paper, AM Best says there are differences between the insurance impairments and the defaults, which are traditionally used to compare ratings. Most critically, it says, impairment rates for insurers are much higher than default rates.

"One can't merely acknowledge there is a difference and then ignore the difference while purporting to provide the full story," says Greg Carter, managing director of analytics for Europe Middle-East and Africa at AM Best. "Our position is that it is not possible to compare apples and pears, that impairments and defaults are not one and the same, and that the numbers are certainly not comparable."

He continues: "AM Best has a long and established track record and expertise in the insurance sector to analyse and assess the risks inherent in an insurance company. Rather than applying a cap to a rating without due consideration of an individual organisation's profile, we believe true analysis of a company's risk is a more appropriate approach.

"We see no analytical justification that start-up ratings should be capped at BBB+. There is no statistical evidence to support such a rating cap or any suggestion that start-ups have a default or impairment record that is consistent with a BBB+ or below. It is also a myth that all start-ups receive an AM Best A-. In some cases, our ratings, often unpublished, are more conservative than those given by other rating agencies."

The importance of IFS ratings
AM Best also points out that in a recent study of rating equivalence within the European framework, the European Insurance and Occupational Pensions Authority concluded that A- level ratings from the major rating agencies are equivalent.

IFS ratings are vitally important to policyholders, brokers, insurers and reinsurers as at the most basic level they assess the ability to pay of the carrier. The plurality of analysis and opinion from the four major CRAs is often considered a boon in this regard.

However, Fitch's white paper does raise questions as to how each CRA arrives at a rating through its own methodology and criteria. It also highlights the potential for different CRA views on any given company to emerge. Does this mean that some IFS ratings are more worthwhile than others? Or is it even necessary for an equivalence to exist between the IFS ratings assigned to carriers by the CRAs?

In point of fact, AM Best will be updating its methodology in 2017. Currently it is based on five pillars: balance sheet analysis; operating performance; business profile; enterprise risk management; and country risk.

Carlos Wong-Fupuy, a senior director in AM Best's London office, explains: "The starting point is balance sheet strength and all the other elements are linked by how they feed into that balance sheet strength. For example, if you have a company that is profitable but those profits are very volatile or are not retained, they would not be contributing to that balance sheet strength. We would have a more positive view if those profits were part of a stable, consistent strain that continues to support the business.

"In terms of weighting, this is not very explicit at the moment, but it is something we are trying to make much more transparent. In our new methodology, the balance sheet assessment will give us a baseline and all the other elements are going to add or subtract notches from the ratings scale until we reach a final conclusion on the rating to be published."

He adds: "It is very difficult to translate all the numbers we have into one letter rating, there has to be some room for judgement. The methodology provides strong guidelines on how all the different quantitative factors should be interpreted."

Using building blocks
Whereas AM Best begins by creating this baseline from a company's balance sheet, by contrast S&P uses the business risk profile as the first of its building blocks and then the financial risk profile as the second.

Mark Nicholson, a director in S&P's insurance ratings team, explains: "The business risk profile comes from the insurance industry country risk assessment, for example the life insurance market and the non-life insurance market in each country and our assessment of the industry profit dynamics for that sector. We balance these with the company's position within its market and its strength relative to its peers.

"The starting point for the financial risk profile is S&P's capital model. It is a factor-based model that assesses the capital that is available to the company, be it equity or eligible debt. The model then places charges against the elements of the company's balance sheet, notably its investments, premiums and reserves, in order to stress test the capital.

"We moderate this assessment through the company's risk position and other factors that could affect its capital base: the volatility it faces, its investment exposure and its ability to raise fresh capital."

In addition, S&P takes into account the track record of a company's senior management and its liquidity profile.

Another difference is AM Best doesn't explicitly constrain an insurer or reinsurer's ratings by its domicile's sovereign rating. It also takes a more qualitative, case-specific approach to size, while the S&P criteria can apply explicit rating factor adjustments at different size levels.

Karin Clemens, senior analyst at London-based Litmus Analysis, comments: "The proposed criteria from AM Best will bring significantly greater transparency to how they reach their rating conclusions. It also highlights some key differences in approach between them and S&P.

"Inevitably these will sometimes lead to different rating outcomes on the same insurer or reinsurer. For ratings users and rated (re)insurers, being aware of these differences remains as important as ever.

"Regulators and others invariably stress the importance of competition within the ratings industry. Logically that means a desire for a plurality of rating opinions and therefore the need for market participants to understand how each agency reaches its conclusions."

Insurers and reinsurers will not only have to assess the value of the ratings they obtain from CRAs for themselves but be able to apply the criteria successfully when deciding on which reinsurers they will work with too.

"There are a number of influencing factors," says Craig Martindale, group head of capital management at Hiscox. "Where business is written is a key consideration as different agencies are more prominent in different markets and client expectations reflect this. For example, some clients' credit committees have specific policies about carriers they do business with having certain ratings. So if you write across multiple platforms, as we do at Hiscox, you may well need multiple ratings.

"The type of ratings you have is another important factor. Some agencies are more prevalent in the rating of debt versus financial strength in relation to policyholder obligations."

If you are a sophisticated investor, you should know that you can't just compare the ratings. The problem is that it is not always sophisticated investors looking at the ratings" - Antonello Aquino, Moody's

The fourth major CRA, Moody's Investor Services, uses a scorecard approach to assess the ability of insurers to pay their customers and assign them the relevant IFS.

"That is the first step," says Antonello Aquino, associate managing director for EMEA within the insurance group at Moody's. "And the second step is the analysis overlaying on top of the scorecard. The second step is very important with the work that the analyst does to adjust some of the scores that come from the scorecard. Also we perform some peer analysis and compare the rating among its peer companies in Europe or globally.

"We have a methodology that is very transparent. We start with the scorecard approach because we want to make it clear to insurance companies and investors who look at the ratings how we assign these ratings and they can find them at the bottom of our analysis."

Moody's says the factors are then weighted with a carrier's market position and brand given the highest weighting at 20%, followed closely by its capitalisation at 15%, and the overall score gives a starting point of the analysis.

Aquino continues: "Moody's published the scorecard approach to show investors exactly how we assign our ratings. We make sure there are no ‘black boxes', that everything is clear.

"If you are a sophisticated investor, you should know that you can't just compare the ratings. The problem is that it is not always sophisticated investors looking at the ratings.

"The rating is an opinion. At the end of the day, what we would say is: ‘Don't just look at the rating. What is important is the research that is assigned with the rating.' That explains how we assigned the rating and how the different factors apply to it."

Seeing the big picture
Insurers will continue to assess a number of factors when considering which rating agency to work with. These may include credibility of a rating agency in a particular market, the view of customers and brokers, and external investor expectations.

Gavin Wilkinson, group performance & capital director at RSA, explains its point of view: "The quality of the rating team is also important, as well as the alignment between rating agency methodology and how an insurer thinks about, and runs, its business.

"At RSA, we work with two rating agencies, S&P and Moody's. They provide customers with confidence on the strength of RSA as an insurer and, for investors, signal the quality of RSA as an investment."

He concludes: "Many insurers have a number of rating agencies as it provides greater coverage and enhances information available to investors, whether that's an insurer's own rating or that of its issued debt."