Mark Shumway, Vice President
Rating activity was remarkably low in 2008, despite the forcible removal of several billion dollars of capital from the global reinsurance industry. The confluence of one of the costliest insured catastrophe loss years to date and the ongoing financial catastrophe have had a material impact on the earnings and capital position of nearly every major player. A few downgrades, including most of XL Capital’s subsidiaries, were counterbalanced by a small number of upgrades. Both Standard & Poor’s (S&P) and A.M. Best, for example, upgraded Hiscox operating companies, and A.M. Best moved its rating on CCR up to the highest category of A++.
Outlook changes were more abundant than actual rating changes in 2008. A.M. Best raised the outlook for several companies, including Hannover Re, Max Bermuda, and Paris Re. S&P also raised a few outlooks, including ACE, Montpelier and Scor, and lowered those on several others, such as Everest Re and Mapfre Re. S&P also revised several positive outlooks back to stable, citing the economic downturn in most of these actions.
A Deliberate Approach to Rating Changes
The lack of negative rating changes may seem counterintuitive in a market where vast amounts of capital were destroyed. A closer look, however, shows the underlying reasons for the limited rating activity. The most profound driver, of course, was the reinsurance industry’s capital levels at the start of 2008. Record earnings in 2006 and 2007 bolstered balance sheets, and reinsurers had an estimated excess capital position of USD30 billion at the beginning of the year.
Further, at least one industry event that contributed to a substantial dislocation of capital is now theoretically “baked” into ratings. A.M. Best’s addition of standardized stress tests to its risk-based capital adequacy modeling in 2005 and S&P’s refined model introduced in 2007 (which includes the consideration of modeled PML from 2004) contributed to the industry’s excess capital position and significantly reduced the number of downgrades following a shock loss. Losses incurred from Hurricane Ike generally were within risk parameters.
Damage from the credit crisis and the ensuing financial catastrophe has been concentrated at larger, diversified risk carriers that had more excess capital at the beginning of the year. Natural catastrophes, on the other hand, tend to impact smaller property catastrophe specialists disproportionately, leading to more rating actions and the greater dislocation of capacity.
Finally, the rating agencies appear to have proceeded cautiously this year, perhaps to avoid exacerbating the effects of the turmoil in financial markets. They are keenly aware of the house of cards created by debt covenants and reinsurance cancellation provisions based on ratings. Negative rating action at the AA- and A- levels may be circumspect, as this will generally limit the type and quality of business written and, at the latter rating, likely put reinsurers out of business.
Regulators Take Interest
Regulatory attention on rating agencies has increased, as expected. We noted this likelihood last year during the subprime credit crisis. The chain reaction of interconnected financial markets has underscored the potential problems associated with an over-reliance on credit ratings.
The credit rating agencies began to prepare for a regulatory shake-up in 2007 and continued to introduce reform measures in 2008. With the most significant proposals yet to take tangible form, Fitch, Moody’s, and S&P have released statements supporting a limited set of new rules. The agencies have also improved their disclosures of rating methodologies and taken other small steps to limit conflicts of interest.
The European Commission noted in January 2007 that its voluntary code of conduct for credit rating agencies was working, but the deepening crisis led to renewed cries for reform. In November 2008, the EU proposed new, strict guidelines, including the following:
- Credit rating agencies may not provide rating advisory services
- No ratings should be allowed on financial instruments where the agencies do not have information of sufficient quality
- Rating models, methodologies, and key assumptions must be disclosed
- Agencies must publish an annual transparency report
- The agencies must create an internal position to review the quality of ratings
- There must be at least three independent directors on the board of each agency, one of which must be an expert in securitization and structured finance
The EU’s rules are clearly aimed at preventing the loose application of criteria and limiting harm from the conflict of interest involved in rating structured financial products for a fee. They will also impact agencies focused primarily on financial strength ratings of (re)insurance companies. The final point in particular may prove an insurmountable obstacle for privately held rating agencies operating in the EU and may lead to some reshuffling in this space.
In the United States, the Securities and Exchange Commission (SEC) has introduced new rules, but they are quite weak relative to the EU’s tough proposals. For example, the SEC has proposed prohibitions on:
- Rating debt that the rating agency helped structure
- Analyst involvement in fee negotiations
- Gifts to rating analysts valued over USD25
The first of these measures-the ban on rating debt that the agency helped structure-codifies a practice that the agencies recently imposed on themselves. The other prohibitions will have little impact on the major rating agencies, as Nationally Recognized Statistical Rating Organizations (NRSROs)-including the three largest credit rating agencies and A.M. Best-already adhere to similar rules to promote the independence of rating decisions.
The SEC’s proposals for rules governing disclosure and record keeping will be more onerous and may improve transparency, but they do not address directly many concerns over conflicts of interest, the practical application of criteria, and analyst competency. Mandatory disclosures will include:
- A history of complaints against analysts
- Statistics on rating actions and defaults for each rated asset class
- A record of any deviation from the final rating assigned to structured debt and the rating implied by the agency’s quantitative model(s)
The SEC’s rules are expected to become effective in the first half of 2009. Additionally, members of the U.S. Senate’s Banking Committee have promised legislation directed at rating agencies and the use of ratings for 2009.
A Stable Outlook for 2009
For the second consecutive year, all four major rating agencies maintained stable outlooks on the global reinsurance industry in their September 2008 reports. While they bullishly pointed to stronger balance sheets and record profits to support this stance in 2007, however, they were more circumspect in 2008. All four continued to cite strong or “solid” balance sheets and good risk-based capital positions, but calls for discipline in the face of cedent-advantaged conditions were more strident.
Improved quality and applicability may result from rating changes, but there is ultimately no substitute for due diligence and risk analysis. Ratings are best used as an initial filter, not as the decisive factor in choosing appropriate counterparties. Cedents can avoid over-reliance on ratings by including fundamental credit analysis, qualitative assessments, and market-based metrics (such as credit spreads and valuation) in the process of vetting reinsurance security. A diverse panel of reinsurers can add strength and stability and help limit material losses from uncollectible reinsurance. This type of approach ultimately enhances capital management, with the potential benefits extending all the way to the shareholders.