Author: Adrian Nusaputra
Executive summary
- S&P has published a revision to its insurance rating criteria and capital model.
- The new criteria affect the capital score of 30% of companies, but only 10% are expected to have their rating changed.
- While the final criteria are largely similar to the latest Request for Comment (RFC), there's more clarity about the treatment of senior debt, especially with regards to Bermudians.
- Companies that the new criteria negatively impacts will be those with a narrow product profile, especially in longer-tailed casualty lines, or in lines with oversized exposure to catastrophe risk.
- Carriers that the new criteria negatively impacts could find capital relief through reinsurance products such as adverse development covers (ADCs) or loss portfolio transfers (LPTs), or by purchasing additional tail cover.
After two years of RFCs and revisions, S&P has published its final version of its insurance rating criteria and its capital model.
Published on November 20, 2023, the ratings agency revisions were largely in line with expectations, given the previous RFC, although we've received more clarity on how the agency will treat senior debt.
S&P’s aim with these criteria is to further differentiate companies with stronger capitalization than others, and to provide greater consistency in the application of the criteria.
It provides this differentiation through two metrics — the Financial Strength Ratings (FSRs) of the operating insurance companies and the Issuer Credit Ratings (ICRs) of both the operating companies and the holding companies.
S&P stated that 30% of companies will have their capital scores impacted by the new criteria, while only 10% of companies will incur a rating change, of which most will be positive.
Companies that are negatively impacted by the new criteria will be those with a narrow product profile, especially in longer-tailed casualty lines, or in lines with oversized exposure to catastrophe risk but, as we explore, there are reinsurance solutions available which can provide capital relief and lessen the impact.
What's changed?
The following are key changes since the previous model introduced in 2010:
- Non-life deferred acquisition costs (DAC) are included in capital calculations.
- The discount rate of Property and Casualty (IP&C) reserves has changed. The previous model used the 10-year government treasury rate to discount P&C reserves, while the new criteria use the yield rate of the government bond maturity that's closest to the reserve duration. This change better reflects the economic value of the reserves and will benefit insurers during an inverted yield curve environment.
- S&P changed the calculation for debt and hybrid capital tolerance, making it more consistent between the regions. The new method won't have a material impact on current capital levels but could affect capital management in the future.
What has changed from the latest RFC is S&P’s allowance in total adjusted capital of senior debt for certain regions. This change allows Bermudians to retain capital at the holding company (with a 20% haircut), while also maintaining the capital credit for senior debt. - S&P is more explicitly capturing the benefits of risk diversification for lines of business in addition to updating correlation assumptions.
- Capital charges are increasing for almost all risks — including investments, reserves and premium exposure. The increased capital charges are especially impactful for longer-tailed reserve lines, which have doubled or tripled.
- The natural catastrophe (Nat Cat) stress at the AA and AAA levels moved to 1-in-333-year and 1-in-500-year return periods respectively, from the base 1-in-250-year return period in the previous model.
S&P’s CreditWatch Negative outlook changes on Bermudians and certain US life insurers
Two other developments are worth noting: firstly, S&P has listed 64 companies for which the new capital model could cause a significant change in their capital score, leading to a change in either the FSR, the ICR, or both. The S&P will complete a rating review for these 64 firms by February 2024, with remaining companies assessed afterwards.
Secondly, the agency has put the ICR on the holding companies of Bermudian-based (re)insurers and certain US life insurers under a CreditWatch Negative (the FSR ratings of these entities aren't anticipated to change).
Unlike most US companies, Bermudian (re)insurers have a two-notch difference between the FSR and ICR, reflecting the Bermudian Monetary Authority (BMA)’s flexibility in transferring capital between the operating companies and holding company.
However, S&P is reassessing its stance, since the BMA would restrict payments to debtors if the operating companies don't maintain adequate regulatory solvency targets. The BMA’s capital management framework hasn't changed, but S&P has elected to revise its view, based on feedback it received from market participants during the RFC process.
For the three US life insurers that received non-standard notching, S&P assumes their exposure to multiple diverse regulatory authorities for their operating companies would allow them to enjoy more flexibility in transferring capital — again, S&P has elected to review this assumption.
These reviews don't immediately impact the operating insurers’ capital base or operations — but the reviews are significant, as they could make future debt and hybrid capital more expensive to issue, given the lower rating. Lower ratings would be especially expensive if companies are forced to issue non-investment grade hybrids.
This could make reinsurance a more attractive source of capital than hybrid capital financing.
Next Steps
For insurers that are negatively impacted by the new criteria, certain reinsurance products may be helpful in providing capital relief:
- For companies with large reserve books, ADCs or LPTs could help to reduce the net liability exposure or factor charges associated with the reserves.
- For companies with large Cat exposure, purchasing additional tail cover could provide necessary capital relief.
- Quota Share structures will reduce both premium and reserve exposure amounts, thereby enhancing model score.
We will continue to monitor the ratings movements due to the new criteria. Cedants and reinsurers are encouraged to engage with their Gallagher Re representatives on ratings, and capital management strategies.
