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GIRO 2001 Glasgow Credit Rating Workshop Simon Harris October 2001 1 Presentation Overview • Credit rating overview • How it is done • Debt ratings • Use of models • Ratings for Lloyd’s • What about the failures ?! • Example credit analysis • Numbers but no formuale ! 2 Insurance Financial Strength Ratings • Opinion on the insurer’s ability to repay punctually senior policyholder claims and obligations (policyholder perspective) • Globally consistent rating scale • Between major rating agencies, coverage in most markets is extensive (NB, PI vs full rating) • Used to varying degrees by brokers and internal security panels 3 Rating of debt instruments • Usually at least one rating required for a new ‘sale’, 2 ratings more common • Used by professional investors to assess risk - often guidelines on debt they can hold • Effectively outsources ‘research’ to agencies, and gives independent view • Also important in secondary market 4 The role of the rating agencies • Independent assessment of financial adequacy.. • ..used by intermediaries, lenders, policyholders • In standardised markets, of greater importance • Debt ratings used to support primary and secondary markets • Assist generally in transparency, cross-border awareness 5 How financial strength is assessed (the ‘black box’) • ‘PI’ vs full ratings • Combination of qualitative and quantitative factors, varies by agency • Usually a committee decision, with extensive discussion of the company, peers, industry • Ratings need to be comparative globally and across industries 6 Financial strength assessment - example detail • Qualitative – Market position, brand, distribution, ownership – Management quality, strategy, attitude to risk • Quantitative – capitalisation, earnings capacity, reserve adequacy – profitability, expense levels, gearing 7 Is a ‘Quant’ model a good idea ? • Difference between rating agencies • Actuaries like models…... • ….but model and ratio analysis is by definition backwards-focussed, whilst liabilities can be far into the future • Management, brand, franchise, distribution etc. remain key influences on security 8 Rating the Lloyd’s market • Is a market rating appropriate ? - different approaches evident • Are all syndicates the same, in terms of operating performance, capital support etc..? • Impact of capital providers’ resources, cash calls, Central Fund, stop-loss • A complex business 9 Lloyd’s market rating A good idea • Central fund, other central resources support market • Lloyd’s ‘franchise’ applies to all synds • RBC captures differences in capital support and liability profiles Not a good idea • Syndicates have different capital support • Some may be ‘nearer’ to CF than others • Differences in mgt, u/w performance • May lead to (long-term) damage to market franchise 10 Generic approach to debt rating • IFSR is starting point.. • ..and expected loss concept drives relationship between IFSR and debt rating • Priority of claims in liquidation is key, which until recently favoured debtholders, EU legislation now protects all policyholders • ..so debt tends to be at least one ‘notch’ below IFSR • ..but subordination, corporate structure may change this 11 Moody’s expected loss graph corporate bonds 30 Zahlungsstörungsquote (%) 25 20 15 10 5 0 B Rating Ba Baa A Aa Aaa 1 3 5 7 9 11 13 15 17 19 Jahre 12 Credit rating example • Example company analysis • Basic concepts of – subordination – priority of claim – interest cover and leverage analysis • Not a definitive analysis !! 13 Structural Subordination • Key to many credit / debt ratings • Policyholder rankings and seniority of claims in a wind-up situation • Can be improved by a guarantee 14 Subordination and Notching (1) • All about cashflows • ABC Insurance plc ABC Insurance Group ABC plc Holding company ABC Insurance Holdings Finance company ABC Insurance plc Operating Company ABC Insurance USA ABC Insurance UK – insurance company where cashflows are generated. Also benefits from ownership of operating subsidiaries. • ABC Insurance Holdings – dependent on ABC Ins plc for cashflows • ABC plc – dependent on operating cashflows lower down and also pays shldr dividends 15 Subordination and Notching (2) • Aa3/AA- IFSR at ABC Ins plc ABC Insurance Group ABC plc Holding company ABC Insurance Holdings Finance company ABC Insurance plc Operating Company ABC Insurance USA ABC Insurance UK – implied senior debt of A1/A+ • Subordination applies to hldg co’s – A2/A senior debt at ABC Ins Hldgs • Guarantee aids rating – A1/A+ g’teed (by ABC Ins plc) debt at ABC plc 16 Subordination and Notching (3) ABC Insurance Group • Diversity of earnings can be a positive for holding co. ABC plc Holding company Aa1 senior debt ? XYZ Insurance USA XYZ Insurance UK Aa3 senior debt A1 senior debt XYZ Ins Asia A2 senior debt • ‘Two-party pay’ principle XYZ Asset Mgt Aa3 senior debt 17 Analysis of Interest Cover • Cashflows are main focus (default occurrs through non-payment, not high leverage) • Focus on realistic earnings level – what are sustainable earnings ? (mediumterm) – start point is regulatory earnings – important to include ‘reasonable’ investment income • ..compared with interest payments 18 Analysis of Leverage • Common focus is debt / (debt + equity) • Debt – issued debt, other borrowings, hybrid equity – focus on ‘core debt’ (i.e. not matched borrowings) – exchangeable bonds may be excluded • Equity – statutory free assets / equity, hybrid equity 19 Impact of debt on IFSR • Debt at holding company can restrict IFSR • As can debt at operating company • Consolidated approach used to include all features, in leverag analysis (not notching) 20 What about the failures ? • Independent, HIH, (Equitable Life) • Rating agencies find it difficult dealing with ‘event risk’, but was that the case here ? • Reinforces need for qualitative assessment ? Would / did a model help ? • Should regulation use rating agencies’ opinions ? 21 Effects of the WTC attacks • Ratings reviews and downgrades by most agencies • ‘Event risk’ that is not normally captured in ratings.. • …but does this signal a change in view of the risk profile of the industry generally ? 22 Comparing across industries • Many re/insurers are rated Aaa, compared with e.g. banks • Are industry barriers falling ? (ART ?) • Is the risk profile changing ? • Aaa ratings (Moody’s) – Re/insurance (Allianz, Munich Re, Swiss Re, GE/Cologne Re) – Banks (Lloyds TSB, Rabobank) – Corporates (GE, Pfizer, Shell) – Sovereigns 23 Final discussion points • Is the industry as a whole a ‘good’ credit risk ? • Are brokers / policyholders becoming more or less credit-sensitive ? • Do actuaries help with ‘risk’ assessment ? • Will financial condition reporting improve analysis by external parties ? • Is management the ‘real’ risk for most ? 24