The announcement that Standard & Poor’s will use Enterprise Risk Management when they assess insurance and reinsurance companies has changed the rules of the ratings game, says Andrzej Czernuszewicz of EMB.
The implications of the Standard & Poor’s decision are potentially dramatic. We will have to see what happens in practice, and whether other agencies follow suit, but insurance and reinsurance companies are already frantically calculating how it might affect them. There is already some suggestion, misguided in my view, that it will lead to higher capital requirements for all and therefore higher premiums. As with any change, there will be both winners and losers. It will scare the life out of some organisations, whilst others stand to benefit.
The important thing is that we appear to be moving towards a fairer, more transparent way of assessing financial strength. Not only is this obviously good news for buyers, it will help risk carriers too. They will find it much easier to develop coherent corporate strategies by bringing together the requirements of regulators, security ratings and shareholders as never before. This is especially relevant as Europe moves towards Solvency II - more of which later.
To understand the significance of the S&P decision we need to wind the clock back to slightly more than two years ago, when several high-profile companies had received downgrades. Most were furious, at least in private, arguing that the ratings agencies had got it wrong.
Of course, the companies affected had their own self-interested motives for complaining, and some downgrades were undoubtedly justified. Nonetheless, the nature and extent of the agencies’ actions raised serious questions about the way they made their decisions. The tables turned, and the analysts found themselves under the spotlight, their methodologies questioned as never before.
The central charge was (and still is) that they use out-of-date models to assess financial stability. These essentially are based on a series of risk charges applied to various different risk types based on market average data.
The simplicity of this approach is both a great strength and a weakness. It is fast and cheap, but does not pay due attention to the particular characteristics of each company. As a result the capital requirement is set with an inadequate view of the true risk involved.
To many insurers and reinsurers the ratings agency models were the problem; if you ask the wrong questions you get the wrong answers. At around the same time the Financial Services Authority (FSA) was coming to the same view in its revised approach to insurance regulation. In particular, its regime takes into account financial models constructed by individual insurers.
Modern financial modelling, unlike the previous S&P approach, involves a detailed analysis of an insurer or reinsurer’s own data, most notably its exposures and reinsurance programmes. By feeding in thousands of simulated scenarios designed to replicate the financial consequences of a range of feasible events, a company can measure what effect those events would have on its security. In that way it can test its robustness with an accuracy that was previously not possible. It also enables more efficient use of capital, so that an insurer or reinsurer can responsibly reallocate capital that it might otherwise hold back for fear of unduly exposing its security.
Among the advantages of this approach, you can measure the danger of insolvency. This should be of real value to the analysts as ratings can then directly reflect the risk of default. The lower the percentage chance of failure, the higher the rating.
S&P are now moving decisively in this direction, and should be congratulated. Although they do not explicitly demand that re/insurers create their own financial models, they do provide some pretty strong hints. For example: “Economic capital and other complex risk models can be very powerful tools in achieving ERM objectives.”
In the long run, this will contribute towards a more efficient market. It will make for more accurate ratings, it should not be unduly onerous on well-managed risk carriers and it is unlikely to cause a rise in premium rates.
One of the main reasons that the approach taken by S&P and the FSA can work is that the models have to be integrated into the business. It is not possible to build a model to satisfy the rating agency or the regulator and put it on the shelf ready for the next visit. It has to be part of the business.
Perhaps most important of all, the new emphasis on ERM will make it much easier to give an insurance or reinsurance company a consistent strategic direction. Most managements face pressure from three interest groups, all of whom must be satisfied: regulators; ratings agencies and shareholders. Previously, the three different drivers of financial strategy have pulled in opposing directions. They are now converging.
The starting point here is that the interests of shareholders demand financial modelling as this is the only way to measure your economic capital requirements in a detailed and accurate way. This process can help you answer vital questions about the markets you should be in, the way you allocate capital, reinsurance purchase, Alternative Risk Transfer, pricing structure and many other strategic issues.
These calculations tended, however, to be at odds with the requirements of regulators and ratings agencies. Now that Europe, at least, is moving towards Solvency II and risk-based capital, the regulatory divergence is largely resolved. If the ratings agencies are also adopting ERM, then all three stakeholders are at last moving in the same direction.
In short, ERM holds out the prospect of a fairer, more transparent ratings system – one that measures risk and the ability to handle it more accurately than before. The result will be to encourage the efficient use of capital and make it possible to satisfy the new regulatory regime without being penalized by the agencies.
This has the potential to be a genuine breakthrough.
How will the new system work?
S&P will want to examine companies’ internal financial models before assessing their strength. This part of the process will, quite rightly, be just one part of the mix. Nonetheless, to quote S&P: “ERM will be seen as a leading indicator.” Any risk carrier whose modelling falls short can expect to be penalized.
Entities based in the UK will be well-placed since the FSA already require Internal Capital Assessments; some other countries like Australia also have compatible systems of risk-based capital.
Elsewhere, larger insurers and reinsurers already use financial models for their own business purposes. Some may be uncomfortable about the additional scrutiny of their methods. Smaller companies, meanwhile, may not have their own models or those in place may be fairly basic. It is a reasonable assumption that they will be placed at a disadvantage.
Will the new ratings be more reliable?
Yes, they should be, as they will be based upon a more accurate assessment using criteria relevant to each company. They should also be easier to understand, and therefore more transparent.
Will companies have to employ additional capital to maintain their ratings?
There will be winners and losers. Potential winners include any company that has a robust internal financial model and can demonstrate it has accurately measured its risk and determined capital levels accordingly. These companies may achieve a better rating whilst employing the same amount of capital as before, or the same rating with less capital. Other risk carriers may find that their capital no longer appears to be as impressive as it once was. We will probably see a use of various risk mitigation techniques being employed in these cases.
Will insurance and/or reinsurance rates rise?
The change is unlikely to make much difference either way. Only if the losers in the above scenario significantly outweigh the winners might we see upward movement in prices.
This article appeared in Insurance Day in November 2005
