S&P: Insurers centre stage in criteria updates

S&P on 1 July released updated criteria for the insurance sector and hybrids, with insurers’ issuance most impacted by the latter. Dennis Sugrue, senior director and insurance sector lead, S&P Global Ratings, explained the thinking behind the changes and its consequences for insurance companies and their hybrids to Bank+Insurance Hybrid Capital.

S&P recently published a set of new criteria notably covering insurance and hybrids. Can you outline the scope of the new criteria?

On 1 July we published four new criteria pieces — Hybrid Capital: Methodology And Assumptions, Insurers Rating Methodology (IRM), Bond Insurance Capital Adequacy, and Group Rating Methodology (GRM). The two pieces with the biggest rating impact for the insurance asset class were the IRM and hybrid criteria.

The rationale for updating the criteria was to consolidate criteria articles where possible, to enhance transparency, and to incrementally increase the scope for analytical judgment. We also wanted to align these criteria articles with the new criteria format and definitions we adopted across S&P in late 2017, which included a new concept of guidance documents, as well as to reflect recent learnings from our default and transitions analysis. Criteria are the published analytic frameworks we use for determining ratings, and guidance documents help communicate how we may apply certain aspects of a particular analytic framework.

I’d like to emphasize that for each of these updated articles the fundamentals remain the same, as evidenced by the limited ratings impact.

For the hybrid criteria update we consolidated 11 pieces of criteria into one article. These criteria apply globally to all hybrid capital instruments issued by corporates, financial institutions and insurance. The impact on ratings and equity content are minimal, but insurance was the most impacted sector, with just under 5% of instruments expected to see a change in equity content and eight ratings changed (less than 2% of rated insurance hybrids). In the corporate sector, we expect fewer than 1% of hybrid ratings to change and fewer than 1% of hybrids to experience a change in their equity content assessment. We expect no changes to ratings or equity content assessments of hybrids issued by financial institutions.

Similarly, the revised insurance criteria consolidated nine pieces of criteria into one article. We expect an impact on about 3% of insurance ratings from the update to the insurance criteria.

What are the key takeaways from the RFC process?

We found the RFC process to be very insightful and were pleased with the engagement from the market, particularly the insurance space. We received most comments from the market on the hybrid and IRM RFCs. The volume and depth of comments were impressive and much appreciated. The comments covered a broad range of topics, such as calculation of insurers’ leverage or the residual maturity limits for regulated insurers’ hybrids. The “Marmite” subject was the balance between granularity and analytical judgement, as respondents either welcomed the greater focus on the key drivers of the ratings or preferred us to retain scoring of subfactors.

What are the key changes introduced in the insurance ratings criteria?

As mentioned above, the fundamentals on how we assess insurers’ creditworthiness remain the same. There were a few changes in the structure to allow for greater differentiation across the rating scale and the removal of explicit caps and the scoring of subfactors to allow for incrementally more analytical judgment, where appropriate. We also took the opportunity to enhance consistency of our ratings through a single global approach to our liquidity analysis and including all insurance sectors in scope of the criteria.

We’ve integrated ERM and considerations around management and strategy directly into the relevant rating factors in the business and financial risk profiles. For example, we consider the effectiveness of an insurer’s risk controls in our assessment of their risk exposure (formerly known as risk position) and the success of their ability to execute strategy in our view of competitive position. We’ve also increased the focus on risks posed by governance deficiencies through a separate governance modifier.

Another change worth mentioning is the change in how we calculate financial leverage in our assessment of funding structure (formerly financial flexibility). We will no longer use the economic capital available (ECA) metric from our capital model in the denominator of the ratio, but rather will look to publicly reported shareholders’ equity instead. We believe this will improve transparency and comparability for users.

How is the role of the S&P insurance capital model evolving in the current context, in particular following the introduction of Solvency 2 and the discontinuation of the publication of the MCEV by some insurers?

We regard the implementation of Solvency 2 capital standards as a positive step forward for the European insurance sector, and the standards are in our view substantially more appropriate than Solvency 1. However, we will continue to use our risk-based insurance capital model as our main tool to assess insurers’ capital adequacy for rating purposes. This partly reflects our need to have a global tool to assess capital adequacy, for consistency and comparability with other regions. It is, however, important to highlight that the new insurance criteria provide for a greater ability to apply analytical judgement to the output from our risk-based capital model if we believe capital adequacy is over- or understated. In fact, we published a comment last year indicating that despite the discontinuation of embedded value reporting by many issuers, we retain the ability to give credit for the present value of future profits using Solvency 2 information.

What are the notching guidelines for Solvency 2-compliant subordinated debt?

For all ratable hybrids, we notch down, i.e. rate lower, from the starting point of the issuer, typically the ICR for insurers. Notching for hybrids generally combines one or two notches for subordination and one or more notches to reflect the risk of non-payment of coupons or principal, i.e. payment risk.

For all hybrids, including Solvency 2-compliant instruments, our analysis would consider all features that generate payment risk, e.g. coupon deferral, or principal loss absorption. Rating committees would opine on whether the payment risk created by these features is adequately captured in the issuer’s ICR, or whether hybrid noteholders faced materially higher payment risk that should be reflected in a rating that is one or more notches lower. The same approach applies across all jurisdictions, and also applies to other payment risk factors such as mandatory coupon deferrals upon earnings triggers.

Do you differentiate between Tier 2 and Tier 3?

If we assess the payment risk to be materially different for an issuer’s Tier 2 instruments compared to its Tier 3 instruments, we will assign different ratings. Conversely, for issuers where the payment risk is not materially different, the ratings would likely be the same, for example, for highly rated insurers with robust solvency levels.

However, as solvency levels deteriorate, the ratings could diverge if the payment risk increases for one class of instrument relative to the others. For instance, the minimum requirements for an eligible Solvency 2 Tier 3 instrument are for mandatory coupon deferral upon a breach of the minimum capital requirement (MCR). The MCR, in our view, is akin to a point of non-viabilty (PONV) for a European insurer, and we would therefore expect that the ICR would deteriorate closer to D as the insurer’s solvency ratio approached the MCR. In circumstances like this it is less likely that we would widen notching on an issuer’s Tier 3 hybrids as a decline in the ICR together with the standard notching is likely to adequately capture the payment risk.

On the other hand, Solvency 2 Tier 2 instruments have a mandatory deferral trigger upon a breach of the solvency capital requirement (SCR) and issuers have often chosen to include optional deferral triggers where they could choose to defer coupons before their SCR is breached. We expect that an issuer would typically be a going-concern, albeit likely under some stress, as their solvency level approaches their SCR and the ICR could still be sufficiently high that the standard notching may not fully capture the payment risk. Therefore, as the solvency ratio deteriorates, we could widen the notching between the hybrid and the ICR if we determine there is a material increase in payment risk.

How could the Solvency 2 capital position affect the hybrid ratings?

When rating a hybrid we need to consider whether the payment risk to the hybrid noteholders is adequately reflected in our starting point, typically the ICR, and the standard notching — or whether there are factors that put the noteholders at increased risk of non-payment of coupons or principal that should be reflected by wider notching, or lower ratings.

We observe very little correlation between Solvency 2 capital ratios and our own capital adequacy assessment; however, we do expect a directional relationship between the two, i.e. as a company’s Solvency 2 position deteriorates we would generally expect a deterioration in the S&P capital position.

A deterioration of regulatory capital, or even S&P capital adequacy, does not necessarily result in a downgrade of the issuer’s financial strength rating or issuer credit rating. However, a deterioration of the Solvency 2 ratio will heighten the risk that the SCR is breached, and that the issuer will be required to skip coupon payments. In instances where we believe that this incremental payment risk is material to the investor, we could widen the notching on an issuer’s hybrids.

In the guidance we published to accompany the new criteria, we indicated two solvency ratios that we believe are good sense checks when considering the rating of a hybrid. It’s very important to note that we do not see these solvency levels as absolute triggers that will lead to rating actions, but rather as reference points that we can use in our discussions with issuers to understand their capital management plans, solvency sensitivities, risk appetite, etc.

How is S&P going to assess the volatility of the Solvency 2 ratio?

The volatility of the Solvency 2 ratio will be one of the important factors we assess when rating European insurers’ hybrids, in addition to the features mentioned before (e.g. insurer’s current proximity to the deferral triggers, capital management plans, solvency sensitivities, risk appetite, etc.).

We would consider various sources of public and non-public information in order to assess the volatility of the issuer’s solvency ratio. These include annual reports, regulatory filings and investor day presentations, as well as materials provided to us as part of the rating reviews with regards to current, expected and stressed solvency positions relative to both the coupon deferral triggers (e.g. SCR or MCR) and to the two solvency ratio sense checks mentioned above. We would consider these along with our understanding of the insurer’s business profile, risk appetite and ability to take remedial capital improvement actions in order to ensure that the risk of non-payment is reflected in the instrument rating, either through the ICR, the notching, or both.

It’s important to note that our intention is not to introduce volatility to hybrid ratings. As mentioned above, those solvency ratio sense checks are not explicit triggers for rating actions; and where appropriate we expect to take a forward-looking view on solvency and the capital position based on management’s targets and action plans, our forecasts and consideration of anticipated regulatory actions, and wider market conditions. We expect that these factors will allow for rating stability consistent with what we’ve observed to date.

Why has S&P decided to reduce the minimum residual maturity to 10 years for the intermediate equity content classification?

We received significant market feedback stating that our proposed approach to residual maturity for insurance hybrids, which was the same as that for hybrids issued by corporates that are not subject to prudential regulation, did not take sufficient account of the prudential regulatory oversight that influences insurers’ decisions regarding redeeming and replacing hybrids. Insurers have to take account of their regulatory solvency measures (both current and projected) and other regulatory views when deciding how to manage their hybrid capital base. Given that the regulatory framework also acts as a constraint on insurers’ plans to manage their capital, and reinforces the potential for a hybrid to absorb losses or conserve cash, we determined that the residual maturity standards for insurers do not need to be the same as for non-prudentially regulated corporate issuers. Examples of the potential regulatory actions include how regulators can: prevent a hybrid redemption; direct a company to stop paying coupons; for certain instruments, enforce a principal write-down, conversion into common equity, or extension of the principal maturity date; and oversee capital-raising plans.

In setting a minimum standard of 10 years for all insurance hybrids, we considered how this compares with our approach for bank and corporate entities, as well as the residual maturity standards required by insurance regulatory authorities. We note that the regulatory standards can still differ considerably by jurisdiction. We therefore decided not to apply intermediate or high equity content automatically to all insurance hybrids that are included in regulatory capital measures. Instead, we decided to apply a global standard for residual maturity that determines whether the hybrid is eligible for high or intermediate equity content or whether it should be classified as having no equity content. This also reflects how we typically have a longer time horizon when assessing insurance capital than do insurance regulators when assessing regulatory solvency.

What is the impact on outstanding ratings of the new criteria? What is the expected timing to conclude the review on affected ratings?

On 18 July we took rating actions on the nine insurance hybrids that had been placed under criteria observation and removed those ratings from under observation.

We upgraded five Restricted Tier 1 (RT1) instruments and placed another on CreditWatch Positive. When we reviewed the payment risk of these RT1s, compared with that of other hybrids in the issuers’ capital structures, we determined that, in each case, payment risk for the RT1s was not materially greater than for other instruments that would also be required to defer coupons upon a breach of the issuers’ Solvency Capital Requirements (SCR).

We downgraded two instruments issued by Lloyd’s. We previously reflected the payment risk for these hybrids with only one notch. We now consider that the payment risk on these notes is greater than for similar hybrids rated in the A range. Although Lloyd’s market-wide SCR has improved in recent years, reaching 149% at year-end 2018, it is materially closer to the point of mandatory deferral (below 100% SCR) than closely-rated peers. Widening the notching between the ICR on Lloyd’s and the rating on Lloyd’s hybrid also allows for a smoother transitioning of the rating on the instrument if the market’s solvency cover were to near mandatory deferral.

We affirmed the rating on the Tier 2 hybrids issued by operating company If P&C Insurance Ltd as we continue to believe that one notch is sufficient to reflect the payment risk for these notes. The mandatory coupon deferral trigger in these notes refers to the SCR coverage of If Group (203% at the end of the first quarter of 2019) and If P&C Insurance Ltd (publ) (171% as per year-end 2018), rather than that of Sampo Group.

We do not anticipate taking any further rating actions on insurance hybrid instruments as a result of applying the revised methodology. However, our ongoing surveillance incorporates our view of payment risk to hybrid noteholders, which may change. We expect that as the risk of non-payment increases — for example, as a mandatory deferral trigger point approaches or we determine that there is an increasing likelihood that an optional deferral could be exercised — hybrid instrument ratings will generally follow a measured transition down the rating scale. This could come through the lowering of the ICR, resulting in: a lower hybrid rating based on standard notching; the widening of the notching between the hybrid rating and the ICR; or a combination of both.

Main photo: #ChangePays installation to commemorate International Women’s Day by Michael Murphy, sponsored by S&P Global at the Oculus World Trade Center; Credit: Kasnia/Shutterstock