GIRO 2001 Glasgow

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GIRO 2001 Glasgow

• Credit Rating Workshop
• Simon Harris

October 2001
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Presentation Overview

• Credit rating overview
• How it is done
• Debt ratings
• Use of models
• Ratings for Lloyds
• What about the failures ?!
• Example credit analysis
• Numbers but no formuale !

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Insurance Financial Strength Ratings

• Opinion on the insurers 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

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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

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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

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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

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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

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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

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Rating the Lloyds 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

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Lloyds market rating
A good idea
Not a good idea

• Central fund, other central resources support
  market
• Lloyds franchise applies to all synds
• RBC captures differences in capital support and
  liability profiles

• 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

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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

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Moodys expected loss graph - corporate bonds
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Credit rating example

• Example company analysis
• Basic concepts of
• subordination
• priority of claim
• interest cover and leverage analysis
• Not a definitive analysis !!

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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

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Subordination and Notching (1)

• All about cashflows
• ABC Insurance plc
• 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

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Subordination and Notching (2)

• Aa3/AA- IFSR at ABC Ins plc
• implied senior debt of A1/A
• Subordination applies to hldg cos
• A2/A senior debt at ABC Ins Hldgs
• Guarantee aids rating
• A1/A gteed (by ABC Ins plc) debt at ABC plc

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Subordination and Notching (3)

• Diversity of earnings can be a positive for
  holding co.
• Two-party pay principle

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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 ? (medium-term)
• start point is regulatory earnings
• important to include reasonable investment
  income
• ..compared with interest payments

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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

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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)

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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 ?

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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 ?

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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 (Moodys)
• Re/insurance (Allianz, Munich Re, Swiss Re,
  GE/Cologne Re)
• Banks (Lloyds TSB, Rabobank)
• Corporates (GE, Pfizer, Shell)
• Sovereigns

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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 ?