1 GIRO 2001 Glasgow Credit Rating Workshop Simon Harris October 2001

2 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 !

3 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

4 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

5 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

6 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

7 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

8 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

9 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

10 Lloyd’s market rating Central fund, other central resources support market Lloyd’s ‘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 A good ideaNot a good idea

11 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

12 Moody’s expected loss graph - corporate bonds

13 Credit rating example Example company analysis Basic concepts of –subordination –priority of claim –interest cover and leverage analysis Not a definitive analysis !!

14 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

15 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

16 Subordination and Notching (2) Aa3/AA- IFSR at ABC Ins plc –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

17 Subordination and Notching (3) Diversity of earnings can be a positive for holding co. ‘Two-party pay’ principle

18 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

19 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

20 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)

21 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 ?

22 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 ?

23 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

24 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 ?