Asbestos, Financial Disclosure And Credit Ratings

How do rating agencies assess an insurers exposure to asbestos? And how does that assessment impact an insurers credit ratings?

Those are two key questions Fitch Ratings has been asked more frequently as insurers disclosures regarding their asbestos exposures and reserves have received more attention in recent periods.

As a point of background, in July of 2002, Fitch came to several conclusions when we published our first comprehensive asbestos study for U.S. insurers. First, we estimated that the industry was under-reserved for asbestos by up to $35 billion as of year-end 2001, implying that significant reserving actions would be needed by a number of insurers in future periods. Given asbestos-related reserving action taken since last July by firms such as Travelers, ACE, Chubb, Munich Re and Employers Re, I dont think anyone would argue with our thought that the industry was, and still is, under-reserved.

Second, Fitch concluded that it is generally inappropriate to analyze asbestos reserves on a basis that discounts for the time value of money.

Though clearly asbestos claims will be paid well into the future, which implies discounting may make sense, present value theory also says that a risk-adjusted discount rate should be used.

When discounting a liability, the risk is that the liability could be larger than estimated. Thus, any risk premium should be subtracted from the nominal interest rate, such as a Treasury rate, to arrive at the appropriate discount rate. We believe the risk premium needed to capture the volatility surrounding the uncertainty of asbestos claims could easily result in a risk-adjusted discount rate of zero.

Third, putting our first two thoughts together, we surmised that the appropriate survival ratio target for the industry was 16-times–a level over 30 percent higher than the 12-times standard previously used in the industry. Recall that the survival ratio is simply net asbestos reserves divided by the average three-year net asbestos payments. All else equal, the higher the ratio, the more adequate (or less deficient) are an insurers reserves.

Finally, Fitch said that in 2003, we would start to more strictly apply our 16-times target into ratings. Simply put, to the extent an insurers year-end 2002 survival ratio is below 16-times, we will calculate the amount of additional reserves needed to reach 16-times, and the difference will be our estimated deficiency.

We will reduce capital and surplus by the amount of that deficiency, and calculate pro-forma risk based capital (RBC) and other leverage ratios. To the extent these pro-forma ratios fall outside of our ratings parameters, the insurers ratings could be lowered.

So, is asbestos analysis nothing more than looking at survival ratios?

No. For most insurers, there are many other steps, as well discuss below. But in some cases, when an insurers financial disclosures are poor and management hasnt done its homework through comprehensive ground-up analysis, the 16-times survival ratio target will dominate our thinking.

Recall that the survival ratio was developed for a very simple reason–because the only substantive financial information publicly reported by most insurers on their asbestos exposures has been year-end reserves and annual claim payments. This hasnt left analysts too many options. We could divide those two numbers, and thats about it.

However, we believe the industry is finally reaching a point at which financial disclosures are expanding, and managements analysis supporting their asbestos reserving levels is becoming robust.

This trend is best illustrated by Travelers announcement in January of this year that it was adding $3.2 billion to its gross asbestos reserves. Not only are we comforted that the net 3-year survival ratio ended up slightly above our standard, at just under 17-times, but Travelers thoroughly reviewed how it built its reserves based on an updated ground-up analysis, and publicly disclosed the results of their study.

For example, in a 55-page presentation made available on its Web site, Travelers provided an unprecedented level of disclosure on its asbestos study. Information was segmented by type of claimant, including the number of policyholders, a breakout of reserves and claim payments, and a description of specific reserving methods. Travelers also broke out its unallocated incurred-but-not-reported reserves.

This type of breakdown is critically important to a more detailed analysis. For example, one of the criticisms of the survival ratio is that it penalizes companies who have reached structured settlements on large claims because such settlements increase paids (the denominator of the survival ratio) and lower the survival ratios. Travelers new disclosures allow for settlements to be excluded from the survival ratio analysis.

Therefore, answers to the following questions will help influence our view on how an insurers asbestos exposures could impact its credit rating:

Has a ground-up analysis been completed? Were third-party experts brought in to help validate the conclusions?

To what level of industry-wide reserves does the ground-up study relate? Is the industry estimate at least as conservative as Fitchs $35 billion deficiency estimate at year-end 2001?

Is reserving, payment and other data available on a segmented basis? Will updated segmented data be provided on a regular basis?

What reserving assumptions were used for each segment? How sensitive is the final answer to modest changes in the assumptions?

What portion of the gross asbestos exposure is ceded? What is the level of provisioning for reinsurer bad debts?

What is the level of unallocated IBNR, and how was it determined?

Clearly, to the extent a robust and conservative analysis has been made by management, supported by strong current and ongoing disclosure, the more comfortable a rating agency will be.

Such detailed analysis is especially necessary if the survival ratio is below our 16-times standard.

If there is good reason to believe reserves are adequate at levels below 16-times, we will likely back off from our standard for that insurer. However, we generally will not back off from our standard based on simple anecdotal evidence presented by management that is not supported by hard data and analysis.

We also expect that Fitch will likely be able to develop additional benchmarking ratios as more insurers increase their disclosures and normative data becomes available. As just one example, the ratio of “IBNR to Total Asbestos Reserves” could prove interesting.

Just like the survival ratio, every new ratio will have its strengths and weaknesses, but the more tools we have, the better equipped we will be to make informed ratings decisions.

Ultimately our ability to expand our analysis beyond simple survival ratios rests on management teams throughout the industry expanding public disclosures in a meaningful way based on robust grounds up analyses.

A number of companies have commendably raised the standard for review and disclosure of their asbestos exposures. Going forward, companies that do not provide similar information are likely to face increasing scrutiny and skepticism from rating agencies, investors and other interested parties.

Keith M. Buckley, CFA, is the managing director of Fitch Ratings in Chicago.

Reproduced from National Underwriter Edition, March 24, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.

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Asbestos, Financial Disclosure And Credit Ratings

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