Insurers that invest heavily in common equities and write long-tailed lines of insurance might see their capital charges increase in an updated capital model announced by Standard & Poor's.
However, the capital model is only one element of the rating, S&P analysts stressed during a recent conference call intended to fill in details behind a report released to insurers.
"The capital model itself does not define a rating," said Grace Osborne, managing director of North American insurance ratings for S&P.
She detailed changes to the structure of S&P's methodology and to factors that are proposed under the new capital component of S&P's rating model. The factors, sometimes referred to as charges, are applied to various balance sheet and income statement items.
She noted that in addition to the capital component, S&P also examines eight other ratings components, including competitive position, enterprise risk management, operating performance and financial flexibility, among others.
Focusing on the capital model revision, however, she said that for life and non-life insurers, the capital model will come up with "significantly increased" capital needed to cover investments in common equities, and decreased capital required for reinsurance recoverables.
For non-life insurers, specifically, she said, "both on the pricing risk and the reserving side, there is definitely going to be more capital required." A slide presented along with her remarks indicated that the higher requirements would apply mainly to long-tailed lines of business.
"I really do think we need to look at [this] away from just models and factors," she said, attempting to justify the hikes.
"From 1990-2005, the U.S. non-life insurance industry has posted underwriting losses for each year, with the exception of 2004," she noted. "The underwriting losses have been significant in several years, with a cumulative loss of $276 billion."
She added that "without the benefit of investment returns [or] the financial flexibility to raise more capital … the non-life insurance sector would have been in severe financial stress."
Explaining that "the volatility … is what's driving the sharp increase[s] in many of the non-life factors," she said that while "this is the first time S&P will directly incorporate the volatility in a quantitative fashion in its capital model," analysts have "acknowledged and worked through the pressures on earnings and capital" qualitatively throughout the last 15 years.
Still, S&P, in its report "Request For Comment: Revisions In The Risk-Based Capital Model," said that "given the substantial breadth and scope of the risk factors that were under review for this capital model update, we see that markedly different views of an insurer's total risk-adjusted capital could emerge."
Ms. Osborne noted, however, that in mitigating such changes, "prospectively, [S&P's] focus will be on how companies are measuring and managing their risks so that [the] unexpected underwriting exposure" that S&P is attempting to capture through the non-life pricing and reserving risk charges in the capital model "can be mitigated or avoided … such that their capital bases are not in jeopardy."
During the conference call, she also said that S&P has introduced a "significant departure" to its methodology for calculating pricing factors for excess-of-loss reinsurers.
Because data is captured for U.S. reinsurers on their annual statements in a way that "renders statistics meaningless," she said S&P will use primary charges surcharged 25 percent for U.S. business and 50 percent outside the United States.
In a supplemental report detailing answers to frequently asked questions about the updated model, S&P also noted while new catastrophe risk charges were announced well in advance of this latest capital model, S&P analysts believe that "more substantial changes should be evident with the introduction of this full update."
During the conference call, however, Ms. Osborne seemed to suggest that, if anything, some companies will get a small break on the catastrophe risk charge with the latest update.
Specifically, she said that while the catastrophe risk factor will still be based on a 1-in-250-year aggregate probable maximum loss figure (put in place for reinsurers in 2005 and for insurers in 2006), with the update, "we will be calculating these charges on an after-tax basis where it applies."
Therefore, "reinsurers that are in a tax jurisdiction will be able to have that benefit incorporated into the capital model prospectively," she explained.
(In June 2005, S&P announced that catastrophe-specific capital charges for reinsurers would reflect their ability to withstand losses from natural catastrophes that occur once every 250 years, replacing a previous 1-in-100-year event standard.
(The change was not just to the number of years. Rather, the new charge encompassed a company's losses from natural disasters in the aggregate, as opposed a single event. In 2006, S&P introduced the same catastrophe-risk charge to primary insurers.)
Ms. Osborne said that up until Feb. 14, 2007, S&P will be soliciting feedback about the updated model, and the rating agency will hold a follow-up workshop to further describe the model changes on Dec. 12, 2006.
The plan is to have the factors finalized during the first quarter of 2007, she said, adding that both models will be run simultaneously during S&P's rating reviews in 2007.
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