The Independent Inquest

Ratings companies need to take note.
August 6,2001

So Independent is no more; yet another apparently successful and highly-rated insurance company has gone. Once all the investigations and hearings are over and the finger of blame has stopped wagging, the industry will have yet another legacy to live and deal with.
Already the fall-out is being felt, as counterparties begin to ask whether 'A' rated companies offer enough financial security. This begs the questions about the creditability of BBB and A ratings, which are defined as secure. Increasing numbers of industry players are concerned that the rating agencies' franchise may have been tarnished and that the industry's response may be excessive.
A possible response may be that is a knee-jerk reaction on the part of rating users resulting in an unprecedented flight to AAA and AA rated companies. In reality there are not enough of them to absorb such a shift, but even if there were, such a response would be disastrous and entirely wrong. The damage to the market would be irreparable and result in excessive monopolistic practices.
In addition, the rating agencies must be careful not to become overly cautious. To penalise deserving companies by not uplifting ratings because of nervousness on their part would be equally undesirable.
Rating agencies endeavour to convince the industry that companies rated BBB- and above are 'Good' security; indeed if rated A- or higher they are at the very least providing 'strong' or 'excellent' financial security, according to their own definitions. The problem is that in the last decade we have seen several companies that were still rated in the A or BBB range within 12 months of their demise.
Companies rated above the BB range provide adequate security. However, the very nature of rating scale indicates secure companies still have exposure to default, albeit smaller the closer to AAA you get. This very existence of default probability requires that rated insurers' counterparties to try and bridge the default gap. That is not achieved simply by using AA or higher rated companies, as default exposure still exists. Getting a second and partial opinion should help to bridge that gap.
So, how should industry players respond to this ' default gap'? As long as the current rating scales exist as they must continue to view ratings above BB + as potentially secure providers of risk transfer, whilst taking care to qualify that opinion with their own research.
Whereas the insurance industry is still relatively new to the ratings culture, the banking sector has a longer and more involved history.
Independent: demise left question marks over the ratings system with them and has learnt the proper use and value of the system. In the banking world, one will find many more entities rated in mid-A range, very happy to be deemed such security and accepted as such by their counterparties. Bankers understand that they must mind the default gap as a part of their counterparty exposure strategy, hence the large investment in their own analytical research.
The insurance industry's romance with AA and AAA ratings is not only contrary to the experience of other sectors of the financial industry but is also highly self-defeating. Any counterparty that accepts AAA security over BBB security without the benefit of their own analysis deserves what it gets if that AAA- rated company defaults. After all, AAA entities still have a 2.3% chance of default within 15 years.
Current default experience shows that secure BBB rated entities have a default expectation of 4.2%, rising to 16.8% for a vulnerable BB rating. While this highlights the significant default variation between entities deemed secure and those deemed vulnerable, it tends to mask the perpetual existence of default potential at the upper end of the scale. Default potential exists in all companies and counterparties must 'mind the gap' every time they enter into any contractual third party arrangement.
So much for the responsibility of the counterparties. But what of the agencies' duty to the market? Through the establishment of their business models, the agencies have assumed a responsibility not just to warn against insurer default, but against the devaluation of their ratings franchise. The devaluation of their ratings and subsequent alienation of excellent companies as acceptable security would be against their best interests and a catalyst for action on their part.
Any good agency director appreciates that his company's franchise is only as good as the industry perceives it. If the industry felt the franchise to be devalued, over time that industry could begin to develop its own measures to dilute the influence of ratings agencies and disenfranchise them as a core component in determining financial security.
Agencies jealousy protect their franchise as they appreciate that it is paramount if they plan to maintain and further develop their industry role. However, to devise a response or series of watertight arguments following the most recent A-rated insurer demise that will protect the franchise and protect customers may be difficult as more users question the validity of the ratings.
With the Basle Accord not too many years away from adoption and the role of the rating agencies being enhanced, the insurance industry must now deal with the issues. Maybe rating agencies could do more now to prove to the industry that they understand insurance and reinsurance companies by focusing more on policyholder obligations and less on shareholders' interests.
With hindsight, many non-rating agency organisations are now jumping forward and declaring that they identified the potential demise of Independent over a year ago. If this is true, why didn't the agencies? Maybe they had but didn't really appreciate the evidence - perhaps they didn't see the wood for the trees.
If the future security of the industry is to be placed in the hands of rating agencies then we would urge them to strengthen the rating franchise in a way that builds rated-entities' confidence in the value of their rating; encourages subscribers to qualify ratings by forming their own opinion; and better educates the end-user of the relativity of the rating spectrum.
Carne Curgenven
Counterparty Risk Services
BRIT Insurance Ltd

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The Independent Inquest

Ratings companies need to take note.August 6,2001

Ratings companies need to take note.
August 6,2001