By Rob Jones and Karin Clemens
In Standard & Poors Ratings Services opinion, the European insurance industry seems nervous as it enters the second half of 2011. We believe that insurers have largely restored their balance sheets from their low point in the first quarter of 2009. However, the negative implications of economic trends on the industry are compounded, in our view, by the potential impact of industry-wide projects such as the implementation of Solvency II supervision and the International Accounting Standards Boards Phase 2 insurance accounting project. Furthermore, later this year, the Group of Twentys Financial Stability Board will announce which entities it has designated as systemically important financial institutions on a global basis (G-SIFIs). While we expect that most G-SIFIs will be banks, some insurers may also be in the frame.
The bias in our rating profile is consequently negative. Of our current ratings, 18% carry negative outlooks or CreditWatch placements, versus 5% with positive outlooks or CreditWatch placements. The remaining 77% carry a stable outlook. Nevertheless, our view of the sector remains strong relative to other rated corporates; the average long-term issuer credit rating on the 156 insurance groups we rate stands at A-.
Until the first quarter of 2009, we saw the mark-to-market and impairment effects on insurers investments deplete their balance sheets substantially. Since then, we believe that many of Europes rated insurers have restored their capital adequacy through a combination of good earnings and the reversal of adverse corporate credit spreads. Insurers were generally not forced sellers of the investments that were most affected during the turmoil. However, capital adequacy remains a weakness for the ratings on some insurance groups, typically those with a large life insurance business.
We see signs that insurers are getting accustomed to the economic consequences of the turmoil. Low interest rates are an issue for many life insurers, especially where they have liabilities relating to with-profit products that provide minimum guaranteed investment returns. While the resulting reinvestment risk is likely to be problematic for such insurers, we believe its main effect will be to lower profitability. We anticipate that the pressure on ratings on the affected insurers is likely to increase if interest rates remain low for a prolonged period. A potential medium-term scenario of rising inflation and higher interest rates would relieve this pressure. However, we anticipate that it would also be likely to have an adverse effect on mark-to-market balance sheets and would erode expense margins.
We believe the economic consequences are also limiting life insurers new business prospects. We attribute this to lower investor confidence (affecting savings and investment products), lower housing market activity (affecting mortgage-related products), and lower disposable incomes. Furthermore, lapse rates for life insurance policies have risen somewhat as policyholders surrender their policies or discontinue premium payments to realize or conserve cash.
We have observed that in periods of low investment returns, insurers costs typically substantially reduce the yield passed on to policyholders on saving products, which generally makes them less appealing compared with noninsurance savings products.
In our view, these top-line issues have a direct bearing on insurers profitability, as do the weaker returns on investments backing non-linked policies and the charges that insurers levy on unit-linked policies and asset management products (which are largely based on the market value of the managed investments). On the non-life side, as is typical of recessionary conditions, claim frequency has increased because of the higher propensity of policyholders to claim, and a higher incidence of fraudulent claims.
We have found that non-life insurers currently tend to see inflation risk as a source of concern. Those with significant long-tail exposures, where inflation risk may not be adequately provided for in pricing, nor compensated for in likely future investment returns, are especially vulnerable. In our view, price adequacy in most lines of business is still softening or flat in most European markets. Exceptions include the U.K. and Italian motor insurance business, where we have seen material price corrections that were long overdue, in our view. These markets have performed very poorly in recent accident years. Overall combined ratios have been in the region of 120%, indicating weak underwriting profitability.
Looking ahead, we think that there will be an adverse effect on future non-life operating performance if economic activity does not continue on its modest upward path. This is also true of investment earnings, which are making a much smaller contribution to insurers overall performance at present than they did in the first half of the decade.
Non-life natural catastrophe activity has been very high in the first half of 2011. While the events may erode capital levels for some reinsurers, most of these events were outside Europe and they mainly affect the global multiline insurers based in Europe.
We anticipate that the reinsurance programs at these insurers should contain the effect of the catastrophe events on loss ratios to below 5% (see Global Multiline Insurers Are Heading For Continued Ratings Stability, Despite Multiple Hurdles, published on June 28, 2011).
Below we summarize the trends in credit quality exhibited by life and non-life insurers for the larger insurance markets in Europe (see Table 1). There is no direct linkage between these trends and the outlooks on local insurers, mainly because parental support influences many of our ratings. However, the trends describe our view of the underlying direction of the credit quality of insurers stand-alone credit profiles.
Insurers Have Limited Exposure To Sovereign Risk
In our opinion, sovereign risk is more likely to erode profits than present a capital threat to the European insurance industry. The only nondomestic rating action directly attributable to the spate of recent European sovereign downgrades was that on Groupama, which we downgraded because of its exposure to Greek sovereign debt. Although some of Europes larger insurers have significant holdings of Greek, Irish, and Portuguese sovereign debt, aggregate exposure has materially reduced over the past year. Furthermore, most exposure resides within life insurance operations where the impact of any losses may be shared with policyholders.
Our downgrade of the Republic of Ireland and consequent downgrades of Irish banks were followed by downgrades on three non-life Irish domestic insurers (Allianz PLC, Aviva Insurance (Europe) SE and RSA Insurance Ireland Ltd.). These insurers are affected, in our view, through their holdings of government debt, deposits with Irish banks, and the prospects for the Irish economy.
We continue to monitor insurers exposure to sovereign dept, not only the ones mentioned above. We are also monitoring exposures to financial institutions hybrid securities and, for those insurers with large U.S. subsidiaries, commercial mortgage-backed securities, collateralized debt obligations, commercial mortgages, commercial real estate, and residential mortgage-backed securities, that is, subprime and Alt-A.
Solvency II Supervision And New IASB Accounting Standard May Put Cost Of Capital Under Pressure
We have observed that insurers have concerns about the implementation of Solvency II supervision, which is officially planned to go live on Jan. 1, 2013. The European Commission (EC) moderated the advice on solvency capital requirements provided by the Committee of European Insurers and Occupational Pensions Supervisors (which has since become the European Insurance and Occupational Pensions Authority) in the final calibration of the fifth Quantitative Impact Study (QIS 5). Despite this, the capital requirements are significantly higher than those in the QIS 4 calibration. We consider Europes larger insurers are likely to be less affected because of the relatively high capital credit they will probably receive for diversification under Solvency II and because they are likely to use internal models for solvency purposes.
Even so, we believe that supervisory capital may become a binding constraint for many insurers. We believe that the final Solvency II implementing measures will reduce capital requirements in aggregate compared to QIS 5, but the nature and extent of the changes has yet to be publicly communicated. These measures are also expected to include a package of transitional provisions (involving the treatment of hybrid securities and non-EU supervisory equivalence, for instance) that we expect will limit the initial impact. Until these measures are made public, and ultimately finalizedwhich is not expected to happen before the first quarter of 2012uncertainty will remain. With the planned implementation date approaching, we believe insurers are concerned about the amount of time they will have to execute Solvency IIs still-uncertain requirements.
While the cost of capital concerns (based on QIS 5) may ultimately be mitigated in the final implementing measures, similar concerns remain regarding the likely greater reported profit volatility arising from the IASBs phase 2 insurance accounting standard. The IASB is nearing completion of the standard, which is due to be published by December 2011, although implementation is unlikely before 2014.
Some Insurers May Be Designated G-SIFIs
The group of Twenty (G-20)s Financial Stability Board (FSB) could designate some insurers as globally systemically important financial institutions (G-SIFIs) in November 2011. This issue is prominent on the agendas of the CEOs of the worlds largest insurance and reinsurance groups (see Rating Implications For G-SIFI-Designated Insurers). For the insurers affected, we believe that it ranks alongside solvency reform and International Financial Reporting Standards in terms of its potential impact. We believe that most insurers will avoid being designated as G-SIFIs, but some may be unsuccessful.
Although the FSB has not yet made the consequences of being designated clear, we expect these to include greater regulatory oversight, higher capital requirements, and legal restructuring. All of these could have either negative or positive rating implications. If the designation signals the increased likelihood of extraordinary government support for the insurers affected, we would need to consider the implications, because our criteria for imputing rating support only apply to banks (see How Systemic Importance Plays A Significant Role In Bank Ratings, July 3, 2007).
Although the sector remains strong, all of the above emerging issues add to the uneasiness we observe among insurers and contributes to the negative bias that is present in our ratings. ..
Rob Jones, London, (44) 20-7176-7041;
Karin Clemens, Frankfurt, (49) 69-33-999-193;