“Yes” seems to be the consensus, ever since Snowden J commented in Premier Motorauctions that the absence of a credit rating indicated that an insurer might be at greater risk of defaulting.
But those interested in facts will know that the importance of insurers’ ratings are largely mis-portrayed to the extent that it is dangerously misguiding and misleading. Ratings do serve a purpose but much like a health product, a rating should carry a health warning explaining what it really is, how it should be used and the consequences of mis-using it. One may laugh, but it’s not the first time such a suggestion has been made.
Before I start though, let me come clean. I represent Acasta, an unrated, Gibraltar-regulated insurer, named in Snowden J’s judgment as the insurer with “little or no evidence about its history or current operations”. Presumably, Snowden J was not made aware by either set of lawyers that under the extensive EU regulatory framework that is Solvency II, all European insurers must make publicly available an annual Solvency and Financial Condition Report, which would have provided precisely the evidence he says was lacking.
Of course, I would say this, but it’s rooted not in bias but in fact. For example, it is a fact that this unrated question crops up time and again. And time and again, we explain (usually to a shocked audience) the basic facts behind why an insurer’s rating is not the bible one has been led to believe. And it is a fact that those who understand ratings question why Solvency II was not even referred to in Premier Motorauctions.
Rely on facts, not ratings
Those who blindly vouch for rated markets often avoid talking about anything that undermines their position. Therefore, you may not have heard from them about the few insurers that have found themselves in a bit of a pickle in the recent past.
On 1 February 2019, one of the market’s leading providers of “rated” after the event (ATE) insurance paper, Legal Protection Group (whose major shareholders include Aaron Banks) ceased underwriting. Another big rated player, “rated” Amtrust, went private last November after a touch of accounting-related turmoil, followed quickly by a withdrawal from one or two European markets and the sale of its Lloyd’s business earlier this month. 2017 saw the wind-down of “rated” Elite, followed last year by the collapse of Alpha Insurance, both ATE insurers, the latter being a direct consequence of the failure of a “rated” insurer, CBL.
Of course, the comeback is that there were other reasons (exceptional circumstances, anomalies, one-offs) for why these all happened. But a simple fact remains; whatever the reasons for each being in a pickle might be, it wasn’t captured by the rating.
For a start, ratings are paid for by the “rated”, so they can provide a guide to their stakeholders and beyond. Ratings provide detailed and useful analysis and yes, it certainly helps to understand the rated entity. But they are not the bible. They are merely an opinion which by definition is backward looking because most of the inputs for a rating are supplied to them by their fee-paying clients, which in any case are mostly outputs of Solvency II.
But knowing this makes clear that ratings are not the definitive authority on an insurer’s credit worthiness.
If in doubt, let’s consider the past. Perhaps the failure of the “rated” Independent Insurance Company Ltd might be too far back for most memories, but it was only 2008 when AAA-rated AIG collapsed. In fact, it’s always worth reminding ourselves of some other headlines regarding ratings in the credit crisis:
- 13,000 AAA-rated structured finance bonds downgraded during 2007 and 2008 from one rating agency alone.
- Financial institutions paid more than US $150 billion in fines in the US alone, the bulk (approximately US $90 billion) of which related to the mis-selling of structured finance bonds.
- S&P and Moody’s agreed to pay the US authorities settlements of US $1.375 billion and US $864 million respectively in relation to their ratings of structured finance bonds leading up to 2008.
To put it bluntly, ratings may feel “safe” but to rely on them is inherently lazy and recent history has shown that it is also risky and dangerous.
Solvency II is what really matters
What really matters is Solvency II, the regulatory framework set out in Directive 2009/138/EC of the European Parliament and the Council of 25 November 2009, that dictates how European insurers run (or should run) their business down to the minutiae. Ask any insurer and Solvency II occupies their mind day and night. It is the sponge of the cake, in comparison to ratings which are simply the icing that a cake can live without.
But why is Solvency II so infrequently discussed with litigation lawyers compared to ratings? In fact, why was Solvency II not mentioned at all in Premier Motorauctions? It may be long and complicated, but that’s too poor an excuse for a professional industry. Yet, the reality it seems is it is just too tempting to fall back on the easy metric of a rating.
But not so for insurers, who are afforded no such luxury of a lazy option. We are fully accountable to our regulators, not just retrospectively but proactively and on a very regular, on-going basis under the Solvency 2 framework. It defines every commercial decision, whether underwriting or operational, that we take.
While this blog is not sufficient to delve into the detail of Solvency II, understanding even the very basics of the three pillars can put things into a great deal more context.
Pillar one, the quantitative pillar, establishes the amount of capital that an insurer must hold (for essentially paying claims) to be able to withstand a 1-in-200 event over a 12 month period, using figures calculated by conservative actuaries with the stress of a risk margin overlaid. An insurer with this much capital is considered to be at 100% solvency, but most insurers hold capital which exceeds this 100% benchmark in practice. For example, an insurer that claims “120% solvency” holds 20% of capital in excess of that required to withstand a 1-in-200 event. And to pre-empt a question on everyone’s tongues, yes, it is possible, and has happened, that an A-rated insurer can be below 100% solvency.
And arguments that this level of implied probability of default still does not warrant a rating are somewhat weak when one compares it to the implied probability of default in the sovereign bond markets versus a sovereign’s credit rating.
Then, there is the extensive supervision handled through a network of local regulators and a central regulatory body (EIOPA). This is captured in the remaining two pillars. Pillar two covers governance and supervision, setting out reporting requirements which cover an insurer’s corporate governance, risk management, internal controls and general supervision, including how stresses, scenario analysis and simulations are created. This is captured by a regularly updated own risk solvency assessment (ORSA) provided to the regulator.
Pillar three focuses specifically on the reporting and disclosure requirements, in particular via quarterly reports (QRTs) to regulators which update the health and status of an insurer on a quarterly basis. The other key document is the solvency and financial condition report (SFCR), an annual report that is made publicly available, usually via an insurer’s website, as we’ve already discussed.
Why is this so relevant to the legal industry?
Firstly, because it’s important that lawyers give their clients the right advice based on facts readily available to them in the public domain.
Secondly, because since Premier Motorauctions, the question of whether ATE insurance sufficiently provides costs protection for defendants has been at the fore but tackled with such blind skew to rated insurers that is potentially misleading.
Fortunately, lawyers are generally not ones to be hoodwinked and they are gradually realising, at least from Acasta’s experience, that being led on ratings alone is dangerously inadequate. In fact, the next time there is a security for costs hearing that focuses on an insurer’s credit worthiness, Solvency II will most likely play a very central part in the debate in a way that it failed to do so in Premier Motorauctions.
Perhaps it’s worth finishing off with a thought. Consider for one moment a world where the ATE market consisted only of unrated insurers. Without the luxury of ratings to fall back on, everyone would clearly be embracing Solvency II.
