Downside Pressure Eases Mid-2014

For Most Global Insurance Key Risks

Primary Credit Analyst:
Michael J Vine, Melbourne (61) 3-9631-2102; michael.vine@standardandpoors.com
Secondary Contacts:
Rob C Jones, London (44) 20-7176-7041; rob.jones@standardandpoors.com
Mark Button, London (44) 20-7176-7045; mark.button@standardandpoors.com
Dennis P Sugrue, London (44) 20-7176-7056; dennis.sugrue@standardandpoors.com
Tracy Dolin, New York (1) 212-438-1325; tracy.dolin@standardandpoors.com
Angelica G Bala, Mexico City (52) 55-5081-4405; angelica.bala@standardandpoors.com
Ron A Joas, CPA, New York (1) 212-438-3131; ron.joas@standardandpoors.com
Table Of Contents
Negative Outlook Bias Eases
Interest Rates Remain At Low Levels Versus Historic Norms In Key
Markets
Global Economic Activity Is Slow To Recover
Global Reinsurers Ratings At Risk From Soft Pricing
Regulatory Uncertainty Creates Strategic And Operational Challenges
Sovereign Risks Continue To Impact Ratings
Related Research
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Downside Pressure Eases Mid-2014 For Most
Global Insurance Key Risks
Downside risks have eased for primary insurers globally, but they have not gone away. Interest rates stagnating at low
levels or spiking too sharply on recovery remain key risks affecting insurers' credit quality in mid-2014. Global
economic conditions are improving after a period of uncertainty and instability in 2012-2013, but they are leveraged to
the U.S. recovery, and some negative economic and geopolitical pressures remain in a number of European countries.
While risk from a nasty China hard landing is now remote, and sovereign risks have largely subsided, insurers' ratings
are still constrained in Spain, Italy, Portugal, and Ireland, among others, and the negative outlook on Japan impacts
some insurers' ratings. Soft pricing in global reinsurance rates has benefited the primary market--but we believe that
the ratings-trend impact will be negative for the reinsurance sector after eight years of stability. Regulatory uncertainty
continues to pose strategic and operational challenge as Solvency II nears in Europe; and there is wider regulatory
reach into global systemically important insurers (G-SIIs) and business conduct regulation. Ratings stability has
increased markedly over the past year or so, and the negative bias has receded considerably. This suggests that global
risks continue to dissipate, in our view, and indicates that insurers, although less so reinsurers, are largely resilient to
the risk environment outlook.
Interest rates have risen from their lows over the past 18 months, providing some relief, but risk remains, especially for
life insurers seeking improved yield relative to guaranteed rates. Earnings pressure from low interest rates is prompting
some insurers to seek investments further down the ratings scale in order to increase yield. At the same time, more
illiquid assets are making their way into investment portfolios. Insurers can be exposed to risk when interest rates rise
too quickly, with a rapid move in rates tempting life policyholders to switch to other products that offer higher returns.
The resultant increase in surrenders could weaken the liquidity and financial profiles of some players if those
competitors are forced to realize losses on their bond portfolios. The U.S. Federal Reserve appears in no rush to raise
interest rates given inflation is at low levels, although strength in the labor market and ongoing economic recovery will
continue the trend to normalize monetary policy. We view the property & casualty market, and more specifically
global multiline insurers as more resilient to changing interest rate scenarios (see "Global Multiline Insurers Show
Ratings Resiliency To Interest Rate Swings").
OVERVIEW
Risks abate for global insurers, with a gradual lift in interest rates from troublesome lows and traction from
slowly improving economic conditions, particularly in the U.S.
Ratings stability is more evident compared with a year ago, as eurozone sovereign outlooks resolve, offset
somewhat by Eastern Europe, and we assess greater capital and earnings certainty.
Reinsurance sector risks heighten after a long period of stability, as we expect earlier soft market- pricing
conditions to continue into the June/July renewal season.
Regulatory uncertainty around the impact of G-SIIs, Solvency II, and business conduct regulation, amongst
others, continues to pose strategic and operational challenge.
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The recovery in the U.S. is back on track after a short intermission in the first quarter, and appears to be doing O.K.
Credit conditions are largely favorable, helped by improved consumer spending despite a miserable winter, some
traction in labor market, and a revival in the manufacturing sector. While the economic recovery is now evident in the
eurozone, it is very uneven and fragile. Markets still faced with economic, political and financial difficulty, however,
have already seen ratings adjustment in line with sovereign rating downgrades over 2013. The risk of a China hard
landing scenario is easing, with GDP growth likely to settle around 7% over the next few years as policymakers shift
from higher investment and credit fuelled growth to consumption growth, although financial sector risks in shadow
banking and wealth management products simmer away (see "Cracks in the Fortress? Challenges Rise Within China's
Financial Sector" and "China Walks Policy Tightrope In The Midst Of Rising Financial Pressure"). Potential
destabilizing risks are increased vulnerability of emerging markets worldwide and unpredictable geopolitical flare-ups,
such as an escalation of the Ukraine-Russia crisis (see "Standard & Poor's Says Global Credit Conditions Are
Improving, But Some Risks Are Shifting To Emerging Markets" and "Russia-Ukraine: An Unfolding Crisis").
Table 1
Key Risks
Risk Trend
Interest rates remain at low levels versus historic norms in key markets Decreasing
Global economic activity is slow to recover. Decreasing
Global reinsurers ratings at risk from soft pricing Increasing
Regulatory uncertainty creates strategic and operational challenges Increasing
Sovereign risks continue to impact ratings Decreasing
After a long cycle of ratings stability in the global reinsurance sector we see a possible negative ratings trend in 2014,
following evidence of competition in premium rates and conditions that we believe will weaken profitability in 2014
and 2015 (see "Past The Tipping Point: Competition And Soft Pricing Could Lead To Rating Pressure For Global
Reinsurers"). Further evidence emerged in the form of headline rates being down 10%-15% in the April 1 renewal; U.S.
property catastrophe rates are poised to retreat further at the June and July 1 renewals.
Regulatory developments continue to feature prominently in 2014. Detailed guidance on Solvency II will emerge later
in 2014, and the changes could be implemented in 2016 after the political agreement at the end of 2013. New federal
regulatory bodies are also beginning to influence the U.S. insurance market. Consequences of the capital and earnings
impact and risk requirements for G-SIIs remain unclear, while we see growing business-conduct regulation imposing
on insurers. Smaller insurance companies, especially in emerging markets where variations of Solvency II are going to
be implemented could also suffer. Their technological, operational, and cost structures may prove insufficient for
meeting requirements and fostering a trend to consolidation.
The U.S. regulatory environment has increased in its complexity and uncertainty. There is a now a plethora of
regulatory agencies, entities, and departments responsible for providing oversight at the Federal level, in addition to
the pre-existing state-based system. The Federal Reserve is currently developing its views on capital standards that
should be applied to the systemically important financial institutions; however, there are concerns that banking-style
capital requirements could be introduced into the insurance sector, which may not address the risks and liabilities
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taken on by insurance companies, nor the means of managing those risks insurance companies have developed over
the years.
Negative Outlook Bias Eases
Around 81% of Standard & Poor's Ratings Services' ratings on insurers globally had a stable outlook at the start of May
2014, compared with about 73% at the start of 2013, indicating our expectation that insurance ratings will be largely
resilient to the risk environment outlook. Outlook drivers are biased toward capital and earnings expectations, the
influence of sovereign rating outlooks, and, to a lesser extent, merger and acquisition activity and expected changes in
competitive position metrics.
The negative cohort in ratings outlooks and CreditWatches has receded to about 11% from 20% over the 16 month
period, as economic conditions slowly mend, sovereign ratings stabilize in the eurozone, and the risk from low interest
rates declines. Ratings on positive outlook or CreditWatch comprise 8%, from 7% at the start of 2013. Overall, the
negative bias has improved markedly to only 3% at May 2014, from 5% at January 2014, and 13% at January 2013.
Chart 1
Regional variation remains, with negative indicators at only 10% (negative bias 3%) in North America as insurers
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benefit from the economy gaining steam. Western Europe comes in at 11% (positive bias 1%), on the back of greater
economic and sovereign stability, and 7% (neutral bias) is Asia-Pacific's negative rate, with solid growth fundamentals
offset by capital and earnings pressure in some markets and the Japan sovereign negative outlook. A higher negative
rate is in Central and Eastern Europe, the Middle East, and Africa (CEEMEA), at 20% (negative bias 12%), largely from
sovereign constraints; Latin America's is 19% (negative bias 13%).
This improved shift in outlook bias also came after the implementation of our new insurance criteria, with more than
91% of ratings affirmed, 7% raised, and 2% lowered in the second half of 2013. The ratio of upgrades to downgrades
was 2.2 to 1 over the course of 2013, reversing the negative bias in 2012, when there was acute economic and political
uncertainty and instability in many markets. The median stand-alone credit profile (SACP) for the insurance sector
remains at 'A-', despite this slight improvement in SACP and ratings distribution.
Interest Rates Remain At Low Levels Versus Historic Norms In Key Markets
Rates have risen in most developed markets from their lows over the course of 2013, but they remain a risk, especially
to life insurers' credit quality in markets such as Germany and Japan, which have low bond yields relative to
guaranteed rates. The extent of insurers' resilience to the current low interest rate environment differs according to the
market in which they operate and the strategic direction their managements take to manage interest-rate risk. Of the
large European markets, German life insurance is the most sensitive to low interest rates, but has managed this
exposure and maintained current ratings. We believe many rated European insurers will continue to implement
measures, such as changing business models and adding new products to prevent their credit quality from eroding
further. Other markets face similar issues, but the effects are mitigated either by product design (more unit-linked
products, more flexible policy bonus rates, lower guaranteed rates), shorter liability duration, and/or longer asset
duration. The Japanese market, having grappled for decades with both low interest rates and an aging population, has
gained growth from health-related and living benefits products such as cancer and long-term care insurance. The risk
of rates falling significantly from current very low levels in Japan is remote, but with some minor adjustment from the
current 0.6% 10 Year Japanese Government Bond yield possible.
Earnings pressure from low interest rates is prompting some insurers to seek investments further down the ratings
scale to increase yield. At the same time, more illiquid assets are making their way into investment portfolios, including
commercial mortgage loans, private placement bonds, asset-backed securities, infrastructure assets, and alternative
investments. Although such investments add risk to insurers' credit profiles, the moves have been relatively modest to
date, and have not affected ratings.
While interest rates are gradually rising, they remain below historical levels in most markets as governments and
central banks manage sluggish GDP growth and low inflation. In sophisticated markets, rating actions on insurers due
to interest rate risk have been limited because of the industry's asset-liability management (ALM) and enterprise risk
management (ERM) practices, which have generally improved since the onset of the global financial crisis. In our view,
insurers with well-constructed and well-implemented ERM programs generally minimize the risk of losses outside of
their predefined risk tolerances. Additionally, we deem insurers with strong ERM, including strong strategic risk
management, to be better equipped to manage changing macroeconomic circumstances. For example, in the U.S,,
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since the global financial crisis we have seen an uptick in interest rate risk hedging for life insurers, which helps
stabilize economic results regardless of changes in interest rates, but may add accounting volatility to reported results.
Life insurers have also significantly reduced their offerings of the most interest-sensitive life, annuity, and long-term
care products while emphasizing fee-based products to reduce their interest-rate sensitivity. Within the property &
casualty sector, insurers--particularly those with longer-tail liabilities--have been preparing for a rise in interest rates by
keeping their asset durations shorter than their reserve durations. Our ratings on global multiline insurers were resilient
to our stressed interest rate scenarios (100 basis points higher and lower than our economists are forecasting).
Interest rates in Italy and Spain have moved in the opposite direction as perceived eurozone risk has receded, but have
now reached levels that are more consistent with their sovereign rating levels. This has eased the pressure on insurers'
marked-to-market balance sheets and solvency levels.
The unwinding of quantitative easing in the U.S. has also proven to have an impact on foreign exchange and interest
rates around the globe, particularly in emerging markets. A disorderly response by financial markets to the unwinding
of quantitative easing remains a shared and moderate risk for credit conditions around the world. The return to more
normal monetary policy in the U.S. could lead to disruptive effects, and markets' reaction to shifting policy
expectations could still create some financial volatility, particularly in emerging markets. Even without this volatility, a
shift in policy could weigh on credit conditions because it would likely make for higher borrowing costs for consumers
and businesses, weaker collateral performance, and losses for financial institutions if interest rate increases aren't
accompanied by strengthening GDP growth. Still, we expect the U.S. Fed is likely to continue to wind down its
bond-purchase program throughout 2014, with an end date likely in October. Economic instability in emerging
markets could reduce the attractiveness of them to global insurers that are looking to expand. This could slow
insurance penetration in those markets, and increase saturation and depress pricing in developed markets as insurers
struggle to deploy capital elsewhere.
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Chart 2
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Chart 3
Global Economic Activity Is Slow To Recover
The global economy continues to improve in 2014 after a period of uncertainty and instability through 2012-2013.
Downside credit risks are improving, in our view, but some risks are shifting to emerging markets. We view the top
global risks to be geopolitical developments that could result in financial crisis or economic shock, such as an
escalation of the Ukraine-Russia crisis, unexpected turbulence in China's financial sector around the repricing of risk,
and financial market reaction to a disorderly exit from quantitative easing, particularly on emerging markets.
Especially vulnerable to the U.S. fiscal policy uncertainty are some emerging markets, including Brazil, Argentina,
India, and Indonesia, although this time around, a lot of adjustment has already taken place, and interest rate and
foreign exchange rate impact may be less severe. Risks from the eurozone remain high, with several European markets
still suffering from high unemployment and weak disposable incomes that will weigh on revenue growth for the
insurance sector. The risk of a China hard landing scenario is easing, as policymakers seek to gradually shift to growth
fuelled by consumption rather than investment and credit. Risks from China's financial sector, particularly in local
government debt and shadow banking, including wealth management products, remain but are viewed as manageable.
Japan's stimulus measures have increased insurance revenues in Japan, with the sector also benefiting from improved
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investment markets. The risk of these benefits eroding from adverse effects of the consumption tax hike and inflation
pressure are yet to be fully tested, but promising at this stage.
The U.S. economy is likely to continue gaining momentum after a false start first quarter as it emerges from the deep
winter, with a resilient private sector, housing rebound, and gradually strengthening job market. We expect less fiscal
drag in 2014 with debt ceiling negotiations extended until March 2015, although 2014 elections could alter the debate
on budget, debt and stimulus measures. Low interest rates, which remain the primary impediment to life insurers'
earnings, appear poised to increase.
Economic conditions are stabilizing in the eurozone, assisted by the Outright Monetary Transactions (OMT)
purchasing program of the European Central Bank. Credit conditions in Central and Eastern Europe generally continue
to have a negative bias, with worsening economic, political, geopolitical and financial system risks in several markets
over 2013 already factored into our ratings via sovereign downgrades. The risk level has moderated in 2014 as
economic conditions slowly improve, but a strong recovery is not in sight. Sluggish and fragile economic conditions
are likely to prevail as structural weaknesses, high levels of indebtedness and unemployment, and broken credit
channels fail to subside.
Asia-Pacific's credit conditions remain largely unchanged in second quarter 2014, with Chinese GDP growth gradually
moderating in line with policymakers' desire to rebalance the economy and rein in financial excesses. China's growth
has stabilized at around 7%-7.5%, and authorities have indicated that, although they are intent on engineering a more
sustainable growth rate, they are not going to allow a sharp downturn (widely understood to be growth of below 7%)
to threaten China's development or social stability. Japan's growth should also moderate as the initial boost from
Abenomics subsides. As a trade-oriented region, Asia-Pacific continues to face the risk of lack of resistance in the U.S.
economic recovery, but its trade dependent economies should benefit as the U.S. and possibly Europe improves.
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Chart 4
Global Reinsurers Ratings At Risk From Soft Pricing
After eight solid years of ratings stability in the global reinsurance sector, Standard & Poor's believes that there'll be a
negative ratings trend in 2014. The tipping point came in early January, when we observed increasingly competitive
behavior between reinsurance companies. This trend has continued through the year:
Headline rates in the April 1 renewal were down 10%-15%;
There are early indications from issuers of more significant pricing decreases in U.S. property catastrophe rates at
the June and July 1 renewals; and
Market reports indicate that soft-market pricing conditions are affecting rates in other casualty and specialty lines.
This downward pressure on reinsurers' top lines leads us to think there will be weakened profitability in 2014 and
2015. In our opinion, these competition-related risks are the most prominent threat to the sector, usurping, for now at
least, the macroeconomic risks we highlighted in September 2013. We estimate that nearly half of our global
reinsurance ratings are materially exposed to these pressures. Companies that are unable to navigate the difficult new
landscape could experience negative rating actions.
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Capturing the risk, capital allocation, and pricing of un-modelled catastrophe risk is an issue for reinsurers, as it
generally represents 10%-15% of the average reinsurer's capital. We suggest that insurance penetration in developing
markets will outpace modelers' ability to generate reliable models for those perils/regions, so the amount of
un-modeled risk on primary and reinsurance companies' books could increase in coming years, adding to risk profiles.
There could be a paradigm shift for the reinsurance market in 2014, as reinsurers will be forced to differentiate
themselves in order to succeed. A benign catastrophe loss year in 2013 coupled with continued inflow of new capital
has kept capacity/supply near all-time highs, further pressuring pricing. Against this backdrop, it is the reinsurers who
are able to leverage their expertise, scope, diversification, and global reach, which will thrive. We are beginning to see
signs of a bifurcation in the reinsurance renewals for 2014, with larger, higher-rated reinsurers seeing more business at
more favorable terms. Complacency is a real risk, and if insurers don't innovate and maintain their relevance to the
marketplace, they risk being marginalised or swallowed up by a competitor.
Regulatory Uncertainty Creates Strategic And Operational Challenges
Regulatory developments will continue to feature prominently in 2014, especially in Europe. Eight of the nine groups
the Financial Stability Board (FSB) classified as G-SIIs in July 2013 are rated global multiline insurers (GMIs): AIG,
Allianz, Aviva, AXA, Generali, Metlife, U.S.-based Prudential Financial, and U.K.-based Prudential PLC. Ping An is the
only non-GMI on the list. The consequences of being a G-SII remains unclear. It may include higher capitalization,
resolution plans, more detailed risk reporting, or stricter supervision. Consequently, the GMIs' designation as G-SIIs
has had no immediate consequences for their ratings. In any event, we believe any incremental capital requirements
are unlikely to be imposed until 2019 at the earliest. This might put G-SIIs at a disadvantage relative to other insurers.
On the other hand, G-SIIs may benefit from a more favorable perception of their status in the market, for example
because of the implied potential for government support. That said, we do not currently reflect potential government
support in our insurance ratings, other than for government-related entities.
We expect that the FSB will indicate which, if any, reinsurers it will designate as G-SIIs this November. The
International Association of Insurance Supervisors is also due to elaborate on its basic capital requirements (BCR) by
November. These will be applied to G-SIIs first and as a part of the IAIS's Common Framework (ComFrame) for the
supervision of (approximately 50) internationally active insurance groups. The development of the BCR is to inform
the development of the international capital standards due in 2019 for internationally active insurance groups,
requirements which may ultimately filter out to the broader insurance industry globally.
Whereas the regulatory environment in the U.S. has always been somewhat dynamic, the current environment has
increased in complexity and uncertainty. With the passage of the Dodd-Frank Act in 2010, a number of new agencies,
departments, and entities are now involved in providing oversight for the industry, including the Financial Stability
Oversight Council (FSOC), the Federal Insurance Office (FIO), and the Federal Reserve Board (Fed), to name a few.
This is in addition to the pre-existing state-based system of commissioners and superintendents. The increase in
regulatory oversight has raised concerns within the industry as to how effective regulators might be, and whether
confusion versus certainty would result from the various regulators' involvement, should another financial crisis occur.
Equally concerning to market participants is the fact that the Fed is responsible for the capital standards that would
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apply to systemically important financial institutions (SIFIs). By some interpretations of the Dodd-Frank Act, the Fed
does not have the ability to interpret the Act in a way that would allow for flexibility in setting capital standards for
these insurance companies they regulate. As a result, some market participants are concerned about the possible
introduction of bank-style capital requirements into the insurance industry. Such an approach may not fully address
the risks and liabilities being managed by insurance companies, or the compensating risk-management techniques.
Accordingly, capital requirements could be impacted, as could the products and costs to the market more broadly.
Solvency II should be implemented in 2016 after the 2013 political agreement. However, many details are uncertain,
and could still adversely affect solvency ratios and the ability of insurers to invest in long term asset classes. Solvency
modernization is also prominent in the U.S., with ORSA, principles-based reserving and group solvency being hot
topics. The U.S. Fed has little experience in overseeing insurers, but it has assumed responsibility for the group
supervision of U.S.-based G-SIIs and Domestic-SIIs. Smaller insurance companies, especially in the emerging markets
in which a variation of Solvency II is going to be implemented, could suffer. Their technological, operational, and cost
structures may prove insufficient to meet requirements. This could result in consolidation in some countries to meet
the requirements of regulatory change.
Alongside these developments in prudential regulation, we see a growing focus on conduct-of-business regulation.
This responds to a growing consumer lobby and the separation of prudential and market conduct regulation in some
markets. We expect the changing regulatory landscape will create operational challenges for insurers and could have
strategic and financial implications for certain entities. This poses an event risk for some companies, in our opinion.
Market-conduct regulation is likely to become more prominent in 2014, which might curb the sales of some products,
increase selling costs in others and resulting in more damaging misselling issues. This has been an evolving issue for
example in Australia, with earlier focus on unit pricing and misselling issues now largely resolved through industry
consultation and enforceable undertakings.
Sovereign Risks Continue To Impact Ratings
Sovereign risks in the 18 member-state eurozone have stabilized over the course of 2013 and into 2014, and risks have
generally moderated. Country/sovereign risk constrains some ratings in Spain, Italy, Portugal, and Ireland; however,
eurozone outlooks are stable or positive, except those on Italy and, more recently, Finland. This is mirrored in insurer
outlooks that are now more evenly balanced between the upside and downside. Japan's sovereign negative outlook
continues to constrain some ratings.
Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit
Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its
subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or
affirmation of, a Credit Rating or Rating Outlook.
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Related Research
Insurance Industry And Country Risk Assessment Update: May 2014, May 14, 2014
Global Multiline Insurers Show Ratings Resiliency To Interest Rate Swings, April 14, 2014.
Credit Conditions: Financial Market Volatility Will Continue To Constrain Latin America's Credit And Economic
Growth, March 26, 2014
Credit Conditions: Largely Stable In Asia-Pacific, With A Dash Of Negative And A Focus On China's Financial
Sector Risks, March 26, 2014
Credit Conditions: North America's Credit Conditions Remain Largely Favorable Despite Fed Tapering, March 21,
2014
Credit Conditions: Europe Is On A More Stable Path, Amid Turbulence In Emerging Markets, March 21, 2014
Cracks in the Fortress? Challenges Rise Within China's Financial Sector, published March 3, 2014
Past The Tipping Point: Competition And Soft Pricing Could Lead To Rating Pressure For Global Reinsurers,
published Jan. 20, 2014
Possible Ratings Implications For Global Systemically Important Insurers, published July 19, 2013
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