S&P: How insurance ratings are affected by sovereign stress

Sovereign downgrades can put pressure on insurer ratings, but insurers’ sensitivity to sovereign stress depends on their asset base and the scope of operations, according to a report from S&P Global Ratings.

Insurance company ratings are not limited by the rating on their sovereign, but they are affected by the economic and market consequences that typically occur in times of sovereign stress, says S&P in the report. It adds that it is unusual to rate an issuer above the sovereign unless it benefits either from external support or limited exposure to the sovereign domicile. S&P rates 93 insurance companies higher than the sovereign of their domicile, although the majority of these benefit from one of these two factors.

During the past year, S&P Global Ratings has taken a number of negative rating actions on sovereigns including Bahrain, Oman, Ecuador, Chile and South Africa, which has put pressure on the ratings on some insurance companies domiciled in those countries.
“When we rate an entity above the sovereign foreign or local currency rating, we are expressing our view that the entity has sufficient creditworthiness to withstand a sovereign default.

Specifically, an entity rated above the sovereign should have the ability to service its financial obligations superior to that of the sovereign. Ultimately, if there is a sovereign local or foreign currency default, there should be an appreciable likelihood that the issuer will not default,” states S&P in the report.

It adds: “Given that a sovereign default is likely to be associated with a significant asset shock and potentially other stresses (such as mandated changes in insurance contract terms), the financial strength of an insurer may be impacted by the country of its domicile. Similarly, an insurer bears risk from significant exposures outside of its jurisdiction of domicile.”

The report explains that sovereign default or distress scenarios are associated with a number of economic effects that can harm insurers. These include decline in GDP, rise in unemployment, increase in interest rates, haircuts to holdings in debt instruments and bank deposits, price declines in equity and real estate markets, currency devaluation, and increase in inflation. Each of these factors can act as a transmission mechanism that affects the operations and capital bases of insurance companies in the event of a sovereign stress scenario, says S&P.

An S&P insurance rating above the sovereign indicates that there is an appreciable likelihood that the insurer would not default if the sovereign were to default – the insurer has a superior ability to service its liabilities than the sovereign. S&P notes, however, that a rating above the sovereign does not indicate that an insurer will maintain the same financial strength as before.

According to S&P, if the sovereign rating weakens, it would expect the insurance financial strength rating to weaken as well, although it would remain above the sovereign rating if S&P believed that it would continue to operate and meet its liabilities as they came due. “Nonetheless, the level of economic stress that is expected to coincide with a sovereign default (in particular a local currency default) sets a high bar for an insurance company to surpass,” adds S&P. “Unfortunately for insurance companies’ management teams, they must grapple not just with dynamics they can control, such as pricing and staffing, but also with the fiscal, monetary and policy actions of their governments, and global business cycles, which are well outside their sphere of influence. However, some businesses have characteristics that make them better placed than others to weather the storm.”