Broker calls for ERM credit

London-based Aon says that ratings agencies should give more credit to a company’s insurance programme as part of its ratings process for corporate debt. The broker has started to raise the issue with ratings agencies, in particular Standard & Poor’s, one of the largest providers of ratings for both corporate debt and insurance companies. “In our view, ratings agencies do not assign proper value to insurance,” said Bryon Ehrhart, Chief Strategy Officer for Aon Benfield and Chairman of its Analytics and Investment Banking units. “It is not that we claim they have got it wrong, it’s just that there is an opportunity to improve as debt becomes an even larger component of corporate capital structures in the continuing low interest rate environment.” According to Mr Ehrhart, insurance can make a big difference to a company’s corporate debt ratings if it were to suffer a catastrophic event, like a multi-billion dollar liability claim or significant property damage affecting key income producing assets or supply chains.hideFor example, multi-billion liability claims have caused even large companies to draw down all liquidity facilities, exit the commercial paper market, sell significant income producing divisions or, in some cases, the entire company—all impacting the interest coverage ratio, ratings and capital. Currently, ratings agencies do not give explicit credit for a company’s insurance arrangements as part of the debt rating process. “We are interested in a company’s insurance programme as part of its overall risk management strategy,” said Mark Puccia, Global Criteria Officer, Corporate Ratings at Standard & Poor’s. “But we do not normally analyse the programme in detail nor focus on particular features such as risk limits, deductibles, self-insurance, etc., unless doing an after-the-fact evaluation of the impact of a particular loss event.” Rating agents should look at insurance arrangements in more detail than they currently do, according to Stuart Shipperlee, Partner at ratings consultancy Litmus, and former Managing Director at Standard & Poor’s and AM Best. “In my experience, ratings agencies have not looked at insurance arrangements in depth and have just presumed that companies follow good practice and buy appropriate insurance, and therefore they don’t feel that they need investigate it further,” said Mr Shipperlee. A bond default following an uninsured or underinsured catastrophic loss is unlikely. However, investors would not expect to see investment grade bonds drop below BBB because of a lack of adequate insurance protection in the event of a large loss. BP’s experience with its Deepwater Horizon oil platform is a good example of what can happen when a company carries large levels of retained risk that could otherwise have been insured. The 2010 fire and explosion, and subsequent pollution, may cost BP some $40+bn. In 2010, ratings agency Fitch cut BP’s credit rating by six notches from AA to BBB—just two notches away from junk status—on concerns over the Gulf of Mexico oil spill disaster. Energy companies are not the only businesses with such killer exposures. For example, a pharmaceutical company could suffer from large product liability claims, a mine from a major flood or fire, while an airline would face huge liability costs from a catastrophic crash. While insurable catastrophe exposures are more relevant to specific sectors, there is also a general shift toward increased liability for all firms, according to Mr Shipperlee. “Catastrophic exposures are becoming more generic to all industries. Liability risks have been rising and companies now face so many different ways of being sued. Contingent business interruption is also making large exposures more of an issue—global supply chain disruption can cause major financial problems for a company,” he said. However, S&P argues that large loss events rarely impact an organisation’s credit rating. “We are far more likely to downgrade the rating of a company that experiences a large plant explosion or mining accident due to a diminished view of its operational effectiveness than we are to downgrade it based on the actual financial loss associated with such events,” said Mr Puccia. “While a company with a good insurance programme will fare better after an adverse event than one without one, those differences have rarely amounted to so large a financial impact as to impact negatively the latter company’s rating,” he said. Aon believes that insurance could become even more relevant to the long-term success of an organisation if it were given credit in the ratings process. In theory, companies would buy higher levels of protection if insurance tangibly improved interest coverage and capital ratios in debt stress scenarios associated with insurable events, argues Mr Ehrhart. He believes that if appropriate rating agency credit for insurance was recognised, insureds and insurers would more often design coverage that would protect material deterioration to interest coverage and leverage ratios from otherwise insurable events. Insurance would then more often pay for itself through lower cost corporate financing, he said. For example, the specific credit given for reinsurance in the insurance rating model has helped create a much bigger market for catastrophe reinsurance than would otherwise be the case, he said. “Insurers have more capacity to write larger programmes than they ever have so it is strange to see that corporate insurance growth is rising at a far lower rate than the growth in corporate debt,” said Mr Ehrhart. While such a move is not likely to happen in the near future, there are several factors in its favour. “Ultimately ratings agencies should give credit for insurance in the ratings process on a case by case basis and where there is a degree of risk to the balance sheet that can be insured,” said Mr Shipperlee. “Financial markets are already evolving to encourage corporates to buy insurance and protect the balance sheet against volatility,” he said. The biggest potential driver for ratings agencies to give credit for insurance may come from the increasing use of enterprise risk management. Risk management has become an important part of the ratings process for insurance companies and some ratings agencies are now starting to look at a company’s enterprise risk management as part of the corporate credit ratings process. “The roll out of ERM in the insurance rating process has been significant in recent years, and that is now starting to make its way across to rating corporate debt. It’s not yet at the same level but it is heading in that direction,” said Mr Ehrhart. Elements of ERM are already found in S&P’s Management & Governance Credit Factors criteria. “We had experimented with evaluating ERM per se, but have found that mapping key elements of ERM to the Management & Governance headings was a more practical way to integrate ERM into our processes,” said Mr Puccia. While S&P does not give ‘credit’ for ERM in its debt ratings, analysts generate a positive, negative or neutral opinion about the effectiveness of a company’s executives and board oversight on 15 different factors, and companies that are executing ERM successfully will more likely achieve positive scores, he said. As ratings agencies pay more attention to ERM they are likely to give more weight to a company’s insurance arrangement, said Messrs Shipperlee and Ehrhart. “Risk managers could take on this cause. Rating agency credit would boost their cause when they increase insurance protection to cover increasing risks,” said Mr Ehrhart. Insurance buyers would welcome a more detailed analysis of insurance and risk management in the debt rating process, however, such a move is not without challenges, according to John Hurrell, Chief Executive of the UK insurance buyers’ association, Airmic. Assessing insurance in the corporate debt ratings process is massively complicated, he said. “For example, would credit be given for captive insurance? How do you decide what deductible levels are appropriate; how do you assess the adequacy of third party limits? Who is going to assess the relevance of critical exclusions? How do you adjust for the strength of the balance sheet to take high levels of self insurance?” Mr Hurrell also questions if the ratings agencies would have the expertise to assess the adequacy or efficacy of the insurances, although they could develop this, he added.

Broker calls for ERM credit

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