Rating Methodology. Insurance Company Ratings. Global Master Criteria for Rating Short Term Insurance and Reinsurance Companies.

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1 Rating Methodology Insurance Company Ratings Global Master Criteria for Rating Short Term Insurance and Reinsurance Companies Updated July 2014 Related Methodologies Criteria for Rating Newly Established and Start-Up Insurance Companies (Updated July 2014) Criteria for Rating Cell Captive Insurers (Updated July 2014) Criteria for Rating Insurers Debt and Hybrid Equity Instruments (Updated July 2014) Criteria Summary GLOBAL CREDIT RATING CO. GCR s claims paying ability ( CPA ) ratings are accorded to short term insurers and reinsurers, and give an independent opinion of an entity s ability to meet policyholder and assumed reinsurance obligations, excluding funds where investment or other risk rests with the policyholder through a contractual agreement. The CPA rating is the basis for any other ratings accorded to insurance and reinsurance companies. This criteria report replaces the version published in July There are no significant amendments to this criteria. Accordingly, it is not expected that the update of any of this criteria will have an impact on any ratings accorded using this criteria. This criteria is effective immediately on the day of publication. Most of the changes related to enhancing the alignment of the methodology and the structure of the rating reports. Certain updates and changes better reflect the manner in which GCR applies rating factor assessments. Furthermore, factors were removed in instances where these were found not to be considered, relevant or measurable across all regions or companies. Such items may still be used for analytical insight by GCR, on a case-by-case basis. Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 1

2 Rating methodology overview Methodology overview GCR s methodologies provide an overview of the frameworks that guide the analytical process. The methodologies explain the key rating factors that are assessed (in terms of their relevance to the rating, and how they are analysed), while also discussing the broad principles incorporated into our assessment. The following guidelines provide a general overview of the quantitative and qualitative factors that GCR considers when analysing an insurance or reinsurance organisation. For the sake of simplicity, this methodology will use the term insurer(s) to refer to short term insurers and reinsurers. Rating coverage / Scope of the rating GCR s CPA ratings reflect an opinion on the relative financial strength of insurers. The ratings do not directly consider the entity s quality of service levels or the appropriateness of its product offering, unless these factors directly impact on the organisation s longer term sustainability. CPA as the anchor rating The claims paying ability rating forms the basis of our assessment of insurer and reinsurer credit quality. Given that an insurance company s contractual obligations to policyholders usually rank senior to all other obligations, the claims paying ability rating is normally the highest rating accorded to an insurance organisation. In turn, the rating of a company s debt issues, as well as ratings accorded to an insurer s broader group structure, are influenced by creditworthiness in terms of meeting policyholder obligations. Support framework A top down approach is applied when assessing the insurance entity s access to capital and other forms of support from its holding company, where it is important to consider the financial strength of the shareholder and its ability and willingness to provide this support when necessary. GCR s opinions are based on a clear understanding of the fundamentals of the rated organisation and the industry in which it operates. These guidelines are intentionally broad in scope, recognising that the process of assigning credit ratings is a dynamic one, and that each specific entity possesses unique characteristics and assumes varying levels of risk. Whilst appropriate financial and credit metrics will vary amongst companies in different sectors, GCR will benchmark an insurer s financial performance and metrics against market peers. Nevertheless, the individual financial metrics or credit ratios are not considered solely against the peer group, but their strength and relevance is determined by their relationship to all other company characteristics. The layout of the methodology follows the structure of the analytical process adopted, and includes annexures that detail additional explanations of process and approaches used for specific rating types: 1. Operating environment 1.1. Country overview 1.2. Industry overview 2. Business profile 2.1. Corporate profile 2.2. Competitive positioning 2.3. Product distribution 2.4. Earnings diversification 3. Financial profile 3.1. Profitability 3.2. Reinsurance 3.3. Asset quality 3.4. Capital adequacy 3.5. Reserving 4. Modifiers 4.1. Risk management 4.2. Support framework 5. Appendix A: Explanation of national scale versus international scale ratings Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 2

3 Operating environment // Introduction GCR s assessment of a rated entity s operating environment forms the cornerstone of the credit rating analysis. The relevance of this factor s impact on companies credit ratings stems from the linkage between broad country and industry factors, and the underlying fundamentals of market participants. Accordingly, GCR assesses the operating environment, in terms of both country risk factors and industry risk factors, in order to gauge the degree to which operating conditions are expected to impact on the credit profiles of related market participants over the rating horizon. Operating environment // Country overview GCR s country assessment addresses economic, political and systemic risk factors that impact on an organisation s operating environment. An analysis of the political and economic environment provides the context against which both the historical performance and future expectations of a rated entity are considered. Economic trends and government policies are analysed to determine their impact on the demand/consumption function within the economy in general, as well as their impact on industry subsegments. This linkage is often heightened in emerging markets, where the political and economic environment tends to be significantly more volatile. Scale and growth prospects The size, composition and growth prospects of an economy directly impact on the performance of the insurance sector. GCR incorporates the rate of GDP growth and GDP growth per capita into its assessment of economic prospects. These metrics are viewed on both single year and multi-year bases. The former contributes to the understanding of review year factors (with the isolation of specific drivers supporting the analysis of operating performance at company level in the review year), while the latter provides a medium and longer term view in order to smooth cyclical factors. GDP growth has been strongly related to insurance industry growth prospects, and as such GCR s forward looking opinion on an industry s premium development will be impacted by economic growth forecasts. GCR also places emphasis on understanding potential structural problems facing the economy, which may require policies that depress economic growth (e.g. structurally high inflation). Sectoral analysis The scale of the economy, and the level of economic activity, is supported by an assessment of sub-sector activity. In this process, sectors that are most likely to be affected by an adverse movement in the economy are identified, as high exposure to such sectors could result in the deterioration of an insurer s operating performance or balance sheet strength. High growth sectors and burgeoning industries, in contrast, offer much by way of growth and diversification, although the level of complexity and associated risk of such markets is assessed in order to place operational impact into context. Macroeconomic variables Macroeconomic variables that reflect strength and stability of both domestic and external factors are taken into consideration. Inflationary trends are observed in terms of broader impacts such as the sustainability of monetary and exchange rates, while also being assessed for the direct impact the variable has on insured values and claims fluctuations. Interest rate levels and movements supplement the inflationary analysis and outlook, while again filtering into an industry specific view (with interest rate risk bearing substantial earnings capacity pressure for insurers). Interest rate movements are also considerations in terms of financial system stability, given the banking industry s interest rate sensitivity. Household sector The economy s income level is also viewed in the context of household wealth, taking into account variables such as unemployment rates, consumption growth, wage indices and levels of household indebtedness. External sector and global / regional considerations External economic considerations are taken into account, including exchange rate movements, trade balances, and commodity prices where applicable. Further, given the increased interconnectedness of operating environments, economic analysis may extend beyond country or regional borders to account for global trends where applicable (in terms of expected impact on business and financial risks). Nevertheless, GCR has discerned that, particularly in the less developed markets, the economic environment is driven more by domestic factors than by international trends. Operating environment // Industry overview The industry overview provides an outline of the market-wide factors that GCR views as impacting on the credit profiles of participants. In similar fashion to the economic overview, a number of external Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 3

4 conditions and risks may have a material influence on an individual company s operating performance, with participants in lower risk insurance markets typically receiving higher credit ratings, all else equal. The industry analysis consists of elements that are assessed consistently (across all countries, and across both general and life sectors), as well as unique factors that are relevant to particular industries. Insurance penetration and density Industry penetration (industry GWP as a proportion of GDP) indicates the level of significance of an insurance market within the broader economic context. Insurance density (GWP per capita) illustrates the extent of insurance utilisation by the underlying population. Both measures contribute to an overview of the level of development of the industry within the local context. Industries with higher levels of development tend to exhibit enhanced resilience to external shocks, while providing market participants with a framework more conducive to operational efficiencies. This notwithstanding, attention is paid to the lower risk underwriting or operating risks related to less developed markets in terms of product risk. Industry composition GCR analyses the industry structure and composition, looking at the number of participants (and the resultant level of industry concentration or fragmentation), as well as the relative positioning of those entities in terms of tiered groupings. This informs the level of relative competition within each of these sets, and influence on pricing and other competitive dynamics. Consolidation trends and intermediary functions, if pertinent, will also form part of this overview. Industry growth trajectory In understanding the risks inherent to the insurance industry, GCR places emphasis on analysing the basic structure of the market, including its relative size. Industries with scale and strong growth prospects allow for development and enhanced significance within the broader economic framework, while fostering potential for scale efficiencies and risk diversification at company level. Accordingly, industry growth is factored into the market review and outlook, while taking cognisance of various qualifying features. As an example, growth that is accompanied by excessive risk taking (in the form of underpricing, or a broader loosening in underwriting disciplines) will likely have a negative impact on the market outlook, due to the potentially destabilising effects thereof. Industry performance Industry performance primarily looks at the profitability of the market at both the underwriting and net levels, taking into account the underlying risk composition. Factors such as industry cycles, the general claims patterns, commission structures and the level of scale efficiencies will support the analysis where relevant. Barriers to entry Barriers to entry are viewed from both a regulatory and operational perspective. In terms of the former, barriers take the form of regulatory requirements for granting licenses (inclusive of minimum capital requirements), shareholding structures, and other regulatory hurdles. Operational barriers relate to the existing competitive dynamics of the market and the scope for new entrants, coupled with the availability of requisite resources. Regulatory environment and transparency The insurance supervisory framework is examined. Apart from an understanding of the legislation governing the industry, GCR considers the instruments used to monitor the insurance system, which include the forms and quality of reporting to the regulatory authorities, as well as the frequency and content of on-site examination and off-site surveillance conducted by supervision authorities. The actions and measures that regulatory authorities are empowered to use in avoiding problems and potential failures of insurers within the system are identified, and the regulatory track record of implementation, intervention and/or risk mitigation is examined. Industry ceiling In certain instances, particular risks or structures at either the industry or country level may result in GCR applying an industry rating ceiling, which caps the rating that a participant in a particular market can achieve. An industry rating ceiling may be imposed by GCR should the fundamentals and characteristics of a particular market represent an inherent limitation on the credit rating profile assessed at a rated-entity level. Such rating limitations can include (but are not limited to) systemic risks that impact on all participants, market maturity, limitations in terms of organisational structure and associated capital flexibility, or regulatory disciplines that impact negatively on key criteria and decisions relative to credit rating criteria. Business profile // Introduction The assessment of an insurer s business profile entails an overview of an insurer s strategic model and objectives, the translation thereof into critical success factors, and an evaluation of the insurer s resultant competitive position. This is supplemented by a breakdown of an insurer s products, distribution channels and target markets, which are both a function of historical strategy and positioning, as well as a launchpad for future strategic implementation. Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 4

5 Business profile // Corporate profile A company s corporate profile provides an overview of the organisation s past and current market presence and ownership structure, as well as an overview of pertinent aspects of the entity s historical corporate development. Key operational relationships and related recent developments are also examined. Ownership and structure Differing ownership structures may have a positive, negative or neutral rating impact. GCR assesses the impact of ownership structures by taking into consideration the operational and technical support provided, capital access, flexibility and management, as well as ownership and creditor interests. Such factors may have a direct influence over an entity s capital position and cash flows over time. Shareholding arrangements impacting on rated entities by way of lean capital structure requirements, or demanding return on equity conditions, may have a neutral or negative impact due to inherent limitations on future capital adequacy or scope for retained earnings (particularly where a track record affirming these traits has been established). Instances in which protracted disagreements or conflicts between shareholders impact negatively on an insurer s operations or balance sheet, or the medium to longer term attitude of influential shareholders towards an organisation have similar effects, are likely to result in negative rating pressure. In contrast, an ownership structure with a demonstrated track record of being conducive to operational and balance sheet strength may have positive rating implications, if viewed to be an enhancement to other fundamental characteristics. Relationships giving way to material operational synergies, or allowing for the transfer of discernible technical support and efficiencies, may support such a view. Insurance groups can provide established systems and process frameworks to subsidiaries, allowing for the incorporation of tried and tested mechanisms into operations. Detail in terms of the rating upliftment emanating from potential financial support of subsidiaries is discussed in the Support framework section. Strategic overview The strategic overview describes the key attributes of an insurer s overarching business model, including an assessment of key focus areas, core capabilities and offerings, and related strategic relationships and systems. Factors are addressed in the context of the company s growth strategy in the short and long term, competitive advantages and defensive characteristics. Business profile // Competitive positioning The assessment of an insurer s future financial strength is strongly influenced by the entity s competitive positioning, and the competitive advantages that the insurer has carved out in its chosen market(s). The level of operational effectiveness achieved via comparative strengths relative to competitors is assessed with respect to a company s track record in addressing industry challenges, its cycle management strategy, and resultant expected growth and profit benefits. A demonstrated competitive advantage is typically exhibited in a superior operating performance, and/or an elevated growth trajectory. The presence of distinct competitive advantages across products, distribution channels or market segments suggest that the company is well positioned to defend its position and earnings capacity in the face of increasing competition, and/or adverse operating conditions. Over an intermediate to long term horizon, strong entities would be expected to display a solid growth trajectory, taking these factors into account. Market position // Market share general discussion // Business quality & pricing power A company s market share is an indication of the degree of acceptance in the market and insurance buyers perceptions of capacity and brand strength. Accordingly, GCR views the size of an insurer s market share as a contributing factor to a company s ability to respond to changing market conditions over time, and manage adverse market conditions. Larger competitors tend to benefit from greater cost efficiencies, as well as enhanced bargaining power and pricing power (attracting higher quality business, while positively influencing pricing, terms and conditions), translating into more stable profit trends over time. Additionally, insurers with strong franchise values tend to exhibit strong product uptake and policyholder retention rates, which serve to support market positioning through future business and industry cycles. This notwithstanding, while the relative size of the company is considered, GCR places greater emphasis on strategic advantages and the sustainability of the business model. Market position // Assessment of niche players within the market positioning discussion Market share is analysed at both a general industry level, as well as a specialist level (should a particular insurer s corporate strategy primarily target a distinct industry sub-segment). Smaller companies with a Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 5

6 strong brand and representation in a chosen niche, specialised expertise and/or captive distribution channels are often able to protect their market position and achieve above average underwriting profitability. Such companies, displaying sustainable competitive advantages and sound credit protection measures, can receive high ratings should a track record of strong earnings be demonstrated, and should such earnings capacity be viewed to be sustainable by GCR. Market position // Sustained core activity The combination of pricing power and access to better risk-exposures also promotes continued activity in insurers core lines and markets. This contributes to the development of existing underwriting frameworks and risk pools, while positioning an insurer to capitalise on new advantageous business opportunities. In contrast, insurers looking to gain significant market share, or lacking similar bargaining powers, may seek business from less familiar risk types or risk pools, or may have to price in higher discounts (away from technical rates), thereby introducing potential volatility and profit-risk into future underwriting performance. Market presence An insurer with an established market presence often possesses standing relationships with market players (policyholders, intermediaries and the like), as well as on-the-ground market knowledge. These can, in turn, translate into competitive advantages, or contribute to strategic adjustments required to address market challenges. Accordingly, GCR will recognise an established market presence as a rating factor if it is viewed as a means of elevating, or at least maintaining, market positioning in the face of increasing competition. Industry and peer group analysis GCR has developed a substantial database of industry statistics in all of our key markets, which assists in positioning a company in its particular industry or sub-segment. Following this analysis, GCR is able to define an appropriate peer group benchmark and contextualise the critical success factors of the business model. The peer group consists of a set of insurers viewed as comparable on a certain basis, or set of criteria. Most generally, the peer group will consist of players operating in the same sector or market segment. Where relevant and available, peers occupying similar niche markets, or insurers with similar business models, will be compared. If a peer group is too small using these parameters, then it may be expanded to include more broadly comparable insurers. Peer group modifier Competitive positioning assesses a particular entity s business profile metrics relative to its peers. In this regard, a peer group comparison may have a positive, negative or neutral rating impact. A favourable rating impact can occur in instances where an entity s criteria compare favourably to its industry-specific peer group. The latter may result in a relative strengthening in market positioning. Conversely, a weaker overall position relative to peers may undermine relative competitiveness. Business profile // Product distribution The business model assessment is supplemented by an overview of the linkage between the company s distribution channel structure and market focus, and the underlying product offering. The success and alignment of this distribution and marketing framework contributes to the development and resilience of an insurer s competitive advantages in a chosen market, while facilitating enhanced pricing and distribution controls. Distribution channels Insurers with effective and diversified distribution channels are better equipped to grow revenues, retain business, align products with target markets, and control costs. In so doing, insurers with strong distribution functions typically exhibit stronger business profiles relative to players with distribution weaknesses, and as such tend to reflect stronger ratings. Market segment analysis GCR s analysis of an insurer s operations includes market segmentation and diversification. Different markets display varying characteristics in terms of both buying and claiming patterns, which impact on growth and profitability. Furthermore, a demonstrated ability by an insurer to achieve differentiation through access to less congested market segments may provide a significant competitive advantage. GCR views distribution channel concentration, and in particular concentration to individual counterparties, as a potential threat to earnings stability. This is due to the disruptive impact that the loss of large portfolios or key blocks of business may have on the insurer s operations should relations with such distribution entities be discontinued. This, in turn, may impact negatively on line of business weightings and related diversification benefits, distribution channel efficacies, scale efficiencies and overall strategic objectives. As such, GCR incorporates the assessment of distribution channel spread into an overall diversification assessment. The relative diversification or concentration of business sources are evaluated within the context of Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 6

7 the rated entity s specific operational framework, and relevant mitigating factors are taken into account. Particular industries may reflect an inherent aboveaverage weighting of particular intermediaries due to their specialised nature, or long-standing barriers to entry. In such instances, an insurer would likely be unable to achieve a level of channel diversification that materially exceeds the industry or sub-segment norm. As such, the impact of this counterparty exposure may be factored into the industry assessment should it be viewed to have a marked impact on participants performance and future rating factor metrics. An overview of policyholder exposures is also conducted, which again aims to assess the level of risk associated with concentration in business sources. Policyholder concentration levels are compared to broad benchmarks (feeding into an overall diversification grade), as well as industry or peer averages where applicable. Qualitative assessment of rating factor The impact of the channel and market linkage impacts directly on the rating via the assessment of average growth, the delivery cost ratio and strategic implementation measures. Beyond this, GCR assesses the distribution channel on a qualitative basis, in order to ascertain the sustainability of the current key variables related to this. GCR also seeks to understand the alignment between the channel structure and strategy, which in turn contributes to the assessment of the achievability of the insurer s budget. Business profile // Earnings diversification The product offering or lines of business in which an insurer participates impact directly on its financial profile, due to the varying exposures, volatility and dynamics at play within each class or product segment. Accordingly, GCR analyses the product risk associated with an insurer s business mix, which subsequently filters into the assessments of earnings capacity and capital adequacy. Diversification benefits can also be priced into products, providing a competitive advantage over less diversified competitors. Diversification The earnings assessment relates to product or line of business diversification, with stronger rated entities typically displaying elevated levels of diversification. The analysis looks at diversification by class/product, on both a gross premium and net premium basis. GCR calculates and compares the revenue distribution across classes of a rated entity relative to peers, as well as the broader industry. Analytical judgement may be applied to the trade-off between product diversification and product focus, should a specialised approach result in concentration that is offset by strategic advantages. The maturity of the company and the industry as a whole are considered if impacting on diversification. The analysis of the line of business diversification is both quantitative and qualitative. Growth // The relevance of growth to the rating outcome GCR assesses the impact of an insurer's growth trajectory on market positioning, quantitative rating factors and risk exposures, while assessing the manageability of growth. This is assessed within the context of differing phases of companies business and operational cycles, as well as broader underwriting and economic cycles. In addition to this, specific business models and target markets will also impact on growth objectives and prospects. Growth // Low or negative growth may be favourable in particular cycles This notwithstanding, there are times when low or flat growth is considered to be favourable, as a means of preserving profitability, particularly through cyclical adjustments or changes in underlying industry fundamentals. Similarly, negative growth cycles, aimed for example at portfolio clean-up, may impact positively on earnings. Financial profile // Introduction An insurer s financial profile is reviewed on both a nominal and cross-cycle basis, in order to gauge the fundamental financial strengths and capacities available in medium-term operating periods. The assessment of an insurer s financial profile is also viewed relative to the industry and peers. Financial profile // Profitability Insurance companies that are able to demonstrate consistent profitability and a lower degree of volatility generally receive higher ratings. A track record of underwriting profitability through rating cycles attests to the relative success of the company s business model and management s ability to adapt to changing market conditions. In this regard, a company s financial performance and flexibility will ultimately drive future balance sheet strength and sustainability. Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 7

8 Underwriting profitability assessment GCR considers several measures of underwriting profitability, assessing these through the cycle and with reference to other insurers that operate similar business models under the same market conditions. The following aspects are assessed where applicable: Pricing and premium rate changes. Exposure to high severity / frequency lines. Claims management. Expense efficiencies and adequacy of infrastructure to sustain new business volumes. Technical profitability trend by class, division or market segment, at both a gross and net level. Underwriting profitability trend (on both a nominal and, where applicable, adjusted basis), and associated claims and cost ratios. Net profitability assessment Profitability, in terms of magnitude, stability, flexibility and sustainability, is reviewed at both the underwriting and net profit level. This comprehensive analysis of performance determines how balance sheet strength will be enhanced, maintained or eroded over time. Returns on equity are also an important consideration for insurers looking to access funding through capital markets. The following aspects are assessed: Average investment yield over a five year period, including and excluding unrealised investment movements. The real return on investments and stability of investment yields. Average return on equity and the shareholders return benchmarks. Impact of foreign currency fluctuations. Retained income to premiums. Adjusted net income, which excludes nonrecurring items. Profitability for heavily reinsured entities Insurers that utilise reinsurance to a substantially higher degree than typical insurance entities often display net underwriting profitability that is not necessarily reflective of the overall performance of the underlying portfolio. In such instances, the sustainability of the portfolio, in terms of composition and pricing levels, and the resultant impact on the insurer s market sustainability, may be better captured through an assessment of gross underwriting performance, particularly in instances of entities that are reinsuring heavily into their parental structure. Financial profile // Reinsurance Reinsurance is used to support underwriting capacity and solvency, during book building as a capital management mechanism, and as balance sheet protection against adverse claims experience. Prudent use of reinsurance as a means of limiting capital erosion is viewed as a positive rating factor, while retention of large portions of risk relative to capital can result in strong negative ratings pressure. Simultaneously, the creditworthiness of the reinsurance partners is assessed, with strong reinsurance counterparties supporting higher rated ceding entities. Reinsurance structure and counterparties GCR analyses the reinsurance structure relative to the nature and size of underlying risk exposures, as well as the diversification and credit quality of the reinsurance counterparties. Specific factors that are analysed include, where applicable: The scope of reinsurance cover relative to the risks underwritten. Net retention per risk and event as a percentage of capital. Estimated gross premium income and minimum deposit assumptions. Treaty limits and use of facultative reinsurance. Changes to treaty terms, capacity and participants on the treaties. Premium retention trends and strategy going forward. Internal reinsurance arrangements and potential for accumulation risk at group level. Reinsurer technical profitability over a three to five year time horizon. Profit leakage Catastrophe risk Catastrophe risk holds potential for high severity event losses to occur unexpectedly, resulting in rapid erosion of policyholder protection. The potential shift in the frequency of such events heightens the need for increased supervision of this risk component going forward. GCR assesses insurers catastrophe risk management capabilities, taking into account data quality, exposure monitoring techniques and process controls. Assessing potential changes in reinsurance // pricing and capacity The cost of the reinsurance programme impacts on net underwriting profitability. The median trade-off of the programme is calculated relative to the earnings protection that it aims to create, as well as the balance sheet capacity offered. The insurer s net Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 8

9 technical margin is also compared to that of the reinsurance grouping, in order to gauge the balance of profit flows. Over the medium term, skewed aggregate profitability (in terms of technical margins) towards either party may be indicative of potential changes to the programme, relating to pricing, structure or capacity. These potential changes require analytical judgement in terms of their impact going forward. For example, the loss of reinsurance capacity may result in an entity s adjustment to its product offering, while increased pricing may weaken profit potential in particular areas, or limit competitive positioning. Financial profile // Asset management The quality and composition of the investment portfolio has a direct impact on an insurer s profitability and capital levels, and is a key consideration in GCR s analysis of balance sheet strength. Assuming that reserving is sufficiently prudent, higher ratings will generally be accorded to companies that match policyholder liabilities with investment classes that are relatively liquid and subject to a lower degree of market volatility. Companies with a short track record and those that are susceptible to greater underwriting volatility would be expected to maintain more conservative investment portfolios, given their lower tolerance for market fluctuations and potential reliance on investment returns to support capital accumulation. Investment strategy alignment to ERM Insurance companies should have clearly defined investment guidelines that stipulate minimum counterparty ratings and concentration limits, and should be able to show that this policy has been adhered to over time. Liquidity From a liquidity perspective, the company s ability to fund short term cash flow requirements with strong, sustainable and consistent operating cash flow generation is assessed. Furthermore, the rating would consider the extent to which foreign currency denominated liabilities are backed by investments that mitigate currency risk. Liquidity metrics may be analysed under base and stressed scenarios when relevant. Diversification of banking counterparty risk may also be measured, carrying increased significance in environments exhibiting weaker financial system stability. The following ratios are incorporated into the liquidity assessment: Cash and liquid investments as a proportion of net technical provisions. Cash coverage of average monthly claims. Cash coverage of average monthly operating costs. Liquidity // Government debt GCR typically recognises domestic government debt in base liquidity ratios, on the basis that governmentissued instruments are typically a proxy for risk-free securities, or at least securities exhibiting characteristics of minimal risk. This notwithstanding, in countries with an elevated level of political or economic risk that points to a weakening in sovereign willingness and ability to meet financial obligations in a domestic context, government debt will be treated as a normal bond instrument, with relevant capital charges applied based on applicable debt ratings. Non-cash exposures Companies with stronger ratings typically reflect a lower exposure to higher risk and illiquid assets, such as listed equities, unlisted investments, property investments, and advances. GCR assesses diversification by counterparty, sector and individual security, as well as credit quality of securities. Capital exposure to variations in asset valuations represents a significant threat to balance sheet strength. Suppressed financial market conditions can depress both asset values and earnings, in turn softening capital strength. The exogenous nature of such volatility gives rise to inherent risk, which may exacerbate other operational challenges. Accordingly, where viewed as appropriate, asset haircuts may be applied in order to determine the potential impact on capital, with strained solvency emanating from aggressive investment positions being factored into the rating decision. High weightings of illiquid assets in the investment portfolio offer limited liquidity relief in periods of increased liquidity requirements, while exposing the insurer to a concomitant high degree of capital risk. Liquidity is also a particularly important consideration in periods of sizeable fair value reductions in market-related instruments, reflecting the company's ability to hold securities until their economic value recovers. In this regard, a high degree of liquidity enables an insurer to meet unexpected needs for cash without the untimely sale of investments or fixed assets. The latter may otherwise result in the conversion of fair value losses (due to temporary market conditions) into economic losses with a permanent weakening capital effect. The quality of the overall asset base is also analysed, with particular consideration given to the proportion of capital tied up in outstanding premium and reinsurance debtor balances, and non-income generating assets. Insurers with a high weighting in such assets can face liquidity constraints, while their return on capital may be limited. Where an entity has large related party transactions and balances, GCR Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 9

10 ensures that the purpose and terms of these transactions are clearly understood, and discounted where appropriate. Quantitative assessment measures of investment and asset risk include: Higher risk assets as a percentage of total invested assets and capital. Revaluation reserves as a percentage of shareholders funds, and the timeframe over which these reserves have been accumulated. Long outstanding debtors or other assets that expose the company to undue credit risk, relative to capital. Premium and reinsurance receivables as a percentage of capital. The quantum of inter-company loans. Regulatory considerations In certain markets, insurers are restricted in terms of their investment opportunities, as a result of the fundamentals of the investment market. This is typically the case in less developed capital markets, and GCR may impose a rating ceiling on the industry if the associated lack of flexibility and diversification has an adverse impact on policyholder protection. Financial profile // Capital adequacy Insurers that are well capitalised are in a better position to withstand adverse changes in the operating, regulatory and economic environment, underwriting and investment cycles, and the impact of shock scenarios such as catastrophe losses and investment market corrections. Accordingly, the strength of a company s balance sheet and, most importantly, its ability to preserve and grow surplus capital is a key determinant of its longer term financial soundness and credit quality. The analysis of capital adequacy interacts with other key rating factors that contribute to the holistic credit assessment, while not being directly linked to capital adequacy via the measurement of exposures. Capital constraints can also limit an insurer s ability to achieve strategic growth, or enhance capacity for particular lines, which may filter through to various parameters of future operating performance. Overview of GCR s risk-based capital adequacy assessment GCR incorporates a risk-based solvency approach into its capital adequacy assessment. Excess capital is viewed as a buffer against adverse developments across an insurer s risk spectrum, and as such the risk-based tool provides an indication of the ability of a company to absorb unfavourable risk deviations. These risk modules cover the underwriting, market, credit, operational and reserving risk components of the business. Insights drawn, in conjunction with various qualitative factors, are utilised to form an overall opinion of capital adequacy. The following main factors are considered: The underwriting risk composition. The quality, sustainability and diversification of earnings and ability to support internal capital growth. The quality of the asset base, investment portfolio mix, liquidity levels and exposure to market risk. The structure of reinsurance, participating reinsurers credit quality and diversification. The adequacy of reserves based on historical trends and run-off patterns, where this information is available. Regulatory capital considerations GCR assesses an insurer s capital adequacy as per the local regulatory framework. Capitalisation levels that exhibit limited buffers relative to statutory requirements, or register within a band of regulatory sensitivity, may be at risk of supervisory intervention that sees suspension of particular lines or products, or stronger action such as curatorship or license withdrawal. Use of the rated entity s internal capital model GCR recognises that risk based capital models are playing an increasing role in maintaining appropriate economic capital levels and efficient reinsurance structures. The outcome of a company s internal risk based capital model is taken into consideration in the rating process, incorporating the maturity of the model and the degree to which it has been tested through the cycle. Furthermore, cognisance is taken of the need to align internal capital models with regulatory requirements in the respective jurisdictions. Models that have been independently tested by professional bodies carry more weight. Capital adequacy and ERM Each of the key capital adequacy factors is analysed using standardised measures that can be compared with an appropriate peer group or industry benchmark, and GCR s solvency margin guidelines for a particular rating band. In this regard, it is important to obtain a clear understanding of the company s capital management approach, dividend policy, and supplementary capital flexibility considerations such as sources and availability of additional funding and any holding company guarantees that are in place. These factors are used to assess risk management across underwriting, market, credit, operational and reserving fields to supplement capital adequacy calculation. Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 10

11 Financial profile // Reserving Companies that make prudent provision for future policyholder obligations are less likely to be impacted by unexpected shocks and capital volatility. GCR assesses reserving levels and trends relative to the underlying risk composition and in the context of industry norms and regulatory requirements. The company s internal reserving approach and extent to which reserving adequacy is independently assessed, as well as the frequency of these reviews are considered. In addition to the qualitative aspect, the following reserving ratios are used: Net technical reserves and reserve transfers relative to net business volumes written, and reserve development over time, where relevant information is available. Net reserves as a percentage of shareholders funds. Compliance with regulatory requirements and the relative stringency of these guidelines. Modifier // Risk management // Introduction Enterprise risk management ( ERM ), corporate governance, and strategic management, are factors that impact on almost all elements in the credit rating assessment. A robust oversight and directional framework is a contributing factor to creditworthiness. ERM pertains to a holistic approach to identifying, measuring and managing all of the risks facing an organization. GCR assesses corporate governance and management in order to gauge the combination of strategic flexibility and efficiency available within a framework of strong business practices. The realisation of operational effectiveness derived from such structures is likely to contribute to controlled credit fundamentals, while enhanced market positioning may be borne out of a clear strategic agenda. material risks, and their interrelationships. Accordingly, through a holistic understanding of an entity s risk profile, decisions regarding risk management and capital allocation can be coordinated to optimise financial stability and resilience. Insurers that develop a formal framework to quantify and manage risk within accepted risk tolerance levels are better equipped to manage potential volatility in earnings and capital. Stringent ERM processes often contribute to fortified performance relative to peers, throughout the challenges of both the underwriting and broader economic cycles. Accordingly, a rated entity s demonstrated ability to monitor and control risk can be a rating differentiator. ERM assessment overview GCR s assessment of ERM centres on the level of development of an insurer s ERM capabilities, the degree of ERM operational integration, and enterprise-wide implementation track record. ERM is viewed within the context of the nature, scale and complexity of the business, encompassing a proportional approach, noting that the extent of sophistication differs depending on markets and industry requirements. Nevertheless, all insurers, independent of their size and complexity, need to have some capabilities to limit their risk exposure and losses within their chosen risk tolerances, viewed from a holistic perspective. Risk framework The ERM assessment begins with an overview of the risk management structure in place at a particular organisation, whereby GCR looks to gauge the degree of formalisation and sophistication of the ERM framework. In particular, the transition from risk management primarily aimed at facilitating the identification of risks, to a more developed format is key. The latter pertains to the incorporation of risk measurement and management into strategic and capital management decisions. This is optimised by an effective risk management function that is independent of risk-taking business units. Modifier // Risk management / ERM ERM refers to the process of identifying, measuring, and managing risks via a comprehensive framework, whereby an insurance entity undertakes a selfassessment of all reasonably foreseeable and relevant Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 11

12 Risk identification Risk interdependencies Risk tolerance ERM Framework Risk profile assessment Risk modelling Risk limits Risk management policies Risk measurement Risk aggregation Risk appetite U/w Reserves Reinsurance Market Credit Risk selection Risk monitoring Emerging risk management Risk mitigation Operational Risk framework // Entrenched and formalised The degree of ERM integration into the operational framework supports the evaluation, with strongly embedded ERM systems reflecting the incorporation of risk tolerances into day-to-day strategic decision making. This requires an entrenched risk management awareness that extends to all aspects of the business. Risk management must be integrated with the control culture of the organisation, looking at both the propensity to take risk and to exercise control. Risk framework // Reporting and structure An insurer s risk management practices and procedures should incorporate both top-down and bottom-up approaches. The responsibility for effective ERM policies and procedures ultimately rests with the board and senior management. They should provide suitable oversight of the risk management system, which includes setting and monitoring policies to cater for all reasonably foreseeable and relevant material risks. Responsibility for risk management should be clearly allocated. This may include the appointment of a suitably qualified risk manager, where appropriate and proportionate. A bottom-up approach enables specific risks to be monitored and managed at a business or activity level within risk limits that are consistent with the overall risk tolerance of the insurer. Employees should have a clear understanding of their role in risk management, and it is the responsibility of senior management and delegated risk management authorities to ensure this. An insurer should be appropriately resourced so that monitoring systems are able to evolve with its business risks and are able to meet the increasing sophistication of ERM requirements and practices. Risk framework // Group considerations Cognisance is taken of the ERM functionality within certain group structures, which may differ from a stand-alone entity in terms of the layout, while providing the equivalent level of risk control. In this regard, certain tasks may be performed in higher layers of the group in terms of conventional ERM structuring. GCR takes such structuring into consideration, assessing whether risk is being adequately managed at the appropriate level within the group. Risk identification The ERM framework should identify all reasonably foreseeable and relevant material risks to which an insurer is, or is likely to become, exposed. Such risks should include underwriting risk, market risk, credit risk and operating risk, as well as other material threats such as liquidity risk, group contagion risk and reputational and legal considerations. An insurer should consider the causes of different risks and their impacts, and assess the relationship between risk exposures. The insurer should also identity external risk factors which, if they were to materialise, could pose a significant threat to the business. Risk measurement Risk measurement is the combination of the impact that a particular risk will have on an insurer, and the probability of such a risk materialising. Risk quantification is supported by the company s access to scientific risk measurement tools, such as catastrophe modelling, actuarial reserving techniques and hedging instruments. Risk modelling Optimally, risks should be modelled to assess their potential effect on an insurer s business. Different approaches may be appropriate depending on the availability of reliable data for the behaviour of varying risks. For example, there may be limited data for low frequency, high severity risks such as catastrophes, particularly in areas which are exposed to such a risk (although historical experience has been very limited). Techniques to measure such potential impact of exposures will differ from methods pertaining to high frequency risks, which reflect high levels of claims experience data. Stress and scenario analyses can be used as measurement tools to analyse the impact of such events, which also contribute to long term business plans in terms of changing exposures and the implications for risk management. Where risk is not quantifiable on the above bases, as is the case for certain operational Global Credit Rating Co. Global Master Criteria for Rating Insurance Companies (Updated July 2014) Page 12