A study from Standard & Poor’s Ratings Services examines recent changes in the U.S. capital markets, and concludes that they have “have sparked interest in the credit ratings on small and mid-size insurance companies.”
S&P describes the changes as including “new-found access to capital markets through pools that issue CDO securities, the low interest rate environment, and the greater availability of venture capital following the hardening of rates in the property/casualty market.” It called the current environment “the best of all possible worlds for small insurers seeking access to the capital markets.”
S&P notes that some P/C insurance companies “were forced to change strategies following losses incurred in the late 1990s in an inadequate price environment and have sought investors to bolster their balance sheets as they implemented their turnarounds. The investors, in turn, have sought to access capital markets as a way of enhancing their potential total return on their investment.
“The most important factor driving small and mid-size insurers to seek ratings is their desire to join CDO pools. For small and mid-size insurers, this can be a relatively efficient method of raising capital. These CDOs form pools of securities issued by a number of companies, which often include both banks and insurers.” The announcement also noted that the last pure insurance trust-preferred CDO rated by S&P closed in June 2004, “but a number of predominantly bank trust-preferred CDOs have included some insurance trust-preferred securities in their pools.”
S&P said that during the three years ending in December 2004, it had “rated 52 trust-preferred bank and insurance transactions, with a rated volume of $14.3 billion. Of those, nine were predominantly insurance-backed deals, with a rated volume of $3.2 billion. Very often, the securities issued by the insurers are in the form of trust preferreds, though they may issue other forms of debt or hybrid securities. Typically, the companies in a pool borrow predetermined amounts between $10 million and $25 million, and they pay principal and interest payments to the pool. Pools are highly structured, with tranches for investors seeking different levels of risk. ”
Concerning the rating factors it uses, S&P explained: “The ratings on the individual issuing companies in the pool are not directly related to the ratings on the various tranches. Rather, the structure and protection against default that are part of each tranche will be more important to the investor, but a key component of assessing risk in the CDO tranches will depend on the underlying credit ratings on the issuers in the pool.
“Consequently, the ratings on the pool members are often confidential and not disclosed to investors. This makes it easier for companies with lower ratings, including speculative-grade ratings, to participate in pools without having to deal with the competitive issues related to lower ratings in their insurance businesses.
“If a company is not rated by Standard & Poor’s, the pool organizers typically seek an estimated credit rating using one of a range of ratings products, including Standard & Poor’s Private Credit Assessment, Credit Estimates, or public information ratings. Methods used in estimates of credit ratings are highly model driven and retrospective by nature. Management meetings and the use of confidential information are generally not inputs to the rating process.
“Because these estimates involve largely quantitative tools, they do not have the ability to account for prospective and recent improvements in operations and earnings that have resulted from proactive management actions and strategic changes. In such cases, the company may believe that an estimated rating will not result in an accurate reflection of actual risk. In other instances, the estimated rating may provide a rating assessment that results in a borderline rating relative to the standards set by the pool organizers, and the additional precision of an interactive rating may be viewed as necessary for pool participation. Interactive ratings—the qualitative aspect of which takes into account management strategies for companies that, for example, are emerging from financial difficulty or are undergoing a financial restructuring exercise—could lift the rating above the threshold required for CDO pools or into investment-grade territory.
“Standard & Poor’s may assign a financial strength rating directly to the operating insurance company or assign an issuer credit rating to the holding company, which the pool organizers may then use to imply a notched-down rating for the operating company.
“Most smaller insurance companies that have taken advantage of these developments to access capital have not been rated as strongly as insurance companies that Standard & Poor’s has historically rated. Standard & Poor’s currently rates 416 active property/casualty companies filing a yellow blank with less than $50 million in total adjusted capital as well as 93 active life and health insurance companies filing a blue blank with less than $50 million in total adjusted capital. Those that have recently received interactive ratings are occasionally rated in the ‘A’ range but are much more likely to be rated ‘BBB’ or even below investment grade at ‘BB’ or ‘B’. By comparison, the average rating on life insurance companies interactively rated by Standard & Poor’s is currently ‘A+’, while property/casualty insurers are assigned an average rating of ‘A’.
“The advantage to smaller insurance companies of issuing debt through CDO pools has been related chiefly to access and cost. Many companies regarded the low interest rate environment in 2004 as an opportunity to borrow at rates that were conducive to high returns. Smaller issuers generally do not have access to the capital markets, and the cost of funds has been lower in CDO pools than direct debt issues to private investors or borrowing from banks.
“Smaller insurance companies have a range of motives for issuing debt. Ongoing consolidation in the insurance industry has made growth imperative to better manage unit costs and support strategic initiatives, and certain forms of debt can be used to increase statutory surplus. Another reason is that start-up and fix-up companies have been funded or bought by venture capitalists and other investors who are interested in ratings as part of the acquisition process and see the low interest rate environment as favorable to issuing debt to better leverage their investment. Yet a third reason is that fallen angels (companies with ratings that have fallen from investment grade to speculative grade) have also been candidates for CDO pools.”
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