Ratings agency Standard & Poor's warns capital requirements could rise on certain lines of business and in certain geographies as a result of its decision to review and change the way it models capital adequacy levels in the insurance industry.
Major changes to the way it models affected companies are set to be outlined for review in July, when the provider of financial data will look for industry feedback.
One of the objectives of the changes will be to make S&P’s modelling more sensitive to current risk.
Since introducing its current model for calculating risk in the early 1990s, S&P says increasing complexity of products and changes to volatility of risk mean it must update the way it does its calculations.
What this means in practices is explained thus: “When the new model has been implemented, S&P will estimate target capital required for each rating level based on the company’s risk profile.”
“We will compare the total adjusted capital to the required target capital, which will now include all risks, including asset, credit, interest rate and insurance risks. Finally, we will calculate the redundancy or deficiency of target capital to total adjusted capital at each rating level based on the financial strength rating.”
According to S&P’s ratings system of using 'AAA' to indicate the strongest companies, this will require a 99% “confidence level” under the new model in terms of the company’s ability to absorb risk.
An ‘A’ rating would require a 98% confidence level, while ‘BBB’ would suggest a 96% minimum confidence level.
S&P adds it does not expect the model change to result in immediate ratings changes, but that over time it will “provide new information that will prompt detailed reviews with insurers about potential deficiencies in their capital positions relative to their perceived risks.”
That said, the industry as a whole is in a far better position than in 2001-3, when there was significant focus on capital adequacy with regard to ratings then in force.
Another major change set to take place as the model changes is the commitment to adjust to unfunded liabilities.
“Although this is not standardised across all countries, accounting practice in Europe increasingly requires companies to eliminate unfunded liability from equity, and S&P’s calculation of capital will reflect this practice.”
“In making these calculations, S&P wil luse the fullest measure of the unfunded liability on an after-tax basis: the projected benefit obligation minus net assets, which is the ultimate obligation for an ongoing enterprise….where the amount of unfunded obligtations causes adjusted leverage to increase by 10% or more, suggesting a lower rating category, S&P will be evaluating management’s longer-term capital strategy in making its assessment of the ratings impact of unfunded obligations. Credit will not be given for any surplus reported on the balance sheet.”
S&P plans to finalise the new model in the last quarter of 2006, while its introduction in 2007 will run alongside the current model to continue its stress testing.IFAonline
Since first announcement
In process of recovering money
Expected to complete in Q2
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