The coronavirus pandemic is an unprecedented event which has caused global market volatility. The impact of COVID-19 on capital markets continues to develop. Credit rating agencies (CRAs) have an important role in supplying commentary regarding the credit ramifications of COVID-19 and we look at how this will impact on the (re)insurance sector.

The Regulation of CRAs

The European Securities and Markets Authority (ESMA) is the sole direct supervisor of CRAs in the European Union (the EU).  Regulation (EC) 1060/2009 (the CRA Regulation) provides for a pan European approach to the regulation and supervision of CRAs. Registration and certification are core activities within ESMA’s supervisory responsibilities.  Under the CRA Regulation, it is possible for a CRA established outside of the EU to have its ratings recognised and used for regulatory purposes in the EU.  If a non-EU CRA rating is not recognised in this manner, the ratings cannot be used for regulatory purposes under relevant EU regimes (e.g. Solvency II).

ESMA publishes an annual market share calculation for EU-registered CRAs. In 2019, the following were the top three CRAs by market share: 

1. S&P Global Ratings – 42.09%;
2. Moody’s Investors Service – 33.39%; and 
3. Fitch Ratings – 16.62%.

There are 38 EU-based CRAs on the ESMA register for the purposes of the CRA regime.    

CRAs and the Impact of COVID-19 on (Re)insurers 

CRAs can impact on (re)insurers by:

• industry outlook ratings: many sectors are experiencing ratings downgrades due to the market volatility prompted by COVID-19. The (re)insurance sector’s outlook rating is currently negative in Europe;
• company financial strength ratings: COVID-19 has resulted in a decrease in financial strength ratings; and
• corporate bonds and other rated instruments: bonds and other rated instruments can affect (re)insurers as they form part of a (re)insurer’s investment portfolio. For example, credit ratings can have an impact on (re)insurer capital calculations, as the size of the capital charge under Solvency II depends on the issuer’s rating. 

(Re)insurers must be cognisant of valuation impairments. In non-life insurance, the insurer is typically exposed to all the risk if investments underperform. The loss may be shared in life insurance between the insurer and the policy holder, to the extent that unit-linked or profit-participating business has been written. Although the insurer often absorbs a greater loss, particularly on protection or guaranteed-type business.

In light of COVID-19, we can expect there to be a focus on threshold and lower credit rating levels. Meaning that due to emerging exposures, there will be negative rating actions and according potential consequences for (re)insurers.

Reinsurance and Collateral

Solvency II sets out requirements applicable to insurance and reinsurance companies in the EU. Solvency II requires capital to be held in respect of counterparty default risk to reinsurers. The amount of capital depends on the credit rating and the capitalisation of the reinsurer. 

Solvency II applies threshold requirements to be considered by cedants in the calculation of their solvency capital requirement and prescribes that the reinsurer must be either: 

1. an EEA reinsurer;
2. a reinsurer from a jurisdiction deemed equivalent for reinsurance; or  
3. a reinsurer with a credit rating of at least “credit quality step 3” (i.e. a calculation by reference to probability of default). 

Notably, the cedant may still claim credit to the extent that the reinsurance exposure is covered by collateral arrangements of sufficient quality. 

A reinsurer’s capital position and credit ratings may become a concern if COVID-19 market instability continues. For example, any substantial decrease in capital strength or credit rating may lead to non-EEA third country reinsurers no longer meeting qualifying criteria. Furthermore, a reduction in the credit rating of a reinsurer may see it fall below a threshold set in a cedant’s own counterparty risk policy which might result in the insurer needing to:

1. replace the reinsurer;
2. or amend the counterparty risk policy to facilitate the downgrade in credit rating (temporarily, to deal with the practicalities of sourcing replacement reinsurance, or to allow time for existing reinsurers to recapitalise or otherwise restore their ratings).

The exposure to the downgrade in credit rating could thus be substantial if sufficient collateral arrangements are not in place.  

ESMA and COVID-19

ESMA is engaging with CRAs in order to assess the impact of COVID-19 on their operations. ESMA is concentrating on the areas of business continuity and adherence to the key requirements of the CRA Regulation – ‘the proper application of methodologies, conflicts of interest, internal controls, transparency and governance’. ESMA is monitoring CRA’s rating actions and is sharing information with Member State national competent authorities. 

On 30 March 2020, ESMA published a call for evidence on credit rating information and data. ESMA states that the purpose of this call is to gather information on the specific uses of credit ratings as well as how the users of credit ratings are currently accessing this information.

European Central Bank Measures

While not directly relevant in the context of insurance, on 22 April 2020, the European Central Bank announced that it has adopted temporary measures to mitigate the effect on collateral availability of possible rating downgrades resulting from the COVID-19 economic fallout. These measures accompany a “collateral easing” package that was announced on 7 April 2020. The measures will apply until September 2021.

If you have any questions in relation to the above, please get in touch with your usual William Fry contact or any member of our Insurance team.

Contributed by Shannon O’Neill