Insurance Companies

10th October 2019 (Version 2)

Executive Summary:

General insurance (Non-Life) companies play an important role in the financial services sector by offering risk cover against various non-life related risks through a wide range of products and services. They offer a wide range of products and services across business segments such as motor, fire, health, marine, aviation, engineering, liability, personal accident etc. Acuité assigns 'Financial Strength Rating' (FSR) to the general insurance companies to reflect the ability of the insurance company to meet its claims related obligations towards the policy holders.

Acuité assesses the standalone credit risk profile of the general insurance company based on the evaluation of the industry risk, business risk, and financial risk profiles of the company. In addition, Acuité also factors support by parent/group/government into the rating for companies backed by strong parent/promoter groups or the government, which are expected to provide regular support to the rated insurance company to meet its growth and regulatory capital requirements.

Rating Methodology:

Industry Risk:

Industry risk assessment includes evaluation of various factors impacting the general insurance industry including the market size and historical growth trend, future growth potential and drivers for the same, competitive dynamics of the various segments within the general insurance industry and the players therein, and impact of competition on the pricing strategy and business practices of the insurance companies. Acuité also analyses the impact of the economic conditions, government policies and regulatory environment for the industry and various individual segments. Any material changes in regulations or industry practices in the underwriting norms, claims and investment pattern, solvency margin requirements or taxation may significantly impact the industry and alter the competitive positioning of the players.

Business Risk:

Market position

Market position assessment includes evaluation of the rated entity's presence across business segments within the industry, its competitive strength compared to other players within each business segment, franchise, distribution network, and growth enablers including assessment of business/operational linkages with the parent/group. Leadership position across one or more business segments provides competitive edge over peers in the industry and pricing flexibility. Diversity across business, customer, and geographical presence provides long-term business sustainability and flexibility during times of stress.

Underwriting policies and practices

Evaluation of the rated entity's underwriting policies and practices is a critical input to the business risk assessment, as it is the key to the long-term sustainability of the company in the industry. It reflects adequacy/inadequacy of the pricing of risks against the claims to be incurred in future. A separate business segment wise and an overall assessment is undertaken as the risk dynamics are different across the various business segments and can significantly impact the overall performance.

It involves assessment of the impact of the past and current underwriting policies and practices on the company's performance (past and future) as well as the management's future strategy. Underwriting policy and practices will be driven by the various factors including industry dynamics and management's strategy with respect to future growth plan and mix, market penetration, risk-based pricing, profitability etc.

India has seen emergence of single business segment focused insurers in recent times – several standalone health insurance companies are present in the market and competing with the diversified general insurance companies. The ability of these companies to have deep understanding of the business and price the risks appropriately, is critical for their growth.

Apart from qualitative factors, the evaluation also includes various quantitative factors of business performance such as underwriting margin, combined ratio, incurred claims ratio, among others.

Reinsurance strategy

Reinsurance is critical for any insurance business as it enables sharing of risks across the global insurance sector, especially in case of any major catastrophic risks. It enables general insurance companies to limit the losses on the originally underwritten portfolio, thereby strengthening their underwriting capabilities. The assessment includes evaluation of the reinsurance strategies with respect to the proportion of the reinsurance undertaken through various reinsurance schemes across business segments, sharing of claims in excess of the retention limit, track record of reinsurance claims recoverability and the credit profile of the reinsurance companies. The assessment also includes evaluation of reinsurance accepted by the rated entity from the other insurance companies and the track record of claims payable from such reinsurance.

Investment management

General insurance companies invest policy holder funds surplus in line with the stipulated regulatory guidelines across various asset classes including equities, corporate debt and government securities. Consequently, investment management is integral part of the general insurance business and enables to boost the overall profitability (or helps in mitigating the pressure arising due to underwriting related losses). A well-diversified good quality portfolio with limits on single borrower and industry exposure concentration is expected to generate stable returns over the long term. To achieve this, disciplined investment management across economic and business cycles is critical. In addition to the historical performance, the assessment includes evaluation of the investment and risk management philosophy in relation to the insurance liabilities and the internal controls, especially with respect to credit risk, market risk and liquidity risk. Assessment also includes evaluation of the top exposures across asset classes including equities, corporate debt, and others.

Financial Risk:

Capitalisation

Evaluation of capitalisation is critical for assessing the Financial Strength Rating of an insurance company. General insurance companies must ensure compliance with minimum capital (Rs.100 Cr. currently) and solvency margin (1.5 currently) requirements.

Solvency margin of an insurance company is the size of capital relative to the risk taken, which is all liabilities subtracted from total assets. It indicates the soundness of the insurance company and ability to honour all the claims. Solvency ratio (defined as available solvency margin / required solvency margin) indicates adequacy of capital against underwriting risks and growth.

The analysis also includes assessment of the planned capital infusion and projected solvency margin. Furthermore, ability and willingness to bring in additional capital to meet any catastrophe or significant unforeseen underwriting losses is critical to sustain business operations. It will enable assessment of the availability of adequate capital for growth and insurance company's ability to honour claims to the policy holders.

General insurance companies are also permitted to raise other forms of capital (Preference Shares and Subordinated Debt), which helps them to diversify their capital base and also buttress their solvency margin. However, there are stringent requirements associated with this form of capital, especially to service the dividend / interest on these instruments.

Profitability

A general insurance company's business model assessment provides an indication of the quality and sustainability of its earnings profile and overall financial strength. A company with a healthy business risk profile will be able to achieve profitable growth despite high competitive intensity in the industry. Sound underwriting practices and good investment management philosophy will enable the insurance company to sustain a healthy earnings profile over the medium term. A detailed assessment of the underwriting practices across each business segment is undertaken to evaluate the inherent risks, claims ratio and underwriting performance and its impact on the overall underwriting profits. Underwriting profits are the core earnings of any insurance business and a reflection of its long-term sustainability. However, any volatility in the underwriting performance (even underwriting losses) can be offset by stable investment income. The investment portfolio including the mix of debt and equity also needs to be analysed to assess the stability of its returns and the extent of volatility in the same.

Liquidity and financial flexibility

Any insurance company needs to maintain adequate liquidity to meet its claims related obligations towards the policy holders on a timely basis. This will be primarily in the form of a highly liquid investment portfolio and the operating cash flows. Hence, the risk assessment of the underwritten portfolio, crystallisation of claims and the management's philosophy towards maintaining adequate liquidity on a regular basis in line with the emerging claim obligations is critical. Other sources include the financial flexibility of the promoters to facilitate funding in times of need.

Management Risk:

Corporate Governance

Corporate governance evaluation takes into account management risk in terms of performance and accountability of the management towards various stakeholders such as regulators, shareholders, employees, customers and suppliers. Acuité shall also analyse the qualitative and quantitative parameters that determine accountability of the management towards various stakeholders. In addition, management is appraised on the following parameters

Competency

Competency of the management is assessed based on the management credentials, organisation structure, performance track record, strategies employed by the management in response to the change in environment and finally impact of the strategy implemented on the performance of the company.

Integrity

Integrity of the management is assessed based on track record of the management in adhering to statutory requirements by various regulatory authorities, litigation and such related issues. The management for this purpose includes senior management of the company, directors and promoters.

Risk Appetite

Risk Appetite of the management is an important parameter in assessing management risk. It is ascertained based on the willingness of the management to enter into riskier business segments, exposure to such segments in the past and management philosophy for mergers and acquisitions.

Parent/Group:

Acuité will also factor in parent/group or government support in case of general insurance companies, which are promoted by strong parent/groups/government (please refer to the criteria 'Criteria For Group And Parent Support' for details). It is based on evaluation of various factors including strategic importance of the insurance business to the parent/group, ownership pattern and management control, operational linkages and synergies, common branding, past and future financial support. Acuité also assesses the financial flexibility of the parent/group to provide support both for growth and to address the losses arising from any catastrophic events.

SECTION ON RATING OF HYBRID INSTRUMENTS ISSUED BY INSURANCE COMPANIES

The capital of insurance companies primarily comprises of equity capital from the shareholders. In November 2015, Insurance Regulatory and Development Authority of India (IRDA) allowed insurance companies to raise following other forms of capital to augment their capital position:

  • Preference shares
  • Subordinated debt

These instruments, also known as hybrid instruments, will help insurance companies to improve their Solvency Margin while growing their business and increasing insurance penetration.

The starting point for any hybrid debt rating of an insurance company is its 'Financial Strength Rating' (FSR), whether it is in general or life insurance sector. The parameters considered for arriving at FSR have already been covered in this document. Subsequently, the rating will be notched down to factor in the additional risks associated with these instruments. The risks include non-payment of dividend/interest if the Solvency Margin breaches regulatory requirements. Also, regulatory approval is required if the general insurance company reports a loss or the loss increases due to such payment of interest/dividend. Acuité will also factor in the articulation and demonstration of timely support by the parent/group to meet regulatory stipulations associated with the hybrid instruments.

Risk Features - Hybrid instruments issued by general insurance companies:

These instruments are akin to the Upper Tier II bonds issued by banks under Basel II regulations. The risk of principal and coupon non-payment on the Upper Tier II bonds is linked to the banks' overall capital adequacy ratio falling below the regulatory minimum (9 per cent). Servicing on these bonds also requires regulatory approval in the event of a loss.

Hybrid instruments issued by general insurance companies carry additional risks because of the restriction on debt servicing on the instrument if the solvency ratio of the insurance companies falls below the regulatory stipulation. Further, in case of insufficient profit or loss, approval from IRDA is required to service these instruments.

Features of the hybrid instruments issued by insurance companies

Instrument

Preference Shares Subordinated debt

Limits
on the
instruments

Total quantum of these instruments shall not exceed:
1. 25 per cent of total of paid up equity share capital and securities premium of the insurance company
2. 50 per cent of the net worth of the insurance company

Maturity period

Preference Shares and Subordinated debt shall be for a tenure as follows:
- Minimum Ten years for Life, General Insurance and Reinsurance Companies
- Minimum Seven years for Health Insurance Companies
- Subordinated debt can be perpetual in nature as well.

Call/Put options

Call option after the instrument has run for at least 5 completed years. Solvency ratio to be met before and after the exercise of the call option
No put option is permitted

Return

Dividend / Interest can be fixed or floating rate linked to a market determined rupee interest benchmark rate

Servicing conditions
for dividend/
interest

1. Solvency position of the insurance company being above the regulatory minimum at all times including after such payment of dividend or interest
2. Prior approval of IRDA mandatory if such payment of dividend or interest results in a loss or increase the net loss of the insurance company
3. No loss absorption feature, which may result in conversion of the instrument into equity

Dividend/
Interest
discretion

Cancellation of dividend distribution on preference shares or servicing of the subordinated debt must not impose restrictions on the Insurer, except for distribution of dividend to equity shareholders

Cumulative/
Non-cumulative

Dividend on preference shares shall be non-cumulative
Interest on subordinated debt not paid in a particular year may be paid in subsequent years subject to compliance with the servicing conditions for such instruments
Insurance companies permitted to pay compound interest on the missed interest payment on the subordinated debt

Instrument
amortisation

Instruments shall be subjected to a progressive hair cut for computation of Solvency Margin on straight-line basis in the final five years prior to maturity. Accordingly, as these instruments approach maturity, the outstanding balances are to be reckoned for inclusion in capital as indicated below:

Years to Maturity

Included in Capital

5 years or more

100%

4 years and less than 5 years

80%

3 years and less than 4 years

60%

2 years and less than 3 years

40%

1 years and less than 2 years

20%

Less than 1 year

0%

Seniority
of
claims

1. Claims of Preference Shareholders shall be superior to the claims of investors holding equity share capital but shall be subordinated to the claims of the policyholders and all other creditors
2. Claims of the holders of subordinated debt shall be superior to the
claims of the investors in preference shares and equity shares in that order but shall be subordinated to the claims of the policyholders and all other creditors.
3. Instruments shall neither be secured nor covered by a guarantee of the Insurance Company or other arrangements that legally enhance the seniority of the claims as against the claims of the insurer’s policyholders and creditors


Rating approach:

Acuité would first arrive at or analyse the Financial Strength Rating (FSR) of the general insurance company, as the claims of the policy holders are senior to the claims of these instrument holders as well as that of the equity holders. It would then notch down the FSR rating to reflect the risks associated with the hybrid instruments to arrive at its final rating on the hybrid instruments issued by the general insurance companies. Acuité would factor in the parent/group/government support based on the articulation of, and demonstration of, the support to the general insurance company.

Major risks associated with the hybrid instruments and its assessment:

Hybrid instruments issued by general insurance companies carry additional risks because of:

  • Inability to service interest/dividend on the hybrid instruments in the event of breach of solvency margin regulatory threshold (current minimum requirement is 1.5) by the insurance company. This can be because of factors such as
    • significant growth in business and premiums, especially in segments with relatively high risks resulting in higher reserve requirements,
    • significant losses due to sharp increase in claims, or
    • Changes in regulations requiring higher reserve requirements
  • Regulatory approval required if the payment of dividend or interest results in a loss or increase the net loss of the insurance company

Hence, the rating on the general insurance company shall be notched down to factor in the additional risk on the hybrid instrument as the non-payment of interest/dividend on a timely basis will be treated as an event of default.

While assessing the notch-down, Acuité will consider following factors to arrive at the final rating on the hybrid instruments:

  • Historical trend in solvency ratio and the buffer maintained over the regulatory requirements
  • Articulation and ability of the parent(s)/group to bring in additional capital and the demonstration of such support in the past to support the growth requirements and meet the regulatory requirements
  • Historical trend and the future expectation on the insurance company's claims ratio,any vulnerability due to business concentration etc.
  • For Preference shares, availability of distributable reserves to assess the ability to service the dividend payments

The extent of notch-down will be based on the assessment of the past track record of the Solvency Margin buffer and the future expectation.

The rating on the hybrid instruments will be very close to the financial strength rating of the general insurance company in a scenario of fairly high solvency margin above the minimum requirement and a strong likelihood of a sustainability in the existing buffer levels. On the contrary, lower the Solvency Margin buffer expectation, higher will the notch-down from the financial strength rating of the general insurance company. The rating on these instruments are expected to have higher transition intensity as compared to the financial strength rating on the insurance company as the rating is highly sensitive to the Solvency Margin levels and the earnings.

Please click here to access the previous version of the criteria on "Hybrid Instruments Issued By Insurance Companies”

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