As the former head of A.M. Best in London and a senior executive with Standard & Poor’s, Litmus Analysis Senior Partner Stuart Shipperlee has a very complete knowledge of what insurance and reinsurance company ratings are and, perhaps more importantly, what they are not. We sat down with him in the lobby of the Hotel de Paris during the Reinsurance Rendez-Vous de Septembre, where he provided the following insights.

“We have an interesting situation with the rating agencies,” he said. “Three of the four major agencies—S&P, A.M. Best and Moody’s—have the reinsurance sector on a negative outlook.” S&P was the first to do so at the beginning of the year; the other two have followed suit.

Shipperlee pointed out, however, that “Fitch actually has a stable outlook for the ratings but a negative view of the sector, meaning it thinks the sector’s got a problem even if the ratings [are] reasonably stable.”

The other three rating agencies are basically indicating that over various different forward-looking time periods they expect more downgrades than upgrades. “They have a sector outlook that’s negative, but if you look at the individual ratings, each of them has its own outlook. With one or two exceptions, there are almost no negative outlooks from the individual companies.

“What they’re basically saying is that the market conditions—a soft market, particularly in property catastrophe-exposed companies—would mean that the prospective financial health of those organizations will weaken,” he continued. “That’s what would trigger a downgrade, or at least a negative outlook for an individual rating.” However, he said, “being downgraded from A+ to A still means that you have a pretty robust position.”

That is the reason why there’s a “dichotomy of negative sector outlooks but no negative ratings,” he explained. “In fact, the reinsurers we observe analytically, in terms of their ratings, had a couple of upgrades this year. Mainly affirmation stuff upgrades. The reason for the dichotomy is that the capital position of most of these organizations is very strong. In fact, the soft market is partly because there’s too much capital.”

“At what point do you start saying, ‘Too much capital and weak profitability—a positive and a negative from the analyst’s point of view—equals a downgrade?’ That’s why we haven’t seen the individual downgrades happen yet.”

As a result, the companies whose profitability is most likely to be affected soonest would induce the rating agencies’ credit analysts to “move to the profitability argument rather than the capital strength argument soonest,” he said, as these companies would be those “most exposed to the softest markets. That’s property catastrophe reinsurance, but they haven’t said anything negative yet about any of those organizations that one might assume would be covered by that.”

He also pointed out that there’s an issue over “how soft is this soft market.” Media headlines frequently quote sources as “saying it’s the worst ever or the worst in 20 years, which I think is unlikely.”

“There’s a lot of noise. There’s a lot of negative noise, but if you talk to these companies away from the headlines for their rates and say, ‘How much is it going to impact you?’ you’re often seeing people saying, ‘Well, you know, our combined ratio might be worse than our normal catastrophe experience for the rest of the year, by a couple of points.'”

Overall combined ratios, however, will rarely rise above 100 percent, which is still more or less considered to be a healthy market. “That’s what begs the question,” Shipperlee said. “How do you jump to pose the headline—10 percent, 20 percent reduction in rate—with only a couple of points on a combined ratio?

“Their answer to that question is, ‘But, actually, though, we write primary business. We write proportional reinsurance. We do casualty and property cat, and so the aggregate softening in the market is nothing like the headlines.’

“That’s the optimistic scenario. The pessimistic scenario is that underwriters, and underwritable organizations, inevitably feel some need to maintain volume. They have fixed costs they have to service. They have capital they have to change over every term.”

That’s the real danger, as the people managing the reinsurance companies are tempted to say, “Well, you know what, I’m going to write this piece of business even though it’s 10 percent off from what it was last year because I feel it’s fundamentally good business.’ Individually, they’re making good decisions, but in the aggregate somebody is not running good business.” Eventually, some of those companies will suffer losses on this marginal underwriting, because the law of averages suggests they will not have written business that turns out to be as good as they thought it was.

“If you follow that logic through, that would mean that, basically, they’re underreserving,” he explained. “Not deliberately, but notionally underreserving. They’re expecting a better loss experience.”

Even in this case there is also a more positive scenario, which at least partially explains why “this is not impacting results as much as one might imagine from the headlines. They’ve [reinsurers] just got a lot of spread. They’ve got a lot of diversification away from markets that are impacted by this. The negative scenario is they’re too rose-tinted, they’re too bullish. They’re actually going to incur more pain on the way back than they would have realized was going to be coming up.”

Asked if there is any significant difference in the current market between the smaller bullish players and the big reinsurers, Shipperlee said: “There’s a lot of talk that the bigger players are being positively selected versus the smaller players. In the market there’s too much available capacity. There’s too much supply and not enough demand. People tend toward the biggest players because they have the market power, because they have the reach, because they provide the total cover and because they have the higher ratings, generally speaking.

“You might get a good deal, and you do get a good deal, from an AA- rated global reinsurer versus an A-rated, suspicious reinsurer. All other things being equal, maybe you’d find that rather nice. However, our own view is that that’s an oversimplification.”

He indicated that “insurance buyers are also conscious of the market power of the big reinsurers in a negative sense. They’re going to be overly beholden to the big companies. “Number one, they don’t particularly want to put all their eggs in one or two or three reinsurers’ baskets. They have a certain interest in maintaining their relationships with smaller or more specialized places.

“Conversely, the reverse is also true. One of the problems of scale is you end up needing to own a large part of almost everything. We’re not talking about small. If you’re smaller, a couple of billion of capital or something like that, you can be a bit more choosy. It’s easier to say, ‘Well, that sector is not great. We’re going to do less of that and more of this.’ You have more flexibility.

“It’s probably true that the biggest firms are somewhat advantaged in the stock market, but it’s not as simplistic as is often presented. There are opportunities for some of the smaller firms in this context.”

He also denied that ratings are “simplistic.” They “blend three things: capital and balance sheet strength, which is adjusted; business position strength, which is your fundamental ability to be profitable for whatever reason—anything from the quality of your underwriting to the power of your brand to your relationships with brokers. Then, underpinning that, is the quality of their enterprise risk management and the quality of financial management governance of the organization. It’s a triangle of those three things.”

He added that the situation in the present environment is “almost like a stress test of companies’ ERM and management governance. In the hard market they say, ‘We will only ever write for profit.’ That’s a management issue. Let’s see if that actually happens. We won’t know that until the results come through for this year, next year and later years. All the talk here means it’s not going to be a hard market in 2015, that’s for sure. Softening may tail off, but it’s already gone down quite a long way.

“In my mind the bigger issue is there’s already some leakage of the soft market into casualty, away from property cat, because all the capacity is saying that ‘property cat is underpriced. Let’s do a lot more casualty business.’ Or some of it is. That inevitably leads to softening contagion, if you will.

“If we get into the position where the entire market [is affected]—and maybe even the primary market, because ultimately reinsurance rates will influence the primary market—if that softening continues across the entire sector, then the argument that, ‘actually, the headlines are not impacting the ultimate returns,’ goes away because then most lines of business are affected. That could happen. It’s not clear that it would happen, but it could happen. If that happens in 2015, it would be very messy.”