Dagong Europe Proposed Criteria for Rating Insurance Companies 31 July 2013

Transcription

1 Dagong Europe Proposed Criteria for Rating Insurance Companies 31 July 2013 Request for Comment Carola Saldías Senior Director Financial Institutions Analytical Team Christina Sterr Director Financial Institutions Analytical Team Fabio Boninsegni Senior Credit Officer DAGONG EUROPE -

2 This request for comment details Dagong Europe s Proposed Criteria for Rating Insurance Companies. Market participants are invited to review and comment on the proposed criteria to: consultation@dagongeurope.com by 29 August 2013 TABLE OF CONTENTS I II III SCOPE SUMMARY OF CRITERIA FOR RATING INSURANCE COMPANIES INDIVIDUAL FINANCIAL STRENGTH ASSESSMENT (IFSA) Operation Environment Corporate Governance and Development Strategy Sustainability and Competition Risk Management Financial Analysis Stress Testing and Scenario Analysis IV V EXTERNAL SUPPORT ASSESSMENT (ESA) OTHER CONSIDERATIONS FOR INSURANCE COMPANIES CREDIT RATINGS 1

3 I SCOPE Dagong Europe has developed a comprehensive set of criteria for the process of assigning Credit Ratings to Insurance companies. It is applicable for Life- and Non-Life insurance companies, as well as reinsurance, other insurance operations (health, mortgage, global credit and trade, title) and insurance companies with mixed insurance operations. Procedures, criteria and models applied by Dagong Europe in its credit rating process are developed in agreement with the Dagong Europe Sector Heads and Credit Officers and approved by the Committee for Credit Policies. II SUMMARY Dagong Europe has developed a comprehensive Insurance Rating Criteria. The analysis follows a flow from macro to micro level based on specific characteristics that apply to any insurance company. The analytical approach followed by Dagong Europe when assigning Credit Ratings to Insurance companies, is based on the framework applied for Financial Institutions ( Dagong Europe Proposed Criteria for Rating Financial Institutions published 18 June 2013). However, the Criteria take into account the peculiarities of the insurance industry, in terms of financial performance, industry dynamics and competitiveness. The framework, therefore, is based on the Financial Institutions Rating Criteria but prepared with the specifications of insurance companies concerning Operation Environment, Sustainability and Competition, Risk Management and Financial Analysis, allowing a broader comparison tool in terms of credit analysis within companies that belong to the financial industry. Using the Financial Institutions Criteria for Rating Financial Institutions as a base, Dagong Europe applies the same overall framework for insurance companies. The application of the Financial Institutions analytical framework provides a thorough comparison of the Credit Ratings among insurance companies with different business models, and also with other financial institutions (mostly banks). For Dagong Europe, this is a key aspect to highlight the comparability of Credit Ratings within the financial industry. Accordingly, the Credit Rating assigned by Dagong Europe to an insurance company comprises its ability to service obligations in relation to policyholders and debt holders. 2

4 Exhibit 1 Components of Dagong Europe s Credit Ratings for Insurance companies Individual Financial Strength Assessment (IFSA) External Support Assessment (ESA) CREDIT RATING Source: Dagong Europe The Individual Financial Strength Assessment ( IFSA ) The IFSA represents Dagong Europe s opinion on the standalone and individual financial health of an entity. This opinion represents Dagong Europe s analytical view on the financial strength based on its solvency fundamentals and business model. The IFSA does not under any circumstance represent a credit rating, or a default indication of the debt issued by the entity. Nevertheless, Dagong Europe s opinion on the IFSA is helpful for direct comparisons between entities, and is the main driver of the Credit Rating. The IFSA is used within all kinds of financial institutions (insurance companies, banks, nonbanking financial institutions, consumer finance, etc), offering the market a thorough and useful tool to compare the financial strength of any entity, independently of its business model, nature or location. The External Support Assessment ( ESA ) The ESA represents Dagong Europe s view on the likelihood of the external support (from a parent entity or other eventual support providers) that an insurance company could receive, to prevent default when in financial distress. When insurance companies find themselves in extremely depressed conditions -- mainly when the ability to fulfill policyholders obligations or market debt is deteriorating, or a significant reduction in capital or reserves that could weakening the financial profile -- external support is crucial in overcoming the financial stress or rebuilding market confidence. The opinion on external support completes the overall analysis when assessing the likelihood of an insurance company s default, following a more restricted approach of the eventual support providers when compared with other financial institutions (mostly banks). The sections that comprise the analytical framework applied by Dagong Europe for assigning the IFSA and ESA for insurance companies are detailed in the chart below: 3

5 Exhibit 2 Credit Rating CREDIT RATING Individual Financial Strength Assessment (IFSA) Operation Environment Corporate Governance & Development Strategy External Support Assessment (ESA) External Support Provider Level of Support Sustainability and Competition Risk Management Financial Analysis Source: Dagong Europe III INDIVIDUAL FINANCIAL STRENGTH ASSESSMENT (IFSA) The IFSA reflects Dagong Europe s evaluation of the stand-alone, intrinsic financial health of an entity based solely on its financial fundamentals, business model and operating environment. The IFSA is directly comparable with other entities within the financial industry since it does not include any adjustments related to external support. The IFSA criteria applied by Dagong Europe to insurance companies varies between Life and Non-Life insurers. Decisions on applying the appropriate criteria (Life or Non-life) for insurance companies with mixed business models reflect the dominance of a respective segment. However, in cases of highly diversified and equally relevant business models, the combination of factors that represent each sector is used. In addition, Dagong Europe assesses whether the business nature of the entity is accurately represented by non-adjusted metrics. If this is not the case, adjustments are made to reflect the financial profile and risks that otherwise may not be identified (e.g. if off-balance sheet accounts are relevant for analytical purposes). It is worth noting that any adjustment, if necessary, is clearly highlighted and disclosed for analytical and benchmark purposes. The IFSA is the first stage in Dagong Europe s process of assigning a Credit Rating. It is worth noting that the IFSA does not, under any circumstance, represent an ultimate indication of default risk or severity of loss. The higher the IFSA score, the stronger the entity s stand-alone financial health and therefore, greater ability to fulfill its financial commitments. 4

6 The IFSA is presented in lowercase letters to distinguish it from the final Credit Rating, which is presented in uppercase letters. The IFSA uses the scale detailed below. Except the IFSA of 'aaa' and 'cc/c/d', each IFSA can be modified by adding a plus or a minus, expressed as a (+) or (-) respectively, indicating a higher or a lower IFSA within each category. Exhibit 3: Definition of IFSA - Individual Financial Strength Assessment aaa aa a bbb bb aaa denotes the highest score of the individual financial strength assessment, with excellent and strong indicators in all the factors that comprise the IFSA. Represents entities with solid and recognised successful business models supported by an excellent risk management framework. A sound capital base to support organic growth and to face expected and any unexpected underwriting risk is also available. Entities are typically located in stable economic environments with highly efficient and predictable legal and regulatory frameworks. 'aa' denotes very strong individual financial strength, with a combination of excellent and sound indicators within the factors that comprise the IFSA. Represented by entities with solid and recognised successful business models supported by a very good underwriting risk framework. A sound capital base to support organic growth and to face expected and unexpected underwriting risk is available. Entities in this category are typically located in stable economic environments with highly efficient and predictable legal and regulatory frameworks. 'a' denotes a strong individual financial strength assessment with a mixed combination of good indicators within the factors that compose the IFSA. It represents entities with stable business models supported by good underwriting risk frameworks. A healthy capital base to support organic growth is available with a comfortable base to face expected and underwriting risk. Entities are typically located in stable economic environments with efficient and fairly predictable legal and regulatory frameworks. 'bbb' denotes a satisfactory individual financial strength assessment with a combination of satisfactory performance indicators within the factors. It represents entities with specific or stable business models supported by an adequate but still requiring improvement, management of underwriting risk. An adequate capital base to support organic growth is available; strengthening of capital ratios and reserves is expected. Entities would be typically located in economic environments with some level of stability however some deficiencies in the level of development of legal and regulatory environment exist. 'bb' denotes a moderate individual financial strength assessment with a combination of moderate indicators within the factors that compose the IFSA. Represents entities with business models that face tough competition and with underwriting risk models that require improvement. The capital base to support organic growth and to face expected and unexpected risks is highly sensible and should be strengthened to provide more stability. Entities are typically located in economic environments with deficiencies in the level of development of legal and regulatory frameworks. 5

7 b ccc/cc/c and d 'b' denotes a weak individual financial strength assessment with a combination of weak performance indicators within the factors that compose the IFSA. Represents entities with limited business models that face tough competition and with basic risk management frameworks that requires material improvement. The capital base does not support organic growth and does not provide financial stability to face unexpected underwriting risks. Entities are typically located in economic environments with evident deficiencies in the level of development of legal and regulatory aspects and with unpredictable behavior patterns. 'ccc/cc/c/d' denotes a very weak individual financial strength assessment, with a combination of poor and very weak indicators within the factors that compose the IFSA. Represented by entities with limited business models that face tough competition and with extremely deficient underwriting risk management. The capital base and reserves are weak and should be increased. Entities would be typically located in economic environments with evident deficiencies in the level of development of legal and regulatory aspects and also with extremely unpredictable regulatory behavior driven by individual objectives. Source: Dagong Europe The IFSA is the result of a five key analytical factors matrix with specific weights, which Dagong Europe believes represent the main drivers that lead an insurance company s intrinsic financial profile. For details about the weights applied to the five specific factors, please refer to the tables at the end of Section III of this document. The basis for the financial analysis is the combination of a 3-year period financial database (to avoid misleading interpretation of cyclical performance that could trigger a biased analytical conclusion) and most recent financial data available to identify trends. It should be noted that Dagong Europe uses the IFSA in combination with the ESA to determine the Credit Rating. It represents the foundation of the rating committee process and should be carefully interpreted by the market. The five key factors include both qualitative and quantitative guidelines. Qualitative factors and sub-factors are expressed on a seven-scale opinion, ( Excellent, Very Strong, Strong, Satisfactory, Modest, Weak and Very Weak ). Quantitative factors are compared to a range of possible outcomes studied, analysed and tested by Dagong Europe in order to determine a continuous scale that compares the soundness or weakness of each of them. The factors and sub-factors are described in the chart below: 6

8 Exhibit 4: IFSA Sub-Factors Individual Financial Strength Assessment (IFSA) Operation Environment Corporate Governance & Development Strategy Sustainability and Competition Risk Management Financial Analysis Regulatory Environment Corporate Governance Competitive Position Underwriting / Investment Strength Capital Local Macroeconomy Development Strategy Size Product Risk Reserves Legal Environment Diversification Product Risk Management Liquidity Profitability Source: Dagong Europe A Operation Environment The rating assessment of any financial institution, therefore, of any insurance company starts with the analysis of the operation environment. The international and domestic macroeconomic climate is deemed to be crucial to the financial profile of individual entities, setting the starting point for any fundamental analysis and credit risk evaluation. Dagong Europe includes three sub-factors within the Operation Environment which group the key elements that determine the economic, legal and regulatory environment where an insurer sets and develops its business model. In case of geographically diversified businesses, the sub-factors are computed as the weighted average of all the countries in which the entity keeps relevant businesses. For Dagong Europe, weightings are assigned on the basis of the company s annual net premiums written (or assets, depending on disclosure) generated per country. 7

9 A1 Regulatory Environment The regulatory environment provides the base in which an entity develops and sets its business practices. A sound and transparent regulatory environment, with a framework set by a fully independent and credible regulator that shows evidence of empowerment and has control over entities with best practices, promotes a healthy industry environment with adequate incentives. The regulatory environment ranges from multilateral agreements (e.g. Solvency II) to customised regulations based on country specifications (mainly concerning capital adequacy levels, minimum reserve requirements or specific reporting standards). For Dagong Europe, it is expected that the main objective of the regulator is to promote a healthy insurance industry framework. Following on from this, Dagong Europe expects that the regulatory framework should be aligned with the best interests of market participants. Advances in terms of promoting best practices and anticipating upcoming regulations from different regulatory authorities is highly valued and assessed accordingly. It is worth noting that regulatory homogeneity in the insurance industry in terms of reporting is also addressed and analised. The different levels of information disclosure required by country specific regulators, represents a challenge for comparison purposes and therefore should be addressed carefully. For insurers that have operations in more than one country where the size of operations in other countries are relevant (primarily in terms of gross premiums, net premiums written or, depending on disclosure earnings contribution or assets), the analysis includes an assessment of the secondary country s regulatory framework as well. The Regulatory Environment is determined by a seven-point qualitative opinion from Excellent to Very Weak for both Life and Non-Life insurers. A2 Local and Macro-Economy The importance of local and macro-economic conditions, is highly correlated to the performance of the insurance industry. Due to the nature of the insurance industry, the state of the local and macro economy has direct effects on the demand for insurance services and thus the ability of market players to generate earnings. Since insurance products are very diverse in its origin, the demand for more specific and sophisticated products is highly dependent on the country s development stage and the penetration level of insurance products within its population. For example, it is known that in more mature markets, the offer of very specific and more specialilsed insurance products is larger, e.g. specific health insurance, income insurance etc. On the other hand, economies highly exposed to natural disasters (e.g. floods, earthquakes, hurricanes etc.) are very specific in terms of the minimum insurance coverage required. In those cases, the analysis of the local and macro economy and the level of supply and demand of insurance products need to be addressed. Hence, the analysis and assessment of a country s trend in economic growth is a key driver to understand its demand for insurance services and further, to interpret an insurance company s expected performance. 8

10 For those insurance companies that develop global business models, such as life reinsurance, trade credit insurance, some property and casualty (P&C) and marine protection and indemnity (P&I), the macro analysis focuses on a weighted average of all the countries in which the entity keeps relevant businesses. Dagong Europe evaluates the stage of the economy through the following macro indicators: GDP / capita (based on IMF data, last full year or most recent data related to analysed results), which represents the absolute market attractiveness in terms of economic wealth and potential, using a weighted average if there is presence of business operations in different countries. Industry development (qualitative judgment), which represents the risks faced by an entity on both the stage of development of the insurance industry in a specific country and the stage of its own business model. Dagong Europe focuses its industry development analysis amongst others on the following drivers: growth potential of insurance products, supply and demand equilibrium of insurance products, barriers to entry and exit for insurance companies and penetration of insurance products into the population. Unemployment rate (based on IMF data, last full year or most recent data related to analysed results), which indicates the prospective economy strength in terms of potential purchasing power and size of the population with real disposable income. Sovereign risks are incorporated as a reference factor within the local and macro economy analysis. However, it does not automatically affect or drive the operation environment evaluation. Dagong Europe attemps to identify macro factors,which composed the sovereign environment, that are highly correlated with the business of a specific financial institution and isolate those that do not affect the entity s financial profile in the long-term. A3 Legal Environment The Legal Environment is an important factor in setting the operational framework of insurance companies. A well-established and proven legal framework, with clear legal claim procedures as well as the ability to enforce re-insurance contracts is vital to provide a smooth operation environment. In addition, situations when a country s legal framework requires high minimum insurance coverage for specific products (mostly health insurance and P&C) and when the base costs and ability to manage underwriting expenditures is less flexible, should be s highlighted as a legal constrain within the analysis. Dagong Europe evaluates and compares the strengths and weaknesses of each country s legal framework with the aforementioned characteristics in terms of minimum product standards and operation environment. The score on Legal Environment is determined by a seven-point scale based on a qualitative opinion ranging from Excellent to Very Weak. 9

11 B Corporate Governance and Development Strategy B1 Corporate Governance The assessment of an insurance company s Corporate Governance framework follows the same assessment applied for Financial Institutions ( Dagong Europe Proposed Criteria for Rating Financial Institutions ). Dagong Europe recognises that Corporate Governance is an important factor in determining the quality of management, the fulfillment and predictability of the strategic plan and long-term performance. It therefore affects the long-term financial stability and sustainability of an insurance company. Since the approach to Corporate Governance can be very different depending on the ownership structure of an entity, the qualitative judgment made by Dagong Europe takes into account also the complexity of the ownership structure. The assessment includes an opinion on how the insurance company manages its relationship with all stakeholders including shareholders, financial markets, regulatory entities, employees, policyholders and any other relevant parties. A review of the own vision, mission, definition, procedures, internal policies and business practices is crucial to understanding and identifying potential risks from lack of governance or management weaknesses. Dagong Europe s opinion on Corporate Governance is defined as a qualitative score that is Neutral, Weak or Very Weak. The rationale behind this qualitative opinion is based on the fact that Corporate Governance should be a minimum standard of best practices in every insurance company. Dagong Europe gives no credit to strong Corporate Governance frameworks, since it should represent a standard level of professionalism and responsibility. However, there is a negative stance for those frameworks that in Dagong Europe s opinion are not complying with minimum industry standards or best practices; therefore, represent a flaw that could lead to potential governance risks. A comprehensive list of questions and topics that are usually discussed when evaluating Corporate Governance are: Composition of the board of directors/supervisory board and background. Concentration of power of decision making processes. How are strategy and objectives communicated within the organisation and how aligned are they within the organisational structure. Is risk tolerance appetite clearly determined and communicated? How is the risk management function structured and managed? How experienced is the senior management? Are internal procedures and practices clearly defined, communicated and applied? What has been the outcome of the last inspection made by the regulator? Complexity of the ownership structure. Structure of the management compensation packages. Are the incentives for management compensation aligned with a sustainable long-term perspective of the institution? Quality of reporting, controls and monitoring of the board to management level. 10

12 Detailed explanation for any legal or regulatory dispute. Any compliance breach, exception, or fine from a regulatory institution. As part of the Corporate Governance assessment, Dagong Europe also highlights the importance of financial reporting in terms of quality, transparency and timing. The disclosure of financial information of poor quality that lacks transparency or is published late is considered weak Corporate Governance by Dagong Europe. Dagong Europe applies a -1 notch adjustment for Weak Corporate Governance framework and a -3 notch adjustment on Very Weak Corporate Governance framework for the final IFSA level. As mentioned above, a Neutral assessment does not alter the IFSA level. B2 Development Strategy As described in Dagong Europe s Proposed Criteria for Rating Financial Institutions, the analysis of the development strategy of any insurance company ranges from a basic review of the organisational structure to a more in depth analysis of the management skills and ability to fulfill the strategic plan and focus on the long-term sustainability of the business model. In any business model, the business philosophy and strategy plays key roles in determining the long-term objectives and risks that the management is willing to undertake for achieving its strategic goals. It is important that the management s philosophy and actions provide realistic strategies that reflect the real competitive advantages and disadvantages of the company. Unrealistic expansionary strategies, relaxing underwriting standards, aggressive pricing strategies, increasing commissions to intermediaries to gain market share all unnecessarily increase the company s overall risk appetite and misalign the real performance from approved policies. On the other hand, an overly conservative management strategy may result in missed business opportunities and reduced competitive strength in the long-term.a comprehensive analysis of management s ability to implement the business strategy and its competency in achieving it are fundamental to Dagong Europe. As a key tool to analyse the quality of management, Dagong Europe request access to a company s management reporting system and reports to address the soundness of the information and data shared for decision-making purposes and successful execution. The analysis of the growth strategy also includes any merger and acquisition (M&A) process put in place. It is well known that M&A involve risks that are sometimes difficult to identify. The success and value creation through M&A depends heavily on an adequate strategic fit among the merging entities. Management's business decisions and plans for poorly performing business units or those that no longer make strategic sense represent another relevant area for analysis. Objective appraisals of business units and disciplined approaches in dealing with under-performers (divestiture, restructuring, discontinuation etc.) are reviewed. In addition to the company s strategic analysis for the long-term, Dagong Europe includes within the Development Strategy analysis a view on the trend in household savings and indebtedness in relation to the GDP. This analysis is focused specifically on 11

13 Life insurance, basically to address the coherence of the growth strategy with the future macro scenario in which the company is developing its business model. The score on Development Strategy is determined by a seven-point qualitative opinion scale ranging from Excellent to Very Weak. C Sustainability and Competition Sustainability and Competition factors are materials that help an entity to position itself within the competitive environment and develop a successful business strategy. The ability of an entity to scale its operation and gain a stable market share provides a basis for long-term earnings and therefore financial sustainability. For Sustainability and Competition, Dagong Europe analyses the following sub-factors: C1 Competitive Position The ability of an insurance company to develop a competitive advantage provides a basis to generate stable profits and long-term returns. In that context, an insurance company should carefully manage and monitor the competitive environment to foresee the effects that any competitive change would have on its business model and eventually, competitive position. Since the insurance industry is very sensitive to changes in pricing and underwriting policies, the ability of a company to compete and offer differentiated products with adequate risk pricing without jeopardizing the shortterm profitability is carefully analysed by Dagong Europe. The competitive advantages can be a result of an internal strength or an external factor that allows the entity to offer a distinctive product. However, insurance companies develop competitive advantages trough mastering specific market knowledge on specific segments or focusing on business lines where they are able to demonstrate above-average underwriting performance. Controls over distribution channels, adequate agreements with insurance intermediaries, an efficient underwriting cost structure and easy access to target or captive markets are cores for an insurance company to strengthen the competitive position within the insurance industry. Market dominance in terms of market share is important; however, it is analysed not only in gross terms but detailed by market, product, underwriting ability, loss rate track record and ability to absorb unexpected risks or actuarial changes. The score on Competitive Position is determined by a seven-point qualitative opinion scale from Excellent to Very Weak on each of the following measures: Competitive Position (Market Share): Market position and market share per market and product; client recognition; brand name; strong niche market position. Distribution Channels for Life Insurance: number of distribution channels with more than 10% premiums, measures the strength and dominance of the company s ability to keep control over any distribution channel. 12

14 Distribution Channels for Non-Life Insurance: underwriting expenses / net premiums, measures the strength and dominance of the company s ability to keep control over any distribution channel. C2 Size Dagong Europe believes small companies can enjoy a significant competitive advantage when they build defendable market positions in niche segments through specific market knowledge in terms of product underwriting risks, pricing and management of loss ratios. Within the Criteria, however, small or modest size is considered to be an adverse factor in the insurance industry when it is not supported by a proven market specialization in niche segments or business lines (e.g. P&C focused on catastrophic risks, agriculture insurance etc.). Small companies with no market specialization tend to be more concentrated geographically and also in terms of product, supplier and customer base, exposing themselves to adverse situations if unexpected catastrophic events occur or health risks arise. Although Total Assets size is taken into consideration for scoring insurance companies within the Size indicator, additional attention is given to relative revenues, as it determines market position, extent of diversification and financial flexibility. C3 Diversification Diversification is an important factor to be considered in the analysis of any insurance company. In the case of both, Life and Non-Life insurance companies, geographic and product diversification can help to spread the concentration of underwriting risks and reduce the exposure of the balance sheet to unexpected losses as a consequence of specific events (natural disasters in the case of P&C, country economic recession in the case of global credit trade, actuarial changes in annuities, etc.). In addition, the diversification effect can help insurance companies develop a more resilient business model with reduced dependence on premiums generated by fewer business lines, target segments or any other risk concentration. That said, diversification help insurance companies to spread the risks they underwrite and reduce the effects on the balance sheet from the occurrence of a single risk event. Developing business segments that are not of the entity s expertise, or that are in markets where broader knowledge of risk occurrence or large business intelligence are required to be successfu, could be viewed as a potential weakness instead of a business opportunity. In that context, insurance companies that claim to enter a market or to develop a business line only for diversification purposes is carefully analysed in order to determine the potential benefits in terms of underwriting capabilities. The level of business diversification is also influenced by the degree of risks the company is willing to accept, both in terms of business mix and market segmentation. One of the key factors to improve diversification in insurance companies is the geographical spread of underwriting risks. Premium volume or market share alone does not represent the business coverage adequately. For Non-Life insurance, mostly P&C and credit - trade insurance, the geographic location of their business can have a material impact on its financial profile if unexpected catastrophic events take place, such as natural disasters, terrorist attacks, etc. 13

15 In addition, business lines concentrated in market sensitive products in terms of regulatory pressures (e.g. health care insurance) are also evaluated carefully to identify its diversification benefits. Since underwriting expertise is extremely important in terms of the business diversification strategy developed by any insurance company, the Underwriting Strength analysis also complements the analysis on Diversification. Dagong Europe analyses and reviews in detail the nature of the diversification and the expertise of the entity in terms of market and business model, to fairly assess the diversification effect. The score on Diversification is determined by a seven-point qualitative opinion scale ranging from Excellent to Very Weak on each of the following measures: Product Lines Geographic Segmentation D Risk Management For Dagong Europe, proven ability and expertise to successfully manage risks is a key qualitative factor for insurance companies that demonstrates their long-term individual financial sustainability. An insurance company s ability to generate operating profits under a solid risk management framework in terms of underwriting policies, investment strategy and product risk management is analysed and challenged. The business model developed by insurance companies carry underwriting, product and asset risks that need to be managed well to provide long-term profitability. This profitability is in turn, the result of an appropriate pricing structure that identifies and fairly estimates the underwriting risks acquired. Since the overall profitability that insurance companies achieve is highly determined by the level of risks accepted and rejected, the management of underwriting risk should be economically profitable in the long-term. The analysis of the management framework to determine, price, monitor and control risks is assessed in the business context for which the insurance company is set. The coherence of the risk management framework with the business model is the starting point for the analytical opinion. In this context, Dagong Europe assesses risk components managed by insurance companies separately: Underwriting/Investment Strength, Product Risk and Product Risk Management. D1 Underwriting / Investment Strength The importance of the risk appetite assessment in terms of underwriting policies for Non-Life insurance companies and investment strategies for Life insurance, the identification of business incentives and the review of the practical application of risk appetite are vital factors for assessing an insurance company s risk management. For Non-Life insurance, Dagong Europe evaluates the Underwriting Strength in terms of underwriting policies, risk acceptance, pricing and re-insurance policies to determine the level of overall product risk and ability to manage catastrophic events in the longterm. The analysis of re-insurance policies includes also a view on the reinsurance 14

16 record including past responses and current disputes that can affect the ability of an insurance company to transfer risks and eventually to pay to policyholders. Depending on the risk appetite of any insurance company, the level of re-insurance is a tool to spread risk concentration and protects against any undesirable risk present in the balance sheet. In the case of Life insurance, the analysis focuses on the Investment Strategy. Quality and diversification of the investment portfolio are taken into account when analysing the ability to manage reserves and to keep an adequate asset buffer to provide the agreed minimum yield to policyholders. This is more critical in the cases of guaranteed products, in which the volatility of the underlying investment portfolio could substantially affect the ability of a company to pay to policyholders in the long-term. It is worth noting that the investment strategy is also important for Non-Life insurance companies, as most of the net profit comes from the proceeds of the investment portfolio generated by the level of premiums earned. For Non-Life insurance companies with combined ratios near 100%, the core of the non-insurance profits from the return on the investment portfolio is key to keep solvency in the long-term. A detail of the investment portfolio is evaluated and analysed to identify the overall risk of asset default and the company s absorption capacity without affecting substantially its policyholders commitments and other debt obligations. A broader diversification in terms of asset classes, geographic and maturity, with good asset quality and liquidity will mitigate any uncertainty in terms of reserves sufficiency to absorb losses if forced asset sales are needed to face cash flows reduction to back policyholders obligations. Hence, Dagong Europe is keen in understanding the company s investment strategy, guidelines and how those are applied in practice to follow the company s operating cash flow needs and strategy. Dagong Europe analyses in detail the largest investment exposures or single investments that exceed a material portion of the total capital, which also represent a substantial portion of the company s total investment portfolio. In that case, in addition to a qualitative judgment on investment strategy, Dagong Europe monitors and evaluates (if possible) the reinvestment rate and any other relevant investment indicator, to understand the rationale and application of the investment strategy and their long-term effects on policyholders liabilities and other debt obligations. Dagong Europe s opinion on Underwriting / Investment Strength for both Life, and Non- Life Insurers, is based on a qualitative score of seven categories from Excellent to Very Weak. D2 Product Risk Opinion The product mix chosen by an insurance company gives an indication of the overall risk appetite, acceptance and ultimately risk absorption performance. The underwriting risk of a product is sometimes not entirely known when it is created and commercialised. Therefore, the real risk of the products arises only after its lifetime. If any specific product risk is not identified, chosen and managed well, it can have material effects on the operating profitability first with higher than expected loss ratios and secondly, affecting the level of reserves and deteriorating capital ratios. In that context, Dagong Europe evaluates the ability of an insurance company to manage its product mix in 15

17 terms of granularity, product loss ratio volatility, reserve requirements and product underwriting policies and limits. Dagong Europe s opinion on Product Risk is based on a qualitative score of seven categories from Excellent to Very Weak. D3 Product Risk Performance To complement the analysis of Product Risk, Dagong Europe applies more detailed qualitative factors to analyse the specific framework to manage product risk. Dagon Europe realises that data disclosure and data quality is not necessarily consistent across entities and markets. For this reason, in addition to a qualitative judgment on Product Risk, in the case of Life insurance, Dagong Europe monitors and evaluates the framework applied by the company to manage the mix of product risk and investment strategy. For example, special attention is given to the composition of the investment portfolio in terms of high risk investments (highly volatile equity, highyield debt obligations etc.) as a proportion of the total policyholders equity or over the total investment portfolio. Since this information is subject to each companies disclosure, due to lack of standardization on minimum requirements for data disclosure, in some cases this information is not easy to compare across companies and therefore, difficult to be used on a comparable ratio basis. This is the main motivation for Dagong Europe to analyse the Product Risk Management separately from the Product Risk. In the case of Non-Life insurance, the analysis of Product Risk Management includes a thorough understanding of the reinsurance policies and its dependence to determine the overall level of risk underwritten and the ability to manage catastrophic events. For Life insurance, the most straightforward financial ratio to analyse the level of risks carried in the balance sheet is based on the Loss Ratio. The ability of an insurance company to manage and absorb losses in the past and to allow flexibility to face any further increase in losses is key for analysing the strength in terms of financial flexibility and therefore sustainability. High volatility in the Loss ratio due to changes in underwriting policies, is evaluated carefully since it could generate further losses in the future that are not promptly recognised. On the other hand, losses due to unexpected events that were modeled or where pricing was not properly designed can affect substantially the company s ability to manage product risks going forward. The analysis of reinsurance includes also a view on the past response of reinsurance counterparties and the stage of current disputes that can have a material effect on the company s ability to fulfill its obligations with policyholders. However, a high level of reinsurance recoverables can increase significantly the dispute risk and expose the insurance company to counterparty risks that are difficult to manage. In addition, where there is concentration in few reinsurance counterparties, their ability to fulfill the reinsurance agreements is analysed accordingly. Product diversification, sound reinsurance counterparties (in terms of credit quality and record in response to claims), prudent reinsurance policies and reasonable risk pricing are important factors of Product Risk Management. Companies that have little economics of scale and no further loss absorption, the need to align their reinsurance 16

18 programs with the business strategy to provide enough protection from those risks that the company itself cannot absorb smoothly with their own cash generation. More detailed information is requested in terms of catastrophic protection, mainly for P&C companies. The measures that Dagong Europe uses to assess Product Risk Management strength are: Product Risk Management qualitative judgment Applicable for Life insurance only Loss Ratio / Net Premiums most recent year or year-to-date data Applicable for Non-Life insurance only Reinsurance Recoverables / Shareholder s Equity most recent year or yearto-date data Applicable for Non-Life insurance only E Financial Analysis The last component of the IFSA is focused solely on financial analysis, and includes a detailed view on Capital, Reserves, Liquidity and Profitability. This analysis provides a set of ratios to assess the financial soundness of insurance companies, which is then used also for peer comparison. A sound financial profile which can withstand peak of insurance losses and also economic cycles of lower demand for insurance products are the basis for a healthy and sustainable company s overall financial profile. The assessment of operating performance, balance sheet strengths and weaknesses, capital and reserves positions represent key drivers for long-term solvency prospects. Thus, Dagong Europe has divided the analysis into four sections: Capital, Reserves, Liquidity and Profitability. E1 Capital Capital is fundamental to the financial stability of any insurance company. It is the most certain source of funds to absorb potential and unexpected losses caused by the normal operation of risk underwriting and any other unexpected weakening of operational earnings, due to reduction in premiums written or increase in operational expenses related to changes in distribution channels. Capital is also the sole source of funding that is completely reliable to support any organic growth expansion if needed. To maintain a reasonable level of protection to policyholders, insurance companies are normally required by regulators to keep higher capital levels than those obtained from internal models, to offset potential operational losses. In that context, the capital analysis also includes an understanding of the minimum regulatory requirements and its comparability across countries. Dagong Europe reviews the composition of the company s capital base, the tools the management has in place to control and the capital needs, internal limits and minimum capital levels that are defined to face business cycles. Dagong Europe focuses its 17

19 attention on a company s minimum internal capital adequacy as an important indication of risk tolerance and ability to manage operational losses under tight financial scenarios. The internal capital adequacy level is also compared with any regulatory capital requirement if it exists. Since regulatory requirements in terms of capital adequacy may change within countries, the comparability is calculated based on the surplus over regulatory requirements as a portion of total capital, rather than the absolute surplus. In addition to capital ratios, the analysis includes the financial leverage managed by any insurance company to measure the indebtedness level in relation to its total capitalisation. A prudent management of capital and financial leverage can prevent an insurance company from being exposed excessively to unexpected losses, catastrophe risks, and adverse changes in underwriting that could affect the operational performance and deteriorate its capacity to pay policyholders commitments and financial debt. In addition, for Life insurance, the effect of poor investment performance or eventual investment portfolio losses can be mitigated by a stronger capital position that easily absorbs downturn economic and market conditions. The capital analysis emphasizes standard ratios, providing a high level of comparability between institutions and countries. The ratios that Dagong Europe uses to assess Capital Strength of any insurance company are: Capital Adequacy Ratio (Total Equity/Total Assets) - most recent year or yearto-date data Financial Leverage (Liabilities / Total Equity) - most recent year or year-to date data E2 Reserves The analysis of available loss reserves as well as a proven ability of loss reserves management is an important part of Dagong Europe s financial analysis. Track record of historical loss ratios, reserves adequacy volatility and reserve management techniques are being assessed. Poor reserve management techniques can impact negatively both operational profitability and capital levels, often with a certain time-lag, after products with underestimated risk profiles have been sold. Dagong Europe recognises that the quality of data available to analyse reserves adequacy is limited and also confidential --used for internal models only. In addition, reserves adequacy can be subject to volatility due to underlying changes in business mix, underwriting policies, actuarial changes or other causes. The reserve position and adjustments are carefully evaluated to understand the insurance company s ability to anticipate or manage eventual losses coming from underwriting policy changes, incorporation of new products or changes in reinsurance policies. The reserve adequacy level and growth observed in the past is key to understand the additional risks added to the balance sheet, and how the company build buffers to absorb them. For P&C, this will also help to identify trends in the industry in terms of changes in risk appetite and its alignment with the growth on premiums underwritten. This is also a tool to identify companies that have historically been under-reserved and those that present a stronger reserve position in the long- 18

20 term. The reserve adequacy is also complemented with the opinion provided by internal actuaries who work on proprietary reserve management models. The measures that Dagong Europe uses to assess Reserves are: Reserve Adequacy (1 year change in Reserves / Equity (3 year average) ) most recent year or year-to-date data Applicable for Non-Life insurance only Reserve Ratio (Policy Liabilities/Total Liabilities) most recent year or yearto-date data Applicable for Non-Life insurance only Reserve Management (e.g. reinvestment rate) qualitative judgment Applicable for Life insurance only E3 Liquidity The liquidity position in insurance companies, in general, is more related to the anticipation of cash needs to cover the policyholders claims and debt creditors requirements. The liquidity should not only be focused on cash availability or significant free cash flow generation, but also consider the investment strategy that allows easyto-liquidate investments possession. Dagong Europe gives special attention to liquidity management tools, including a qualitative analysis of liquidity plans (under contingency and normal scenarios) and a thorough understanding of the historical liquidity dynamics that an entity has faced during economic cycles with higher-than-expected policyholders claims. For Life insurance, a sound asset and liability management framework is utterly important, since certain business and product characteristics might require high investment leverage. Internal tools to achieve better cash flow that matches long-term liabilities are reviewed accordingly. For Non-Life insurance instead, the availability of liquidity buffers to match claim expenses is important, when the level of operating cash flow is not large enough and therefore exposes the entity to the risk of forced sales. The definition of the company s cash holding is subject to the information disclosed and the availability of detailed marketable securities portfolio -- to consider securities like e.g. government bonds (with the highest credit quality) as easy-to-liquidate securities in specific cases. Since the liquidation of this type of e securities would typically not cause any market loss, the total amount would be added to the definition of cash. The ratios that Dagong Europe uses to assess liquidity are: Cash / Policy holder Liability most recent year or year-to-date data Applicable for Life insurance only Cash / Technical Reserves most recent year or year-to-date data Applicable for Non-Life insurance only 19