Does the “sovereign cap” apply to credit ratings for insurer solvency reporting?

This came up in a discussion about treatment of reinsurance and choice of Credit Quality Step (CQS) under South African regulations.

Usually a local currency, international scale credit rating from a credit rating agency is the most direct way to establish a reliable CQS. Where an external rating is not available, one idea is to leverage the table in section 10.9 of FSI4.3 and mapping the relevant factor against the table in 10.8 to find the CQS.

This approach leverages tables from the Concentration Risk module and applies it to the Spread and Default Risk module so it’s not simply a direct application of the FSIs. It places emphasis on a table calibrated to European risks and not intended for use outside of concentration risk.

But what does any of this have to do with the sovereign cap?

South African government’s current long term local currency international scale rating at BB is typically mapped to CQS 11.

The primary danger with adopting the suggested approach is that a (re)insurer , with all assets (including many RSA ZAR government bonds) and staff and business exposures in South Africa with a 1.75x SCR cover would be mapped to a CQS of 7. This is unreasonable, since the risk of economic disruption from government default or debt restructuring in South Africa would affect this (re)insurer.

Even for a leanly capitalised (re)insurer (SCR cover 1.2x) this implies a CQS of 8, better than the largest, most conservatively capitalised insurers in South Africa.

No externally rated insurer or reinsurer in South Africa has a CQS of better than 11 or 12. The table in 10.9 ignores sovereign or country risk in the default risk assessment. Therefore, it significantly understates spread and default risk.

The question here is not whether there is an absolute sovereign cap that no South African entity can be rated above. The issue is that applying this table almost certainly understates the risk and CQS relative to rated entities because it ignores sovereign risk.

In terms of the sovereign cap, the risk of exposure to South Africa is (and should be) factored into the rating for entities with significant exposure (asset, operations, profit sources, regulatory risk, inflation, appropriation et al) in South Africa. This usually results in predominantly South African businesses not having a credit rating better than the sovereign.

There is more to reinsurance optimisation that interpreting the FSIs. The application of the sovereign cap is also mostly a distraction from the choices of reinsurer and reinsurance programme to manage risk and capital.

#capitalmanagement #reinsurance #CQS #optimisation #sovereigncap #creditrisk