Insurers taking a chance by tying fate to financial ratings: S&P’s

Insurance companies are taking an ill-advised risk by tying their fates to maintaining specific credit rating levels, Standard & Poor’s says in a recent report, ‘Evaluating Liquidity Triggers in Insurance Enterprises.’
“When an insurer agrees to pay a higher rate of interest on certain debt issues if its rating goes down, it would in most cases not have an immediate dramatic impact on its creditworthiness,” S&P’s observes in its report. “However, we believe there is a considerably higher risk when an insurer agrees to credit puts [puts are options to sell a given stock at a certain price before a given date] that require it to retire large chunks of its financing or to post new collateral against trading positions in the event of a downgrade.
“In this scenario, a downgrade could precipitate serious liquidity problems, or even cause insolvency. In such a case, a proposed rating action may be larger, or quickly followed by additional rating changes as a result of these events.
“Although a rating trigger may be intended to protect a lender, or counterparty, from the risk of dealing with a company that has a deteriorating credit rating, it could in some cases contribute to serious liquidity problems, or even bankruptcy, which could affect all parties.”
The S&P’s report cites what happened to the American International Group (AIG) as an example of a situation in which the rating-related triggers contained in its contracts required the company to post significant collateral.
Unable to draw from its well-capitalized insurance operations, AIG sought — and received — a US$85-billion U.S. government bailout package to avoid bankruptcy. (The terms and amount of the credit facility have since been restructured.)
“We do not play a role in companies’ decisions to use ratings-related triggers or covenants and do not encourage the practice,” S&P’s says. “In fact, we have taken the public position that we believe doing so creates additional risks. Moreover, this may contribute to our negative view of a company’s management if it countenances such risks.”
S&P’s also cautions that substituting some other financial benchmark for a credit rating may not prove to be effective because it might lead to a similar outcome.