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MOODYS.COM
4 OCTOBER 2012
NEWS & ANALYSIS Corporates 2 » Tempur-Pedic’s Agreement to Acquire Sealy Is Positive for Sealy,
Negative for Tempur-Pedic » David’s Bridal Leveraged Buyout Will Increase Debt, a Credit
Negative » Valid’s Acquisition of Vmark Would Be Credit Positive » UK’s Proposed Crackdown on “Back Door” Listings Is Credit
Positive for Investors » Sony’s Alliance with Olympus Will Hinder Efforts to Reduce
Leverage, a Credit Negative » Sharp’s New Syndicated Loan Agreement Is Credit Positive » F&N Shareholders Approve Brewery Sale, Reject Cash Distribution;
Credit Negative for ThaiBev
Insurers 9 » UK Investigation of Private Motor Insurance Is Credit Negative for
Insurers
Asset Managers 11 » Geithner’s Call for Alternatives to SEC’s Money Market Fund
Reforms Is Credit Positive for Fund Managers » Invesco’s Acquisition of 49% of Religare Asset Management Is
Credit Positive
Sovereigns 14 » Egypt’s Loan from Turkey Is Credit Positive » Côte d’Ivoire’s Efforts to Redress Missed Payments Improve
Sovereign Creditworthiness » Resumption of Oil Exports Would Be Credit Positive for South
Sudan
CREDIT IN DEPTH European Insurers 18
European insurers are key players in the financial markets, although by virtue of their business model they are less affected by the deterioration in credit quality of European sovereigns than European banks. Nevertheless, their credit quality is linked to that of the sovereigns in which they are domiciled and conduct business.
RECENTLY IN CREDIT OUTLOOK
» Articles in last Monday’s Credit Outlook 25 » Go to last Monday’s Credit Outlook
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NEWS & ANALYSIS Credit implications of current events
2 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Corporates
Tempur-Pedic’s Agreement to Acquire Sealy Is Positive for Sealy, Negative for Tempur-Pedic
On 27 September, Tempur-Pedic International Inc. (unrated) said it had signed an agreement to acquire Sealy Corp. (unrated) in a deal valued at around $1.3 billion. The deal is credit positive for rated subsidiary Sealy Mattress Company (B2 review for upgrade) because it will strengthen its credit quality. However, the transaction will weaken Tempur’s credit profile.
Tempur has a stronger credit profile than Sealy owing to its superior credit metrics, better growth opportunities and dominant market share in specialty mattresses, which is the fastest-growing segment of the mattress industry. We placed Sealy’s ratings on review for upgrade following the acquisition announcement.
We estimate that the combined company will have pro forma EBITA margins of around 16% and debt to EBITDA of about 4x as of June 2012, excluding transaction costs and synergies. That compares with margins of around 8% for Sealy and debt to EBITDA of almost 7x in a similar timeframe.
The deal is credit negative for Tempur-Pedic because the company’s debt will increase and its credit metrics will weaken. We estimate that Tempur’s EBITA margins are currently in the mid-20% range and its debt to EBITDA was around 1.5x as of June 2012. The exhibit shows the effects of the merger.
Recent and Pro Forma Credit Statistics for Tempur-Pedic/Sealy Merger Tempur-Pedic Estimate Sealy Combined Pro Forma Estimate
EBITA Margin mid-20% 8% 16%
Debt to EBITA 1.5x 7x 4x
Source: Moody’s
Tempur will acquire Sealy’s outstanding common stock for $2.20 per share and assume or repay Sealy’s debt. The companies said they expect that the deal will close during the first half of 2013 and that they will continue to operate independently.
In addition to potential cost and revenue synergies, we think the transaction makes strategic sense because it broadens the companies’ product offerings across all price points, particularly in the specialty/premium mattress brands. It will also allow the combined entity to capture the pent-up demand that we think is building for mid-tier brands with middle-income consumers.
Kevin Cassidy Vice President - Senior Credit Officer +1.212.553.1676 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
3 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
David’s Bridal Leveraged Buyout Will Increase Debt, a Credit Negative
Last Thursday, private-equity firm Clayton, Dubilier & Rice provided details on how it will finance its acquisition of David’s Bridal, Inc. (B2 stable) when it began marketing the leveraged buyout of CDR DB Sub, Inc. (B3 stable), the acquisition vehicle it will use in the transaction. The buyout is credit negative because it will raise the retailer’s financial leverage.
The LBO, which values the retailer at $1.05 billion, or roughly 9x EBITDA, will boost the bridal company’s pro forma debt to EBITDA above 7x versus just under 6x for the 12 months ended 30 June. We expect leverage to improve owing to modest revenue and earnings growth driven by same-store-sales increases, new-store openings and the expansion of wedding gowns priced higher than the company’s core value-oriented prices. However, we don’t expect leverage to fall below 6x for the next couple of years.
Funding for the LBO will come from a $500 million term loan, $270 million of senior unsecured notes and $335 million of common equity, including rollover equity from David’s Bridal’s current private-equity owner, Leonard Green & Partners. Following the buyout, Clayton, Dubilier & Rice will own 75% of the company and Leonard Green will own 25%. We expect the transaction to close and be funded in mid-October.
After completion of the transaction, we expect David’s Bridal to maintain good liquidity over the next 12 months given the $125 million asset-backed revolving credit facility that is part of the buyout, our projections for modest cash-flow generation and the lack of near-term maturities. Bridal retailers are somewhat resistant to recessions, and David’s Bridal is a well-known brand. But the earnings of these niche retailers are vulnerable owing to changing consumer spending patterns, such as brides’ willingness to buy accessories or make other purchases beyond the gown.
Concurrent with the transaction, David’s Bridal will pay off its existing debt, which consists of a $276 million term loan and $161 million senior subordinated notes, and we will withdraw our B2 rating on the company. We assigned a B3 corporate family rating and stable outlook to CDR DB Sub, Inc., an acquisition vehicle that will merge with DBP Holding Corp., David Bridal’s parent company, when the transaction closes. DBP will be the surviving entity and obligor under the new capital structure.
Mariko Semetko Analyst +1.212.553.0522 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
4 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Valid’s Acquisition of Vmark Would Be Credit Positive
On 27 September, Valid S.A. (Ba2 stable) said it would bid for Vmark (unrated), a Chicago-based provider of plastic cards, direct mail and marketing data, which is currently operating under bankruptcy protection. If Valid prevails, the acquisition would be credit positive because the Rio de Janeiro, Brazil-based provider of payment, identification and SIM cards would significantly increase its market position in the US and increase its geographic diversification while increasing leverage only modestly.
Under an agreement filed with the bankruptcy court, Valid would pay about $51 million (BRL100 million) for substantially all of Vmark’s assets, Vmark said in a press release. Valid would borrow this amount, which would increase leverage to 1.5x debt/EBITDA from 1.0x as of 30 June. The higher leverage would be within an acceptable range for its ratings.
Valid’s expansion into the US is an attempt to capitalize on a major transition in the payment card business. Credit card companies such as Visa, MasterCard and American Express plan to switch US customers to cards that store data on chips rather than magnetic strips. Valid hopes to apply its experience with chip-based cards in Brazil to the US.
Valid made its first US acquisition in May, buying PPI Secure Solutions LLC (unrated), a Pennsylvania-based disaster recovery services company.
Vmark and its nine affiliated companies voluntarily filed for Chapter 11 protection in August 2011. Vmark said it filed “to separate itself from negative publicity arising from unrelated litigation surrounding the failure of Mutual Bank,” an underperforming subsidiary. Valid has agreed to be a stalking horse bidder for Vmark. If other bidders emerge, an auction would be held within 60 days, according to Vmark. The closing of the transaction would require approval of the Bankruptcy Court for the Northern District of Illinois.
Soummo Mukherjee Vice President - Senior Credit Officer +971.4.237.9520 [email protected]
Barbara Mattos Assistant Vice President – Analyst +55.11.3043.7357 [email protected]
Wendell Goncalves Associate Analyst +55.11.3043.7348 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
5 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
UK’s Proposed Crackdown on “Back Door” Listings Is Credit Positive for Investors
Last Monday, the UK Financial Services Authority (FSA), Britain’s financial regulator, proposed a number of changes to enhance protections under UK listing rules for publicly traded companies. Specifically, the proposals aim to close loopholes allowing reverse takeovers and introduce tougher corporate governance standards for listed companies with a dominant shareholder. Increasing investor protections and improving transparency is credit positive, particularly for investors in London-listed natural resources companies based in emerging markets.
The proposals form part of the UK government’s efforts to improve market confidence in listing rule standards following a few high-profile scandals, including Kazakhstan’s Eurasian Natural Resources Corporation Plc (Ba3 negative) and Indonesia’s Bumi PLC (unrated). Last Monday, Bumi announced that it had launched an independent investigation into allegations of financial and “other irregularities” at its Indonesian coal mining affiliate Bumi Resources Tbk (P.T.) (B1 negative).1
Critics have condemned reverse takeovers or reverse mergers, in which a private company takes over a publicly listed one, often just a shell company, for posing risks to investors. Companies in emerging markets, many of which are in the natural resources sector, have used this “back-door” process to fast-track listings and avoid the relatively more stringent corporate governance requirements in developed markets, including the UK.
Essentially, the FSA’s proposal would disallow the use of reverse takeovers as a back-door route to list companies that exchanges would otherwise consider ineligible, and follows a similar move in December 2011 by the FTSE Group, which administers the FTSE 100 Index of blue-chip stocks.
Many of the firms the FSA is targeting with this proposal are controlled by a small group of individuals that often use complex and opaque ownership and share voting structures to retain control and whose interests can differ from those of minority shareholders and bondholders. These firms often lack basic corporate governance protections such as a meaningful number of independent directors on the board.
To address those shortcomings, the FSA is proposing requiring listed companies with a controlling shareholder to agree to regulate the relationship between the controlling owner and listed company and provide regular updates. The FSA is also proposing that company boards comprise a majority of independent directors and that minority shareholders have more say in director appointments through a dual voting procedure. Finally, the proposal makes clear that certain types of companies are incompatible for a so-called premium listing (the higher of the two stock exchange listing segments), including those with voting structures designed to circumvent investor protection.
The proposed changes are subject to an industry consultation, which is open until next January. If put into effect, the changes would likely take effect early next year.
1 See Ongoing Corporate Governance Woes Are Credit Negative for Bumi Resources, Moody’s Credit Outlook, 1 October
2012.
Christian Plath Vice President - Senior Analyst +1.212.553.7182 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
6 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Sony’s Alliance with Olympus Will Hinder Efforts to Reduce Leverage, a Credit Negative
Last Friday, Sony Corporation (Baa1 review for downgrade) announced a business alliance with Olympus Corporation (unrated) in which Sony will inject ¥50 billion of capital into Olympus and become its largest shareholder with a stake of more than 11%. The partnership is credit negative for Sony because it will slow Sony’s efforts to reduce its leverage.
In addition to Sony becoming the largest shareholder in Olympus, a Japan-based manufacturer of optics products, the two companies in December will establish a joint venture to develop new surgical endoscopes by combining Olympus’ dominant position in endoscopes and Sony’s advanced digital imaging technology. Sony will take a 51% share in the joint venture.
The investment itself will not be significant for Sony, equaling less than 5% of the company’s total reported debt of about ¥1.2 trillion as of June 2012. Even if Sony financed the investment entirely with debt, the negative effect on adjusted debt/EBITDA would be around 0.1x.
However, we expect the transaction to delay Sony’s efforts to reduce its leverage. Adjusted debt/EBITDA at the company’s non-financial services businesses was over 5x as of fiscal 2012 (which ended 31 March) and is likely to stay above 3.5x in fiscal 2013, which is weak for its current rating. In the absence of additional non-core asset sales, the Olympus investment will further negatively pressure Sony’s cash flow and make it difficult for the company to reduce debt to improve leverage.
To reduce leverage, the company has three options: 1) reduce operating losses in TVs and mobile phones, 2) reverse declines in earnings from digital imaging products (such as digital cameras and camcorders) and game consoles, and 3) improve earnings from non-core assets. The business alliance would help Sony address its longer-term challenge of diversifying earnings and cash flow away from the volatile consumer electronics products, but immediate benefits from this alliance will be limited. Sony’s goal is for its medical equipment business to produce more than ¥200 billion of revenue by 2020, but that figure equals only 3.6% of fiscal 2012 sales from the company’s non-financial services businesses.
What’s more, the company expects the joint venture’s contribution to be just one third of its medical equipment business, equal to 1.2% of fiscal 2012 non-financial services business sales. Sony and Olympus expect the global surgical endoscope and other related markets to grow to about ¥330 billion by 2020, and are targeting their alliance controlling 20% of that market.
In addition to developing endoscopes, Sony may be able to increase sales of its image sensors to Olympus’ medical devices and digital cameras by broadening their business relationship. However, any increase in sales will be insignificant because the proportion of medical applications and Olympus’ presence in the digital camera market are small.
Yoshio Takahashi Assistant Vice President - Analyst +852.3758.1535 [email protected]
Shinya Dejima Associate Analyst +813.5408.4209 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
7 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Sharp’s New Syndicated Loan Agreement Is Credit Positive
Last Friday, Sharp Corporation (not prime) announced that it had signed a syndicated loan agreement with Mizuho Corporate Bank, Ltd. and The Bank of Tokyo-Mitsubishi UFJ, Ltd. for a ¥180 billion term loan and an uncommitted credit line of ¥180 billion that expires in June 2013. The new syndicated loan is credit positive because it will alleviate liquidity pressures and provide the company with additional time to implement measures that improve profitability and cash flow.
Sharp has worked to meet short-term debt maturities, especially in commercial paper, at a time when its access to the markets has been limited. Sharp had about ¥700 billion in short-term debt as of June, of which ¥362.5 billion was commercial paper and ¥336.6 billion were bank loans. The new bank loans totaling ¥360 billion will enable Sharp to refinance its commercial paper, and we expect major banks to continue rolling over existing bank loans.
The additional funds provide Sharp with more breathing room to implement its restructuring program. The company aims to reduce fixed costs by ¥100 billion and decrease operating losses in its large LCD panels business. To accomplish the latter goal, Sharp has accelerated its reduction of panel inventories, and earlier this year formed an alliance with Hon Hai Group (unrated) to increase sales and improve the utilization rate of its panel manufacturing plant. Sharp’s goal is to generate operating margins of 2% and operating profits of ¥30 billion in the second half of the March 2013 fiscal year, compared with a first-half negative operating margin of 12% and an operating loss of ¥130 billion, based on its performance forecast.
By resolving its immediate funding needs, Sharp can turn its focus to finding alternative sources of capital and liquidity, including a potential capital injection from Hon Hai. However, we expect any such injection from Hon Hai to be much smaller than the ¥66.9 billion figure the two companies announced in March owing to the more than 60% decline in Sharp’s stock price. Moreover, we expect Hon Hai to try to increase its involvement in Sharp’s management to increase Sharp’s chances of staging a recovery.
Although the company’s restructuring efforts will help improve earnings, Sharp still faces a challenge generating enough internal cash flow to repay its maturing bank facilities. The company also has about ¥200 billion in bonds that will mature in September 2013. As a result, the company faces having to refinance a large majority of its bank facilities and bonds.
A timely recovery of earnings and cash flow will be a critical factor for Sharp to receive continued strong support from banks.
Yoshio Takahashi Assistant Vice President - Analyst +852.3758.1535 [email protected]
Shinya Dejima Associate Analyst +813.5408.4209 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
8 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
F&N Shareholders Approve Brewery Sale, Reject Cash Distribution; Credit Negative for ThaiBev
Last Friday, shareholders of Singapore conglomerate Fraser & Neave (F&N, unrated) voted to sell its 40% stake in Asia Pacific Breweries (APB, unrated) to brewing giant Heineken NV (Baa1 stable) for SGD5.6 billion ($4.6 billion). However, they rejected F&N’s proposed cash distribution to shareholders of approximately SGD4 billion ($3.3 billion). The sale of APB to Heineken and the rejection of the cash payout to shareholders are credit negative for F&N shareholder, beer and spirits producer Thai Beverage Public Company Ltd. (ThaiBev, Baa2 review for downgrade). As a result of these developments, ThaiBev’s leverage is likely to remain elevated, and, as a shareholder in F&N, its exposure to businesses unrelated to its core beverage business, such as real estate, implies new business risks.
The cash distribution proposal lost because ThaiBev and TCC Assets Ltd. (unrated), a vehicle controlled by ThaiBev’s main shareholders, Charoen Sirivadhanabhakdi and Khunying Wanna Sirivahanabhakdi, opposed it. ThaiBev and TCC together control approximately 30.7% of F&N. Why ThaiBev voted against the capital reduction is unclear. To date it has spent around SGD3.6 billion, all of it debt funded, to acquire its stake in F&N. Without the cash distribution, ThaiBev misses out on approximately SGD1.2 billion in proceeds that it could have used to reduce its debt. If all the proceeds had been used to reduce debt, ThaiBev’s debt-to-EBITDA ratio would have improved to around 3.0x from 4.1x. Without the shareholder distribution, ThaiBev will remain reliant on internal cash flow generation to reduce debt, which means its balance sheet would remain stretched for a longer period of time.
Although APB, the maker of Tiger Beer, will be sold, ThaiBev, as a substantial shareholder in F&N, can still explore opportunities to expand its core non-alcoholic beverage business internationally. For example, ThaiBev could access F&N’s consumer beverage regional network to distribute its beverages and introduce F&N beverages into the Thai market. Such opportunities would be aligned with the company’s strategy to expand internationally, but because it is uncertain if ThaiBev can execute quickly or successfully, any cash flow benefits will not be immediate.
Furthermore, ThaiBev’s stake in F&N exposes it to an unrelated business, real estate. Following the disposal of APB, real estate will account for 70%-80% of F&N’s net profits, based on its results for the fiscal year ending 30 September 2011. F&N’s property portfolio has different business risks and capital requirements than ThaiBev’s beverage business, and provides limited opportunity for ThaiBev to directly and immediately increase its operating cash flows because there are no clear synergistic opportunities between these businesses.
In addition to these recent developments, TCC has an outstanding mandatory conditional cash offer to buy all of the issued and paid-up ordinary shares of F&N that it does not already own directly or indirectly through ThaiBev. The offer raises additional credit concerns, including the uncertainty of TCC’s motivations and its apparent influence over ThaiBev’s strategic direction and acquisition appetite, and leaves little clarity regarding ThaiBev’s role in the group’s overall strategy, a further credit negative.
Annalisa Di Chiara Vice President - Senior Analyst +852.3758.1537 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
9 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Insurers
UK Investigation of Private Motor Insurance Is Credit Negative for Insurers
Last Friday, the UK’s Office of Fair Trade (OFT) affirmed its decision to refer the British private motor insurance market to the Competition Commission (CC) for a full investigation into allegations that insurers are preventing, restricting or distorting competition. The CC’s investigation is credit negative because at a minimum it will create uncertainty for the industry and more significantly could result in lower motor premium rates.
A reduction in revenue from lower premiums would hurt profitability, particularly for those UK general insurers with the greatest market share in private motor insurance, as shown in the exhibit below.
Largest UK Private Motor Insurers by Gross Written Premium at Year-End 2010 Personal Motor Insurance Ranking
Direct Line Group 1
Aviva 2
Liverpool Victoria Financial Services 3
AXA Insurance 4
Munich Re 5
RSA Insurance Group 6
Ageas 7
esure Holdings 8
Co-operative Financial Services 9
Zurich Financial Services 10
Source: Association of British Insurers
The OFT’s affirmation follows a provisional decision in May to refer the motor insurance market to the CC after a study found that insurers of at-fault drivers had limited control over the way repairs and replacement vehicles were provided to not-at-fault drivers. This lack of control enables insurers of not-at-fault drivers, brokers, credit hire firms2 and repairers to generate revenue through rebates and referral fees, thereby artificially inflating claim costs.
Specifically, the market study highlighted the following:
» The cost of replacement vehicles was, on average, 106% higher when the at-fault insurer did not control the repair and replacement-vehicle process, amounting to a difference of £560 per hire.
» Costs for vehicle repairs were around £155 higher than they would have been if the at-fault insurer had managed the repairs.
» Insurers spend up to £60 million annually attempting to trim not-at-fault repair and replacement-vehicle costs, around £20 million of which is spent challenging excessive claims.
2 Credit hire firms work with not-at-fault drivers to arrange repairs to their damaged vehicles, provide drivers with replacement
vehicles, and pursue the at-fault driver’s insurer for reimbursement.
Helena Pavicic Associate Analyst +44.20.7772.1397 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
10 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
The OFT study estimated that these market practices increase claims and expenses by £355 million a year3 and have contributed to the underwriting losses recorded by motor insurers for the past 17 years. Those losses, in turn, have led to higher premium rates for motorists.
The CC will have two years to examine the market, compile a report and propose remedies to address problems if it determines that these practices harm competition. Unlike the OFT, the CC has the power to ask the UK government to pass new laws and ban certain practices outright.
The primary aim of any solutions proposed by the CC is to decrease premiums paid by motorists, which would consequently reduce motor insurers’ revenue. Lower premium rates would intensify the negative pressure on what is already an unprofitable line of business for many UK insurers.
Furthermore, given the earlier ban on referral fees in personal injury claims, it is plausible that the CC will seek to impose limitations, or possibly ban, referral fees and rebates received by insurers (and other market participants) from repair shops and credit hire firms. Those fees totalled £130 million in 2011. However, in the longer term, the negative effects of lower revenues would be neutralised if claim costs fell as a result of the action taken by the CC.
3 Office of Fair Trade: Private Motor Insurance Report, published in May 2012.
NEWS & ANALYSIS Credit Implications of recent worldwide news events
11 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Asset Managers
Geithner’s Call for Alternatives to SEC’s Money Market Fund Reforms Is Credit Positive for Fund Managers
On 27 September, US Treasury Secretary Timothy Geithner urged the Financial Stability Oversight Council (FSOC) in a letter to consider proposing reform options to address money market funds’ structural vulnerabilities and to mitigate the risk of runs. Mr. Geithner, who serves as chairman of the FSOC, suggested that the council explore less onerous alternatives to recent Securities and Exchange Commission (SEC) proposals that included creating a capital buffer and allowing the net asset value of money market funds to float. Such alternatives would be credit positive for asset managers offering money market funds, such as FMR LLC (A2 negative), Federated Investors, Inc. (unrated) and Charles Schwab Corp. (A2 stable), because it opens the door for the consideration of options that would be less burdensome.
In addition to the options the SEC has considered, Mr. Geithner in his letter opened the door to another, and perhaps less onerous, option. This option entails “imposing capital and enhanced liquidity standards, potentially coupled with liquidity fees or temporary ‘gates’ on redemptions that may be imposed as an alternative to a minimum balance at risk requirement.” He also advanced the idea that the council should be open to “alternative approaches that satisfy the critical objectives of reducing structural vulnerabilities inherent in money funds and mitigating the risk of runs.” Such a proposal could result in the adoption of one or more measures that are less severe than the SEC’s proposals, which would diminish the economic viability of money funds and reduce assets under management (AUM).
In August, the SEC’s proposals reached an impasse when they did not garner the support of at least three of the five commissioners. We believe this prompted Mr. Geithner to write the letter urging FSOC members to recommend that the SEC proceed with money market reform. As part of that effort, Mr. Geithner directed the FSOC to issue for public comment a set of reform options that would serve as a basis for a final recommendation to the SEC. If the SEC fails to act, it could trigger a lengthy process as either the FSOC or another US regulatory agency devises its own set of proposals.
Money market fund investment management revenues have been under pressure for four years owing to historically low interest rates, declines in investment management fees, declining AUM and capital outlays to support distressed credits. Had the SEC’s proposals come to fruition, money funds revenue, which totaled an estimated $5.4 billion last year, would have taken a severe hit. According to our analysis, the cost of the capital buffer alone, applied to risk adjusted prime funds only, would equal anywhere from a few months to almost three years of money fund management fees.4 Therefore, alternatives around enhanced liquidity standards, liquidity fees or temporary gates on redemptions, even in combination with a modest capital buffer, would lessen the financial effect on money fund management firms.
4 See SEC’s Cancellation of Money Fund Reform Vote Is Credit Positive for Fund Managers, Moody’s Credit Outlook, 27
August 2012.
Henry Shilling Senior Vice President +1.212.553.1948 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
12 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Invesco’s Acquisition of 49% of Religare Asset Management Is Credit Positive
On 27 September, Invesco Ltd. (parent of Invesco Holding Company Limited [A3 stable]), announced that it would acquire 49% of Religare Asset Management Company Limited (RAMC, unrated), a subsidiary of diversified Indian financial services group Religare Enterprises Limited (REL, unrated), for INR4.6 billion ($88 million). The acquisition is credit positive for Invesco because it offers the company’s global asset management business additional diversification and further builds on its presence in India, a market with substantial growth potential. Certain features of RAMC’s business, including its geographic dispersion and its relationship with REL, help limit the risks to Invesco, which contributes to our favorable view.
RAMC is among the top 15 asset management companies in India, with assets under management (AUM) of INR146 billion as of 31 August 2012 (nearly $2.8 billion) and a presence in 53 cities across India. Invesco is paying a valuation equal to 6.43% of AUM, a level in line with recent similar transactions in India (see exhibit). The price appears high when compared with the 2%-4% of AUM valuation range of US deals, but that does not take into account RAMC’s rate of AUM growth, which has been 15% in the current fiscal year that ends on 31 March 2013. In addition, the consideration that Invesco will pay equals approximately 12% of its second-quarter 2012 cash and equivalents.
Valuations of Indian Asset Management Company Acquisitions in 2012 Acquirer Target Percent Acquired Valuation (% AUM)
Invesco Ltd. Religare AMC 49% 6.43%
Nippon Life Reliance AMC 26% 6.64%
Schroders Axis AMC 24% 6.50%-7.00%*
L&T Finance Fidelity (India) 100% 6.20%
Note: * Estimated value Sources: Business Today, Economic Times, Financial News, SourceAsset and company reports.
A number of challenges, including equity market volatility, the slow uptake of equity products by retail investors, and challenging relationships with local distributors, have impaired the profitability of some Indian asset managers and prompted local investment managers to seek tie-ups. At the same time, some asset managers such as Fidelity International Ltd. (Baa1 stable) have exited the Indian market, while others such as Aberdeen Asset Management (unrated) and Vanguard (unrated) have turned down opportunities to enter India.
RAMC would provide Invesco with product diversity and dedicated distribution. RAMC’s mutual fund unit had 61 funds with an aggregate AUM of $1.9 billion at 31 March, including open-end equity, fixed-income and liquidity funds, closed-end equity-linked savings and fixed income funds, and index and gold exchange-traded funds. The fund group has achieved good diversification in four years, and was marginally profitable in its most recent fiscal year.
Given the size and diversity of India’s population, both in terms of geographical and wealth distributions, asset managers have faced challenges gathering assets efficiently. The need for localized distribution and small average account sizes are economic hurdles to asset raising. According to Business Today, retail investors comprise 97.4% of the investor population, yet they account for only 23.6% of the industry’s AUM. In the US, Investment Company Institute data show retail investors own 64.8% of mutual fund AUM.
Local regulation has also limited retail mutual fund growth. In 2009, the Securities and Exchange Board of India (SEBI) banned sales commissions (loads) on mutual funds to address the problem of
Neal M. Epstein, CFA Vice President - Senior Credit Officer +1.212.553.3799 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
13 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
portfolio churning. However, the SEBI in August allowed asset managers to increase mutual fund expense ratios to support distribution efforts in smaller cities. It also allowed funds to charge service taxes to the ultimate investor. We expect REL and Invesco to benefit from the timing of these changes. REL is a distributor with activities in brokerage and insurance, and a presence in 53 cities, which gives it additional reach. Invesco hopes to cross-sell its own products into REL’s distribution network.
NEWS & ANALYSIS Credit Implications of recent worldwide news events
14 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Sovereigns
Egypt’s Loan from Turkey Is Credit Positive
Last Sunday, Egyptian Minister of Finance Momtaz El-Saied announced that the government of Turkey (Ba1 positive) would lend the Egyptian government (B2 negative) $1 billion to strengthen its weak finances. Turkey has also promised to lend another $1 billion to finance trade between the two countries. External financial aid is credit positive for Egypt because it will help shore up the sovereign’s balance of payments.
The Egyptian Ministry of Finance website contains a report that quotes Turkey’s embassy in Cairo as stating that the financial support package, half of which would be in loans, aims to strengthen Egypt's foreign currency reserves and support investment in infrastructure.
Following the January 2011 revolution, Egypt’s balance of payments has been heavily pressured: the country’s current account deficit reached $7.9 billion (3.1% of GDP) in the fiscal year that ended in June, while the financial account recorded a $1.3 billion deficit (see quarterly developments in exhibit below). As a result, the central bank’s international liquidity has plummeted 58% since December 2010 to $15.1 billion as of the end of August, although this amount is still adequate to cover external debt repayments that are due during the next 12 months.
Egypt’s Balance of Payments Is Stabilizing
Source: Central Bank of Egypt
Egypt’s foreign exchange reserves have stabilized since March 2012, mainly because of external support from regional governments. Turkey’s loan follows members of the Gulf Cooperation Council sending funds to Egypt in recent months, including Saudi Arabia and Qatar, which have disbursed $3.1 billion of $5 billion pledged. The Egyptian government is also in negotiations with the International Monetary Fund (IMF) for a $4.3 billion programme (or 300% of Egypt’s quota, a level that is a common practice by borrowing governments) that will likely help support a measured pace of structural reforms and act as a catalyst to bolster private-sector confidence. But the first disbursements from the IMF program are not imminent, and may not come until late 2012 or early 2013 because of the political sensitivities involved in the negotiations.
Egypt’s stabilizing political landscape has paved the way for external aid. Recent presidential elections eased the country’s transition to civilian rule and diffused further protests. In addition, the new
-10
-8
-6
-4
-2
0
2
4
6
8
$bill
ion
Current Account Balance Net Foreign Direct InvestmentNet Portfolio Investment Change in Central Bank Reserve Assets
Mathias Angonin Associate Analyst +971.4.237.9548 [email protected]
Thomas Byrne Senior Vice President +65.6398.8310 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
15 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
government’s fiscal policies reflect a prudent approach to reducing the post-revolution pressures, which has mobilized regional bilateral donors. For example, Mr. El-Saied has reasserted the new government’s determination to secure an IMF loan. Also, on 25 September, Osama Kamal, Egypt’s new petroleum minister, reiterated the government’s intention to reduce and rationalize energy subsidies.
Egypt has some room to increase external debt. At 9.9% of GDP in March, Egypt’s general government external debt is at a record low, limiting its vulnerability to confidence shocks. Private-sector external debt adds a mere 3.1% of GDP to the country’s external debt. Moreover, multilateral and bilateral creditors hold most of the government’s foreign currency debt, which has moderate interest rates and long maturities, and marketable foreign-currency bonds totalled only $2.75 billion. In this context, bilateral financing will help ease the upward pressure on the government’s interest bill.
NEWS & ANALYSIS Credit Implications of recent worldwide news events
16 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Côte d’Ivoire’s Efforts to Redress Missed Payments Improve Sovereign Creditworthiness On 21 September, the government of the Republic of Côte d’Ivoire (unrated) reiterated its intention to make a reimbursement proposal to the holders of the country’s outstanding $2.3 billion step-up bonds due in 2032 following three missed semi-annual coupon payments between January 2011 and June 2012. The government announced it had commissioned international investor relations consultancy DF King Worldwide to identify investors to assist in the preparation of this transaction.5 Hiring DF King is the strongest signal yet that the government is committed to recompense bondholders and improve bondholder communication, a credit positive. It confirms the Ivorian government’s commitment to servicing its outstanding debt and provides more evidence of the government’s continuing reforms to secure macroeconomic stability and generate sustainable growth.
The Ivorian government resumed coupon payments in June after President Alassane Ouattara pledged in January to resume debt service payments. The country missed three payments following the post-election crisis and civil war in late 2010 that resulted in the ouster of former president Laurent Gbagbo. Côte d’Ivoire made a goodwill payment of $2.1 million to bondholders in late June and a scheduled $43.7 million coupon payment in early July. We see the hiring of DF King as an attempt by Ivorian authorities to gain clarity on the exact composition of the investor base before it can commence negotiations regarding the magnitude and method of repayment of arrears.
The effort by the West African country to reimburse bondholders underscores an improvement in the government’s willingness to pay, which is a key determinant of sovereign creditworthiness. Achieving macroeconomic stability and debt sustainability to further enhance creditworthiness will require the country make progress with the government’s comprehensive poverty reduction strategy, generate employment opportunities for the large contingent of unemployed youth, and continue reforms and prudent macroeconomic policies.
Earlier this year, the so-called Paris Club, a group of 19 creditor governments from major industrialized countries, cancelled nearly $6.5 billion (or 99.5%) of debt owed to them by Côte d’Ivoire in light of continuing economic reforms, efforts to reduce poverty, and stable macroeconomic policies. The Paris Club agreed on 29 June to debt relief of $1.77 billion under the International Monetary Fund (IMF)-World Bank Heavily Indebted Poor Countries (HIPC)6 initiative and member countries agreed to grant a further $4.73 billion in debt relief on a bilateral basis, including $4.67 billion in debt forgiveness by France. The Ivorian government committed to using the resources freed by the debt relief for priority areas such as health, education and basic infrastructure.
But even with the Paris Club debt cancellation, around $6 billion in external debt remains.7 Restoring investor confidence after a decade of civil conflict is imperative if Côte d’Ivoire is to return to capital markets to finance growth-supportive infrastructure spending and achieve debt sustainability. A three-year arrangement under the Extended Credit Facility approved by the IMF on 4 November 2011 currently supports Côte d’Ivoire’s economic program. Mr. Ouattara has an ambitious plan to kick-start Côte d’Ivoire’s once vibrant economy and achieve double-digit economic growth by 2014 and to turn the country into an emerging economy by 2020. However, tensions between his supporters and those who remain loyal to his ousted predecessor remain high, with the spectre of descent into civil war lingering.
5 See Ministere de l’Economie et des Finances press release dated 21 September 2012, available here. 6 Paris Club members participating in the debt cancellation included Austria, Belgium, Canada, France, Germany, Italy, Japan,
the Netherlands, Norway, Spain, Switzerland, the UK and US. Associated member Brazil also participated in this debt reorganization. Details are here.
7 The IMF and World Bank-International Development Association estimate Côte d’Ivoire’s external debt totalled more than $12.49 billion at the end of 2011.
Aurelien Mali Vice President - Senior Analyst +44.20.7772.5567 [email protected]
Matt Robinson Director of Sovereign Research +44.20.7772.5635 [email protected]
NEWS & ANALYSIS Credit Implications of recent worldwide news events
17 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Resumption of Oil Exports Would Be Credit Positive for South Sudan
On 27 September, the governments of South Sudan (unrated) and Sudan (unrated) signed a deal that would end a nine-month standoff over their shared border and resume South Sudan’s crucial oil exports through Sudan. The deal also resolves a dispute over oil transit fees that sparked the conflict between the two countries in January. The truce is credit positive for landlocked South Sudan, which depends heavily on oil for its economic activities and entirely on Sudan’s Red Sea Port to transport its oil exports. The deal also staves off a return to a decades-long civil war that left the country with massive developmental challenges.
South Sudan in January shut down its entire oil output of 350,000 barrels per day after Sudan diverted $815 million worth of its oil exports in lieu of unpaid transit fees. Sudan had demanded $36 per barrel in transit and related fees to transport South Sudanese oil, while South Sudan insisted that it owed only $6 per barrel. Tensions between the two countries quickly escalated into an armed conflict in March when heavy fighting broke out along their shared border, highlighting the fragile peace that has existed between the two countries since South Sudan’s secession in July 2011.
Shortly after last month’s deal, South Sudan indicated that it would resume just over half of its oil production within the next three months and has agreed to pay Sudan $9.10-$11.00 per barrel in transit fees. Both countries have also agreed to reach a permanent solution to the wider border dispute within the next two months. However, because this is a contentious topic, we expect that reaching a solution anytime soon is unlikely, which adds a degree of uncertainty to South Sudan’s oil production and economic stability. In the meantime, United Nations (UN) peacekeepers are patrolling the border after both countries’ armies pulled back from the front lines.
Although the dispute adversely affected both countries, South Sudan was particularly hard hit because of its overreliance on oil exports. According to the World Bank, oil accounts for virtually all of the country’s exports, around 80% of its GDP and 98% of government revenue, making it the most oil-dependent country in the world. By contrast, oil accounts for around 12.5% of Sudan’s exports, 20% of its GDP and around half of government revenues. While Sudan still exported its 150,000 barrels of daily oil output during the imbroglio, South Sudan responded by reducing government expenditures by around 30%, including cutting its crucial development budget, drawing down its foreign exchange reserves and borrowing externally to support its economy.
South Sudan’s economy has struggled against a backdrop of growing economic imbalances and increasing hardships for its population. Inflation in May surged to nearly 80% year on year from 23% in February, as limited local food production and the depreciating South Sudanese pound drove up food prices. The population -- impoverished after the civil war, with the UN estimating that 90% live on less than $1 a day -- has had to rely on the UN and other aid agencies for food aid and basic services. And although many in the country supported the government’s oil shutdown, the continued impoverishment of the population risked becoming politically destabilising for the government because of citizens’ high expectation that the country’s independence would bring with it economic prosperity.
Weyinmi Omamuli Vice President - Senior Analyst +44.20.7772.5390 [email protected]
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18 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
How Further Sovereign Stress Would Affect European Insurers and Their Ratings
SUMMARY OPINION
European insurers are key players in the financial markets, both within their home countries and across the euro area. By virtue of their business model, they are less affected by the deterioration in credit quality of European sovereigns than European banks. Nevertheless, their credit quality is linked to that of the sovereigns in which they are domiciled and conduct business.
As major fixed-income investors, European insurers have direct exposure to debt of governments and banks in the euro area, with particular concentrations in countries where they have a sizable business footprint. Insurers are also indirectly affected by the continued weakening of euro area sovereigns because the economic dislocation associated with declines in sovereign creditworthiness affects demand for insurers’ products, business costs and policyholders’ behaviour.
We have analysed the potential effect of three sovereign-related stress events on European insurers’ credit quality and ratings. Although these events do not represent our central expectations, they constitute plausible scenarios given the downside risks in the current macro-economic and sovereign environment across the euro area.8
If Greece (C no outlook) defaults again and exits from the euro area, the negative direct effect on rated insurers’ creditworthiness would be limited in view of their modest financial and operational exposures to this country. We would not expect this event, in itself, to result in any rating downgrades among insurers.
If the credit quality of Spain (Baa3 review for downgrade) and Italy (Baa2 negative) further deteriorates,9 it would affect the creditworthiness of rated insurers domiciled in these countries. In addition, the credit quality and ratings of Allianz, Aviva and AXA, three large European groups whose main operating entities have insurance financial strength ratings of Aa3, could be affected if Spain’s and Italy’s credit qualities fall below investment grade, as a result of these groups’ exposures to these countries.
Modest deterioration in the creditworthiness of large Aaa-rated European Union (EU) sovereigns (to levels consistent with upper- or mid-range Aa sovereign ratings) would not, in itself, directly affect insurers’ credit profiles. The effect for insurers’ credit quality would, however, be higher if Aaa-rated sovereigns’ credit quality deteriorated concurrent with a weakening of other sovereigns, which, given the interconnectedness between European sovereigns, is a plausible outcome. In addition, if the strongest European sovereigns’ credit strength weakened to levels commensurate with single A ratings, then a broader range of Aa-rated European insurance groups could face downward rating pressure.
8 In this report, we present the likely consequences of these events assuming they would occur in isolation, although in practice
they might occur simultaneously or subsequently. See Moody's changes the outlook to negative on Germany, Netherlands, Luxembourg and affirms Finland’s Aaa stable rating, 23 July 2012. This approach allows for sharper analysis, as the implications of more complex sovereign stress scenarios cannot be modeled accurately.
9 See Moody's downgrades Spain's government bond rating to Baa3 from A3, on review for further downgrade, 13 June 2012 and Moody's downgrades Italy's government bond rating to Baa2 from A3, maintains negative outlook, 13 July 2012.
Benjamin Serra Vice President – Senior Analyst +33.1.5330.1073 [email protected]
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19 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
OUR BASE-CASE SCENARIO IS A CONTINUED “MUDDLING THROUGH,” WITH SIGNIFICANT DOWNSIDE RISKS OF SHOCKS
In our global macro-risk outlook for 2012-13, we forecast a modest global recovery (advanced G20 GDP growth 0.9%-1.9% in 2012 and 1.5%-2.5% in 2013), with more muted growth in Europe (euro area GDP growth minus 1% to 0% in 2012 and 0.5%-1.5% in 2013).10
In combination with the expectation of continued weak growth, our base-case scenario continues to assume a material risk of greater use of support programmes, and as a result a continued and gradual increase in credit risk for private-sector lenders to all euro area sovereigns. Specifically, as additional countries need support, the mix of contingent liabilities for supporting countries will continue to rise in magnitude and lead to a deterioration in credit standing.11
In addition, downside risks to our central scenario are significant and include a deeper-than-expected recession in the euro area. We also believe that the likelihood of plausible scenarios, such as an exit by Greece from the euro area or external support requested by Spain (beyond the banking sector recapitalisation programme) has increased recently.
This central scenario and the increased likelihood of adverse scenarios have been incorporated into our recent sovereign rating actions on Germany (Aaa negative), Luxembourg (Aaa negative), The Netherlands (Aaa negative),12 Spain (Baa3 review for downgrade)13 and Italy (Baa2 negative),14 and are also reflected in our current insurance ratings. Given the aforementioned elevated downside risks, this report examines the likely consequences of further sovereign credit deterioration on rated European insurers, including specific potential stress events.
EURO AREA STRESS AFFECTS EUROPEAN INSURERS BOTH DIRECTLY AND INDIRECTLY
Deteriorating sovereign credit quality affects insurers both directly, notably through investment exposures (including investments in sovereign bonds, bank debt, covered bonds and other securities from issuers domiciled in the sovereign), and indirectly through operating exposures. Indirect effects include the economic dislocation associated with a decline in sovereign creditworthiness on demand for insurers’ products, access to capital markets, and policyholders’ behaviour.15
Realised and unrealised investment losses
European insurers are major fixed-income investors and have significant exposure to government debts. They also invest heavily in bank debt, covered bonds and other corporate debt, whose credit quality correlates to sovereigns’ credit quality.16 Therefore, deterioration in sovereigns’ credit quality has a direct negative effect on not only insurers’ asset quality, but also on their capitalisation through an increase in credit risk and in realised or unrealised losses within their fixed income portfolio.
10 See Update to the Global Macro-Risk Outlook 2012-13: Euro Area Debt Crisis Continues to Pose the Greatest Risk, 30
August 2012. 11 See European Sovereigns: Post-Summit Measures Reduce Near-Term Likelihood of Shocks, But Integration Comes at a Cost,
5 July 2012. 12 See Moody's changes the outlook to negative on Germany, Netherlands, Luxembourg and affirms Finland's Aaa stable rating,
23 July 2012. 13 See Moody's downgrades Spain's government bond rating to Baa3 from A3, on review for further downgrade, 13 June 2012. 14 See Moody's downgrades Italy's government bond rating to Baa2 from A3, maintains negative outlook, 13 July 2012. 15 See European insurers: EU sovereign pressures have limited impact on credit profiles so far, 20 October 2011, and How
Sovereign Credit Quality May Affect Other Ratings, 13 February 2012. 16 See European Corporates: EU Sovereign Crisis Poses Growing Risks For European Non-Financial Companies, 17 July 2012,
and Euro Area Debt Crisis Weakens Bank Credit Profiles, 19 January 2012.
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20 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
Most European life insurers have the ability to mitigate these direct effects because they can hold fixed-income securities to maturity and – in the absence of default – avoid crystallising short-term market value losses, and share some portion of losses that do occur with their policyholders. However, the ability to share losses with policyholders varies significantly across the industry and tends to be constrained in a stressed environment, with pressure on valuation of all asset classes and accommodating monetary policies pushing down interest rates and reducing investment returns.17
Challenges to source revenues from domestic customers
A deteriorating sovereign environment would likely also lead to slower economic growth and challenges for insurers in sourcing revenues from domestic customers, owing to their reduced purchase and savings power, which, in turn, negatively affects insurers’ profitability.
Furthermore, in many countries, insurers rely heavily on bank-related distribution channels that could be disrupted in a banking crisis. More broadly, a banking system crisis would likely affect financial confidence, reducing customer demand for financial products offered by insurers.
Potential restrictions in capital market access
We believe that investors’ confidence and willingness to invest in, or provide capital support to, insurers could diminish significantly in the event of further sovereign weakness. We believe that this risk is particularly strong for those groups domiciled in, or with high exposures to, the euro area periphery, where investors have thus far shown the most risk aversion. Positively, most insurers’ short-term debt refinancing requirements remain low, liquidity is sound, and debt refinancing risk remains low.
However, equity market sentiment remains very important. For example, a scenario of sovereign weakness that impairs insurers’ stock valuations might compel insurers to consider various actions (such as subsidiary sales or business unit retrenchments) which could reduce insurers’ overall credit quality in the medium-term.
Potential increase in life insurance policy surrenders
The weak economic environment associated with the deterioration in sovereign credit quality incites households to deleverage and to increasingly withdraw money from their insurance savings policies. Further deterioration in sovereigns’ credit quality would amplify this trend. In addition, continued deterioration in European sovereigns’ and banks’ credit quality may also cause a decline in policyholders’ confidence in insurers, and result in an increase in life insurance policy surrender rates.
We note that in many countries, particularly the UK and Spain, insurers retain the ability to protect their balance sheets in the event of spikes in surrenders through the use of various exit penalties (e.g., market value adjustments mechanisms). Consequently, we regard surrender risk as particularly high in countries where surrender penalties are low, such as France and Italy. This risk would be even higher in a scenario where short-term government bond spreads increased.18
A weakening sovereign environment leading to increasing surrenders would particularly affect insurers with operating exposures in these markets. Nonetheless, even for markets where surrender penalties are high, in scenarios of severe asset-market dislocation (potentially as a result of severe weakening of sovereign credit quality) these mitigants may prove ineffective at halting customer outflows, with negative implications for insurers’ liquidity profiles. 17 See European Insurers: Varied Ability to Share Investment Losses With Policyholders, 20 October 2011. 18 For more details on the surrender risk by country by country and company, see Interest Rate Risk for Life Insurers, 22
November 2010.
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THE EFFECT OF EURO AREA STRESS ON INSURERS VARIES BY SCENARIO EXAMINED
Stress event 1: A Greek exit would in itself have limited direct effect on insurers
Although it is not our base case, the risk of an exit by Greece from the euro area has increased relative to our expectations earlier this year. Please refer to our sovereign research on Greece for more details.19
Greece’s exit from the euro area would almost certainly lead to a devaluation of the new Greek currency versus the euro, causing a loss of value of Greek government bonds and other Greek securities and investments. However, this would have a limited effect on the credit profiles of European insurers, given their marginal asset and operating exposure to Greece. Rated insurers typically generate less than 1% of their revenues and profits from Greece.20 Therefore, we would not expect this event, in itself, to result in any rating downgrades among insurers. This event could, however, trigger stresses in financial markets or in the credit quality of other euro area sovereigns, which may have wider credit implications for European insurers, as discussed below.
Stress Event 2: Deterioration of Spain and Italy would affect insurers to varying degrees
On 13 June, we downgraded the Spanish sovereign rating to Baa3, and placed the rating under review for possible further downgrade, and on 13 July, we downgraded the Italian sovereign rating to Baa2, with a negative outlook. For more details on the risks of further credit deterioration for these countries, please refer to our sovereign research on Spain and Italy.21
Below, we discuss the implications of further credit deterioration in Spain and Italy for different groups of European insurance companies.
Insurers domiciled in Spain and Italy
Credit deterioration in
: ratings will follow credit quality of the sovereign
Spain and Italy would significantly affect insurers domiciled in these countries. Specifically, we believe that insurance groups' key credit fundamentals (asset quality, capitalisation, profitability and financial flexibility) are correlated with, and thus linked to, the economic and market conditions in the country (or countries) where they operate.22 In June, we downgraded the ratings of Mapfre Global Risks (insurance financial strength Baa2 review for downgrade) and CASER SA (Ba2 review for downgrade) following the rating actions on the Spanish sovereign and Spanish banks. In July, we downgraded the ratings of Generali Assicurazioni SpA (Baa1 negative), Allianz SpA (A3 negative) and Unipol Assicurazioni SpA (Baa2 review for downgrade) following the rating action on Italy. Any further deterioration of Spain’s and Italy’s sovereign credit quality would exert additional pressure on these ratings.
Mapfre and Generali’s ratings are currently one notch above the ratings of their respective sovereigns, which reflects their non-domestic operating exposures and, in the case of Generali, the ability to share substantial asset losses with life policyholders. Nonetheless, if the global macro-economic environment continued to deteriorate, the benefits of diversification outside of their home country and/or the ability
19 See Greek Country Ceiling Reflects Heightened Risk of Euro Area Exit: Implications for Greek Domiciled Ratings, 1 June
2012. 20 See European insurers: EU sovereign pressures have limited impact on credit profiles so far, 20 October 2011. 21 See Moody's Review Of Spanish Government's Baa3 rating Likely To Continue Through The End Of September, 30 August
2012, Key Drivers of Moody's Decision to Downgrade Italy's Rating to Baa2 from A3, 16 July 2012, Key Drivers of 13 June Decision to Downgrade the Kingdom of Spain's Rating to Baa3 and Review for Further Possible Downgrade, 23 June 2012, and Rating Euro Area Governments Through Extraordinary Times – Implications of Spain’s bank recapitalisation needs and the rising risk of a Greek Exit, 8 June 2012.
22 See How Sovereign Credit Quality May Affect Other Ratings, 13 February 2012.
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22 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
to share losses with policyholders could reduce over time, which could result in insurance financial strength ratings (IFSRs) for these groups converging towards the ratings of their respective sovereigns.
Others exposed to Spain or Italy
Credit deterioration of
: ratings pressured if Italy and Spain fall below investment-grade
Spain and Italy could also affect insurers not domiciled in these countries, although to a lesser degree than those domiciled in these countries. This includes large groups with meaningful operating and/or investment exposures to Spain and Italy, such as Allianz, Aviva and AXA, whose outlooks we changed to negative in February 2012.23
All three of these groups have sizable operations in Spain and Italy (see exhibit). The credit quality of their subsidiaries in Spain and Italy is correlated to the Spanish and Italian sovereign credit quality, notably through sovereign and banking asset exposures and the effect that a further slowdown in economic growth may have on insurers’ asset and business exposures. We believe that significant deterioration in the credit quality of one sizeable subsidiary could affect the overall group rating.
Given the relatively small weight of Spain for the three groups, a deterioration of Spain, in isolation, would not necessarily impact their ratings. However, the ratings of Allianz, Aviva and AXA could be affected, if the credit quality of both Spain and Italy deteriorates to levels consistent with non-investment grade government bond ratings (i.e., in the Ba-range). Nonetheless, any rating effect for these groups would most likely be limited to one notch.
Operating and Asset Exposure to Spain, Italy, Portugal and Ireland for Select Major Insurance Groups
Allianz Aviva AXA
Operating
exposure as % of
revenues [1]
Govt bond exposure as a
% equity [2]
Banking debt exposure as
a % equity [3]
Operating exposure
as % of revenues [1]
Govt bond
exposure as a %
equity [2]
Banking debt
exposure as a %
equity [3]
Operating exposure
as % of revenues [1]
Govt bond
exposure as a %
equity [2]
Banking debt
exposure as a %
equity [3]
Italy 12% 55% na 8% 70% 5% 6% 27% 4%
Spain 3% 10% na 4% 10% 18% 4% 16% 9%
Ireland 1% 1% na 4% 4% 1% ~1% [4] 2% na
Portugal 1% 1% na 0% 1% 1% ~1% [4] 2% na
[1] 2011 revenues (life and non-life gross premiums written for AXA, excluding International insurance / Life and non-life gross premiums written for Allianz, excluding consolidation and Specialty Lines such as AGCS, Reinsurance, Credit Insurance and Assistance / Based on life new business on a PVNBP basis and non-life net premiums written for Aviva) sourced from the country, as a % of total revenues.
[2] Year-end 2011 investments in government bond from a country as a % of reported shareholders’ equity (including non-controlling interests).
[3] Year-end 2011 investments in banking debts (including covered bonds) from a country as a % of reported shareholders’ equity (including non-controlling interests).
[4] Moody’s estimates.
Sources: Allianz , Aviva , AXA, and Moody’s calculations.
Non-domestic insurers with minimal exposures to Italy and Spain are the most resilient
A third group of insurers with no or low investment and operating exposures to Spain and Italy (mainly some UK, Swiss and Nordic insurers and some reinsurers) would be less affected. Their ratings would likely not change. However, this group could experience portfolio credit deterioration as a result
23 See Allianz, Aviva, AXA: Euro Area Exposures Differ, but Downside Risks Increase for All, 22 March 2012.
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23 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
of any associated decline in equity markets, increase in corporate credit spreads or general weakening of the operating environments across Europe.24
Stress Event 3: Modest deterioration in credit quality of Germany, UK and France would, in itself, not affect insurers’ ratings
In July 2012, we changed the outlook to negative from stable on the Aaa sovereign ratings of Germany, Luxembourg and the Netherlands. 25 The outlooks on the Aaa sovereign ratings of the UK, France and Austria changed to negative from stable in February 2012. 26 Furthermore, we indicated that by the end of the third quarter we will assess the implications of euro area developments for Aaa-rated France.
Weakening of Aaa sovereigns’ to mid- to high-Aa levels has no direct effect on rated insurers
We believe that if the credit quality of Germany, UK and France deteriorated modestly, leading to sovereign ratings migrating to the mid-to-high Aa-range, this would, in itself, have no rating effect on most insurers, including the strongest groups domiciled in these countries such as Allianz, Aviva, AXA, Legal & General, Munich Re and Prudential. In this scenario, the credit risk borne by insurers on their sovereign bond holdings would not constrain their current rating levels. There may also be expectations of a modest slowdown in economic activity, which would affect insurers in those markets, but only to a limited degree, thanks to their strong core credit fundamentals and ability to maintain good levels of business activity, with often dominant market positions and good business diversity (by geography and/or line of business).
However, the effect on insurers’ credit quality would be higher if Aaa-rated sovereigns’ credit quality deteriorated concurrently with a weakening of other sovereigns, which, given the interconnectedness between European sovereigns, is a plausible outcome. This would apply, for example, if this scenario combined with a weakening of Spanish and Italian sovereign credit quality (see Stress Event 2) for those insurers described above that have large exposures to Spain and Italy.
Deeper weakening of Aaa sovereigns would pressure some insurers’ ratings
A scenario of further sovereign credit deterioration, reflected by the strongest sovereigns transitioning into the low Aa range or below, would pressure some European insurance groups. This scenario would cause a more material decrease in the creditworthiness of sovereign and banking debt instruments. Given that insurers typically have significant holdings of such securities, this may constrain highly rated European insurers’ asset quality and capitalisation.
A more pronounced deterioration in credit quality of these sovereigns would also likely be associated with a marked slowdown or even contraction in some of these large economies. Given the importance of these countries to most large European insurance groups in terms of business operations, such a scenario would place negative pressure on all Aa-rated European insurance groups. Specifically, there is a strong likelihood that the European insurance subsidiaries with IFSRs of Aa2, such as the German subsidiaries of Allianz and the UK subsidiaries of Prudential, would be downgraded if the credit qualities of Germany and the UK deteriorated to levels commensurate with single A sovereign ratings.
If the deterioration in the credit quality of Aaa sovereigns was abrupt, this could also trigger a strong reaction from investors in government and banking securities, with a material reduction in the market
24 For more details on these insurers’ exposure to a widening of EU sovereign crisis, see European insurers: EU sovereign
pressures have limited impact on credit profiles so far, 20 October 2011. 25 See Moody's changes the outlook to negative on Germany, Netherlands, Luxembourg and affirms Finland's Aaa stable rating,
23 July 2012. 26 See Moody's adjusts ratings of 9 European sovereigns to capture downside risks,13 February 2012.
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24 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
values of these securities, which could directly affect insurers’ capitalisation ratios, and/or a loss of confidence in insurers from investors and policyholders (see above), both of which would create further negative rating pressure for all Aa-rated European insurers.
Summary table
The table below summarises the effect on European insurers’ ratings of the stress events discussed above, highlighting the most exposed insurance groups in each scenario.
Stress Event Effect on European insurers’ ratings
Greek exit Limited direct credit effect/no direct rating effect
Deterioration of Spain and Italy
High effect (ratings to follow credit quality of the sovereign) on Spanish and Italian insurers: » Generali » Unipol » Allianz SpA » Net Insurance » Mapfre » Caser
Medium effect (possible one-notch downgrade if Spain and Italy downgraded in non-investment grade territory) on groups with significant asset and operating exposure to these countries: » Allianz » Aviva » AXA
Low effect (mostly indirect impacts) on other insurers
Weakening of UK, Germany and France to mid- to high–Aa levels
Limited direct credit effect/no direct rating effect
Weakening of UK, Germany and France to high-A levels
High effect (high likelihood of downgrade) on Aa2 insurers: » UK subsidiaries of
Prudential plc » German subsidiaries of
Allianz
Medium effect on Aa3 insurers (medium likelihood of downgrade): » Allianz » Aviva » AXA » Legal and General » Munich Re » ZFS
Low direct effect on insurers rated A or below
RECENTLY IN CREDIT OUTLOOK Select any article below to go to last Monday’s Credit Outlook on moodys.com
25 MOODY’S CREDIT OUTLOOK 4 OCTOBER 2012
NEWS & ANALYSIS European Sovereign and Bank Crisis 2 » Spanish Banks' Upcoming Recapitalization Is Credit Positive, but
May Be Insufficient » Large European Banks Lag Global Peers on Basel III Compliance, a
Credit Negative » Portugal's Reversal on Social Security Tax Is Credit Negative
Corporates 7 » Texas Instruments Hangs Up on Wireless Activity in a Credit
Positive Move » Proposal to Take American Greetings Private Would Increase Debt,
a Credit Negative » Dean Foods' Exploration of Morningstar Sale Is Credit Positive » Lafarge's Sale of US Assets Is Credit Positive » Schaeffler's Reduction of Continental Stake Is Credit Positive
for Both » Leighton's Telecommunication Divestitures Would Be
Credit Positive » Ongoing Corporate Governance Woes Are Credit Negative for
Bumi Resources
Infrastructure 15 » Proposed Tariff Reductions for Australia's Gas Distributors Are
Credit Negative
Banks 17 » Bank of America's Class Action Settlement Is a Step in the
Right Direction » Zions Bancorporation Exits TARP, a Credit Positive » Russia Mulls Tougher Provisioning for Consumer Loans, a Credit
Positive for Lenders
Insurers 21 » Hartford's Sale of Individual Life Unit to Focus on P&C Is Credit Positive
Asset Managers 22 » DNP's Rights Offering Is Credit Positive for Fund and
Management Firm
US Public Finance 24 » Harvard's Flat Endowment Return Is Credit Negative for It and
Endowment-Dependent Universities
Accounting 26 » FASB Proposal Hurts Comparability by Giving Private Company
Lessees a Reporting Option
RATINGS & RESEARCH Rating Changes 29
Last week we upgraded Claire’s Stores, and downgraded Port Authority of New York and New Jersey, the government of Vietnam and eight Vietnamese banks, South Africa, the Municipality of Naucalpan, Mexico; and the Chicago Board of Education, among other rating actions.
Research Highlights 36
Last week we published on the global pharmaceuticals, our corporate ratings and US default rates, North American telecom bond covenants, US lodging and cruise industry, US for-profit hospitals, US steel, European alcoholic beverage companies, European paper producers, China property, US technology hardware, Latin American telecommunications, US homebuilding, commodity merchandising and processing companies, Russian consumer finance companies, peer comparison of US health insurers, Egypt, Tunisia, Ecuador, Africa, Suriname, Peru, Japanese regional and local governments, and Pennsylvania local governments, among other reports.
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EDITORS PRODUCTION ASSOCIATE News & Analysis: Jay Sherman and Elisa Herr Alisa Llorens