Exchange rate

Some reinsurers believe that the recent downgrading of several major companies, including Munich Re and SCOR, is a reaction to concerns that are industry-wide rather than about specific companies. It has also been suggested that they are an attempt to counter accusations that the failures of companies such as the Independent Insurance Co took the ratings agencies by surprise. The ratings agencies’ methodologies and reliability are being questioned, but as a rating is no more than an opinion, it is difficult to dispute its validity or sustain a case that it is negligent or defamatory.

So, what legal recourse might there be where the basis of a security rating is challenged by a reinsurer, or a cedant suffers loss as a result of a rating that fails to reflect a reinsurer’s financial strength? What legal recourse is there if a ratings agency gets it wrong?

Cedants rely on ratings agencies inasmuch as their purchase of reinsurance will be subject to minimum security requirements and because reinsurance contracts often incorporate cancellation clauses triggered when a reinsurer’s security rating is downgraded. The failure to downgrade a reinsurer in financial difficulty will mean a cedant retains a reinsurer as security, which might ultimately be unable to pay all of its claims. This prompts the question as to whether a cedant can sue a ratings agency for any loss it suffers as a result of such failure. For a cedant to bring such an action, it would first have to establish that it was owed a duty of care.

The duty owed to third parties for negligent misstatements is very limited. Caparo Industries v Dickman (1991) held that it was limited to statements made where it was known they would be relied on by a particular person, or class of persons, for a particular purpose. A duty of care could not be established where a statement was put into general circulation, even if it was foreseeable that certain persons might rely on it. This is clearly the case with ratings agencies whose publications are used throughout the business world. It is, therefore, unlikely any cedant could sustain an argument that it was owed a duty of care by a ratings agency. A further obstacle to such a claim will be disclaimers as to the accuracy of the information and exclusions of liability used by the ratings agencies.

The wrongly downgraded reinsurer

There are no known instances in English law of a downgraded reinsurer taking legal action against a ratings agency. One likely reason for this is that, in most cases, the reinsurer will have had a contract with the ratings agency to produce the rating and it would have been published with the knowledge and consent of the reinsurer.

The position is more interesting when a rating is unsolicited. It is strongly arguable that a duty of care would be imposed in such circumstances, as the loss suffered by the downgraded reinsurer would be reasonably foreseeable and it would be just and reasonable to impose a duty as there would be no other recourse to recover the potentially significant losses resulting from the negligent downgrading.

Having got over this hurdle, the reinsurer has to establish, on the balance of probabilities, that the ratings agency has been negligent in that it has failed to exercise reasonable skill and care in producing the rating. Relevant factors would include: failure to take into account other information in the public domain; inconsistency in the application of the ratings methodologies between different reinsurers; and reliance on inaccurate information in the public domain, such as market gossip, that had not been properly verified by the agency. This raises the question as to what extent the agencies have a duty to verify with a reinsurer the accuracy and completeness of the information on which they have based their rating, although it is arguably the case that this is no more than good journalistic practice that, in most cases, will prevent a dispute.

A case in negligence will be made more difficult to pursue as it is likely that to demonstrate negligence, the courts would rely on a test akin to that applied in professional negligence cases. If other ratings agencies state they would have reached the same conclusion on the basis of the same information, the agency being sued will have a strong defence.

The wrongly downgraded reinsurer may also have a case in defamation if it can establish that it has suffered commercial disadvantage as a result of a downgrading, although no such case has ever been brought under English law. The ratings agency would probably resist such a claim on the basis that the defence of ‘fair comment’ applies. This defence allows the free expression of opinions on matters of public interest, providing the opinions are based on verifiable facts. This, again, raises the question as to whether the ratings agency should verify the facts and obtain a comment from a reinsurer before publishing an unsolicited rating.
The defence of ‘fair comment’ would not apply if it could be shown that the information was inaccurate or materially incomplete.

Ratings agencies are coming under increasing scrutiny as to the validity of their ratings, but cedants and reinsurers face considerable legal obstacles in establishing negligence or defamation cases against the agencies. Ratings agencies are certainly vulnerable to such claims if they do not ensure that the information on which their ratings are based is complete and accurate.

The ratings business
The ratings business is a global industry with approximately 140 rating companies around the world. Of these, four dominate the marketplace: Standard & Poor’s, Moody’s, Fitch and AM Best. Moody’s alone claims to provide credit ratings and analyses on more than $30tr (£16.52tr) of debt.

AM Best specialises in the (re)insurance field and assigns two types of ratings:

  • Financial strength ratings, which provide an opinion of a (re)insurer’s financial strength and ability to meet ongoing obligations to policyholders.
  • Debt ratings, which provide an opinion for the credit marketplace as to the issuer’s ability to meet its financial obligations to security holders when due.

The ratings generated by these agencies are based on quantitative and qualitative analyses. Performance ratios are integrated with subjective evaluation of the company’s operating plans and philosophies.

The ratings process is further complicated when the agency is retained to generate a group rating, which will involve subjective sub-classification of subsidiaries into core, strategic and ancillary enterprises, depending upon whether that company is a standalone enterprise or fully integrated into the group’s operations and established in a particular marketplace.

The rating agencies often pride themselves on their commitment to adapting their rating philosophy and methodology in the ever-changing landscape of the (re)insurance market. However, in light of the amount of subjective analysis involved in the ratings process, cedants/reinsurers often question the rating agencies’ methodologies and philosophies. Against this background, reinsurers find themselves in a legal desert devoid of any real remedy or recourse.

Simon Kilgour is a partner in the reinsurance group at Reynolds Porter Chamberlain