Scottish Re’s Future Uncertain After Double Blow Sparks Downgrades

Bermudian life reinsurer Scottish Re received a one-two punch on July 31. Scott Willkomm, its president and CEO, resigned suddenly with no explanation from the firm, and the company revealed that it expects to post a loss of about US$130 million for the second quarter of this year.

Bermudian life reinsurer Scottish Re received a one-two punch on July 31. Scott Willkomm, its president and CEO, resigned suddenly with no explanation from the firm, and the company revealed that it expects to post a loss of about US$130 million for the second quarter of this year. In response, the company’s share price fell 75% and AM Best downgraded it to the triple-B range, prompting some to question whether the firm can continue.

The firm’s expected loss is only a small fraction of the US$1.24 billion shareholders’ equity it reported as of March 31 this year. But analysts and rating agencies still believe it is a concern, and that there could be worse to come.

“Technically the loss is not that big a deal,” says Andrew Kligerman, analyst at investment bank UBS. “But it’s a question of what other issues there might be. I still have questions about the company’s life mortality risk, which does not appear to have been a big issue here today.”

The firm has hired investment banks Goldman Sachs and Bear Stearns to help it look at strategic alternatives and capital raising possibilities.

Most of the expected loss comes from a US$112 million write-down of deferred tax assets. Several other negative events added to the loss, including a reduction in estimated premium accruals, increased retrocession costs, a write-down of deferred acquisition costs, and one-off severance, retirement and other costs. Scottish Re says its third- and fourth-quarter results will be worse than it previously thought because of lower-than-expected new business volumes, higher than anticipated retrocession costs and income tax expense caused by the inability to recognise future deferred tax benefits.

Paul Goldean, Scottish Re’s executive v.p. and general counsel, has replaced Willkomm on an interim basis. He will be assisted by Scottish Re chairman Glenn Schafer and Paul Caulfeild-Browne, former chief operating officer of Swiss Re Life and Heath North America. Scottish Re did not thank Willkomm for his service in the announcement. He became CEO in December 2004.

To make matters worse for the firm, rating agency AM Best downgraded Scottish Re’s financial strength rating to B-double-plus from A-minus. Fellow rating agencies Moody’s and Fitch Ratings also cut the firm’s ratings; Fitch to A-minus from A and Moody’s to Baa2 from A3. All three agencies have the new ratings on negative outlook, and AM Best and Fitch have indicated they could make further cuts depending on the outcome of meetings with Scottish Re’s management.

Standard & Poor’s has placed the A-minus financial strength ratings of Scottish Re Group’s main operating subsidiaries on negative credit watch.

Investors took the news badly. Scottish Re’s share price plunged to US$3.99 at close on July 31 from US$16 at close on July 28. Bear Stearns downgraded Scottish Re stock to underperform from peer perform, and Oppenheimer downgraded the shares to sell from buy.

Although the losses came without warning and have clearly surprised some, others believe it was only a matter of time before trouble started at Scottish Re.

“I have always been concerned about its mortality exposure and its tax and deferred acquisition cost accounting, but could never be sure about the timing,” says Kligerman. UBS downgraded Scottish Re’s stock to reduce from neutral in January 2005. Kligerman thinks the company’s mortality rates for US life business are its biggest concern.

Other analysts feel rating downgrades pose a big threat to the firm. “We have long been concerned about operational issues given numerous operational hiccups in recent years,” reads a Bear Stearns research report issued before AM Best announced its downgrade. “We are concerned that a downgrade in the financial strength rating would cause substantial adverse consequences.”

Richard Sbaschnig, analyst at Oppenheimer, agrees. He said in a research report that the firm’s ability to stay in business is in doubt. “If [Scottish Re] is downgraded, the ability to generate new business is severely impaired,” he said. “There is also the possibility that a credit ratings downgrade could trigger recapture provisions in the company’s treaties, which could lead to the loss of profitable blocks of business.”

However, Scottish Re issued a statement in response to the rating actions saying that it does not face any near-term liquidity or solvency issues. It says all its regulated entities are capitalised in excess of the minimum required levels, that it is confident it can pay the US$115 million of outstanding debt that will be due on Dec. 6 this year, and that it is not in breach of any of the covenants related to debt, convertible securities or back-up liquidity lines.

It also expects little difficulty from downgrade clauses despite the rating actions. “We have made a concerted effort during the past 36 months to negotiate new business without ratings triggers and have negotiated such terms out of older treaties,” the company said in the statement. It added that treaties with rating triggers represent a very small amount of its in-force business.