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KBRA Releases Rating Report for Watford, an Arch Partner

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August 03, 2018

On June 11, 2018, Kroll Bond Rating Agency (KBRA) assigned insurance financial strength ratings (IFSR) of A to the operating subsidiaries of Watford Holdings Ltd. (Watford Holdings)—Watford Re Ltd., Watford Insurance Company Europe Ltd., Watford Specialty Insurance Company, and Watford Insurance Company (collectively referred to as Watford). KBRA also assigned an issuer rating of BBB+ to Watford Holdings. Additionally, KBRA assigned a rating of BBB- to Watford Holdings' outstanding cumulative contingently redeemable preference shares. The outlook for all ratings is stable.

The ratings reflect Watford's sound financial condition, diversified risk profile, and a seasoned management team. Watford is a global total return re/insurer that combines underwriting medium- to long-tail casualty risks with an investment strategy focused on noninvestment grade credit assets to generate attractive operating returns.

Experienced, disciplined underwriting is provided by Arch Underwriters Ltd. and Arch Underwriters, Inc., both wholly owned subsidiaries of Arch Capital Group Ltd. (Arch) (NASDAQ: ACGL) in accordance with Watford's guidelines that specifically limit exposure to natural catastrophes and other shorter tail risks. HPS Investment Partners, LLC (HPS) is a New York-based global investment platform with a focus on noninvestment grade credit that manages approximately two-thirds of Watford's assets based on guidelines formulated to complement Watford's underwriting portfolio. Watford enjoys a good flow of high-quality business from its strategic relationship with Arch.

Operations are supported by a comprehensive risk management framework and processes that leverage the risk management infrastructures in place at both Arch and HPS. Watford overlays its own proprietary analytics, risk appetites, and risk controls onto the information from its service providers for an integrated approach to monitoring and reviewing its exposures. Underwriting leverage is prudently conservative as Watford opportunistically grows its business in the near- to medium-term, and Watford consciously limits its modeled catastrophe exposure to a level well below that of its re/insurance peer group.

Asset/liability management is focused on mitigating the potential of Watford being required to meet liquidity needs by selling assets in a distressed market. Watford also maintains conservative financial leverage with good interest coverage and has adequate access to multiple sources of additional capital that can be tapped to manage liquidity risk and to facilitate the execution of its business plans.

Balancing these strengths are Watford's limited operating history and its relatively higher level of investment risk due to its leveraged, nontraditional investment strategy and potential liquidity issues in a scenario with simultaneous shock underwriting losses combined with a severe investment market dislocation, though the latter is mitigated by Watford's lower catastrophe exposure.

KBRA believes that while it is common for re/insurers to outsource some or all of their investment function, the outsourcing of the underwriting function has potential downsides; however, in Watford's case, these concerns are offset by the long duration of the service agreements between Watford and Arch as well as the strong alignment of interest mechanisms and favorable cancellation/nonrenewal provisions in those agreements.

KBRA notes Watford's considerable exposure to credit risk as its asset portfolio is largely allocated to below-investment-grade fixed-income assets. Watford performs extensive stress testing on a quarterly basis to ensure the organization's key risks are manageable both on an individual and collective basis. Watford operates in a competitive reinsurance market awash with traditional and alternative capital creating a supply/demand imbalance but is countering this situation by expanding into primary insurance in both Europe and the United States to deploy capital to areas of the market with the highest return potential, regardless of the underwriting cycle. Still, KBRA believes that until Watford finalizes its Brexit plan for its Gibraltar subsidiary, Watford's ability to service existing clients and to expand that business further in continental Europe could potentially be negatively impacted.

The stable outlook reflects KBRA's expectation that Watford will continue to maintain sound capitalization while prudently executing its business plans. Additionally, KBRA expects Watford to maintain sufficient liquidity to cover projected liability cash flows and payment of preferred dividends. The rating is based on KBRA's Global Insurer & Insurance Holding Company Rating Methodology published on October 10, 2017.

The full Waterford Re rating report is now available on the Kroll Bond Rating Agency, Inc. website with complimentary registration.

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