Wednesday 02, August 2017 by Georgina Enzer

Salama/Islamic Arab Insurance Co. 'BBB-' Ratings Affirmed; Outlook Negative

S&P Global Ratings affirmed its long-term counterparty credit and financial strength ratings on Salama/Islamic Arab Insurance Co. (P.S.C.) (Salama) at 'BBB-'. The outlook is negative.

Salama's earnings have remained volatile during the past two years due to major losses from its motor portfolio in the United Arab Emirates (UAE) and Best Re, its subsidiary that is currently in run-off. While Salama has taken corrective measures since the beginning of 2016 by materially reducing the UAE motor portfolio and by making changes in senior management, the group's non-life-related gross written premiums in the UAE dropped by 46 per cent in 2016 to UAE dirham AED 210 million (approximately $57 million) from AED 391 million in 2015. This in turn has caused gross premiums from Algeria, Egypt, and Senegal to rise as a percentage of total premium income, thereby exposing the group to more industry and country risk, in our opinion. While we believe this situation may improve if Salama resumes writing a significant volume of UAE business, the interim exposure to higher-risk markets in Africa, in line with

Salama's diversification strategy, will continue to constrain Salama's business risk profile.

We acknowledge that Salama's earnings in 2016 and first-quarter 2017 show signs of recovery. Losses from continuing operations (excluding Best Re) have declined quarter on quarter: Salama posted losses of AED 89 million in first-quarter 2016, AED 66 million in second-quarter 2016, and AED 27 million in third-quarter 2016, before reporting profits of AED 48 million in fourth-quarter 2016 and AED 18 million in the first-quarter 2017. While this recovering trend points to the new management team's gradual success in containing losses in its UAE motor portfolio, we think it is too early to conclude that earnings will continue to recover toward our satisfactory levels, especially given Salama's track record of earnings volatility over the past five years, with an average net combined (losses and expenses over premiums) ratio of 115 per cent.

Prior to 2015 Salama enjoyed extremely strong capital adequacy ratios, as per our capital modelling. In 2015-2016 there was an erosion of capital due to losses from Best Re reinsurance and further pronounced losses from the UAE motor portfolio. Because of a decrease in business volumes, Salama's capital adequacy appears to have stabilised at our very strong level. But with a growing contribution from prospective retained earnings, we expect Salama will maintain very strong capital adequacy despite forecast business growth over our forecast horizon for 2017-2018. We take into account a steady recovery in earnings over 2017-2018, with combined ratios in the 98 per cent-100 per cent range, which are in line with the UAE market as a whole. While these forecasts differ from Salama's aforementioned track record, we assume that under the group's management--alongside new regulations in the UAE on actuarial pricing of motor and medical and the new unified motor policy implemented in January 2017--Salama will generate underwriting profits at least in line with market averages. However, these marginal underwriting profits are not sufficient to restore the extremely strong capital adequacy ratios that Salama displayed prior to 2015.

Salama has improved its investment portfolio considerably by completely liquidating AED 184 million of unrated Mudharaba deposits. The group moved most of the sale's proceeds into highly rated banks, which has resulted in improved liquidity and counterparty risk positions, in our view.

The results of Salama's efforts to move away from unrated and speculative-grade instruments have also strengthened the group's asset quality. While there has already been a marked improvement, the average asset quality still falls short of our 'BBB' category, as per our methodology, which leads us to assess Salama's financial risk profile as less than adequate.

That said, we believe if management continues to de-risk its investment portfolio by continuing to increase its exposure in investment-grade instruments, we could reassess the group's financial risk profile, which could lead us to revise the outlook on the 'BBB-' ratings to stable, all else remaining equal.

Of the AED 423 million in total investments in bonds and deposits as of Dec. 31, 2016, Salama has AED 185 million (44 per cent) in investment-grade bonds and deposits, while AED 239 million (56 per cent) is held in unrated or speculative-grade instruments. Although the exposure to unrated and speculative-grade instruments remains high, we note the improvement from previous years when the group only held around 15 per cent in investment-grade bonds and deposits, while 85 per cent was kept in unrated or speculative-grade instruments. Nevertheless, we take into consideration that Salama holds around AED 121 million in sovereign bonds from Egypt and Algeria, which is a regulatory requirement in these countries, whereby insurers are obliged to keep investments in government instruments.

As per our liquidity model, we calculate that total stressed assets cover 123 per cent of the total stressed liabilities as of end-December 2016 compared with 113 per cent a year earlier. The primary factor behind this improved liquidity ratio is management's efforts to liquidate its unrated investments and place more funds in investment-grade bonds and deposits. We expect that Salama's liquidity will further improve if management continues to de-risk its investment portfolio by investing in higher-rated banks while further reducing exposure to private-equity investments.

In the Salama group's published accounts, Best Re is deconsolidated and marked as "assets held for sale." In our capital adequacy calculations for the group, Best Re's net assets of AED 74.1 million are fully written, given our belief that there is very little possibility of any significant recovery. Losses from Best Re for 2016 stood at AED 41 million and at AED 11 million in first-quarter 2017, and we anticipate that Best Re will likely continue to hamper Salama's overall results.

We assess Salama's risk position as high predominantly due to its holdings of high risk assets (equities, real estate, and unrated and speculative-grade bonds and deposits), relative to a still-somewhat-weakened capital position. Although we note the improvements in Salama's investment portfolio, the proportion of high-risk asset remains high relative to the group's now-reduced levels of shareholder equity.

The negative outlook reflects our expectation that Salama's earnings volatility and exposure to certain high industry and country risk African insurance markets will continue to constrain its business risk profile over the coming 12 months.




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