Fitch Ratings has downgraded Sri Lanka-based Sri Lanka Insurance Corporation Limited's (SLIC) Insurer Financial Strength (IFS) Rating to 'B' from 'B+'. The Outlook is Negative. SLIC's National IFS Rating was not covered in this review.

KEY RATING DRIVERS

The rating action follows Fitch's annual review of SLIC. The review took into consideration Fitch's current assessment of the impact of the coronavirus pandemic, including its economic impact, under a set of rating assumptions described below. These assumptions were used by Fitch to develop pro forma financial metrics for SLIC that Fitch compared with both the rating guidelines in its criteria and with previously established rating sensitivities for SLIC.

The downgrade reflects the rising pressures in the operating environment and in the insurer's business profile as well as heightened investment and asset risks, all of which are caused mainly by the deterioration in the sovereign's credit profile. Fitch downgraded Sri Lanka's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to 'B-' from 'B' on 24 April 2020 (see "Fitch Downgrades Sri Lanka to 'B-'; Outlook Negative" at www.fitchratings.com/site/pr/10119653).

The Negative Outlook on SLIC reflects the agency's expectations of further weakening in the insurer's investment-related risks because of its sizeable exposure to the sovereign-related assets and any near-term volatility in earnings caused by the pandemic. Fitch continues to factor in SLIC's above-industry capital position in the IFS Rating.

Fitch believes that the sovereign's downgrade underscores SLIC's investment risks as all the insurer's invested assets are in Sri Lanka. Under Fitch's credit-factor scoring guidelines, the insurer's investment and asset risk score is capped at 'ccc+' due to its high exposure to sovereign-related investments. SLIC's risky asset ratio was 219% in 2019 (2018: 203%).

Fitch has lowered SLIC's business profile score under our credit-factor scoring guidelines to 'b+' from 'bb-' due to the agency's view of a weakened operating environment. We continue to rank SLIC's business profile as 'Favourable' compared with that of other Sri Lankan insurance companies due to the leading business franchise, participation in well-diversified and stable business-lines and large domestic operating scale. SLIC is Sri Lanka's second-largest life insurer and third-largest non-life insurer based on gross written premiums.

SLIC's capitalisation - measured by Fitch's Prism Factor-Based Capital Model (Prism FBM) - was 'Strong' at end-2019. Under Fitch's coronavirus rating case, the pro forma Prism FBM score drops to 'Somewhat Weak', which is commensurate with the guideline for 'BB' rated insurers. We expect the insurer's sufficient capital buffers, strengthened partly by its large unallocated participating surpluses, to mitigate the impact from any potential investment losses stemming from volatile financial markets. SLIC's life and non-life risk-based capital (RBC) ratios were 434% and 208%, respectively, at end-2019 (2018: 437%, 200%), well above the industry average and the 120% regulatory minimum.

Fitch thinks the government's measures to contain the spread of the virus, and the subsequent halt in economic activities, could hamper the industry's new business growth. For life insurance, we expect new business generation to be subdued over the near-term as most insurers, including SLIC, predominantly use agency networks that rely on human interaction for distribution. In addition, we expect non-life business growth to slow in light of the government's temporary restriction on non-essential goods imports, including motor vehicles, to control currency depreciation. SLIC's three-year average combined ratio was 95%, comfortably beating industry averages. The combined ratio increases to 97% under the agency's pro forma rating case.

Assumptions for Coronavirus Impact (Rating Case)

Fitch used the following key assumptions in support of the pro forma ratings analysis discussed above:

- Decline in key stock market indices by 35% relative to 1 January 2020;

- Increase in two-year cumulative high-yield bond default rate to 16%, applied to current non-investment grade assets;

- Both upward and downward pressure on interest rates, with spreads widening (including high-yield by 400bp) coupled with notable declines in government rates;

- A COVID-19 infection rate of 5% and a mortality rate (as a percentage of infected) of 1%;

- For the non-life sector, COVID-19-related claims impact on the industry-level accident year loss ratio at 3.5 percentage points (pp) to be offset partially by an advantageous 1.5pp, on average, from the auto line; and

- Impairment in the value of non-investment grade invested assets by 12%.

RATING SENSITIVITIES

The IFS Rating remains sensitive to any material change in Fitch's rating case assumptions on the pandemic. Periodic updates to our assumptions are possible in light of the rapid pace of changes in government action in response to the pandemic, and the speed with which new information is available on the medical aspects of the outbreak. A discussion of how we expect ratings would be affected under a set of stress case assumptions is included at the end of this section to help frame sensitivities in a severe downside scenario.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

- A material adverse change in Fitch's rating assumptions on the coronavirus impact.

- A further increase in its investment and asset risks on a sustained basis.

- Deterioration in Prism FBM score well below 'Somewhat Weak' for a sustained period.

- Significant deterioration in financial performance and earnings for a sustained period.

- Significant weakening in SLIC's business profile.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

- Significant reduction in SLIC's investment and asset risks on a sustained basis will lead to a revision of the rating Outlook to Stable.

- A material positive change in Fitch's rating assumptions on the coronavirus impact.

- A positive rating action is prefaced by Fitch's ability to reliably forecast the impact of the pandemic on the financial profile of both the Sri Lankan insurance industry and SLIC.

- Sustained maintenance of SLIC's 'Favourable' business profile; and

- Maintenance of Prism FBM score well into the 'Adequate' level on a sustained basis.

Stress Case Sensitivity Analysis

- Fitch's stress case assumes the following: a 60% stock market decline; two-year cumulative high-yield bond default rate of 22%; high-yield bond spreads widening by 600bp and more prolonged declines in government rates; heightened pressure on access to capital markets; a COVID-19 infection rate of 15% and mortality rate of 0.75%; an adverse non-life industry-level loss ratio impact of 7pp for COVID-19 claims, partially offset by an advantageous 2pp for motor; a one-notch lower sovereign rating; and impairment of non-investment grade invested assets by 20%.

- The implied rating impact under the stress case would be an additional one-notch downgrade to SLIC's IFS Rating.