The long-term rating on debt issued by Liberty Mutual Capital Corporation -- which has since been merged into LMGI and remains guaranteed by Liberty Mutual Insurance Company -- has also been confirmed at Baa1. The outlook for all of these long-term ratings is negative. The present rating action concludes a review for possible downgrade that was initiated on August 13, 2004. The group's short-term debt ratings were not included in the review.
According to Moody's, the rating confirmations are based on Liberty Mutual's improved core operating earnings performance, as well as commensurate improvement in the group's operational leverage and
risk-adjusted capitalization measures. Additionally, Moody's believes that uncertainty with respect to adequacy of the group's loss reserve profile has declined, and the rating confirmation also reflects
significant growth in the group's capital funds and retained earnings during 2004. Moody's added that earnings and dividend capacity measures relative to interest expense remain strong.
With respect to the group's reserve position, however, Moody's believes that net reserve development could occur in the coming years, particularly in workers' compensation and other commercial liability
lines, as well as on exposures related to asbestos and pollution liabilities. That said, Moody's expects that the company should be able to absorb future volatility with modest disruption to future earnings, in
part reflecting further available limits provided by existing reinsurance programs. In Moody's view, growth in capital during 2004 and reduced reserve uncertainty have contributed to an improving risk-adjusted capital profile for the group.
The rating agency noted that Liberty's financial leverage profile is generally more conservative than its similarly rated peers. However, Moody's believes that, as a mutual company without ready access to public equity markets, Liberty has less debt capacity when compared with its publicly traded peers. Moody's expects consolidated financial leverage to remain below 25% and that future debt issuance will likely occur at LMGI, rather than through surplus notes at LMIC.
Despite these positive trends and improvements in 2004 on key profitability and operational leverage measures, the outlook for these ratings is negative primarily because of Moody's continued concerns about the group's above-average gross underwriting leverage and below-average operating profitability relative to peers. The rating confirmations reflect an expectation of continued improvements in these areas; the negative outlook signals that the ratings will likely be lowered in the event that improvements are not sustained. Specifically, Moody's noted that Liberty's ability to sustain pre-tax operating returns on premium above 7%, with GAAP gross underwriting leverage (adjusted for servicing
carrier business) of 6x or below over the next 12 to 18 months would likely return the rating outlook to stable. Conversely, pre-tax operating returns on premium below 5%, gross underwriting leverage above 6.5x, or adverse reserve development in excess of 5% of GAAP equity would likely result in a downgrade. The current ratings also continue to reflect the expectation that financial leverage will remain less than 25% of total capital, that GAAP pre-tax operating coverage of interest expense will
exceed 5x, and that risk-adjusted capitalization will continue the improvements witnessed during the past year.
Moody's review also considered the notching between various rating levels, across Liberty Mutual's capital structure. Moody's noted that the investme