Moody's ratings on Zurich Insurance Company Ltd ("ZIC", Aa3 insurance financial strength, A1 senior debt, outlook stable) and associated ratings are unaffected by Zurich Insurance Group's (Zurich Group or Group) recently announced reserve strengthening for its German non-life business.
Zurich Group has announced that as a result of a review of its non-life business in Germany, it will strengthen its claims provisions, primarily in the long-tail liability lines, and write off a portion of its deferred acquisition costs. The current estimate of these financial adjustments totals approximately $550 million (before tax) and will be included in Zurich Group's financial results for the first nine months 2012 which are due to be released on November 15. The estimated after tax amount is approximately $390 million. This follows previous reserve strengthening by the Group for its German non-life business at H1 12 of around $100 million, and also at YE11 when reserves, driven by medical and professional liability lines of business, were strengthened by $242 million.
We view this announcement as credit negative as it will meaningfully reduce Zurich Group's Q3 earnings, and therefore negatively impact our profitability, reserve adequacy and earnings coverage metrics. Furthermore, we believe that the extent of this reserve strengthening is not only testament to significant claims activity and the inherent difficulty of reserving for certain long-tail liability lines of business, but may also indicate some current weaknesses in the Group's reserving processes and data quality with regard to its German business. Nevertheless, we expect the reserve charge to be a quarterly earnings as opposed to a capital event. This is based on Zurich Group's statement that its other businesses continue to deliver as expected through Q3, and the fact that the Group's earnings, quarter on quarter, have consistently exceeded this reserve charge amount, which represents only around 1% and 0.7% of Zurich Group's total equity and net non-life reserves at H1 12. We also note that Zurich Group has reported overall reserve surpluses for the last six years.
Going forward, we will continue to monitor Zurich Group's reserve adequacy. In addition to any further need to materially strengthen reserves, the following factors could put negative rating pressure on ZIC's rating: 1) Return on capital over the underwriting cycle below 7%; 2) Adjusted financial leverage consistently above 30% and earnings coverage consistently below 7x; 3) Material weakening of capital adequacy; 4) Material weakening of business franchise and diversification.
Moody's Aa3 insurance financial strength rating (IFSR) of ZIC is supported by the Zurich Group's strong market position across a broad range of countries, and excellent business and geographic diversification with an improving balance between life and non-life insurance. Operating performance has been strong in recent years, and capitalization and financial flexibility are viewed as excellent. Less positively, the outlook remains challenging in a number of Zurich Group's business areas, there is the challenge of reserve estimation in certain long-tail lines of business, and Zurich Group has a relatively high level of goodwill and intangible assets in relation to equity.