Insurance Company Credit Ratings
People and businesses depend on insurance companies to pay them when they suffer an insured loss. Because small risks are usually retained, insured risks are those that would cause a large financial loss to the insured, if not for the insurance payment. But insurance companies can only pay for losses if they have the money. However, like other companies, insurance companies can go become insolvent, rendering them unable to pay for the losses of the insured. Additionally, many people and businesses depend on the insurance company to pay for legal services, such as defending the insured against a lawsuit. Few people can afford the exorbitant costs of today's litigation. Without money for defense, they could be held liable for something that was not even their fault. To prevent these tragedies, it would behoove anyone purchasing insurance to ensure that the insurance company itself is financially stable and dependable. This is the problem that the insurance company credit rating agencies seek to solve for the insurance applicant, by issuing insurer financial strength ratings (IFS ratings).
Rating Agencies: A.M. Best, Fitch, Moody's Investment Services, Standard & Poor's, and Weiss
There are 5 major independent insurer rating agencies who rate the financial strength of insurance companies:
Each has their own rating scale, rating standards, and differ in the companies they rate, but with considerable overlap. All of these rating agencies use public information, such as SEC filings, and the major accounting reports, including the income statement, cash flow, and especially the balance sheet, which shows how much assets exceed liabilities. All of the rating agencies except Weiss obtain additional information from senior management and owners through interviews and questionnaires. A.M. Best specializes in credit ratings for insurance companies and has the broadest coverage of insurance companies, while the other rating agencies also cover many other types of companies and debt securities.
Another feature that distinguishes Weiss from the other rating agencies is that their ratings are paid for by end-users, whereas the other rating agencies receive their payment from the companies that they are rating. This creates a potential conflict of interest, because companies will generally seek those rating agencies that will give them the best rating. In turn, rating agencies may be more inclined to give a higher rating than would be justified by the financial status of the company. This conflict of interest is what partly gave rise to the credit crisis of 2007 to 2009, because some of the rating agencies, such as Moody's and Standard & Poor's, were giving investment-grade ratings to financial securities based on debt, such as mortgage-backed securities and collateralized debt obligations, that, in turn, were based on subprime mortgages. Aside from this conflict, however, information from management through interviews and questionnaires can yield considerably greater insight into the financial viability of the company and its future. The accuracy of the different IFS ratings from different CRAs can be measured by analyzing the statistics of default and impairment rates for each rating category.
- A.M. Best, established in 1900, rates most insurers. It also has a not rated designation for those companies that are not covered.
- IFS ratings from different companies may differ in their designation of credit quality. For instance, an A- from A.M. Best is most comparable to BBB from Fitch, Moody's, and Standard & Poor's.
- Weiss ratings primarily depend on public financial statements; company executives are not interviewed nor are non-publicly available documents used, unless they are willingly provided by the company.
Each rating scale uses uppercase letters for major categories of financial stability, with A being the best, or most financially stable. Minor distinctions within each major category is designated with lower case letters, or pluses and minuses. Note also that rating designations may designate different levels of financial stability among different agencies. For instance, A+ designates the penultimate top rating from AM Best from its 15 categories, whereas that same designation is the 5th highest rating out of 24 categories for Fitch and 19 categories for S&P.
The primary information for the ratings comes from quarterly and annual financial statements that insurers must file with their state regulator, supplemented with publicly available documents, such as SEC filings, business plans, and AM Best questionnaires. Information is also gathered from interviews with executives of the insurance company. Financial strength ratings range from A++, superior, to F, in liquidation.
Not all insurance companies will provide rating information to the rating companies, in which case, A.M. Best and Standard & Poor's will rely on public information, but they will designate the rating that it is based on public information only. A.M. Best suffixes (pd) to its rating, which they call Public Data Rating, while Standard & Poor's will suffix a â€œpiâ€ to their rated designation, which they call a Qualified Solvency Rating. Presumably, â€œpdâ€ means â€œpublic documentsâ€ and â€œpiâ€ means â€œpublic informationâ€.
Insurance company ratings depend on both the rating formula used in calculating the various ratings and the definition of each rating by the reading company. Thus, a good rating by Fitch may not mean exactly the same thing as a good rating by A.M. Best, or the other rating agencies.
Standard & Poor's
Information and Methods Used to Determine the Credit Rating
There are generally 5 steps in developing a credit rating for the insurance company:
- gather the information
- analyze the information
- determine what the rating would be based on that information, which is usually done by committee
- distribute the rating to the public and to other interested parties; and
- continually monitor the company, especially if information that would affect the creditworthiness of the company changes or an event occurs that could possibly affect their credit rating
Qualities that are usually examined are the quality of the management; competitive position; operating performance; long and short-term debt; liquidity; and enterprise risk management. Additionally, each agency requires a minimum amount of capital for each rating designation of their scale.
Information about the insurance companies is obtained from the following: at least several years of annual reports and audited financial statements of the insurance company, and of any parent or subsidiaries; actuarial reports; the governing organization of the company and of any parent or subsidiary; biography of principal officers and owners, especially in regard to their experience and performance in the insurance industry; capital resources, including retained earnings, and access to debt and other financial markets; the use of reinsurance; investment objectives and guidelines; and any other information relevant for rating.
Most this information is obtained from public documents, such as SEC filings, interviews with management, and completed questionnaires by management. Additionally, considering the severe financial consequences of catastrophes, a primary criterion for rating property and liability insurers is catastrophe management policies and catastrophe models that insurers use as an attempt to forecast possible losses.
Enterprise Risk Management
Because many insurance companies are large companies, another factor that determines ratings is their enterprise risk management (ERM) strategy, which considers enterprise risk holistically. ERM covers 5 major categories of risk: credit, operational, strategic, market, and operating risk, including their correlations and interdependencies. Characteristics of an effective ERM program include having a risk aware culture promoted by the board of directors and senior management that is represented by how well risk management is incorporated into corporate procedures. How well risk is identified, measured, and quantified, and the extent that information is shared among the business departments and lines of insurance.
- Operational risk includes changes in management; fraud; business interruption; management of claims; retention of employees; and the reliability and integrity of information systems.
- Strategic risk includes making inferior decisions and/or not implementing them effectively and not reacting timely and effectively to changes in the industry.
- Underwriting risk includes suboptimal pricing, inadequate reserves and event risk.
- Financial flexibility is gauged by the amount of retained earnings, and access to debt and equity markets, and its financial stability. Obviously, higher credit rating provides easier and cheaper access to financial markets. A company with consistent earnings will generally rate higher than a company with inconsistent earnings, but with the same amount of capital. Consistent earnings help to build a cushion of accumulated capital, allowing it to withstand unexpected costs, and represent better management.
Because insurance companies operate in particular countries, rating agencies also rate countries according to risk. For instance, A.M. Best uses 5 tiers, ranging from CRT-1 with the lowest risk to CRT-5, with the highest risk. Country risk is based on 3 macroeconomic risks: economic risk, financial system risk, and political risk. All of these risks are rated from very low to very high.
- Economic risk is determined by the state of the economy and its stability, the labor market, volatility in the financial markets, and inflation.
- Financial system risk includes noninsurance financial risk that can result from a weak banking system, inadequate regulations for the financial markets, depth of its capital markets, accounting standards, and the financial stability of the government. Insurance risk can result from inadequate reporting standards or regulations affecting insurance companies.
- Political risk includes the reliability and integrity of the legal system and political leadership; government bureaucratic efficiency; and the effectiveness of economic policies.
Generally, the average ratings of insurance companies will generally be lower than warranted by their financial status, if they are located in countries with higher country risk.
In addition to the rating agencies' ratings, consumers and businesses can check on information about the insurance companies located in their state, especially about complaints, from most state insurance departments. Complaint information may include the number of complaints filed against the insurer, especially compared to other insurance companies within the state, types of complaints, and what the complaint was about. Most complaints are about cancellations, nonrenewal, premium increases, paying inadequate claims, paying late, or not paying at all. Another source for consumer complaints is the Consumer Information Source, maintained on the website of the National Association of Insurance Commissioners (NAIC).
Tips on Finding Ratings on Insurance Companies
- Check at least 2 or 3 ratings, because each rating agency uses different criteria and methods to rate companies. Also, read the particular descriptions of each rating designation from the websites of the rating agencies to know exactly what the rating designation means.
- Ratings may change at any time, so you should check on any changes at least annually.
- Never rely on the insurance rating published by the insurance company, since they may be taking the most favorable rating.