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. But like other companies, insurance companies can 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, and Standard & Poor's

Major independent insurer rating agencies who rate the financial strength of insurance companies include:

• A.M. Best
• Fitch Ratings (formerly Duff and Phelps)
• Moody's
• Standard & Poor's

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 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 get 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.

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 Great Recession 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 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.

Rating Scale

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 lowercase 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 5^th highest rating out of 24 categories for Fitch and 19 categories for S&P. 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 ratings based on public information only. For instance, A.M. Best suffixes (pd) to its rating, which they call Public Data Rating.

Insurance company ratings depend on both the rating formula used to calculate the various ratings and the definition of each rating by the rating 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.

Information and Methods Used to Determine the Credit Rating

Developing a credit rating for an insurance company involves 5 steps:

1. gather the information
2. analyze the information
3. determine the rating based on that information, usually done by committee
4. distribute the rating to the public and to other interested parties; and
5. continually monitor the company, especially if information affecting the creditworthiness of the company changes or an event occurs that may affect their credit rating

Qualities 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 of capital for each rating designation of their scale.

Types of information about the insurance companies used to determine ratings include:

• at least several years of annual reports and audited financial statements of the insurance company, and of any parent or subsidiaries;
• actuarial reports;
• governing organization of the company and of any parent or subsidiary;
• biography of principal officers and owners, especially regarding their experience and performance in the insurance industry;
• capital resources, including retained earnings, and access to debt and other financial markets;
• their use of reinsurance;
• investment objectives and guidelines; and
• any other information relevant for rating.

The primary information for the ratings comes from quarterly and annual financial statements 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.

Additionally, considering the severe financial consequences of catastrophes, a primary criterion for rating property and liability insurers is catastrophe management policies and catastrophe models insurers use to forecast possible losses.

Enterprise Risk Management

Because many insurance companies are large companies, their enterprise risk management (ERM) strategy is a major determinant for ratings, 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, represented by how well risk management is incorporated into corporate procedures and 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 rate higher than a company with inconsistent earnings, but with the same amount of capital. Consistent earnings help build a cushion of accumulated capital, allowing it to withstand unexpected costs, and represents better management.

Country Risk

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. 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.

The average ratings of insurance companies will be lower than warranted by their financial status, if they are located in countries with higher country risk.

Government Sources of Information about Insurance Companies, Including Complaints

In addition to the rating agencies' ratings, consumers and businesses can check information on 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). Additional resources:

• NAIC State Web Map
• Insurance Information Institute Directory | III