Actuarial Notes

Rating Agencies

By Sholom Feldblum · Casualty Actuarial Society · 2011

Study guide: Exam 6C

A CAS study note (3 October 2011) on rating agencies' financial strength ratings of property-casualty insurers, with background on bond ratings. It explains how agencies help policyholders and agents by assessing insurers' ability to pay claims years in the future, how the ratings process combines quantitative data with qualitative valuations, why ratings are essential for many insurers, what the interactive meetings with senior managers cover, and how the agencies' capital standards differ; its appendices compare insurer ratings with bond ratings, trace the agencies' history, review public perceptions of them and set exercises.

On the syllabus

  • Exam 6C — objectives C2–C4; pp. 1–7, including Appendix A; not Section 4, Appendices B–D, formulæ or the endnotes.

Introduction

  • Rating agencies give credit ratings for corporate, municipal and government bonds and financial strength ratings for life and property-casualty insurers; bond ratings are the primary work of Standard and Poor's, Moody's and Fitch, insurance ratings that of A. M. Best's.
  • Financial strength ratings make insurance markets more efficient by reducing information costs for agents and policyholders.
  • Ratings have entered regulatory and legal arenas: the NAIC Statement of Actuarial Opinion requires the Appointed Actuary to consider reinsurers' ratings, some Canadian courts require A ratings for insurers writing life annuities that fund structured settlements, and RBC bond charges depend on ratings.
  • Downgrades of highly rated debt in 2008–2009 and failures of highly rated firms drew criticism of the agencies; a 2006 law requires extensive disclosure of their methods.

Structure of This Reading

  • The reading focuses on financial strength ratings of property-casualty insurers and presents alternative views on disputed issues, such as whether the agencies make insurance markets more efficient or mimic public information.

1 Rating Agencies Provide Material Benefits to Insurance Policyholders

  • Policyholders depend on insurers to keep long-term promises but lack the expertise, resources and time to examine them; agencies hire financial analysts, actuaries and economists to assess insurers' financial strength.
  • Insurers may spend $1 million a year or more on ratings, in agency fees and the internal cost of preparing for meetings.
  • Some studies suggest agencies respond more slowly than the bond and stock markets: traders reassess a firm at once, while agencies wait to verify their information.

2 Ratings Process Combines Quantitative Data with Qualitative Valuations

  • Over 90% of insurers are rated by A. M. Best's or another agency; unrated insurers can be at a disadvantage with independent agents and with banks issuing mortgages.
  • An interactive rating has five steps: background research by the ratings analyst and submission of proprietary data by the insurer; interactive meetings between analysts and senior managers; a ratings proposal by the lead analyst; decision by the ratings committee; and publication, with the analysis provided to fee-paying subscribers.
  • Public ratings rely on public data only, with no input from the insurer; interactive ratings also rely on proprietary data and meetings with the insurer's senior managers.
  • An insurer should not withhold potentially damaging data the analyst does not request; for an insurer needing ratings each year it is almost always better to inform the agency of likely problems before they become evident.
  • The rating is decided by a committee formed anew for each case from senior members of the agency, not by the analyst; agencies delay downgrades by repeating the current rating with a negative outlook.

3 Ratings Are Essential for Many Property-Casualty Insurers

  • Almost all insurers are rated, though most have no debt and are not publicly traded, for three reasons: agents are wary of unrated insurers, third parties rely on outside assessments of solvency, and rating agencies assess financial strength efficiently.
  • Ratings are particularly important for reinsurance, surety, structured settlements, homeowners and some specialty lines.
  • Primary insurers use a reinsurer's rating to assess its financial strength; a treaty's downgrade clause may require the reinsurer to deposit funds or provide letters of credit if it falls below a set rating, such as A- (reinsurance credit risk).
  • Banks may require homeowners coverage on mortgaged properties from insurers with investment grade ratings, and courts and plaintiff attorneys rely on ratings for structured settlements.

4 The Interactive Meeting with the Insurer's Senior Managers

5 Rating Agency Capital Requirements

  • Best's Capital Adequacy Ratio
  • Stochastic Cash Flow Capital Models
  • Principles-Based Systems

Appendix A Financial Strength Ratings vs Bond Ratings

  • The agencies use letter scales, introduced by Fitch, rather than continuous ones; the highest rating is A++ (or AAA) and the lowest F, an insurer in liquidation.
  • A. M. Best's divides insurers between secure (likely to meet their insurance obligations), rated A++ to B+, and vulnerable (may not meet them in adverse scenarios), rated B to F; a suspended rating (S) may follow a major event whose effects on the insurer are great but still uncertain.
  • Best's also issues credit ratings, investment grade (aaa to bbb-) or non-investment grade (bb+ to d), which refer to the likelihood of payments on debt securities: a short, secured bond may be paid even if the insurer's ability to pay long-term claims is doubtful.

Appendix B History and Growth of the Rating Agencies

Appendix C Efficiency and Benefits of Rating Agencies

Appendix D Rating Agencies Exercises

Endnotes

Sources