Worth the Paper

Standard & Poor’s, the world’s largest insurance rating organization, has been evaluating companies of all kinds for more than 75 years, and began rating the financial security of insurance companies in 1971. Currently, S&P’s insurance ratings universe contains more than 4,000 insurance entities in approximately 70 countries. S&P maintains that all its studies have found a clear correlation between credit quality and the probability of default: the higher the rating, the lower the probability, and vice versa. No matter what the time horizon, says S&P, higher ratings generally correspond to lower default ratios.

The company has developed credit ratings that may apply to an issuer’s general credit worthiness or to a specific financial obligation. Its insurance ratings provide financial strength ratings that are prospective evaluations of an insurer’s financial security to its policyholders.

S&P utilizes two approaches when rating the financial strength of insurers: interactive ratings and ‘PI’ ratings. Interactive ratings take place with full cooperation and thorough review, including an extensive interview with senior management. ‘PI’ ratings are based primarily on public information. The ‘PI’ subscript indicates that the insurer has not voluntarily subjected itself to S&P’s most rigorous rating review.

But, what does S&P look at when rating an entity? What is its highest priority, its lowest priority and what falls in between? And what does it mean to be triple-A, triple-C, or an R? The following, which answers these and other questions, has been excerpted from S&P property and casualty insurance ratings criteria.

The language of ratings

S&P breaks the spectrum of credit quality into two main segments: “secure” and “vulnerable.” The secure categories are representative of companies S&P feel represent good security and have financial security characteristics that outweigh any vulnerabilities. The secure range has four main categories:

‘AAA’ – Extremely strong

‘AA’ – Very strong

‘A’ – Strong, and

‘BBB’ – Good.

The ‘AAA’ rating is reserved for the few companies that have distinguished themselves over a long period as being truly outstanding companies, generally in almost every way, and having extremely strong financial security. Insurers rated ‘AA’ differ only slightly from those rated ‘AAA’ and have very strong security, although such companies may not have always demonstrated the same uniformly high performance as those rated ‘AAA’.

Insurers rated ‘A’ have strong security because they have typically performed at, or slightly above, the average level in the industry in most categories and can be relied on to meet their financial obligations. Insurers rated ‘BBB’ offer good security for most risks, although insurers in this category may have demonstrated some weaknesses in one or more areas and may be susceptible to some adverse financial performance. Nevertheless, in S&P’s opinion, these insurers offer acceptable financial security.

The vulnerable range has five categories:

‘BB’- Marginal

‘B’ – Weak

‘CCC’- Very weak

‘CC’ – Extremely weak, and

‘R’ – Regulatory action

Insurers rated ‘BB’ may be adequate, but in S&P’s opinion, have demonstrated one or more specific weaknesses that lead the rating company to question their level of security. Insurers rated ‘B’ have had clear issues develop that bring into question their ability to meet their obligations. Insurers rated ‘CCC’ have such financial issues that S&P seriously questions their ability to continue as going concerns. The ‘CC’ rating is reserved for situations where a default is imminent on any financial obligation, excluding policyholder obligations, or when a default has occurred, but the insurer has not been placed under regulatory supervision.

Rated “R”

Companies falling under this rating are under regulatory authority. The rating criteria uses both quantitative and qualitative factors in assessing and determining a reinsurer’s financial strength. S&P’s interactive rating process uses similar rating factors employed for primary insurers: industry risk, management and corporate strategy, business review, operating performance, capital, liquidity, and financial flexibility to assess the reinsurer’s financial strength. The reinsurance analyst modifies the process to address the fundamental differences inherent to the reinsurance industry.

Industry risk

This is defined by S&P as the environmental framework in which an insurance company operates. S&P evaluates industry risk based on the types of insurance written (line of business or sector) and geographic profile. Key points considered include:

The potential threat of new entrants into the market;

The threat of substitute products or services;

The sector’s competitiveness and volatility;

* The potential tail of liabilities;

The bargaining power of insurance buyers and suppliers; and

The strength of regulatory, legal and accounting frameworks in which the insurer operates.

Management & corporate strategy

A reinsurer’s strategy, operational effectiveness and financial risk tolerance are considered key factors in its ability to be competitive in the marketplace and build a strong financial profile. Companies with a more diversified range of geographic and absolute risks relative to their capital base are viewed more favorably than companies that have greater concentrations of risk. The ability and willingness to exercise underwriting control — willing to write less premium volume if competitive pressures underprice the risk — is viewed favorably.

Business review

Reinsurers with historically strong relationships with the world’s leading brokers are considered to have a competitive advantage. Although S&P acknowledges that access to the business is important, it is only beneficial if it can be underwritten profitably over the long term.

It is important to understand the business profile of the reinsurer, and how it has changed from the past and how it is expected to change in the future to align with the current corporate strategy. S&P has no preference as to the “best mix” of pro-rata versus excess-of-loss business, but rather seeks to understand the composition of the company’s book of business to both interpret the income statements better and understand the reinsurer’s management of aggregate exposures.

Companies that can offer worldwide coverages with substantial local area presence can better attract and service large multinational companies. Therefore, during the interactive rating process, the analyst will explore the number of new and existing relationships within the reinsurance group. How is business generated, and who decides where the liability will ultimately be booked and evaluated? What type of value-added services are offered by the group? Reinsurers with an enhanced network of subsidiaries that can accommodate the ultimate client’s needs, i.e., offering admitted and non-admitted primary carriers together with a reinsurance package, can often create a competitive advantage for the reinsurer.

Operating performance

Returns on revenue are the primary focus in evaluating a reinsurer’s performance relative to its competitive peers in the markets it typically dominates. Companies that have broader product diversification are viewed more favorably because they are in a better position to move through the underwriting cycle.

Capital adequacy

It is S&P’s expectation that catastrophe reinsurers should have sufficient resources to meet a severe stress test. The test’s underlying principle is that the reinsurer may have to pay out its full limit loss, regardless of the probability of an event occurring.

Reserves

On established lines of business, the analyst will seek information to better understand how the company is establishing its reserves, discuss any changes in the level of reserving, and discuss the prospect and management of reserve deficiencies and redundancies, if any.

Liquidity & flexibility

Financial flexibility, liquidity and investment considerations for reinsurers are comparable with those used
for the property/casualty industry. S&P says that all insurance organizations need to be highly liquid. The agency’s assessment of this area identifies the sources of cash and enables it to determine those companies with strengths or weakness. The primary source of liquidity is derived from operating cash flows. Although cash flow from underwriting is considered in the analysis of investment income, it is essential to measure this element in assessing liquidity. It is important to measure both the absolute level of cash flow from underwriting, as well as the ratio of cash inflows.

A second source of liquidity for a p&c insurer is its investment portfolio. It is relevant to measure this, again, both in absolute dollar terms and as a ratio to the total invested assets. Standard & Poor’s also reviews the liquidity of the insurer’s investment portfolio in relation to any significant catastrophe exposures that may be present. In such events, insurers may need to liquidate assets quickly to pay claims. Finally it is relevant to take into consideration other outside sources of liquidity such as bank lines of credit, established commercial paper programs and other sources.

Financial flexibility, which S&P says is a predominately qualitative measure, is broken down into capital requirements and capital sources. The former refers to factors that may give rise to an exceptionally large need for long-term capital or short-term liquidity. The latter involves an assessment of a company’s ability to access an unusually large amount of short-term and long-term capital. Typically, these sources consist of demonstrated access to multiple types of capital markets, such as the long-term public debt market, the commercial paper market, and the Euro markets. In addition, a company may hold assets with significant unrealized capital gains that could be sold without affecting the basic enterprise. The ability or demonstrated willingness to raise common equity capital is another important source of financial flexibility.

Assigning group ratings

The process begins with the establishment of a group rating that could then be applied to all subsidiaries S&P determines to be core. Next, strategically important subsidiaries are rated first on a stand-alone basis. The key characteristics analyzed are the operating performance, market position, and capital adequacy of each strategically important subsidiary. However, based on S&P analysis of their importance to the entire insurance organization, strategically important subsidiaries will receive one rating category of benefit, up to the group’s rating. Finally, non-strategic subsidiaries are normally rated solely on a stand-alone basis.