Feldblum - Rating Agencies

  1. Shortcomings of rating agencies
    • do not respond as quickly as stock markets /hesitant to change rating quickly
    • conflict of interest: insurer pays rating agencies to rate their securities
    • may not be transparent with their methodologies
  2. Disadvantages of Unrated insurers
    1. Independent agents hesitate to use them
    2. Banks do not issue mortgages without property coverage from a rated insurer.
    3. may receive public ratings, with less control over the info reviewed by the agencies
  3. Advantages and disadvantages of interactive rating
    • advantages:
      • less expensive to pay for rating than to demonstrate financial strength individually to others
      • Agents may be wary of insurers without an interactive rating
      • Insurers have some control over info reviewed
      • Fewer chances of error
    • disadvantages:
      • Intrusive
      • Time-consuming
      • Expensive
  4. Focus of agencies in the rating process
    1. Quality of an insurer’s managers (knowledge of industry trends, experience with adverse scenarios)
    2. Business strategy. do not consider a particular decision if from random fluctuations and market movements
  5. Steps in interactive rating
    1. Background research by ratings analyst and submission of inurer data
    2. Interactive meetings btw ratings analysts and insurer
    3. Prep ratings proposal by lead analyst
    4. Decision by ratings committee after presentation by lead analyst.
    5. Publication of rating
  6. Why is public data not sufficient
    • e.g. reinsurance data do not show attachment and limits of IF treaties;
    • Reserving schedules do not show segmented data that insurers use for their estimates.
    • Rating agencies ask insurers to disclose UW, reserving, investment with supporting data.
  7. Why do analysts specialize by industry
    • if insurer writes property in Gulf Coast states, an analyst with expertise in windstorm models may be needed.
    • If insurer writes LT LOB, an actuary may be needed to prepare reserve analyses..
  8. Rating agencies common types of requested info
    1. Statutory Annual Statements and GAAP f.s.'s
    2. Past major events (mergers, acquisitions, expansions).
    3. Investment strategy
    4. Org charts
    5. Product descriptions
    6. business strategy
  9. Reasons that almost all insurers are rated
    1. Unrated insurers
      • Agents are wary of unrated insurers as they might be hiding financial distress
      • Less expensive to pay for rating than demonstrate financial strength individually to others
    2. Reliance by consumers and TPs
      • Agents use ratings to select insurers. might be sued if provide insurance from financially weak insurer.
      • insurers use ratings to select reinsurers. rely on reinsurer's ratings to evaluate ability to pay obligations
    3. Efficiency
      • Rating agencies are efficient at assessing financial strength (expertise and data)
      • Agents, UWs, regulators do not have time, experience, resources of rating agencies for assessment
  10. LOBs where high ratings are important
    1. Reinsurance:
      • For insurers to assess credit risk
      • can provide LOC to secure obligations, but expensive
      • Strong reinsurers may charge higher prices
      • Small reinsurers with A ratings can compete with larger peers.
      • Large reinsurer below investment grade may not be able to renew its treaties.
    2. Surety, structured settlements, homeowners
  11. How do rating agencies maintain consistency
    • Relate ratings to EC measures
    • Issue ratings by committees independent from ratings analyst
    • Review ratings periodically
    • Collect consistent info from companies
    • follow consistent guidelines in assessing info
  12. How do rating agencies compete
    1. Distinguish weak vs strong insurers:
      • id stable insurers underrated by others -> gain clients who will pay for rating
      • id weak insurers overrated by others -> strengthen reputation for accurate ratings
    2. capital models of major agencies differ:
      • more accurate model attracts insurers who might be mis-rated by generic models.
      • Inaccurate models may damage reputation
      • rating agency with high capital standards and low ratings may lose clients.
      • low standards and high ratings may lose investors’ trust
  13. AM Best Model
    • 1% EPD ratio for all risks
    • EPD rep's avg loss for the worst 1% of outcomes (TVAR at 99%) or PP for unlimited agg XOL reinsurance (attachment point = capital charge for the risk; chosen such that EPD = 1% of MV of reserves)
    • EPD for each risk depends on volatility and size, e.g., equities more volatile than bonds -> higher EPD
    • EPD ratio = EPD / MV of held reserves
  14. Moody’s and Fitch’s Model
    Stochastic CF capital models
    • models are based on loss distributions of each risk and simulate repeatedly from them
    • CFs are projected until all current liabilities are settled
    • Required capital is set using 99% VaR or 99% TVaR for agg distribution
  15. Standard and Poor’s Model
    Principles-based models/internal capital models
    • focuses on evaluating insurer's ERM and internal capital models.
    • bases capital requirements on a weighted average of S&P's own formula and insurer’s EC model.
    • reasons: well-managed insurers evaluate their capital needs more accurately than a rating agency can
  16. Bottom-up vs top-down approaches for EC models
    • Bottom-up:
      • determines capital charges by risk and line
      • combines them with diversification factors.
    • Top-down:
      • overall capital req'ts from multivariate distribution of all risks
      • allocates required capital back to risk and line
  17. Financial strength rating
    • Secure (likely to meet obligations): 3 categories (superior, excellent, good)
    • vulnerable (may not meet obligations in adverse scenarios): 7 categories from fair to in liquidation
    • suspended: might occur after a major CAT, whose effects are great but still uncertain
Card Set
Feldblum - Rating Agencies
Feldblum - Rating Agencies