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
Disadvantages of Unrated insurers
- Independent agents hesitate to use them
- Banks do not issue mortgages without property coverage from a rated insurer.
- may receive public ratings, with less control over the info reviewed by the agencies
Advantages and disadvantages of interactive rating
- 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
Focus of agencies in the rating process
- Quality of an insurer’s managers (knowledge of industry trends, experience with adverse scenarios)
- Business strategy. do not consider a particular decision if from random fluctuations and market movements
Steps in interactive rating
- Background research by ratings analyst and submission of inurer data
- Interactive meetings btw ratings analysts and insurer
- Prep ratings proposal by lead analyst
- Decision by ratings committee after presentation by lead analyst.
- Publication of rating
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.
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..
Rating agencies common types of requested info
- Statutory Annual Statements and GAAP f.s.'s
- Past major events (mergers, acquisitions, expansions).
- Investment strategy
- Org charts
- Product descriptions
- business strategy
Reasons that almost all insurers are rated
- 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
- 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
- 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
LOBs where high ratings are important
- 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.
- Surety, structured settlements, homeowners
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
How do rating agencies compete
- 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
- 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
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
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
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
Bottom-up vs top-down approaches for EC models
- determines capital charges by risk and line
- combines them with diversification factors.
- overall capital req'ts from multivariate distribution of all risks
- allocates required capital back to risk and line
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