CFO Consulting Partners has begun to work with insurance companies to help maximize a company’s rating potential. This article is the first of a two-part series which will discuss the credit rating process for insurance companies. Here we discuss how ratings firms look at capital levels, and how management can demonstrate effective capital management strategies. A subsequent article will review the roles of: operating results, market profile, and additional analytic considerations in the ratings process.
There are generally five Security and Exchange Commission (SEC) registered Nationally Recognized Statistical Rating Organizations (NRSRO), otherwise known as rating agencies, which follow the U.S. insurance industry: A.M. Best Company (AMB) and Kroll Bond Rating Agency (KBRA) are the primary providers of credit ratings to the mid-market segment of the industry. The three larger NRSROs: Fitch, Moody’s and Standard & Poor’s (S&P), tend to focus on the industry’s larger companies.
AMB and KRBA provide two types of ratings on insurance companies, debt and policy issuer strength ratings. Debt ratings are an indication of the insurer ability to meet their interest and principal obligations on specific bonds, a policy issuer strength rating considers the likelihood of a failure to honor a company’s insurance policy liabilities. For policy liability ratings AMB issues Financial Strength Ratings (FSR), and KBRA issues Insurance Financial Strength (IFSR) ratings. Insurance companies seek policy issuer strength ratings for several reasons, for example, ratings are required by insurance agents, by reinsurance brokers and companies, and to insure bonded construction projects. Also, ratings are utilized by boards and other stakeholders as a third-party evaluation of operations and capital adequacy.
There are three primary drivers of insurance credit ratings: risk adjusted capital levels, operating results, and market profile (the overall mix of products, underwriting strength, and risk diversification). These factors form the foundation of the rating and are quantified and evaluated relative to rated peer groups and to industry averages. Enterprise Risk Management (ERM) practices, management quality, and other qualitative factors are also considered and may raise or lower the rating.
AMB uses a proprietary capital model, Best Capital Adequacy Ratio (BCAR), details of AMB’s methodology can be reviewed here: Best’s Credit Rating. AMB is in the process of updating its BCAR model – the most significant change will be the incorporation of scenario modeling of an insurance company’s loss factors at various confidence levels. The revised BCAR model is currently open to public comment before it goes into production, likely prior to year-end 2017.
KRBA’s capital strength assessment uses the National Association of Insurance Commissioners (NAIC) Risk Based Capital (RBC) model. KRBA details their capital adequacy approach within their rating methodology here: Global Insurer & Insurance Holding Company Rating Methodology
Rating agencies look at companies differently than management and other stakeholders – investors, employees, etc. Therefore, as part of any rating review or update management must be able speak to the agency’s perspective and clearly demonstrate management’s understanding of the company’s capital position, how it is managed through existing risk management programs, and how and why it will change going forward. Analysts expect management’s knowledge to extend beyond the results of the agencies capital modeling. Accordingly, management should present a forecast which considers the unique and proprietary aspects of the company’s strategy and operations. The ratings team will also want to discuss the programs in place to manage the company’s long-term solvency. All information presented by management will be distilled and compared to peer groups composed of comparable firms. Also, rating agency analysts cannot, due to SEC rules, provide guidance to companies on how to improve ratings.
To achieve rating upgrades, or to maintain a rating, management should plan to continuously improve risk management programs and strategies, create clear and achievable forecasts, and effectively communicate the various actions taken to maintain capital adequacy and manage the company’s risk profile. It’s critical for management to understand the agencies expectations prior to engaging discussions presenting material at an annual review.