Security assessment in Asian insurance markets is growing in importance. Natalie Wells explains who needs ratings, and how they are calculated.

Mismanaged or poorly structured insurance companies can and do fail. Insurer collapses have dealt direct blows to many markets around the world over the past five years, and Asian insurance markets in particular have been rocked by turbulence. Causes have included alarmingly soft underwriting conditions, the home-grown financial crisis of 1997-1998, ongoing investment volatility, numerous large catastrophe-related losses, and, more recently, a scarcity of reinsurance support. Such developments have highlighted the need to bring the issue of security into sharp focus in Asia's insurance industry.

Now, more than ever, financial strength is one badge that insurers must wear. This fact is underpinned by the widespread and increasing use of insurer financial strength ratings throughout Asian markets. The upsurge in the assignment of ratings to insurers and reinsurers in the major markets of the region is a result of increasing demand from professional intermediaries, risk managers and buyers of insurance who need to make informed decisions according to their risk and reward preferences. Ratings typically are used by companies which wish to promote the security they offer to policyholders, by opening up their operations to independent analysis. These companies are not merely asking policyholders to trust them, but rather are providing higher levels of disclosure, in order to allow their existing and potential policyholders to make informed decisions.

So what do ratings actually mean? Standard & Poor's Insurer Financial Strength Ratings focus on an insurer's capacity to meet policyholder obligations in accordance with policy terms. They communicate the rating agency's judgment of the financial security (or financial risk) that the rated insurer presents. The ratings assigned to an insurance company indicate its capacity to meet insurance obligations over a three-year horizon. The advantage of the ratings system is that it provides a simple system of risk graduation or differentiation between insurers, using consistently applied criteria, and which is objectively based. In other words, it is a standardised assessment, free from bias.

The process of ratings is both absolute and relative. It is absolute in that it determines the safety of the obligor's capacity, and relative in that it determines how `safe' that capacity is compared to competitors. Standard & Poor's ratings are comparable globally, that is, an `A' rated insurer in Hong Kong offers the same level of security as a similarly-rated company in any other country.

There is no single magic formula that can capture all areas of an insurer's financial strength (or weakness, more importantly), so the analysis undertaken by ratings agencies is complex and multifaceted. While many regulatory systems are introducing risk-based capital, which is an important tool, it is no substitute for a broad-based analytical review. Indeed, many well-capitalised companies have failed in the past, often because of overtrading, underpricing or both, under-reserving, poor earnings, poor asset quality, insufficient liquidity, poor reinsurance, poor management, uncommitted capital, fraud or uneconomic size.

Ratings are both quantitative and qualitative. The financial strength rating process is very interactive, and uses a large amount of confidential management information, which is not generally available to policyholders. Extensive discussions with company management aim to review its business strategy, culture, market position, investment philosophy and financial performance, both historic and projected.

A Standard & Poor's analysis comprises examination of major analytical areas including industry risk, business review, management and corporate strategy, operating performance, investments and asset-liability management, capitalisation and reserving, liquidity, reinsurance and financial flexibility.

Time and experience have shown that ratings are highly reliable indicators of security. To put the ratings into context, Standard & Poor's undertakes default studies which trace the ratings history of companies which defaulted. The table illustrates the performance of companies in the various ratings bands. The important features to note are the very low default rates of secure-rated companies, and the more-than-fourfold leap in default rates from the BBB (secure) category to the BB (vulnerable) category. It should be noted that the table reflects the rating of the companies five years or ten years prior to the default, as opposed to the rating at the time of the default.

Over a five-year period, 19% of companies in the vulnerable rating grades (of BB+ and below) defaulted, and 27.1% defaulted within ten years. However, only 1.07% of companies in the secure grades defaulted after five years, and 3.03% within ten years.
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  • Natalie Wells is an insurance analyst at Standard & Poor's, Australia.