The importance of ratings agencies to the corporate risk manager.

Two recent events on either side of the Atlantic have highlighted the vital importance of having an effective risk management programme. One is the Seattle earthquake and the other the emergence of foot-and-mouth disease in Europe.

The Seattle earthquake is estimated to have cost up to $2bn in insured damage, including commercial multiperil losses. Rating agency AM Best has suggested that this could mean between less than one point to 20 points being added to a re/insurance company's combined ratio. For a re/insurer that has suffered through the soft market of recent years, that could turn out to be one catastrophe too many.

The foot-and-mouth crisis has had an impact on a broad spectrum of companies, particularly those operating in the UK, the heart of the recent European outbreak. At the top end of the scale, supermarkets have experienced severe interruptions to their supply networks and where appropriate, risk managers will be looking at their insurance policies to see business interruption coverage. In the middle of the business scale, the cancellation or postponement of events such as the world-famous Cheltenham Festival race meeting will have a serious impact on a score of service companies, including caterers and hoteliers. For these types of events, an accurate assessment by a risk manager should have ensured that the relevant contingency insurance was in place. At the other end of the business scale, where risk management may be no more than an afterthought, will be the individual farmers who have had to cull their entire livestock. The National Farmers Union Mutual insurance company has estimated that only about 10% of farmers will have had adequate protection. In both circumstances it is imperative that a risk manager fully appreciates the significance of an insurance or reinsurance company's rating and understand that risk carriers often take independent advice on which agency may be best suited to their particular niche or needs.

Risk managers wisely know their own limitations. They are not insurance analysts, and they necessarily look to their brokers' security committees, independent consultants and to rating agencies for guidance. Rating agencies present an unbiased view, without the same commercial pressures that handling inwards and outwards business may appear to place upon a broker. However, rating agencies and brokers cannot guarantee the solvency of risk carriers, and consequently risk managers need to tread with care if they wish to avoid embarrassing meetings with their CFO.

The rating agencies' supremacy is such that they are now in the unenviable position of almost being able to make their predictions happen, and rarely will a broker security committee advise a client to place business with a company whose rating is not in the ‘A' range, particularly for long-term business. For short-tail risk, there can be a huge dilemma for a risk manager faced with a pricing choice between an insurer at the top end of the vulnerable scale, and a less attractive financial deal with an insurer with a secure rating. On such an occasion, the risk manager is likely to need external and independent advice.

The position can indeed be unenviable, as we have seen in recent years. Increasing significance is being attached to achieving, and maintaining, a rating within the ‘A' range, which distorts out of all proportion the true meaning of the rating scales. It should not be forgotten that a rating of BBB+, Baa1 or B++, depending on the issuer, is only one notch below the lowest of the ‘A' range and still a ‘secure' rating. It is for this reason that rating agencies on occasion have felt powerless to downgrade companies by this small margin when they clearly deserved it, for fear of a ‘run on the bank'.

There are over 300 companies world-wide offering ratings, but the industry is dominated by just four key players: AM Best, Fitch IBCA Duff & Phelps, Moody's and Standard & Poor's (S&P). For the insurance world this may be further sub-divided into two groups, with S&P and AM Best considered to offer the widest level of coverage. This picture becomes slightly different if one considers all the other markets and financial products that the agencies rate, as AM Best is predominantly focused on insurance, and has only recently entered the debt rating market. Consequently, overall, the two largest players are S&P and Moody's.

The market received a shake-up in June 2000 when the French-owned Fitch IBCA announced it was to merge with Duff & Phelps. They were the third and fourth largest rating agencies respectively at that time. This merger could possibly lead to further consolidation within the market as institutions look towards multi-discipline rating agencies. In addition, it is anticipated that consolidation will occur outside the big four as smaller companies try to increase market diversity and market share. For insurance and reinsurance clients, this should produce the benefit of a competitive pricing environment.

Smaller rating agencies typically offer a rating that will be specific to the country in which the local insurance company operates. This option may be suitable for an insurance company that wishes to only write business on a domestic basis but, given the increasingly global marketplace, the need to have a rating that is easily identifiable should not be underestimated. A rating is a reflection of a company's ability to meet its financial obligations and not, as the rating agencies point out, an indication to buy, hold or sell a company's stock. The process is initiated by the re/insurance company, which is subsequently invited to submit a comprehensive information pack to be reviewed by the appropriate analyst within the rating agency. Information requested includes five years' of published accounts, underwriting guidelines and philosophy, regulatory returns, organisation charts, current business plan outlining strategic goals and objectives, relevant CVs, reinsurance programme and the investment strategy.

This detailed information is then reviewed against the chosen rating agency's appropriate set of criteria. It is important to note that the leading rating agencies have adapted their core criteria to suit the different types of companies that operate, be it a non-life insurer, life insurer, credit insurer, reinsurer, start-up, captive, etc.

Non-life insurers emerge as the most-frequently rated category of company. Each rating agency has slightly differing criteria and emphasis but, generally, a review of a non-life insurance company will be concerned with certain central issues:

  • industry risk – the sector's competitiveness and volatility, alternative products, etc;
  • business review – including distribution capabilities, competitor threat, market share, geographical breakdown, current and future growth prospects;
  • management and corporate strategy - operational effectiveness, ability to implement strategy, internal procedures and controls, risk tolerance, organisation structure, etc;
  • operational analysis – review of operating performance and earnings, both current and future;
  • investments – allocation, strategy, concentration, suitability;
  • capitalisation – measurement of the degree of capital adequacy;
  • reserves – incurred losses, reserving levels and trends;
  • liquidity – review of cash flows; and
  • financial flexibility – capital requirements, additional sources of capital.

    The criteria used in rating an insurance company allow for a fair split of qualitative and quantitative analysis. This split will be dependent on the degree of importance that each rating agency attaches to its capital adequacy model. Both S&P and AM Best have developed highly sophisticated models that provide a starting point for judging the adequacy of capital. S&P defines its model in the Insurance Ratings Criteria as a comparison between ‘total adjusted capital minus realistic expectations of potential investment losses and against a base level of surplus appropriate to support ongoing business activities at a secure rating level (‘BBB')'. Conversely, agencies with no capital adequacy model will allow for a far more subjective appraisal of a company.

    The analytical review of a company is complemented by an in-depth meeting with senior management that provides the analysts with an opportunity to receive additional information or to seek clarification on any matters. Prior to the award of a rating, the lead analyst will present a review of the company to the rating committee in conjunction with the lead analyst's recommendation that will then determine the final rating. Central to the integrity of a rating is the transparency of all relevant criteria. Consequently, all the leading rating agencies provide a full breakdown of their criteria on their respective websites.

    Of the four major agencies, S&P, Moody's and Fitch IBCA use a similar broad band rating scale that is divided into the two categories of ‘secure' and ‘vulnerable'. The top end of the secure scale is denoted by a ‘AAA' rating (Moody's – ‘Aaa') and the bottom end is indicated by a ‘BBB' rating (Moody's – ‘Baa'). The highest rating of the vulnerable scale is a ‘BB+' (Moody's – ‘Ba1'). The scale drops as low as ‘C', however anything below this rating tends to indicate a company is either in run-off or under some sort of regulatory supervision. Within both categories, a modifier indicates where exactly that rating fits within the assigned rating category. For example, Moody's uses a numerical scale with ‘1' representing the highest category and ‘3' signifying the lowest (S&P and Fitch use +/- as their indicator). The AM Best scale is similar to the other three rating agencies in using secure and vulnerable ratings but they utilise a more condensed scale, the highest secure rating being ‘A++' and the lowest secure rating being ‘B+'.

    In certain instances, a rating will be followed by the subscript ‘pi' or ‘q', indicating the rating is unsolicited and based only on information in the public domain.

    The evolving nature of the insurance industry has led to the development of more sophisticated policies and differing demands from policyholders. Consequently, rating agencies have been developing new rating products in order to ensure that the market is kept as fully informed as possible. These developments have included Moody's ‘Lloyd's Syndicate Ratings' and S&P's ‘Financial Enhancement Ratings' aimed at companies involved in credit-enhanced transactions.

    Although the message to risk managers is always ‘caveat emptor', there is now a great deal of information and skilled interpretation by insurance professionals available to assist risk managers in solving the price/security/long-term relationship equation, weighing up the likelihood of future mergers and acquisitions as insurance programmes are evaluated, and the subsequent reinsurance placements.