Insurance Company Rating Agencies

Insurance Company Rating Agencies:

A Description of their Methods and Procedures

January 1992 by Robert W. Klein

NAIC

National Association of Insurance Commissioners

? Copyright NAIC 1992 All rights reserved.

ISBN 0-89382-187-X

National Association of Insurance Commissioners Publications Department (816) 374-7259

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INTRODUCTION

Of particular concern to some regulators and

The activities of insurance company rating the industry are the practices of Weiss Research

agencies have become increasingly prominent and Standard & Poor's (S&P) publication of

with the industry's recent financial difficulties qualified solvency ratings. Both the Weiss "safety"

and the well-publicized failures of several large ratings and the S&P "qualified solvency" ratings

life insurers. The ratings issued by these agencies are based on a strictly quantitative analysis of

represent their opinions of the insurers' financial financial data. While there has been a concern

condition and their ability to meet their obliga- about inflated ratings historically, Weiss has been

tions to policyholders. Rating downgrades are criticized for marketing bad news to consumers,

watched closely and can significantly affect an i.e. ratings that are skewed to the negative. S&P's

insurer's ability to attract and retain business. qualified solvency ratings also have been criti-

Even the rumor of a downgrade may precipitate "a cized for utilizing a scale that appears to be lower

run on the bank," as in the case of Mutual Benefit, than their claims-paying ability ratings. Some

and seriously exacerbate an insurer's financial have accused S&P of using the qualified solvency

problems. There is little doubt that rating organi- ratings to "extort" insurers to pay a $22,000-

zations play a significant role in the insurance $28,000 fee to obtain a higher claims-paying

marketplace.

ability rating. S&P strongly denies these allega-

tions and believes that consumers and agents

Some have expressed concerns about the potential adverse effect of ratings on particular insurers and consumer confidence in the insurance industry in general. Once the province of

properly understand the meaning of the qualified solvency ratings. Both S&P and Weiss contend that their quantitative ratings provide valuable, unbiased information to consumers.

only one organization, A.M. Best, a number of

new raters emerged during the 1980s. Questions

The influence of the rating agencies and the

have been raised about the motivations and meth- practices of Weiss and S&P have prompted some

ods of the raters in light of the recent sensitivity regulators and insurers to suggest that the NAIC

regarding insurers' financial condition and what should limit access to its database, which is uti-

some perceive to be a rash of arbitrary down- lized by both raters. There also have been calls for

grades. On the one hand, insurer ratings histori- regulators and the NAIC to evaluate and certify

cally have been criticized for being inflated or rating agencies to ensure that their methods and

overly positive. On the other side, there are practices meet certain established standards.

concerns that raters, in an effort to regain credibil- However, other regulators have questioned

ity, have lowered their ratings arbitrarily in reac- whether it is appropriate and practical for regula-

tion to recent declines in the junk bond and real tors to withhold data or regulate rating agencies.

estate markets and the resulting insurer failures These regulators suggest that a more appropriate

and diminished consumer confidence.

regulatory role is to improve consumers' under-

standing of the rating process and allow them to

decide how to use the information raters provide.

To facilitate a better understanding of the

The information presented in this paper was

rating agencies, the NAIC's Internal Administra- obtained from published sources; written responses

tion (EX1) Subcommittee, at its September 1991 to an NAIC questionnaire submitted to the rating

meeting, directed NAIC staff to study and de- agencies succeeded by follow-up questions; and

scribe the methods and practices of the most meetings with A.M. Best, Standard & Poor's and

prominent insurer rating agencies. The results of Moody's. All five organizations were coopera-

that study are presented in this paper.

tive and helpful in providing information for this

study.

As directed by EX1, this paper presents

certain factual information relating to the struc-

A detailed description of each of the five

ture and activities of the five most prominent rating agencies is presented in Sections II through

rating agenciesmA.M. Best, Standard and Poor's, VI of this paper. A summary discussion is pro-

Moody's, Duff and Phelp's and Weiss Research. vided in Section VII. A chart summarizing and

Specifically, the philosophy, scope, fees, resources, comparing the rating agencies' activities is at-

process, methodology and classification scheme tached as Appendix A.

of each of these agencies is described. While we

discuss issues relating to certain practices of the

Each organization was given the opportunity

raters, we did not attempt to evaluate the validity to review its section of this paper and offer com-

of the raters' methods or practices. We also do not ments and corrections. For the most part, these

present information on other insurer rating agen- suggestions were incorporated into a revised draft

cies which have not received as much attention as of the paper with the exception of S&P's com-

the five agencies listed above, such as Demotech, ments on the discussion of its qualified solvency

Fitch Investors Service and Thompson Bankwatch, ratings. These comments are incorporated in

or other organizations that provide financial analy- Appendix B to this paper. Any remaining errors

sis of insurers but not ratings per se, such as Ward are the author's responsibility.

Financial Group.

2

H. A.M. BEST COMPANY

discuss the situation with management. If the

The A.M. Best Company has been rating company can present an effective plan to resolve insurance companies since 1906 and its long the problem, Best may not immediately downassociation with the industry is important to un- grade the company. The company's situation derstanding its philosophy and approach. Its would continue to be monitored to ensure that the stated mission is "to perform a constructive and corrective action was implemented.

objective role in the insurance industry towards the prevention of insurer insolvencies." (emphasis added) Best views its ratings as an inducement for insurers to operate in a prudent manner and maintain strong financial health. It actively consuits with and advises companies on the basis for their rating and what actions a company must take to maintain its rating or improve it.

To obtain an alphabetical Best's rating, an insurer must have been in existence for at least five consecutive years of representative operating experience, have net premiums in excess of $1.5 million for a life/health insurer ($1.5 million in surplus for a property/casualty insurer), submit the requested financial information and pay a $500 fee. In the 1991 edition of Best Insurance

The objective of Best's rating system is to ~, 811 life/health insurers and 1,513 propevaluate the factors affecting the overall perfor- erty/casualty insurers received an alphabetical mance of an insurance company to provide its rating. An additional 530 life/health insurers and opinion as to the company's relative financial 970 property/casualty insurers received rating strength and ability to meet its contractual obliga- "not assigned" (NA) classifications which explain tions. Best conducts an extensive quantitative and why they did not meet Best's eligibility requirequalitative evaluation of rated insurers based on ments. Of these non-rated companies, 291 life/ various sources of information and knowledge of health insurers and 597 property/casualty insurers the company accumulated over a long period of received a Financial Performance Index (FPI) time. This knowledge is acquired through fre- assignment (introduced in 1990). Insurers are quent contacts with company officials as well as required to have at least three consecutive years of statutory financial statements, special question- representative operating experience to obtain an naires and a variety of other sources. Typically, FPI rating. The $500 fee does not apply to there will be meetings once a year with company companies receiving a "not assigned" rating clasmanagement at Best's headquarters in Oldwick, sification or an FPI assignment.

New Jersey. There may be more meetings, if

necessary, but Best attempts to meet at least once

Insurers can elect to not have their rating

with a company over a two-year period, in addi- published. If that happens, acompany receives an

tion to telephone contacts and correspondence. NA-9 "Company Request" designation. In this

instance, Best normally requires a minimum of

If adverse developments occur that may af- two years to elapse before the company is again fect a company's financial condition, Best will eligible for the assignment of a rating.

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