The Demands of Rating Agencies on Insurers

On March 22, 2018, Michael A. Cohen, Principal at Cohen Strategic Consulting, spoke at SAA’s Insurer Investment Forum XVIII to discuss what ratings agencies are looking for in their discussions with insurance companies and how insurers should respond to agency demands.

Here are a few of the highlights. The other Conference Presentations can be found here.

The Approach to ERM and Assessing Risk Should be Simple and Focused on the Insurer’s Highest Priorities

Focus on the risks first and foremost that can impede strategy and cause goals not to be met. The conversation with several insurance CEOs over the past decade is, “We had this Enterprise Risk Management (ERM) process in place, with many analytical models supporting it, but once the financial crisis hit, our company was in serious trouble. Our ERM didn’t prevent a substantial erosion of our company’s financial strength.” Many C-level executives felt, “What good is an ERM process if it didn’t prevent the worst crisis of modern times … when we needed it the most?”

The view on an ERM program embraced by top management should be: Determine what can prevent your company from being successful, and structure the process around those risks (but don’t ignore lesser or potential risks, either). Rating analysts often ask executives “What keeps you up at night?” When a CEO answers that question, the most important risks his or her company faces is usually revealed.

Which Stakeholders are Sensitive to the Impact of Which Risks?

An insurer needs to be responsive to the interests of its stakeholders and their tolerance for risk. The most important stakeholders are:

  • – Customers
  • – Producers
  • – Board of Directors
  • – Investors/Shareholders
  • – Rating Agencies
  • – Regulators
  • – Counterparties (Financial, Business Partners)
  • – Executives, Management, Critical Staff

Stakeholders may seek to discontinue their relationships with your company if they feel the risk you are exposed to jeopardizes their situations. For instance … customers may not want to purchase insurance from you and producers may not want to sell for if you do not have a strong enough rating (and might not be around to pay claims in the future).

If your company has too much risk and too little capital, causing your risk-based capital (RBC) to be weak, you could get a visit from the regulators examining your business strategy and things may go downhill from there. Your executives might be concerned about how your company is being managed or where it is headed in the future, and start looking for other employment.

Ultimately, which stakeholder group is the most sensitive to your risks and how might they react? The answer is the ratings agencies.

They are the most tuned in to risk among all stakeholders, given that their ratings (which they state clearly are opinions) are appraisals of a company’s future claims-paying ability and believe…rightly so…that a material level of risk can affect claims-paying ability. Their adverse reactions, negative ratings actions, will hurt you more than those of any other stakeholders.

Rating methodologies as they pertain to risk are somewhat generic in nature. As such, it is incumbent on the insurer to clearly demonstrate that it understands its risks and is taking sound steps to mitigate their adverse consequences. One recommended approach is to aggregate the risks the company faces and their adverse consequences, like the approach ORSA calls for; then provide an analysis of the company’s excess capital position, and how that excess capital amply covers the adverse impacts of risk exposures.

Investment Strategy … How Much Risk Should an Insurer take?

Looking at investment income and its impact on the financial success of an insurance company sheds important light on the types and overall level of risk the insurer should take in its investment strategy. As you’re thinking about what kind of investment strategies to pursue, how much risk you should be taking in the aggregate? If your company’s success is not heavily dependent on gaining a few basis points of additional yield, probably not much.

What Do the Rating Agencies Get Wrong in Terms of Risk Assessment (incl. Adverse Risk Impact) and the Ability of Insurers to Mitigate Risks and Buffer Against their Impact?:

While there is much discussion about risk, the ratings agencies frequently frame an insurer’s risks as “here are the positives and here are the negatives.” However, a critical and more meaningful perspective is “how bad are the negatives (risks) relative to the strength of the organization, and how well does a company’s excess capital serve as a buffer against those risks?”

Rating agency analysts follow the whole industry, so they see common themes and issues … not illogically so. It’s important when discussing investment or business strategies with the ratings agencies to understand that while they know the ‘macro side’ of it, they also understand what your particular company is doing.

The challenge for the insurer is to explain what you are doing something differently from most of the industry, including how you are safeguarded in terms of risk and why there would be no material impact on capital if things were to go wrong. That’s what the rating agencies need to be evaluating, and they need to be made aware of that perspective by the insurer.

For example, a $20 billion insurer had $2 billion of their total $3 billion capital in one equity. The ratings analyst told them their asset holdings weren’t diversified enough. In response, the insurer told them to analyze the company and run a scenario where the equity dropped 50% in value. The result was: $2 billion in capital, $1 billion in this equity holding and $19 billion in total assets. With these results, the insurer asked, “how would you rate the company?” The response was, “A++” by the ratings analyst. Disagreement resolved, although truth be told differences of opinion between the analysts and insurer representatives are frequently not bridged so easily.

In summary, the thinking behind how generalizations are made often overwhelms the ratings discussions insurers have with ratings agencies. It is important to cut through where they have generalized mindsets, and strategically analyze and discuss where things could go wrong and how you the insurer is well prepared to succeed in spite of them.

Are Rating Agencies (And Their Ratings) Consistent?

Not all employees within a company think or act in the same way; the same is true for rating agencies. At the rating agencies, the application of their overall philosophy and specific views on rating factors can become uneven. The key is to know how well the ratings analyst understand and implement the overall rating philosophies and methodologies of the agency, and conduct your rating discussions accordingly.

Analysts discuss extensively how to calibrate companies at particular rating levels. While these discussions often consider peers and/or competitors, the underlying philosophy is that for insurers with a certain rating, even if the line of business or location differs, they are assumed to have a comparable level of financial strength/claims-paying ability.

There are many situations where an insurer feels it does not have a rating as high as it deserves; thus is the case for most insurers! A good strategy to pursue is to identify companies at a higher rating than yours where you feel and can demonstrate that your financial strength is comparable to theirs. It is critical that you are intimately familiar with these other companies, because the rating agencies are.

How Does the Operating Environment Affect Insurers and the Rating Agencies’ Views of Them?

Regarding volatility in the operating environment, ratings agencies don’t give company executives enough credit for actively managing what is going on and making proactive decisions in response. One issue is that ratings analysts have not yet had the opportunity to be an executive of an insurer. Therefore, when they try to envision how a company will respond to volatile situations, such as the economy or financial markets, they don’t have the experience and perspective of potentially serious issues being handled on a day-to-day basis. When analysts see events in the marketplace, they often assume ‘the sky is falling’.

When Speaking with Ratings Agencies, How You are Describing What You Do is Critically Important.

Keeping it simple is key: here’s what we do and here’s how we’re protected against risk.

The onus is on the insurer to educate the analysts and get them to understand its story. It is important to also periodically keep in touch with the ratings analyst and agency, whether things are going well or something might be going the wrong direction, and if there are problems you are addressing them promptly and appropriately. It is every bit as important to be aware of the issues the rating agencies are concerned about. They always want to know that you have processed their concerns, you understand why these issues affect their rating analyses, and that you will respond or act accordingly.