Demystifying the Financial Strength of Insurance Companies

DEMYSTIFYING THE FINANCIAL STRENGTH OF INSURANCE COMPANIES

This white paper is a collection of numerous articles and reference materials that highlight a number of topics addressed during the Professional Liability Underwriting Society (PLUS) 23rd Annual International Conference Panel Discussion November 11, 2010.

Prepared by:

Philip L. Blais

Blais Excess & Surplus Agency of Texas, Ltd.

www.blaisexcess.com

PANEL MODERATOR

Philip L. Blais

SESSION PANELISTS

Dick Evans (Chairman & CEO Frost Bank),

Doug Slape (Chief Analyst–TDI),

Louise G. Crockett (V.P., Senior Marketing Executive – Wells Fargo Insurance Services)

Eric M. Simpson (Senior V.P. – Tower Watson) and

Elizabeth C. Malone (Senior V.P –Wunderlich Securities)

INDEX OF MATERIAL IS LOCATED ON PAGE 109

Discussion Overview:

Many interested parties rely on financial strength ratings published by leading rating agencies like A.M. Best, Standard & Poor’s, Weiss, Fitch as a basis for facilitating business relationships with financially sound (re) insurance companies. Nevertheless, the basis for (re) insurance company ratings are not well understood amidst every-changing requirements imposed by the rating agencies. This panel will review the key factors and issues considered by leading rating agencies in their evaluations. In addition we will provide insights into the significance buyers and(re) insurance carriers place on the financial straight rating the firms provide.

Panelist Introduction:

Mr. Philip L. Blais: Is the President of Blais Excess & Surplus Agency of Texas, Ltd. Blais E&S is a wholesale insurance broker that specializes in the design, placement and service of Executive Lines Insurance products (D&O, E&O, Crime, EPL, Fiduciary and Cyber).

Mr. Dick Evans is the Chairman – CEO of Cullen Frost Bankers, Inc. and Frost Bank. Mr. Evans has guided the San Antonio based financial institution for more than a decade, successfully navigating the company through the financial crisis of 2008.

Doug Slape – Chief Analyst - Texas Commission of Insurance has overseen and coordinated implementation of major insurance reforms directed by the legislature since 2003.

Louise G. Crockett a Senior Marketing Executive for Well Fargo Insurance Services with primary responsibilities in the areas of market security and Contracting Standards.

Eric M. Simpson is a Senior Vice president of Market Services within Towers Watson and directs a team of analysts that monitor the financial stability of the various insurance markets.

Elizabeth C. Malone is a Senior Vice President at Wunderlich Securities. Ms. Malone follows primarily property/casualty insurers. Ms. Malone has a broad background in insurance with over 20 years experience. In addition to her many years as a senior sell-side equity research analyst, Ms. Malone has worked with state regulators as a Financial Manager with NAIC. She has been recognized by the Wall Street Journal “Best on the Street” survey as a top analyst in insurance six times.

Highlighted below are the key focus areas and questions covered during the session:

A.  Rating Agency Competitive Landscape

·  Who are the principal rating agencies?

·  What is the principal role of a rating agency?

·  What are the rating agency scales?

·  Are insurance company ratings all equal?

·  What role does the National Association of Insurance Commissioners (NAIC) play?

·  What is the current insurance company regulatory environment (Federal & State)?

B.  Key Rating Factors and Hot Buttons

·  How does the insurance rating process work today?

·  Are there different methodologies used by the rating agencies?

·  What is the basic financial information used by a rating firm?

·  What key components of an insurer’s capital and surplus are considered?

·  Does the operating cycle of insurance company have an impact on its rating?

·  Can you differentiate between loss reserves, policy reserves, UPR and IBNR reserves?

·  What kind of impairment tests for invested assets do the rating agencies use?

·  What factor does risk transfer in reinsurance play in a carriers rating?

·  How effectively are models used within the decision making process of companies and how does that affect the ratings evaluation?

·  How is catastrophe risk measured and incorporated into the rating agency view of risk adjusted capitalization?

C.  3rd Party Issues and Viewpoints on Rating

·  Does an insurance rating agency consider operational issues?

·  Is there a framework for assessing management and operational risk?

·  What organizational concerns should one consider when looking at an insurance company?

·  Utilizing the rating agencies information can one identify warning signs of insurer experiencing financial distress?

·  What is the likely impact of FASB proposed amendments to U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRSs)?

·  What reliance do rating agencies place on analysts’ judgment?

·  What has been the rating agency track record (assigned top ratings, low ratings, etc.)?

·  What has been the rating agency track record with respect to reporting financial vulnerability?

D.  Insights & Predictions

·  Is there a value in combining all rating agency valuations and can they be compared?

·  In what situations do certain rating agency valuations stand out?

·  What key variables might affect an insurer’s financial results (Financial & Non Financial)?

·  Can a rating agency predict the future stability of an insurance company?

·  What is the future of Financial Regulatory Reform and Need for Clarity?

·  What is the future insurance company regulatory environment (Federal & State)?

o  How will Solvency II impact regulatory reform in the U.S.?

·  What impact does the financial reform legislation have on the way rating agencies operate?

·  How will improvements in enterprise risk management influence the future of the ratings evaluation?

·  What effect will a company’s economic capital model have on the evaluation of risk adjusted capital done by the rating agencies?

·  How will changes in accounting standards both domestically and internationally affect the rating review process?

E.  Questions & Answers

RATING AGENCY COMPETITIVE LANDSCAPE

ü  Who are the principal rating agencies?

ü  What is the principal role of a rating agency?

ü  What are the rating agency scales?

ü  Are insurance company ratings all equal?

ü  What role does the National Association of Insurance Commissioners (NAIC) play?

ü  What is the current insurance company regulatory environment (Federal & State)?

Opening Comments:

Understanding and being able to discuss insurance ratings is vital to all insurance company underwriters, brokers/agents, insurance risk managers, reinsurers and business professionals who play a role in the selection of carriers.

Choosing a financially strong insurance company is important when buying insurance.

·  Several independent rating agencies evaluate the financial stability of insurance companies.

·  The rating for an individual insurance company is an opinion as to its financial strength and ability to pay claims in the future.

·  When evaluating a company, a rating agency may consider a company's balance sheet strength, operating performance and business management and strategies.

It is imperative to consider several issues when using ratings to evaluate a company:

• Ratings don’t provide information on cost, customer service or satisfaction or the quality of an individual policy.

• One should make sure they have the most recent rating available because the condition of a company can change.

• Not all licensed insurance companies choose to be evaluated by all of the rating services.

• Comparing ratings from different rating services can be tricky. Each rating agency has its own rating scale, and the agency may change its scale or the symbols and descriptions it uses. Letter ratings and descriptive words don’t have the same meaning for each agency.

To understand insurance ratings one needs to secure a view of the rating process and factors such as:

·  Key financial ratios used in analyzing an insurer;

·  Level of surplus relative to level of risk;

·  Level of capitalization;

·  Underwriting and investments;

·  Etc.

Overview of the Major Rating Firms

Source: Rating Agency Websites (Reference page 17 for website addresses)

The A.M. Best Co. is the oldest and arguably the most respected insurance rating agency in the business. Founded in 1899, the Oldwick, New Jersey-based operation provides both financial strength ratings for insurers as well as debt ratings on insurers’ ability to meet their financial obligations to security holders. Best’s ratings cover the property/casualty market, the life and health market, reinsurers, health care (including health maintenance organizations) and alternative risk vehicles (such as captives and pools). Best also analyzes Lloyd’s managing agents. A.M. Best is a provider that works exclusively in the insurance marketplace, looking at the strength of an insurance company's balance sheet, performance, and business profile. Companies pay a fee to be rated by A.M. Best, and insurer results are posted on the A.M. Best website.

“Our rating process involves a comprehensive quantitative and qualitative analysis of a company's balance sheet strength, operating performance and business profile. This includes comparisons to peers and industry standards as well as assessments of operating plans, philosophy and management. Where the rating is assigned to a debt security, it also includes a review of the specific nature and details of the security. “

Standard & Poor’s is a major provider of insurance ratings, but it is perhaps best known for its broader financial analysis services. Based in New York, S&P is the world leader in credit rating services, grading governments’ ability to pay on the debts they owe. S&P also sets indices and benchmarks to gauge the performance of various financial markets. Standard and Poor's looks at an insurer's management team, competitive position, and ability to manage risk.

Moody’s Investors Service is a leading global credit rating, research and risk analysis firm that publishes its rating opinions and research on a broad range of credit obligations. These include corporate and governmental capital market obligations, bank loans, managed funds and derivatives, securities, and insurance company obligations. Based in New York, Moody’s is also a leading credit risk management consultancy. Moody's Investors Service uses other factors, such as market position, product focus, asset quality and profitability to determine their ratings of life insurance companies.

Fitch Ratings, also in New York, rates a wide variety of financial operations, mostly dealing with credit risk. Its insurance ratings fall into two separate but related categories: insurer financial strength ratings and fixed income security ratings. The former provides an overall assessment of insurers’ financial strength and security. The latter rates senior and subordinated debt securities, commercial paper programs and other forms of preferred stock, as well as several classes of securities. Fitch Ratings uses a number of criteria to determine the financial strength of an insurer, including financial statements, management reports, and company projections.

Weiss Research, Inc., based in Palm Beach Gardens, Florida, may not be as large as its competitors, but it was mentioned in a 1994 U.S. General Accounting Office report on insurance ratings as the most accurate rating agency in the business. Using nothing but publicly available information,

SPECIAL NOTE

The websites of the various rating agencies provide a lot of information and access to additional tools that aid and support individuals in the analysis of an insurance company. For example:

A.M. Best's unique and comprehensive database of insurers gives them great insight into the default characteristics of insurance companies and they use the data for rating or evaluating many of the insurance-linked transactions. The following tables,

Best's Idealized Default Matrix,

Best's Idealized Default Rates of Insurers and

Best's Idealized Default Rates of Reinsurers were created by A.M. Best specifically for rating insurance-linked securities. These tables were partially derived from their database of over 5,000 rated insurance companies which includes nearly 700 impaired insurance companies.

Additional information on the various rating firms can be viewed by visiting their websites. Highlighted below are the addresses of the websites.

RATING FIRM / WEBSITE /
A.M. Best Company, a leader in insurance company ratings, also rates and evaluates insurance-linked capital markets transactions such as: catastrophe bonds, CDOs of catastrophe risks, sidecars (and their debt), contingent capital solutions, Trups collateralized debt obligations (Trups CDOs), disability reserve securitizations, closed block transactions, life settlements securitizations, reinsurance recoverable hedging transactions, protected cell structures, and other insurance-linked transactions. In addition, the Insurance-Linked Securities Group provides valuable input to the financial strength rating process since nearly all the insurance-linked transactions are designed to be reinsurance substitutes. For example, we evaluate the basis risk and tail risk associated with certain transactions and pass the information on to insurance-company rating analysts. / www.ambest.com
The Fitch Ratings Insurance Group provides ratings and research on insurance and insurance-related companies worldwide. Because of the increasing globalization of insurance markets, the group coordinates all research and analysis through a global organizational structure, whose goal is to achieve consistency of rating methodology across countries. At the same time, Fitch Ratings strives to ensure that its insurance ratings fully incorporate the unique aspects of local markets by assigning regional management and lead analysts with local market knowledge and presence. The Insurance group balances local expertise with global oversight to distinguish their ratings in the marketplace. The group also offers comprehensive research on industry issues and trends. In addition to ratings of insurance companies, Fitch Ratings Insurance group also provides ratings of securitizations of insurance risk, including catastrophe bonds and life insurance securitization. The Insurance group combines timely, accurate and transparent coverage with responsive service to help market participants thoroughly assess their risk.
/ www.fitchratings.com
Moody's Investors Service is a leading provider of credit ratings, research, and risk analysis. Moody's commitment and expertise contributes to transparent and integrated financial markets. The firm's ratings and analysis track debt covering more than 110 countries, 12,000 corporate issuers, 25,000 public finance issuers, and 106,000 structured finance obligations.
/ www.moodys.com
Standard & Poor’s ratings serve as a useful tool for investors and market participants to gauge credit risk and have helped companies and governments access capital. Today, Standard & Poor’s provides ratings for entities that offer different types of insurance products and services including life insurance, property and casualty insurance, annuities, health insurance, reinsurance, title insurance, mortgage and bond insurance. Standard & Poor’s offers the following types of ratings services for insurance-related entities:
·  Insurance Financial Strength Ratings – useful for buyers of insurance, risk managers and employee benefit administrators, this type of rating provides details on an insurance organization’s ability to pay its policies and contracts. Insurance brokers and agents may also use these ratings to meet due diligence and disclosure requirements.
·  Insurance Financial Enhancement Ratings – provides investors with an assessment of an insurer’s willingness to pay financial guarantees on a timely basis.
·  Insurance Security Circle Icon – assigned only to rated insurers who have completed Standard & Poor’s interactive rating process and have obtained a BBB rating or above, this tool can help insurers easily promote their good financial standing to existing and prospective policyholders.
·  Bond Insurance – Standard & Poor's offers the most comprehensive coverage of bond insurance in the marketplace. Our bond insurance ratings are supported by a diverse and global network of sector professionals in structured finance, project finance, public finance, and corporate and financial institutions. / www.standardandpoors.com
Weiss Ratings is the source for accurate ratings that you can rely upon to make sound, informed financial decisions. We are proud to offer a complete line of products designed to direct consumers and business professionals alike toward safe banking and insurance options while avoiding unnecessary risks that could lead to financial losses. We don't accept compensation from the companies we rate for issuing the rating. Nor do we give the companies an opportunity to preview the ratings or suppress their publication if they're unfavorable. We are totally independent and unbiased because our loyalty is to you — the customer. Every quarter, we evaluate the safety and financial strength of more than 12,000 institutions, including life and annuity insurers, health insurers, property and casualty insurers, banks, and savings and loans. / www.weissratings.com

KEY RATING FACTORS AND HOT BUTTONS