Ratings, and rating agencies, occupy a contradictory place in many markets – not least in commercial lines insurance and reinsurance.
They are very heavily relied on by both buyers and brokers, yet subject to a great deal of cynicism.
However, while the agencies certainly don’t always get it right, we would contend that much of the controversy derives from the way many re/insurance practitioners apply ratings within their own decision-making processes.
This stems from a fundamental but all too often ignored reality: Ratings are merely forecasts. They are opinions about the future (the future creditworthiness of the rated re/insurer) based on historical information and forward-looking expectations (both about the re/insurer itself and the markets it trades in).
The use of expert forecasts is central to business life. Indeed, much of the technical side of underwriting itself reflects exactly that. Yet that use normally comes hand-in-hand with a healthy awareness that a forecast is merely an opinion, not a fact. And opinions about the future will, by definition, sometime prove to be wrong.
Both A.M. Best and S&P currently rate well over 2,000 re/insurers globally. One thing we can say with confidence is that not all of those ratings will prove to be correct. Moreover, as with any forecast, when an agency assigns a rating it is not suggesting the rating represents the only outcome for the rated re/insurer’s financial health that it can perceive, merely the one it thinks is most probable.
And yet, many buyers and brokers use ratings as a “‘binary'” selection criteria (acceptable above a certain level of rating and unacceptable below). This is often done without even a review of the historical default or impairment rates associated with each rating level and a related perspective on how long the “exposure” to the re/insurer will be (i.e., the “tail” on the business being placed).
The binary selection approach has three problems.
First, it ignores the fact that the detailed statistics on historic rating performance over different time periods published by the agencies allow for a much more rational approach to assessing the degree of credit risk. Second, it tends to miss important leading indicators from the agencies about potential rating trends (individual rating or sector outlooks, for example). But most important in our view, it leads to a sense that somehow a rating is a fact. The implied assumption is that “if a carrier is ‘A-‘ it must be all right; if its ‘BBB+/B++’ is must be questionable.”
This last aspect of rating in part leads to the degree of angst seen when a rating proves to have been too high. Buyers and brokers looking for certainty when using ratings in this arbitrary way inevitably feel more bitterly about things if an “A”-rated carrier then subsequently fails.
How to Use Ratings
There are many unknowns in the buying and underwriting of commercial lines and reinsurance risks. Professional buyers and brokers invariably invest the time to understand these properly (e.g., the exact nature of required coverage; lost cost trends; economic, political and legal developments; climate changes; emerging risks).
Re/insurance professionals using ratings should invest the time to understand what analytical factors ratings reflect; the leading indicators on their ratings that the agencies provide; the observed credit risk any given rating level has displayed historically; and the impact the duration of the exposure has on that credit risk.