The Ratings Game

Every day, agents and brokers use financial strength ratings of insurers in their business. A carrier’s ratings may affect an agent’s ability to place risks with that insurer, or the client’s willingness to be insured by a vulnerable carrier, given the client’s tolerance for risk.

The bottom line for agents is they hope the ratings issued for a carrier by the major ratings agenciesÑand in some cases smaller agencies devoted to niche, regional carriersÑcan tell them something about the likelihood of their clients’ claims being paid and, ultimately, avoid the pain associated with an insurer insolvency.

The hardened market has affected the ratings game in a number of ways and made life much harder for agents, in spite of higher commissions. First, though one would think the higher premiums and stricter underwriting characteristic of the hardened market would lead to an industry-wide trend of upgrades, that hasn’t been the case.

By contrast, downgrades have outpaced upgrades at all the major ratings agencies. The standard-bearer in the insurance ratings game, A.M. Best Co., has seen downgrades outpace upgrades by five to one in the last year, according to Karen Horvath, vice president of commercial property/casualty ratings.

Fitch Ratings, meanwhile, has seen “very few upgrades,” according to Keith Buckley, managing director of insurance at Fitch. Over half of the universe of carriers has been downgraded by Fitch in the last 18 months, Buckley said.

Large carriers have been hit by huge asbestos and environmental claims that have forced them to re-examine their potential liabilities and strengthen their reserves. Most famously, commercial lines leader AIG took a $1.8 billion charge in February to boost its reserves.

There are several reasons commonly cited by credit analysts for the wave of carrier downgrades: an over reliance on reinsurance relative to assets, loss of reserve adequacy, a weakening credit market, and lower surpluses due to underwriting and investment losses. Paradoxically, carriers’ ratings are now beginning to reflect the ravages of the soft market on their financial strength. The hardened market so far has not done enough to help most recover.

“One of the core aspects of our rating is it’s intended to look through a normal cycle,” Buckley said. “The soft market really took a toll on a lot of companies in terms of reserving and balance sheet integrity, and did permanent damage to many companies. Raising premiums is not a ratings event, because in a cyclical industry that should be expected.

“Where we will see upgrades,” Buckley added, “is if companies take actions to really strengthen capital in the long term, or in the case of a harder market if smaller competitors fall by the wayside; if they improve market share without sacrificing price, doing it the right way by being a stronger competitor able to take advantage of the opportunities available to it. … We’re not really thinking in terms of how they’ll do in next two years of hard market, but how will they be positioned to avoid the problems of inevitable soft markets. We’ll need to see some seasoning of that over the duration of the hard market before we feel comfortable that they’ll do well in a soft market.”

A.M. Best’s Horvath echoed the sentiment. “We’re in a hard market,” she said, “but I don’t think the benefits of that hard market have really caught up with insurers. That means improved rates and tightened underwriting conditions haven’t been able to offset weak underlying conditions of the most recent soft market. Reserving issues and the 1997 through 2001 accident years have really outpaced the benefits of improved underwriting.

“We’re seeing a decline in surplus when volume for many carriers is increasing,” Horvath added. “That’s not just the result of lots of dislocation. There’s actually a lot of new business coming to insurers, and that growth of exposure has an impact when you have a decline in surplus. It’s not supported by the capital they have.”

Steve Dreyer, practice leader for North American insurance ratings at Standard & Poor’s, sees much the same trends accounting for why S&P’s has downgraded so many carriers in spite of the hardened
market.

Reserve additions that have exceeded industry norms, mostly in commercial lines, workers’ compensation, directors and ommissions, have been major culprits, Dreyer said.

Under reserving is a “ubiquitous concern,” according to Bob Hartwig, chief economist for the Insurance Information Institute. He said various sources have estimated the P/C industry is under reserved as a whole between $38 billion and $55 billion, not including asbestos liabilities.

Ratings agencies under pressure
“On the face of it, it would seem there should be more ratings upgrades,” Hartwig said, noting the paradox of downgrades in the hardened market. “More insurers fail or simply go out of business during market peaks and shortly thereafter as opposed to in the depths of the soft market. That’s simply because there’s a lag before a company goes under. They are weakened to the point where even the hard market can’t save it.”

Claims on state guaranty funds skyrocketed during the last hard market of the mid-1980s, Hartwig noted. In addition, there is a “lot more pressure on analysts, including analysts at ratings agencies,” in light of the huge financial scandals of 2001 and 2002. “They prefer to err on the side of the caution.” he added. No one wants to have missed the next Enron.

“Ratings in fact, some will say, are a lagging indicator as opposed to a leading indicator many believe they should be,” Hartwig said. “While the ratings function is very important it does miss a fair number of companies. It’s not perfect. A fair number of companies that have been weakened maintain ‘A’-grade ratings up until the day they file for insolvency.”

Hartwig said that despite a 14 percent increase in premiums
written, the P/C industry still only managed a one percent return
on equity.

“If ever there were proof,” Hartwig said, “that it would be recklessly premature to allow this hard market to end, that’s it. In the past, there has been this situation where prices are dropping so that they’re at rates that are below the rate needed to afford them. Rate increases proceed for a small number of years and there’s no plateau, it’s the edge of a cliff.”

That is why, Hartwig said, so many insolvencies occur in the later part of a hardened market. Whether we have already begun to see that is a matter for debate. A study by the Alliance of American Insurers showed that payments by private insurers to state P/C guaranty funds hit a 15-year high in 2001, the last year for which data were available, thanks to increased insolvencies. Thirty-two state funds levied $739 million in 2001 assessments, according to the study.

The amount of reinsurance purchased by primary reinsurers is another concern driving down ratings, Hartwig said. Moody’s Investors Service, for example, issued 150 downgrades of reinsurers in 2002, compared to only three upgrades, but reinsurance recoverables as a percentage of primary insurers’ assets increased from 10 to 14 percent between 1999 and 2002.

Rupert Hall, CEO of Stockton, Calif.-based Golden Bear Insurance Co., said the caliber of reinsurance is a major concern when looking at a carrier’s financial health. It all boils down to the simple question, he said, of “Who’s going to be around to pay the losses? Who’s going to survive?”

Downgrade mania?
Not everyone is enamored of how the major ratings agencies have handled their charge. In an April 10 story in Forbes Magazine, Richard Lehmann said the ratings agencies have had a “downgrade bias” since the early 1980s, which he called a “perverse trend.”

“Some will argue,” Lehmann wrote, “that the companies themselves are to blame for this credit deterioration because they took on too much debt. While there is some truth to this charge, I believe the credit agencies’ role needs to be reevaluated. The agencies are simply too negative.

“Downgrades,” he added, “have the distorting effect of raising a company’s borrowing costs. And any problems that a company has are only magnified by the downgrade.”

Joseph Petrelli, president of niche carrier ratings agency Demotech Inc., says the major ratings agencies’ actions are often counterintuitive.

“Let’s say a company has a very high rating with one of the other folks,” Petrelli said. “The company strengthens its loss reserves and then the rating goes down. If they had a good rating when under reserved, why do they get penalized for being appropriately reserved? It’s silly to penalize a company for putting money in its reserves, where it belongs.”

Additionally, Petrelli claimed that Demotech focuses more on the strength of a carrier’s balance sheet than its income statement. Demotech also rates carriers regardless of size, for an affordable price, unlike S&P’s, which recently stopped wooing Golden Bear Insurance Co. as a client. The S&P’s Dreyer said that while his agency rates companies regardless of size, smaller carriers often find the fee “prohibitive,” in spite of a sliding scale.

“The other ratings agencies are particularly enamored with size,” Petrelli said. “Bigger’s almost always better. We don’t subscribe to that theory. A small, well-managed company is a better risk than a large, scattered company with more dependence on a variety of reinsurances, and carrying more risk.”

Demotech’s financial stability ratings attempt to gauge the likelihood of a carrier’s solvency for the next 18 months, which is the time period most agents and brokers care about. Demotech’s analysis is usually based on data from the National Association of Insurance Commissioners.

Agents most reliant on A.M. Best
Still, A.M. Best is the ratings agency producers rely on most. It has a long track record and focuses entirely on the insurance industry, unlike Moody’s, Fitch, S&P’s, Hoover’s Ratings or Weiss Ratings. Best’s Horvath described agents and brokers as the company’s “heaviest users.”

Most state insurance departments’ producer licensing exams still refer exclusively to A.M. Best as the source for financial strength ratings of carriers, and many errors and omissions policies that cover agents and brokers require them to place business with carriers rated above a certain threshold by A.M. Best, in particular.

A typical example is the E&O policy that insures the Houston-based brokerage of Brady, Chapman, Holland & Associates (BCH).

The policy excludes coverage for the insured brokerage in case of insolvency unless, “at the time the insurance placed the subject risk with any of the above-described entities, such entity or entities were rated by A.M. Best as ‘B+’ or higher, or alternatively such entities were guaranteed by a governmental body or bodies and/or operated by a governmental body or bodies.”

The “B+” (very good) rating from A.M. Best falls on the low end of its “secure ratings” category, below which carriers fall into the “vulnerable” category of “B” and lower. Charles E. Comiskey, a broker with BCH who testifies often on behalf of E&O carriers against agents and brokers, said a downgrade can cause lots of legal trouble for a producer.

It’s a hassle to place risks with new carriers after a material downgrade, he said, but “you’re buying an E&O claimant if you don’t get off your butt and do it.” Comiskey told of one case in which he was asked to testify on behalf of an agent who talked to his insured about a carrier’s drop in rating from “A-” to “B+,” but took no action.

“He let it run for several months until expiration,” Comiskey explained.” “Now two or three years later it’s suddenly going to trial and the carrier is not in business anymore. The claim is against the agent. Even though I was hired to testify for the carrier, I think it’s better to cut your losses and run than to go through all the trouble. The agent thought it would be safe to let coverage ride, but it turned out to be a fatal error.”

Importance of ratings varies with agency
Still, for some agencies, ratings have definitely become a secondary factor, given the market conditions, according to Scott Hauge, president of San Francisco-based CAL Insurance & Associates, which specializes in commercial lines for small and medium-sized business.

“It’s an interesting situation for an agent to be put into,” he said. “Right now, certainly in California and around the country rates are going up dramatically and the clients and particularly small businesses are feeling the pinch of higher rates. A lot of them don’t care [about ratings]. They’ve never gone through a bankrupt insurance company. They’re in a situation of survival mode. If you come to them with a ‘B+’ versus an ‘A’-rated … they just can’t afford any more. They’re looking for ways to survive.”

There are many cases where CAL’s clients are subcontractors on larger municipal projects and the prime contractor requires an “A”-rated carrier certification, Hauge said. But if there’s any flexibility for his clients, they will take the lower-rated carrier if there’s a difference in premium.

As with so many aspects of the insurance business, how agencies operate depends on who their target market is. Rebecca Korach Woan, principal at Chicago’s Chartwell Insurance Services, will begin to question a rating even if it drops to only an “A-” A.M. Best rating. But that makes sense, given that Chartwell’s specialty is P/C coverage for high net-worth individuals.

“If a carrier gets an ‘A-‘ from Best, we’ll look at Weiss, which seems to be a little more conservative,” Woan said. Otherwise, “there will be some fallout from the insured who just doesn’t want to take that risk, where some claims may take years to settle.

“It’s a hard market,” Woan added, “and we definitely have to work a lot harder just to place business with ‘A’-rated companies.” Woan said a lot of Chartwell’s business has now been placed with surplus lines carriers.

Hauge also has often turned to surplus lines companies, though no such company not “A”-rated will receive any of CAL’s business, because the security of the state’s market conduct review and guaranty fund is not there.

For Woan’s clients, even the guaranty fund is not enough. “When you consider what the guaranty fund is in IllinoisÑ$300,000Ñthat’s not much security. It doesn’t give you much comfort in terms of dealing with a company with a poor financial rating.”

The Boy Scout motto, “Be prepared,” might apply to Woan’s approach, and the approach of any good agent, when evaluating a company’s financial strength with the aid of ratings.

“It never comes as a surprise,” Woan said. “You anticipate the condition of the company and you run your book down so you’re not caught with any exposure with a company that’s going south quickly.”

Ultimately, ratings can only do so much for an agent or broker, according to Paul F. Sherbine, a credit analyst at Marsh. “The key to remember is that this is just one tool,” he said. “The industry has to estimate risk 50 to 100 years out. It’s … unquantifiable.”

To comment on this article, e-mail koreilly@insurancejournal.com.

Topics Carriers Agencies Excess Surplus Reinsurance Market AM Best Property Casualty