For the past several months, Insurance Journal readers have viewed articles discussing Demotech’s Financial Stability Ratings®. This article presents additional information on the origin of those ratings.
Prior to 1989, smaller, regional insurance companies were not rated by a nationally recognized rating service. To assist smaller, regional insurance companies, Demotech Inc. developed a Financial Stability Analysis Model and presented our model to Fannie Mae, Freddie Mac and HUD so that cut-through endorsements and reinsurance endorsements could be eliminated on property insurance policies issued by a (previously) unrated insurance company. We were the first company to have its rating methodology formally reviewed and accepted by these multi-billion dollar enterprises.
Since the date of their respective acceptances, Fannie Mae, Freddie Mac and HUD permit sellers and servicers to utilize any of their accepted rating services. You can utilize Demotech Inc. as a second resource for property insurance ratings.
Our analysis process
The methodology utilized by Demotech relies on the underlying records and/or summaries prepared by responsible officers or employees of the P&C insurer and/or its parent company. We rely on the truth and accuracy of information contained in the annual statements filed with the state Departments of Insurance.
Our Financial Stability Analysis Model® involves a tactile review as well as computation and analysis of critical financial ratios to determine the current and future financial stability of the property insurance company being reviewed.
We generally require the following to prepare a Financial Stability Rating®: five years of annual statements; latest independent audit; latest actuarial opinion and report; latest management’s discussion and analysis.
Our Financial Stability Analysis Model® cross checks, and analyzes, hundreds of financial statement calculations and relationships including: annual and quarterly statements of the insurer, its parent company and its subsidiaries; change in the composition of the assets and liabilities; changes in working capital; change in the restricted cash and receivables from affiliates; comparison of actual versus budget operating results; capital contributions from holding company or parent company.
Financial ratio calculation
A major item to determine the financial stability of a P&C insurer is the calculation of financial stability ratios measured against our financial stability tests. These ratios and tests have been sampled on an industry-wide basis and have been substantiated by other firms as well as Demotech.
To verify the predictive ability of our Financial Stability Analysis Model®, a series of solvent and insolvent P&C insurers were subjected to our battery of ratios and tests in order to determine the predictability and reliability of our financial analysis. Our Financial Stability Analysis Model® would have flagged P&C insurers that became insolvent at least one year in advance of formal regulatory action.
The basic information to develop our ratios is readily available from GAAP or statutory statements. Our strategic weighting of ratios to arrive at a final score is based on regression analysis and multi-variate analysis. The formula is proprietary and for that reason cannot be released.
Some of the balance sheet and income statement items reviewed include but are not limited to:
• Total current assets
• Working capital
• Total liabilities
• Administrative expenses
• Net income
• Total expenses
• Total assets
• Total current liabilities
• Surplus
• Total revenues
• Receivables, including reinsurance
• Amount of business written
Financial stability is, in our opinion, independent of size. This implies that small, well?managed P&C insurers can have better financial stability than larger, highly leveraged P&C insurers.
Definitions
A” (A double prime) – Unsurpassed financial stability
Regardless of the severity of a general economic downturn or a deterioration in the insurance cycle, insurers earning a Financial Stability Rating ® of “A double prime” possess unsurpassed financial stability related to withstanding a general economic downturn or deterioration of an underwriting cycle. The distinction between A double prime and A prime may be related to the magnitude of policyholders’ surplus, market share or national presence.
A’ (A prime) – Unsurpassed financial stability
Regardless of the severity of a general economic downturn or a deterioration in the insurance cycle, insurers earning a Financial Stability Rating® of “A prime” possess unsurpassed financial stability related to withstanding a general economic downturn or deterioration of an underwriting cycle.
A – Exceptional financial stability
Regardless of the severity of a general economic downturn or a deterioration in the insurance cycle, insurers earning a Financial Stability Rating® of “A” possess exceptional financial stability related to withstanding a general economic downturn or deterioration of an underwriting cycle.
S – Substantial financial stability
Regardless of the severity of a general economic downturn or a deterioration in the insurance cycle, insurers earning a Financial Stability Rating® of “S” possess substantial financial stability related to withstanding a general economic downturn or deterioration of an underwriting cycle.
M – Moderate financial stability
Regardless of the severity of a general economic downturn or a deterioration in the insurance cycle, insurers earning a Financial Stability Rating® of “M” possess moderate financial stability related to withstanding a general economic downturn or deterioration of an underwriting cycle.
L – Licensed
Insurers earning a Financial Stability Rating® of “L” are licensed by state regulatory authorities, and, in our opinion, the ability of these insurers to withstand a general economic downturn or a deterioration in the underwriting cycle is below average.
Insurance Journal subscribers can receive a complimentary copy of the latest available quarterly information that appears on Demotech’s Web site by contacting jpetrelli@demotech.com and requesting to be added to the e-mail distribution list.
Joseph Petrelli is the president and founder of Demotech Inc.
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