Rating Methodology Profile for Insurance Companies

INTRODUCTION

Rating tools for the credit analysis of insurance companies are not very different from those used in respect of financial institutions in general. The weights given to each component of an insurance company rating methodology are, however, different.

This methodology must be read in conjunction with the Rating Methodology Profile for Financial Institutions.

The reader should make frequent reference to the rating methodology of banks and financial institutions for any background issue and for any tool shared with insurance companies.

The text below highlights the main differences between banks and insurance companies, and offers a methodology to assess insurance companies taking into consideration those differences.

ASSET AND LIABILITY QUALITY

Bank liabilities are usually well known and would normally not increase or decrease from their book value. In recent years though, banks have, for their funding needs, increased their reliance on financial instruments –such as bonds- whose mark et value may fluctuate, and a strict marking-to-market of such liabilities could theoretically show a discount to book value. The fact that banks have started underwriting insurance types of risk –such as CDS-, or have started to offer insurance products, has changed the way bank liabilities should be analyzed, but the volumes involved remain modest in comparison to total bank liabilities. Bank assets, to the contrary, are subject to potential credit losses, and therefore the assessment of asset quality is important and, in fact, rather complex.

Insurance liabilities, to the contrary, are difficult to gauge and it is particularly the case for insurance products which are long term by nature or by definition. Insurance assets, in contrast to bank assets, are relatively easy to analyze and to mark to market.

While bank asset risk often depends on the creditworthiness of other financial institutions, reinsurance is a very important tool for insurance companies and as such the creditworthiness of reinsurers is a major factor in insurance asset risk analysis. Such twice-remote approach, incidentally, has become more relevant to bank ratings in the context of interbank risk.

The quality of assets held by an insurance company both to satisfy its future obligations and to lodge its excess capital can usually be analyzed in the same way the non-loan assets of a bank are analyzed. Market risk, investment risk and interest risk of course become extremely relevant.

TECHNICAL PROVISIONS

Insurance companies must at all times keep technical provisions to meet their obligations under the various insurance (or reinsurance) contracts.

While banks should always mark to market their assets –even if marking to market a loan is usually done on an approximate basis through loan loss reserves, and even if many rules exonerate banks from marking to markets some of their assets (such as securities held to maturity etc…)-, insurance companies must keep asid e substantial amounts representing their future obligations, sometimes over the long term.

The valuation of technical provisions should conceptually be based on the price the insurance company should pay to another insurance or reinsurance company to take over its rights and obligations in respect of a given item. As there is no ready market for such a pricing to take place, one has to makes estimates based on past experience and specific risk information, as well as expenses, to reach an appropriate level of technical provisions.

Those will vary among product types (life products, for example, will require longer term analysis, as well as different statistical tools, not to mention a closer scrutiny, than non-life products), and will involve some assumptions about economic parameters over future periods.

Potential pricing errors are a major potential source of deterioration for technical reserves. They are, for the external analyst, difficult to measure.

CAPITAL ADEQUACY

The Solvency Capital Requirement measures the technical reserves or provisions needed to absorb financial calls on the insurance company and which will provide a reasonable expectation for policy holders that any payment due to them or the beneficiaries will be provided. This in many ways resembles the notion that banks should keep sufficient capital for expected losses.

Like banks, insurance companies should be sufficiently capitalized to absorb losses beyond the expected financial calls on their assets. Assets that are in excess of the Solvency Capital Requirement are considered as the company’s own funds and are counted as “Tier I” capital funds which, as is the case for banks, should meet certain minimum requirements, should be used to absorb unexpected losses, and should remain available in case the company must be wound up.

Therefore the computation of t he technical reserves is an extremely important step as it has an impact on the economic capital adequacy of an insurance company.

LIQUIDITY

The liquidity management of assets, often over a long period, is rendered complex by the fact that, while liabilities can be estimated, the timing of outgoing payments is less easy to gauge than it is in banking.

As always, assets should match liabilities as much as feasible, and a balance must be found between shorter term assets whose return is lower, and longer term assets with stronger returns. Any substantial funding shortage might result in the untimely disposal of long term assets under less than favorable terms.

It should be noted that, while a solvent bank can face failure if it does not have sufficient liquidity, an insurance company –due to its longer term liabilities- might be insolvent even if it is apparently very liquid. In some ways, the gauging of an insurance company’s creditworthiness in the long run is therefore more difficult than that of a bank.

PROFITABILITY AND OPERATIONAL STRUCTURE

A sustained stream of acceptable profits –provided those figures can be trusted- is crucial for an insurance company whose business is mostly over the long term. Lower levels of profits or more volatile profits can at times be tolerated from insurance companies, or from some of their sub-divisions, that operate mostly on a short term basis.

MANAGEMENT (RISK MANAGEMENT, STRATEGY, CORPORATE GOVERNANCE)

Needless to say, statistical and actuarial tools and skills are as important to insurance companies as credit risk assessment is to banks.

The test of management along the lines of “Do they know what they are doing?” is as important for insurance as it is for banks. In the face of increasing financial uncertainties, Enterprise Risk Management has become crucial.

THE REGULATORY ENVIRONMENT

In virtually all jurisdictions, insurance companies come under regulatory oversight. However, since the quality of regulators and regulations is not uniform worldwide or even region-wide, a critical analytical issue is the quality of prudential regulation. The trend in many countries is to move toward stronger regulation. Europe has recently upgraded its 1973 Solvency rules (for insurance companies) into a Solvency II set of rules, which may become a universal standard. In many ways it does for insurance companies what Basel (I, II and III) rules have done for banks.