Finding The Black Sheep

In the current economic climate, brokers and risk managers are finding themselves awash in information from ratings agencies, regulators and news outlets. Making sense of the facts and opinions has always been a key feature of their due diligence, but now, perhaps more than ever, brokers and risk managers are reportedly investing more time and energy into monitoring the financial health of Canadian property and casualty insurers.

Questions abound as to the credibility, quality and timeliness of available information. Are there factors in a rating that should be given more consideration than others? Is a financial strength rating (FSR) a better barometer of resilience than a minimum capital test (MCT)? If a company has a good financial strength rating (FSR) but a negative outlook, at what point is the gamble too great to bind a policy with the insurer? What other red flags serve to warn a risk manager or broker that an apparently solid carrier may now be showing signs of erosion? And if the parent company of an insurer shows signs of stress but its Canadian branch remains strong, what affect does the parent company have on the Canadian operation’s future?

FSR v. MCT

The two main regulatory solvency tests applied to property and casualty insurers in Canada are the MCT and the Branch Adequacy of Assets Test (the BAAT, used for branches of foreign companies), says Joel Baker, president of MSA Research Inc.

“Both of these tests are quantitative, insofar as they are calculated using risk-based factors and other formulae,” he says.

Exceeding regulatory thresholds for these tests is critical. “Companies that fall below the threshold of 150% will in effect be taken over by regulators,” Baker says. “OSFI often sets higher targets than 150 for companies, depending on their risk profiles, lines of business or financial structure. Risk managers and brokers should be aware of company MCT/BAAT levels and any trending in that metric.”

Foster Cheng, an associate at Standard &Poor’s (S&P’s), says the MCT scores of Canadian property and casualty insurers currently average closer to 200%.

FSRs, on the other hand, are the opinions of rating agency analysts on the insurers’ ability to meet its claims-paying obligations, says Joseph Burtone, assistant vice president at the A. M. Best ratings agency.

With an interactive rating, the FSR will include criteria such as capitalization and underwriting performance in addition to other publicly available information. But, the analyst’s opinion will also be shaped by the insurer’s competitive position in the marketplace, as well as interaction with the insurer’s management on risk management practices and growth strategy.

In its recent report, Interpreting Financial Strength Ratings in Light of Improving Insurer Supervision, S&P’s argues that the FSR is more relevant than a capital test. That’s because the FSR is based on an ongoing discussion that takes into account more than just the pure mathematical factors of the equation, whereas a capital requirement test is a point-in-time measurement.

“In our opinion, historic capital adequacy is a poor lead indicator of insurer failure,” S&P’s says in its report. “We believe categories such as competitive position, ERM, management/corporate strategy, financial flexibility and operating performance are better leading indicators of long-term financial strength.”

But FSRs have challenges as well.

Baker suggests some FSR ratings suffer from some inherent conflicts, the first being that the rated insurer pays for the rating. “Sometimes insurers decide to stop being rated once their rating falls below a certain level,” he says.

As well, Baker says buyers inadvertently create what are known as “rating cliffs.”

“That is, rating agencies are hesitant to drop company ratings below the ‘A’ level out of concern that buyers will abandon the insurer,” Baker says. “So in tough times, many ratings are clustered around the ‘A-‘ level. Once a rating falls into the ‘B’ level, the decline is rapid and climbing back out is very difficult. This rating cliff phenomenon is unfortunate.”

A. M. Best says there is no such thing as a “ratings cliff,” adding that companies merit whatever ratings they are assigned.

“A congregation of ratings around the ‘A-‘ level, I think, is because the companies that we interact with understand what our criteria and methodologies are and they operate their companies in a way to continue to support those ratings,” says Charles Huber, senior financial analyst at A. M. Best. “It is difficult to move from a ‘B++’ to an ‘A-‘ just because, as you get into the higher levels of rating, the criteria becomes more stringent. If your company is run-of-the-mill and there isn’t anything that stands out, then you’re probably going to cluster around where the majority of other companies are rated.”

BALANCING THE GOOD WITH THE BAD

In recent months, many companies — as well as entire sectors of the property and casualty industry — have been given negative outlooks by various rating agencies, despite strong FSRs. This poses another question: If a company has received a strong FSR, but has a negative outlook, how does a broker or risk manager balance the current strength against the potential for problems in the near future?

Donald Chu, director of financial institution ratings at S&P’s Canadian branch, explains his agency has two options if it feels a rating may change. The agency may issue an outlook on the credit (and these days, negative outlooks tend to outpace the positive outlooks), or it may put the credit on CreditWatch negative.

“Typically, if we were odds makers — and it’s never a perfect world — but let’s say there was a 1-in-3 likelihood of a ratings action over the next two years, then that’s an outlook change,” Chu says. Conversely, “a CreditWatch placement means that there is a 1-in-2 likelihood that we would do a downgrade on the credit over the next 90 days.

“The point here is that the time horizon [for a CreditWatch placement] is shorter and the likelihood of movement on the rating is shorter as well.”

A. M. Best outlooks indicate there is a potential rating change over the intermediate term, generally 12 to 36 months, Burtone says. Analysts take into consideration any trends that occur over a longer period, he explains. “If you see a trend where capitalization has declined three years in a row, and the company is projecting that it’s going to decline even further, well, now it’s a trend. Year 2008 was a terrible year for several different aspects. Is it a trend? No. But in Canada we did see some deterioration in 2007 that continued into 2008, not just from the underwriting perspective, and now you throw in the investment performance and you have three years in Canada of deteriorating operating results and some companies with declining capitalization — at this point, the trend is beginning to shape.”

Huber says it’s critical for the broker and risk manager to understand the meaning of each level of rating and the criteria for each when weighing the FSR against any outlooks or projections. “If it’s an ‘A++’ rating, but the outlook is negative, the rating may only come down to ‘A+’ and it’s still a superior company in our opinion. Just not as superior as it once was.”

RED FLAGS AND BEACONS OF STRENGTH

These days, brokers and risk managers are trying to absorb as much information as possible when making their decisions. Many are taking into consideration more than just the FSR and MCT.

“I think if I were to choose an additional area that brokers and risk managers should investigate, I would say that claims development exhibits would be most important,” Baker says. “Companies that under-reserve are at a much higher risk of running into trouble. Sustained adverse development over time can erode capital and signal that reserving is chronical ly inadequate. Inadequate reserving often goes hand-in-hand with under-pricing.”

Huber also suggests monitoring growth strategies as an indicator of health or stress. “We’ve done some statistical study on why companies have failed,” he says. “One of the major reasons why a company fails is because it grows too fast — especially in a soft market. “Its product gets under-priced, its reserves are inadequate and the infrastructure is not built into the company, so that it is able to support all of the business that it’s taking on. That is one of the major reasons why a company fails.”

Burtone says the signs of growth should not always be interpreted as a red flag, though.

“Growth is not always a bad thing,” he says. “If you are growing into lines of business that you have expertise in, then we’re not concerned. But if you’re going into lines of business that you do not have expertise in, or that you do not have the infrastructure to handle, that puts pressure on the company and could impact the results and create an issue with the rating.”

PARENTAL INFLUENCE

Many Canadian property and casualty insurers are outposts of larger parent companies. Thus, even though a Canadian branch may operate within one of the world’s more stringent regulatory environments, and even though it may be among the most conservative players on the investment portfolio front, it may still bear the weight of its struggling parent company receiving a bailout from a foreign government or receiving a downgrade from ratings agency analysts.

“I guess from the broker perspective, the best way to look at this is that the Canadian subsidiaries are a separate operation from the group and they are regulated by the Canadian regulator,” Chu says. “So, technically speaking, if the Canadian regulator wanted to re-assess the [insurer’s] assets they could.”

Hypothetically, when an insurance company is part of a larger financial institution, any one of the group’s subsidiaries’ ratings are tied to the larger group. But “when we generally look at a credit, we look at it on a standalone basis,” Chu says.

For example, an S&P analyst would look at a Canadian subsidiary on its own without any of the benefits of the parent company. But the rating in the public domain includes the benefit of the large and strong group in general.

“Often what we’ll do is take that standalone rating and raise it a couple of notches depending on how involved or supportive the group is to those specific operations,” Chu continues. “That’s the other thing to balance out: the only thing that you see is the final rating. As the strength of the parent continues to weaken and decline, that is going to be reflected in the Canadian rating. But what you don’t see is the standalone rating of those Canadian operations all by itself. Ultimately we speak to the financial strength rating of the company based on everything that we know to date.”

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In tough times, many ratings are clustered around the ‘A-‘ level. Once a rating falls into the ‘B’ level, the decline is rapid and climbing back out is very difficult. This rating cliff phenomenon is very unfortunate.

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One of the major reasons why a company fails is because it grows too fast — especially in a soft market. Its products get under-priced, its reserves are inadequate and the infrastructure is not built into the company so that it is able to support all of the business that it’s taking on.