Insight: – Insurer Financial Ratings: a Slippery Slope

The U.S. has become a hotbed of discussion over the role and weight of rating agency decisions. In the case of Enron, credit rating agencies had rated the trading company’s debt as “investor grade” just days before it filed for bankruptcy. This led to criticism of the agencies’ conduct in an October 2002 Senate report on the downfall of Enron.

In the insurance world, regulators raised eyebrows after Cigna Corp. split its operations into a going concern and a run-off operation in order to preserve the “A- rating” for the going concern from A.M. Best. The regulators’ concern lie in the run-off operation’s ability to fund future claims. The turmoil led New York insurance commissioner Greg Serio to call for a review of the relationship between regulators and the agencies who comment on insurer financial strength.

The National Association of Insurance Commissioners (NAIC) is currently exploring this relationship, including the possibility of having rating agencies regulated. Agencies, for their part, have strenuously objected to this kind of oversight, noting that their decisions should not be subject to political considerations including the availability of insurance or product issues. Serio has voiced concerns over the perception that raters favor large, centralized companies and the implications of rating agencies “advising” companies on how they can improve their ratings.

Last November the U.S. Association of Financial Professionals (AFP) polled senior level corporate practitioners and financial services providers on their view of credit rating agencies. Among the findings, 29% said their company’s rating was inaccurate to some degree. This number drops to 26% for companies recently upgraded, and jumps to 37% for companies recently downgraded (see chart 1). There was similar criticism of the timeliness of ratings changes, with 27% saying they were downgraded more than six months after their company’s financial position showed obvious deterioration. This figure leaps to 57% for companies who waited more than six months to be upgraded following financial improvement (see chart 2). The respondents also indicated that often company ratings reflect to a great extent the overall industry’s conditions as much as the specific company’s position (see chart 3). A full 90% said the SEC should take a more active role in monitoring rating agencies.

POST-ENRON

At a recent CEO roundtable in New York, hosted by the Insurance Information Institute (III), volleys were thrown at rating agencies, particularly concerning their reaction to the sweeping events of the last two years, including 9/11 and the corporate failures. Liberty Mutual Group CEO Ted Kelly commented on the increased conservatism of raters following Enron’s failure, noting, “…the rating agencies have been tarred with — it’s not quite the same brush [as auditors] because it’s a slightly different role – so they are scared and, to some extent, I do think they’ve overreacted.”

Recent downgrades were seen by some CEOs as a bid to enforce increased conservatism on insurers even as they struggle to take advantage of the hard market. “First of all, they’re trying to anticipate where individual company results might go or might head to, based on what they hear and see in the marketplace,” said Ramani Ayer, chairman and CEO of The Hartford Financial Services Group. “They’re also anticipating industry trends, so they’re not hesitant as far as downgrading an entire industry, which is something they didn’t used to do. And, third, I think they’re really putting a lot of pressure on leverage ratios and the balance-sheets and so on, which is going to cause companies to ‘de-lever’, which goes against the ROE issue…”

Just as Enron has pushed rating agencies into the limelight, it was the fall of Confederation Life that brought the focus onto rating agencies here, says Manny Nowacki, group vice president for A.M. Best. Insurers were suddenly lining up to be rated to restore confidence in the industry. And the U.S. corporate scandals have had a spill-over effect in Canada, increasing the desire for independent assessment of financial returns. “Given a lot of the things that have gone on from a corporate perspective, any type of activity that provides an extra level of security is seen as having value,” comments Ross Betteridge, executive vice president and CFO of CGU Group Canada.

Independence is the key to rating agency value and, in Canada at least, this independence has been preserved fairly well, says Neil Parkinson, partner in KPMG’s Insurance Practice. “They do tend to exhibit a fair amount of independence, which they need to do for their ratings to have any credibility.”

LITMUS TEST

Rating agencies have a clear view of their role, and it is much less invasive than the comments by the U.S. CEOs might indicate. “We’re definitely not in an advisory role,” says Donald Chu, a director at Standard & Poor’s Ratings Services who deals with Canadian p&c companies. “We render an opinion on credit-worthiness, and the operative word is opinion.”

“All we do is report,” concurs Ken Frino, assistant vice president at A.M. Best. “We don’t advise, it’s not our role.” Frino recognizes however that companies may seek out the advice of rating agencies in order to maintain a rating or seek a higher one. “Companies will ask us what they need to do to get a higher rating. Sometimes it’s a thing they can control, sometimes it’s a thing they can’t control.” Such uncontrollable issues could include overall industry issues or parent company concerns that the Canadian operation may not have say over.

General consensus amongst sources is that while companies want a higher rating, their own experience and financial results, parent company decisions or other internal factors have more to do with business strategy than ratings do. In fact, rating agencies surveyed for this article agree that while the insurer pays for and uses the rating, there are a host of other audiences including investors, lenders and buyers of insurance, particularly corporate buyers, who may be even more interested in company ratings.

For the federal regulator, ratings act as only a litmus test of its own risk ratings, says John Fernandes, director of regulatory and supervisory practices for the Office of the Superintendent of Financial Institutions (OSFI). If agency ratings and OSFI’s conclusions are disparate, a second look is likely in order. However, he notes, “we have more access to a company than a rating agency does… [and] our ratings are strictly supervisory. We’re not looking at it with the perspective of the investor.” OSFI ratings are also not made public and companies are unable to use them in marketing, as so often is done with agency ratings.

TAKING FLIGHT

“There has been a flight to quality in the last year or so. Clients need to know that a company they are doing business with is going to be around,” asserts Nelson Rivero, managing senior financial analyst with A.M. Best.

There is widespread agreement that ratings have taken on new importance in the current hard market, particularly with the flight to quality in commercial lines and reinsurance. “People never used to pay much attention to it,” says K.K. Leong, director of commercial marketing at AIG. “They [ratings] were just an alphabet, but now it really means something.” He hopes brokers specifically will educate themselves on what ratings mean, many not having lived through hard market conditions before. “This hard market will be a lesson for everyone. When we come out of it, it will be a better industry.”

Larger national brokers seem to place more importance on maintaining a minimum rating judging by the requests for information received, notes Betteridge. Although the company is focused on small to mid-sized corporate clients, his feeling is that “the rating of insurance companies by independent agencies hasn’t received the importance it should by those small and medium-sized companies.” However, longstanding relationships with brokers are often more of a factor than ratings, he adds.

One distincti on that bears closer understanding is that between a non-interactive, or qualified rating, based on public data, versus an interactive rating based on financials and extensive meetings with company management

Unfortunately, not all in the industry are confident ratings are telling consumers and investors all they need to know, particularly in the current environment where downgrades are outpacing upgrades. “Rating agencies are important and I think it’s helpful for insureds and brokers to know what a company’s rating is,” says Bill Star, president and CEO of Kingsway Financial Services. However, he questions if those ratings are in some cases more reactive than proactive.

In the case of his own company, A.M. Best placed Kingsway on watch with negative implications, noting that the company may be growing too quickly and speculating on its ability to raise the capital needed to support this growth. At the time, Kingsway was involved in the third of three capital-raising initiatives and was set to price this last debenture offering when A.M. Best announced the “watch” status. “They almost interfered with our capital raising,” Star says. Neither Dominion Bond Rating Agency nor S&P made a similar move, he adds.

Star questions the concept of placing a company on watch – a move which casts a shadow on a company but does not represent a real change in the view of its financial stability. He sees other companies facing similar issues, and believes that in the case of struggling companies, future plans for improvement are not given enough weight in ratings. Similarly, when a weaker company is purchased, not enough consideration is given to the acquiring company’s plans for turnaround, he observes.

Star is not alone in his concerns about whether ratings are proactive enough. “We may or may not agree with how some of those ratings are calculated,” says Derek Fee, public affairs specialist at State Farm Insurance Cos. (Canada). “In some cases we feel the long-term financial strength of the organization isn’t taken into account as much as it should be.” Rates too often focus on the next 12 to 18 months and not beyond that.

Clearly an interactive rating is preferable to a qualified assessment, and Star says the face-to-face meetings as part of this process are crucial. CEOs, he adds, need to be very vocal in getting across just what their company is doing to improve results or strengthen its capital base.

Interactive ratings are also a means to counteract the criticism that ratings are more reflective of industry conditions than specific company issues, Betteridge points out. “Those interactive ratings allow the agency to come in and get behind the numbers, so they’re not painting all the companies with the same brush.” So far, however, Parkinson notes that many companies have been content with qualified ratings even though they know there is a ceiling to the rating that will be attached to their financial strength without a more in-depth analysis.

THE DOWNSIDE

Star worries that the recent spate of downgrades has the effect of kicking companies when they are down. “I notice a number of companies that are being downgraded and that’s not helping them improve.” If a downgrade leads to lost business, for example the loss of an “A” rating causing brokers to turn away from a commercial carrier, there is little chance for poor financials to be bettered. “It should be more based on the corrections they’ve made than just their past.”

Raters say they are aware that a downgrade can negatively impact business, particularly in a difficult market, and do not make such moves rashly. “We are very cognizant of that [the impact of a downgrade],” says Chu. “We look very long and hard before downgrading.”

One area that did not seem to represent an issue was the impact of rating agencies on reserving strategies. Unlike concerns voiced in the U.S. over the conservatism rating agencies seem to be looking for, in Canada there is a sense that companies are already looking at risks conservatively, including reserving for such issues as Ontario auto claims. “There’s just no getting around the fact that that [reserving] plays a big part in a company’s financial position going forward,” Parkinson says.

Betteridge notes that he has not found rating agencies to be any more conservative recently than in the past. “By their nature, they [rating agencies] tend to be fairly conservative.”

And, there is recognition that Canadian companies cannot escape the losses experienced worldwide by global parents. “It used to be insurance was very domestic, parochial, local, now insurance is becoming more and more international,” Leong notes. Everything from 9/11 to last summer’s European floods is impacting insurer ratings and thereby the ratings of their Canadian counterparts.

Moving forward, there will likely be more downgrades, rating agencies say. However, the tide will slow down, Frino predicts, as Ontario auto results improve. “The market is improving and that’s due to rate increases. Legislation proposed in Ontario [to deal with auto claims] is also a positive step.” However, Chu is less convinced. “With this sector, it’s a systemic issue. The industry is on a slippery slope downward…I’m not sure there will be any sanity returned to the marketplace.”