Question

Debt levels/ratings can signal to investors that a company may be facing financial distress representing concerns regarding the company's ability to repay its contractual obligations. In many cases, a company's stock can be negatively impacted by a 'downgrade' in their debt rating.

Insurance companies are a good example. Insurance firms are evaluated specifically by their debt ratings which represent a key indicator of the firm's performance and servicing of clients.

Answer 1

One factor you should consider when selecting an insurance company is the insurer's financial strength. Analyzing an insurer's financial condition requires a considerable amount of number-crunching. Fortunately, financial ratings firms have done much of the work for you. There are five companies that publish financial ratings of insurance companies. They include Fitch Ratings, A.M. Best, Standard and Poor's, Moody's, and the Kroll Bond Rating Agency. 1 with the exception of A.M. Best, which analyzes insurers only, these firms provide ratings of many types of businesses.

Rating Systems

Each of the five companies has developed a rating system to describe insurers' financial condition. All of the systems use letters of the alphabet (Moody's also uses numbers). The ratings generally range from "excellent" or "superior" to "poor" or "distressed."

Rating organizations consider both qualitative and quantitative factors when evaluating an insurer. For example, KBRA uses all the following to calculate an insurer's financial strength rating:2

• A quantitative assessment using KBRA's long-term credit scale and stress testing. KBRA considers factors such as the insurer's loss reserves, ceded reinsurance leverage, and combined ratio.3
• A quantitative score based on factors like the insurer's balance sheet, its company profile and risk management strategies
• An external considerations score indicating that a parent company may be a potential source of credit. Alternatively, it may indicate that there are outside risks that may negatively impact the firm.
• A potential rating constraint due to currency transfer risk. An insurer that operates in an emerging market may be unable to raise foreign currency to meet financial obligations due to political or economic constraints. 4

How They Differ

While the companies use similar data to calculate their ratings, no two systems are alike. For one thing, the companies use different scales. A.M. Best's system consists of 13 ratings that range from A++ to D. S&P's system includes 21 categories from AAA to C. Moody's system also includes 21 categories but it uses a combination of capital letters, lower-case letters, and numbers (from Aaa to C).5

The rating companies also differ in the methods they use to calculate insurer ratings. Two companies may consider the same factors, such as the macroeconomic environment, but one firm may attach more weight to it than another.

Because rating systems vary, it's a good idea to consider ratings from several companies when evaluating an insurer.

Comparison of Ratings

The top six ratings used by each of the five companies to evaluate insurers' financial strength are listed in the table below. The fact that ratings appear in the same row does not mean they are equivalent to each other. That is, S&P's AA rating may differ somewhat from Fitch's or KBRA's AA rating.

Ratings of Insurers' Financial Strength
FITCH	AM BEST	S&P	KBRA	MOODY'S
AAA	A++, A+	AAA	AAA	Aaa
Exceptionally strong capacity to pay financial commitments	Superior ability to meet ongoing obligations	Extremely strong financial security characteristics. Highest S&P rating	Extremely strong. Almost no risk of default	Superior financial security.
AA	Not Applicable	AA	AA	Aa
Very strong capacity to pay financial commitments	Companies rated A+ are one "notch" lower than those rated A++	Very strong financial security characteristics	Strong. Highly likely to meet financial obligations	Excellent financial security.
A	A, A-	A	A	A
Strong capacity to pay financial commitment	Very strong capacity to meet financial commitments	Strong financial security characteristics	Sound. Likely to meet financial obligations.	Good financial security.
BBB	B++, B+	BBB	BBB	Baa
Adequate capacity to pay financial commitments	Good ability to meet financial obligations	Good financial security characteristics	Adequate financial condition	Fair financial security
BB	B, B-	BB	BB	Ba
Elevated vulnerability to default risk but has flexibility to service financial commitments	Fair ability to meet financial commitments	Marginal financial security characteristics	Questionable financial condition	Questionable financial security. Needs improvement
B	C++, C+	B	B	B
Significant risk of default with limited margin of safety	Marginal ability to meet their ongoing insurance obligations.	Weak financial security characteristics	Weak financial condition	Poor financial security

Rating Limitations

The financial strength ratings are "forward-looking." That is, they are predictions of insurers' future ability to meet their financial obligations. An insurer's primary obligation is to make claim payments to (or on behalf of) policyholders. Insurers may also have contractual obligations to reinsurers and other parties.6

A credit rating is based on assumptions and is not a guarantee of an insurer's future performance. The assumptions underlying a credit rating may prove to be wrong.

The classifications used by rating firms are fairly broad, so each classification is likely to include a large number of insurers. For instance, hundreds of insurance companies may qualify for S&P's AA rating. While these insurers have similarities, they are not identical credit risks.

Insurance company ratings reflect insurers' financial ability to pay claims. They are not a measure of the quality of insurers' claim handling services. The fact that an insurer can pay claims does not mean it will do so efficiently or effectively.