The dilemma insurance brokers face when carriers are downgraded; how should they react?

The related issues of the identification by some carriers of inadequate reserves, and consequent ratings downgrades (or the ongoing risk of these) have highlighted an old problem for many brokers; how, if they use as their base case a minimum rating level of ‘A-‘ (as many do) for their level of automatically accepting carrier security, should they react to a downgrade of a previously ‘A range’ carrier to the ‘BBB range’?

Clearly one reaction is that they should not overly rely on ratings and should be forming their own views; but for most brokers that is not really tenable, especially when it would require the analysis of a complex re/insurance group. We see a range of approaches being used by brokers to assess market security, but, most commonly we observe a reliance on a minimum rating level (generally ‘A-‘) OR a process which involves gaining policyholder approval for the use of re/insurers rated lower, or not rated at all.

However a particular challenge exists when the re/insurer had been rated in the ‘A range’ but then falls to the ‘BBB range’ level.  It is generally unrealistic to expect a ‘client approval’ approach to work with all but the larger and more sophisticated buyers and why would they not simply chose to move their business if the broker is now unwilling to recommend the security? Especially, if higher rated alternative capacity can be found at anything approaching the same price.

The fact that a re/insurer is regulated might be something the broker will feel they can base a recommendation on.   But most regulators (including the PRA in the UK) do not take a ‘zero failure’ regulatory approach.  While they try and minimise the risk of re/insurer failure they do not set their capital and other requirements at levels that mean they indicate there is no chance of such a failure.

 Since brokers have a ‘duty of care’ to policyholders when selecting a suitable re/insurer, the lack of a ‘zero failure’ regulatory regime seems to imply that they should do more than simply assume that regulation solves the market security question for them (which is why many use ratings as an extra source of input to begin with).

However at Litmus we view that the perceived difficulty for brokers in how to react to ratings downgrades comes to a material degree from a wider lack of market understanding of ratings themselves. Ratings are, simply, opinions about the future; in other words forecasts. Forecasts by experts are routinely used as key inputs into business decisions but users of forecasts should never lose sight of the fact that they are not ‘facts’.  The tendency towards using ratings as if they were a green/red indicator (above a certain rating level, fine; below that level, a problem) simply mischaracterises what they are and how they should be used.

Since they are ‘forecasts’, ratings are in practice providing views as to the most likely outcome from a range of possibilities. In addition the rating agencies have very extensive data on what the potential of expected outcomes at different rating levels are. From S&P’s data we can see that the  chance of an ‘A-‘ defaulting over a one-year period has been  0.07%, whereas the chance for a  ‘BBB+’ has been  0.14% (see below*).  So, an S&P rating change from ‘A-‘ to ‘BBB+’ is implying that the agency sees some increase in default risk; but not that the prior credit risk was profoundly lower than the new risk. The policyholder is, in fact, always taking a credit risk when buying re/insurance (though for personal and compulsory lines that is partially covered by a government guarantee).

The downgrade means the agency is now forecasting a somewhat higher degree of credit risk. However the extent to which that is a material change for the policyholder such that a change of carrier should be sought, is – it seems to us - something the broker should evaluate in the light of the data.  Far from this being a subject most brokers feel they cannot be expert in, we would suggest that providing such guidance to policyholders is no different from considering the risks of different types of cover, exclusions, limits or other terms and conditions, as are related ratings issues such as where a given carrier is rated below the level of other members of the group OR where one rating agency has a significantly higher or lower rating on a carrier than another OR whether different views of desired rating should exist for different lines of business.

Clearly for many brokers carrying the analytical resources necessary to conduct their own full analyses of re/insurer financial health is not likely to be possible. But that’s a very different issue from expecting brokers to have a good understanding of what ratings mean in practice and, hence, how they can constructively advise their clients as to what they imply about the suitability of the cover on offer.

*Source: Standard & Poor’s. Litmus Comment: the application of generic bond default data to the risk of rated insurers not being able to pay claims is challenging in that the point at which an insurer is in default in terms of claims payment is hard to define. Moreover ‘financial strength’ ratings address the ability to pay valid insurance claims, not willingness to pay. Nonetheless the data is generally seen as being a good proxy for insurer default risk.


Peter Hughes's picture

Peter is a Managing Partner of Litmus Analysis a specialist ratings advisory, consultancy, training and online application provider focused on the insurance industry.

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