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Friday, September 2, 2011

Understanding Insurance Company Financial Ratings

Understanding Insurance Company Financial Ratings
by Richard F. O’Boyle, Jr., LUTCF, MBA

Triple A, Gone Away

Well, it’s official: The United States Government no longer has a perfect credit score. On August 5, 2011 its credit rating was lowered by Standard & Poor’s to AA+ from AAA. The rating on the debt of the federal government and some specific agencies such as mortgage giants Fannie Mae and Freddie Mac was lowered because S&P deemed it more risky due to the ballooning federal debt and the inability of the political process to reform entitlement programs.

In theory the four top rating agencies – Standard & Poor’s, Moody’s, A.M. Best and Fitch’s – are the arbiters of the Country’s credit score. Despite all the sound and fury from the politicians in Washington, there are some real-life implications for people on Main Street. The lowering by S&P by one notch effectively brings the country’s FICO score down to something like 775 from 800.

It’s not that dramatic since only one of the top four rating agencies took such a drastic approach (the others said the Government’s problems are long-term and would not immediately affect their ratings). I’d like to note that some smaller agencies had already taken the politically unpalatable step of lowering the country’s rating. Let’s also keep in mind that S&P has been under serious political pressure to “get real” about its rating since it did such a pathetic job of rating all of those toxic mortgage-backed securities (see “The Big Short”).

Given all of the political pressure from Congress regarding the mortgage securities fiasco of the last three years, it’s ironic that they should come to downgrade the U.S. Government’s rating. Expect to see “show trials” (i.e., Congressional hearings) in Washington demonizing the rating agencies. Again, it’s ironic since the U.S. has been less than reliable when accounting for future liabilities such as Social Security and Medicare.

But, again, let’s put politics aside and investigate the “real life” implications of the aforementioned “downgrade:”

Insurance Company Ratings: What Do They Mean?

In tandem with the downgrade of the Government’s credit rating, S&P also lowered the AAA rating of a handful of the most stellar insurance companies. They also put the rest of the insurance industry on a “Negative” outlook (downgraded from “Stable”), mainly because of the heavy exposure they all have to U.S. securities in their reserve portfolios.

Companies downgraded to AA+ (Negative Outlook) from AAA (Stable Outlook):
New York Life
Northwestern Mutual
Teachers Insurance & Annuity Association (TIAA-CREF)
Knights of Columbus
United Services Automobile Association (USAA)

Companies rated AA+ with “Stable Outlook” reduced to “Negative Outlook:”
Guardian Life Insurance Company of America
Berkshire Hathaway, Inc.
Assured Guaranty Corp.
Massachusetts Mutual Life Insurance Co.
Western & Southern Financial Group, Inc.

Does this mean that your life insurance company is about to go bankrupt ? Most likely, not. What it does mean is that S&P has decided that insurance companies that invest heavily in one country’s bonds can not have a higher credit rating than the actual bonds that they hold. So, in lockstep, if the U.S. rating goes down, so must the companies that hold a lot of U.S. debt. Needless to say, the affected insurance companies say they are unfairly being hit due to Washington’s political gridlock and that they still merit AAA ratings.

Going forward, the insurance companies will bolster their overall credit ratings by selling off their lower quality assets and buying higher quality ones. This may effectively improve their balance sheets over the long term and even increase their exposure to U.S. debt instruments. S&P maintained AAA ratings on many municipal bonds, so there still are high-quality assets for the insurance companies to put into their reserves. The reason the top handful of companies actually had the best ratings is that often they are better judges of quality than even the rating agencies.

The lowering of the U.S.’ credit rating, in the immediate term, has not led to a sell-off in U.S. Treasury assets. But indeed, we have seen a “flight to quality” as many investors see the U.S. Treasury Bonds as the “cleanest shirt in a hamper full of dirty shirts.” (I believe I can credit economics guru Nouriel Roubini for this analogy on Bloomberg Radio). In effect, U.S. assets at AA+ are still better quality than many European bonds.

Ultimately, the jury is still on whether interest rates on mortgages and credit cards will spike up. Longer term interest rates will be affected more by the strength or weakness of the overall economy and the amount of stimulus provided by the Federal Reserve and Congressional budget committees.

Why Ratings Still Matter

So why do we even care about ratings attributed to countries or businesses or individual financial products? Haven’t the rating agencies done an awful job to date? Are the folks with the green eyeshades who are crunching the numbers and giving their seal of approval so corrupted by the profit motive or fearful of political retaliation that they can’t “do the math” objectively?

In short, there are two reasons: First, we need some type of financial yardstick to compare countries, companies and bonds. There really are no guarantees associated with a rating of “AAA,” for example. It’s just a relative measure and only useful when compared to something with a “B+,” for example. Secondly, a rating gives us the assurance that someone who is somewhat objective with some kind of sophisticated financial education has looked at all the footnotes and read all the fine print… because G-d knows nobody else has (sometimes not even the salespeople). Of course, recent events have dramatically shown that the current system has failed. Unfortunately, it’s the only system we have.

So let’s take a look what the ratings of life insurance companies really mean. Given the hundreds of life insurance companies offering policies in the U.S. it can be a challenge to compare their relative financial strengths and ability to pay claims. The top rating agencies review in detail the accounting statements of publicly traded companies as well as private or mutual life insurance companies. Based on their reviews and further research into competitive intelligence and other sources, they will give an opinion on the credit-worthiness of the life insurance company and assign letter grades to each company and its subsidiaries. Furthermore, agencies will often note what direction they think future rating will head in their “outlook” for the company or industry.

Keep in mind that while the core attribute the rating agencies look at is “financial strength,” they also take into account how well the company operates as a business, the size of their market share, exposure to other businesses (such as investment management advice or property & casualty lines) and overall business mix. For example, every year, S&P positively noted New York Life “outstanding field sales force” as a competitive advantage.

How to Compare Life Insurance Company Ratings From Different Agencies

I’m a big fan of the old adage, “Life is too short to drink bad wine.” With the hundreds of available life insurance companies out there, does it make sense to go with a middle-tier company when there are already so many top-notch ones? Similarly, with all the five star mutual funds rated by Morningstar, why would you invest in a three star fund? A life insurance company’s rating is effectively a guide to its underlying financial strength and its ability to pay its claims when the time comes for you to collect the death benefit.

Keep in mind that many companies have subsidiaries that have similar sounding names (often due to state regulations or their own business strategies). When researching your specific company make sure that you are looking at the actual company that is underwriting the life insurance contract. For example, “MetLife” may actually be “MetLife Investors” if it is the 30-year term plan in New York. Your agent should be able to give you the exact company name. Your state insurance commission will have regular filings from each company that sells life insurance it that state.

Each rating agency uses its own proprietary methodology and mathematical model to assess the strength of the insurance companies they review. They look at factors such as the quality of the insurer’s assets and reserves; their source(s) of funding; profitability based on a review of public financial records and filings; market share in different product categories; management talent; and competitive market analysis compared to other insurers.

Here’s how the various rating agency “grades” match up:


Rank


A. M. Best


Standard & Poor's


Moody's


Fitch


Numerical Grade (*)


Comdex Score (#)


1


A++

Superior


AAA

Extremely Strong


Aaa

Exceptional


AAA


9.0


100


2


A+

Superior


AA+

Very Strong


Aa1

Excellent


AA+


8.3


 


3


A

Excellent


AA

Very Strong


Aa2

Excellent


AA


8.0


90


4


A-

Excellent


AA-

Very Strong


Aa3

Excellent


AA-


7.7


 


5


B++

Good


A+

Strong


A1

Good


A+


7.3


 


6


B+

Good


A

Strong


A2

Good


A


7.0


80


7


B

Fair


A-

Strong


A3

Good


A-


6.7


 


8


B-

Fair


BBB+

Good


Baa1

Adequate


BBB+


6.3


70


9


C++

Marginal


BBB

Good


Baa2

Adequate


BBB


6.0


 


10


C+

Marginal


BBB-

Good


Baa3

Adequate


BBB-


5.7


 


11


C

Weak


BB+

Marginal


Ba1

Questionable




BB+


5.3


 


12


C-

Weak


BB

Marginal


Ba2

Questionable




BB


5.0


40


13


D

Poor


BB-

Marginal


Ba3

Questionable




BB-


4.7


 


14


E

Under Regulatory Supervision


B+

Weak


B1

Poor


B+


4.3


20


15


F

In Liquidation


B

Weak


B2

Poor


B


4.0


 


16


S

Suspended


B-

Weak


B3

Poor


B-


3.7


 


17


 


CCC+

Very Weak


Caa1

Very Poor


CCC+


3.3


 


18


 


CCC

Very Weak


Caa2

Very Poor


CCC


3.0


 


19


 


CCC-

Very Weak


Caa3

Very Poor


CCC-


2.7


 


20


 


CC

Extremely Weak


Ca

Extremely Poor


CC


2.0


 


21


 


 R

Regulatory Action


C

Lowest


C


 


 


(*) Numerical Grade conversions courtesy of The New York Times
(#) Comdex ranks insurance companies based on what other rating agencies have given them. The companies are then graded on a percentile system with only the top five companies in the 100th percentile, and others falling into the scale below that. The placement of the numerical rankings in the chart is my approximation.

Links to Rating Agencies
AM Best
Fitch
Moody’s
Standard & Poor's
Weiss
Comdex Score

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