Featured Image

When Analyzing Insurance Companies, There’s More to Ratings Than Meets the Eye

Companies and Markets

By Joel Salomon, FSA  |  September 16, 2020

Is “adequate” adequate? This is not an existential question, but one every insurance analyst asks all the time. “Adequate” is the rating level of an insurance company that is considered investment grade. Being labeled as investment grade means that the company has a relatively low risk of defaulting on its obligations. In terms of bonds, an investment-grade rating is B++ (or higher) according to A.M. Best or Baa3 or higher according to Moody’s Investors Service or BBB- or higher according to S&P, Kroll, or Fitch Ratings.

These credit ratings represent the opinion from each rating agency that the company will be able to pay back its obligations (also known as its debt) in a timely manner, as contractually defined. This is a simple definition but there is a lot that goes into it. There are only a few companies around the globe that employ credit rating analysts to do the detailed work needed to examine companies and assign these ratings. To do this job accurately, the work entailed is voluminous.

These analysts consider the current and future profitability of the company, its current and future cash flow generation, and its current and future capital position. They also evaluate the sensitivity of all these amounts as well as the company’s assets and liabilities to various future economic and interest-rate scenarios.

Having done this, they then assign a letter rating to the creditworthiness of the company, with “aaa,” “AAA,” or “Aaa” being the highest rating depending on which rating agency you prefer. This rating is also known as “exceptional,” “highest quality,” or “extremely strong.”

Credit Rating vs. Financial Strength Rating

A Financial Strength Rating (FSR) is the rating assigned to insurance companies. Some analysts call this the “Claims Paying Ability (CPA)” rating which then becomes self-explanatory. This rating measures the company’s ability to pay its claims or losses in a timely manner. It is an independent opinion issued by a rating agency like A.M. Best, Moody’s, S&P, Fitch, or Kroll Ratings.

An FSR is not the same as a bond rating. An FSR is only assigned to insurance companies while bond ratings apply to any corporation that has issued a bond. Rating agencies assign ratings to bonds that implicitly assign a probability to that bond getting repaid by the corporation that issued it.

An insurer financial strength rating (sometimes known as an IFSR) is applied to the company, not an instrument, though insurers can, of course, issue bonds themselves.

You should care about an FSR—even if you are an equity analyst or equity portfolio manager. If you know all the drivers of the financial strength of an insurer and you can predict when and how it will be upgraded (or downgraded) you have a distinct advantage over other equity analysts who generally don’t pay attention to FSRs—especially when there haven’t been more downgrades than upgrades across the insurance industry in almost 10 years.

Is There Really a Rating Cliff?

Insurance analysts know the term “rating cliff” very well. It means that if the company is downgraded to a certain level, the insurer is effectively “out-of-business” because either consumers won’t buy their product or other companies won’t do business with them.

In the insurance business, various product lines have a rating cliff. For example, a reinsurer that is downgraded below A- (“Excellent”) on A.M. Best’s FSR scale is unlikely to be able to do business with insurers since their counterparts will take that company off their approved list of reinsurers. Those with ratings below A- are considered just “adequate” in their ability to pay claims.

Similarly, a life insurer that is selling a guaranteed investment contract (GIC) is unlikely to be approved by the plan administrator in the employee benefits department of corporations unless they have an FSR of A- (though some have even more stringent criteria like a single A [without the “minus”]).

Most bond investors will say that relying on one rating agency’s rating is not enough. While the analysts from the different rating agencies may have similar opinions, they may not always agree. Therefore, it’s often helpful to consider the other information they provide.

Rating Modifiers

Rating agencies are helpful, usually letting you know when their opinion is about to change by telling you the rating is “Under Review.” If they are likely to upgrade the company’s FSR, they will tell you: it is “Under Review with Positive Implications,” which means they are likely to upgrade the FSR within a fairly short period of time—about 12-18 months. If they are likely to downgrade the company’s FSR, they will tell you it is “Under Review with Negative Implications,” which means it is likely to be downgraded. “Developing Implications” means there is uncertainty as to the outcome of the review.

Opinion outlooks are also helpful in giving you an idea of the trend. However, these may or may not result in a change in the rating and they are likely to take up to three years to conclude. Opinion outlooks can be “positive,” “negative,” or ”stable.”

What Causes a Rating Change?

There are plenty of reasons why ratings can change. Here are just a few:

  1. M&A. An insurer acquires another insurer that has much weaker (or stronger) FSRs causing a downgrade (or upgrade) of the acquiring company.
  2. Reserve charges (aka reserve deficiencies) are likely to cause a downgrade especially if they represent a meaningful share of current reserves and capital.
  3. A reduction in capital is likely to cause a downgrade just as a jump in capital can cause an upgrade.
  4. A meaningful drop in profitability will likely cause a downgrade.
  5. The risk-based capital ratio dropping below a specific level will likely cause a downgrade. Note that each rating agency also has its capital model with A.M. Best’s being the most popular and known as the BCAR (“Best’s Capital Adequacy Ratio”).

An insurance company rating of “adequate” doesn’t give you the information you need to properly evaluate insurance companies and their subsidiaries. Be sure to look at all the available rating information for a complete picture.

Partner Reinsurance Ratings


New call-to-action

Joel Salomon, FSA

VP Principal Content Manager, Fundamentals Policy & Integration

Mr. Joel Salomon is the Principal Content Manager for Insurance at FactSet. In this role, he is responsible for integrating U.S. statutory and international regulatory data into the system. He joined FactSet in 2019 and prior to that, he worked as an actuary at New York Life Insurance Company, a credit analyst at Moody’s Investors Service, a credit risk manager at Swiss Re, managed a long/short equity and credit portfolio for Citi, and was a prosperity coach. In 2012, Mr. Salomon launched his hedge fund, SaLaurMor, and in 2019, published The 9 Money Rules Millionaires Use: Only The Unconventional Ones, which was a bestseller in both self-help and personal finance. Mr. Salomon is a CFA charterholder since 1995, a Fellow of the Society of Actuaries, and earned a Bachelor of Arts in Mathematics and Statistics, graduating Magna Cum Laude from the University of Rochester.