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