The difference in rating scales and the underlying methodology of rating agencies often make insurance financial strength ratings across rating agencies incomparable at the 'A-' rating level particularly for small-sized insurers with total capital below US$250 million, says a report by Insurance Monitor.
About 40% (56 insurers) of the national insurance sector in the GCC carry financial strength ratings by significant rating agencies of which 20 insurers are UAE based, the report notes. At least 10 GCC insurers, particularly those with total equity exceeding US$250 million, maintain multiple ratings.
S&P and A.M. Best are dominant rating agencies across the GCC, followed by Moody’s with notably a higher rating activity in Kuwait, notes the report.
Generally, a minimum rating of ‘A-’ is the established rating standard by most rating users and represents the target rating for insurance companies.
The report notes that rating symbols used by rating agencies are similar in the use of alphabet letters as grades, however there are important differences to note in the rating scale and methodology. The rating scale used by S&P, Moody’s and Fitch is a 19-21 category scale that is fairly similar with the main difference being the use of positive and negative signs at ‘CCC’. A.M. Best on the other hand uses a 13 category scale.
The report says that A.M. Best is seen to have a much higher tendency to assign a rating of A- to smaller insurers and categorises insurance companies by Financial Size (Total Equity) while the other rating agencies generally do not assign a rating higher than BBB to insurers with total capital below $250 million as such companies are considered small. The view is that smaller companies are more vulnerable to competition from larger companies with greater resources, have less diversification and lower levels of financial flexibility, among other limitations.
Addressing the differences
The difference in insurer financial strength ratings at the ‘A-’ rating grade between rating agencies has the potential to encourage ratings shopping by insurers to obtain the highest rating. Ratings shopping can put ratings users at significantly increased risks when making a purchase or security decision, particularly in the case of smaller-sized insurers, where rating users may be exposed to a false sense of comfort.
One of the most effective ways to manage ratings shopping is for ratings users such as reinsurers, brokers, bancassurance partners, government entities and large corporate customers to strongly suggest that insurers obtain more than one rating.
The issue can also be addressed by insurance regulators in capital adequacy models which include credit risk-based capital charges for receivables on reinsurance ceded to non-affiliates based on the financial strength ratings of A.M. Best, Fitch, S&P and/or Moody’s, using an equivalency.
The ratings of insurers are based on the review of several factors including:
- capital adequacy, leverage and liquidity;
- reserve strength supported by actuaries;
- reinsurance, profitability and earnings;
- market positioning and peer benchmarks;
- investment spread and security;
- governance and management quality;
- risk management;
- dividend policy;
- ownership – financial strength of the parent company; and
- credit rating of the country of domicile (sovereign rating).
Ratings can be vital for insurance companies. A good rating is a marketing tool that can help obtain reinsurance capacity, attract new business and open new possibilities whereas a lower or deteriorating rating may put insurers out of business. Well managed and well capitalised insurers differentiate themselves from weaker counterparts by the financial strength rating assigned by rating agencies.
Ratings may also have an impact on the share price as investor sentiment is influenced by rating movements. Ratings further serve as an access tool to capital markets, for insurers looking to improve the earnings profile through balance sheet restructuring.