The rating agencies and the analysts they employ are the Aunt Sally of the insurance world: For example, ask your JLT Re rep to tell you the one about the cat modeler, the actuary, and the rating analyst. It’s the rare bit of bland industry humor not aimed directly at actuaries (but don’t expect laughs). Is the ridicule justified? Are rating agencies merely quasi-regulatory gatekeepers, devoid of insight and value to the industry?
What good is a rating?
For many (re)insurers, the rating agencies’ main product, a Financial Strength Rating (FSR), is a pearl without price, as critical as a license in many domiciles and with certain (re)insurance buyers. Regulators around the world reinforce this value by making the rating a de facto or even a de jure operating requirement for insurers and reinsurers alike.
But is the value of a rating measured simply by the market access it provides or the savings afforded on fronting fees? Granted, a five-percent fronting fee looks like a pot of gold and may represent the entire expected margin at this point in the market cycle, but is there no other tangible value in ratings? If so, does this value exceed the additional capital and opportunity costs involved with maintaining the rating? If not, why do we perpetuate our credence in and reliance on ratings? And why do many (re)insurers maintain ratings several notches above the minimum requirement for their target business? This edition of Strategically Thinking will provide some food for thought on this subject.
It’s clear that ratings are highly correlated with profitability. Unfortunately, this positive correlation is clear and consistent only for one small segment of the insurance market: The rating agencies. Of the (U.S.) nationally recognized statistical rating organizations (NRSROs), currently: Standard & Poor’s, Moody’s Investors Service, Fitch Ratings, Kroll Bond Rating Agency, A.M. Best Company, Dominion Bond Rating Service, Japan Credit Rating Agency, Egan-Jones Rating Company, Morningstar & HR Ratings de México, only Moody’s is publicly-traded. Taking Moody’s as a conservative proxy for the wider rating agency sector, we can see that rating agencies consistently outperform publicly-traded firms in all other major segments of the economy.
As illustrated below, Moody’s had an average quarterly net profit margin of nearly 25% over the past six years, outstripping all other economic sectors’ margins that ranged between 6% and 14%, and beating out Apple, Google, JPMorgan, Berkshire Hathaway and other market darlings. Moodys’ results are even more impressive given they include a large legal settlement. Clearly, it pays to be a seller of ratings, even in the worst of times.
Where are the customers’ yachts? Quantification of marginal rating value
Unlike insurance financial strength ratings, other classes of ratings carry quantifiable economic value for the buyer. For example, we can see the value of credit ratings in the debt market by comparing bond yields. As illustrated below, corporate bonds rated “AAA” currently trade at an average yield of 3.63% (September 2017), not far above the 10-year Treasury rate of 2.17%. The yield jumps to 4.31% at the “BAA” (BBB) level and catapults to over 10% at “CCC”. As these yields translate directly into costs of capital for issuers, there are clear economic advantages to securing higher ratings, all else equal.
Do higher-rated issuers command a similar premium in the insurance industry? It’s complicated. While higher ratings typically equate to stronger risk-based solvency positions, and thus imply lower credit risk, pricing in the (re)insurance market is not explicitly tied to ratings. Credit rating analysts may argue that this is due to the meddling of intermediaries and follow-the-leader syndication, and this is indeed typical of other risk-taking in financial services industries. Mirroring the insurance sector, highly-rated banks have greater access to large and potentially more profitable programs, but are otherwise price-takers in the market. Competition, facilitated in part by intermediaries in both sectors largely maintains a level playing field in pricing power.
The value of financial strength ratings beyond market entry thus hangs on the notion that improved access afforded by high ratings translates into significantly superior operating results over the long term. To test this hypothesis, we studied eleven years of data for over one thousand rated (re)insurers and determined that there is indeed a positive but inconsistent long-term correlation between ratings and operating performance. As illustrated below, mean combined ratios trend downwards as FSRs improve, albeit with some variation across major lines of business. The liability and workers’ compensation trend lines suggest that better access may not always be a good thing, particularly when it is access to large and, in retrospect, underpriced or emerging casualty risks.
The correlation is consistently most pronounced in retail lines, with the highest-rated carriers’ mean combined ratio 17.5 percentage points lower than the lowest-rated carriers. Setting aside other factors that influence ratings such as group support, capital structure and credit cycle, we find that insurance financial strength ratings have a positive correlation, including a strong Granger-causal relationship, with broad underwriting performance. Even Granger-causality only captures forward-looking correlation, however, and it is clear that causality can and does go both ways: with higher ratings both enabling better operating performance and better performance eventually leading to higher ratings.
The figure above provides further indication of the positive correlation between ratings and underwriting performance and hints at some of the trade-offs involved with maintaining higher ratings: The gap between underwriting return on revenue and underwriting return on equity at the higher rating levels is evidence of excess or inefficiently-deployed capital at these levels. A topic for another time.
Extrapolating historical results with regression analysis, we have derived expected ranges of underwriting returns on revenue (net premiums earned) at each major rating level over the cycle and across all lines of business.
Note: averaging naturally flattens peaks, so these expected results assume relatively low levels of insured catastrophe losses and flat-to-favorable accident year results.
While the question of capital-adjusted value must wait for now, there appears to be clear competitive advantages to maintaining higher ratings, regardless of causality. Indeed, we have worked with many (re)insurers that—in preparation for initial ratings or in pursuit of upgrades—have seen material underwriting performance improvement result from rather prosaic adjustments. These adjustments include written (and followed) underwriting guidelines, efficient loss controls, and fair and transparent claims handling.
If you would like help with your firm’s ratings, please speak with a representative of JLT Re. Our ratings advisory team has an unmatched track record when it comes to assisting (re)insurers with initial ratings, upgrades, and ratings defense. Firms around the world rely on our expertise and practical solutions to achieve their ratings and strategic goals.
We hope you enjoy Strategically Thinking. Our goal is to provoke thoughtful discussion on a wide range of issues that concern the global risk management and (re)insurance community. Feedback is always welcome.
“We don’t see things as they are; we see them as we are.” –Anais Nin
Mark Shumway, Global Head of Strategic Advisory | T: +1 215 309 4535 | E: firstname.lastname@example.org
Ernest Eng, Head of Analytics & Strategic Advisory Asia | T: +65 6411 9314 | E: email@example.com
Nicholas Dranchak, Senior Vice President Strategic Advisory |T: +1 215-309-4583 | E: firstname.lastname@example.org
JLT Re (North America) Inc., (“JLT Re”) and any of its affiliates or subsidiaries as applicable (collectively “JLT Re”) provides this publication for general informational purposes only. This publication and any recommendations, analysis, or advice provided by JLT Re are not intended to be taken as advice regarding any individual situation and should not be relied upon as such. The information contained herein is based on sources we believe reliable, but we make no representation or warranty as to its accuracy. JLT Re shall have no obligation to update this publication and shall have no liability to you or any other party arising out of this publication or any matter contained herein. Any statements concerning actuarial, tax, accounting, or legal matters are based solely on our experience as reinsurance brokers and risk consultants and are not to be relied upon as actuarial, tax, accounting, or legal advice, for which you should consult your applicable professional advisors. Any modeling, analytics, or projections are subject to inherent uncertainty, and the information contained herein could be materially affected if any underlying assumptions, conditions, information, or factors are inaccurate or incomplete or should change. This publication is not an offer to sell, or a solicitation of any offer to buy any financial instrument or reinsurance product. If you intend to take any action or make any decision on the basis of the content of this publication, you should seek specific professional advice and verify its content.