UNDERSTANDING RATINGS CRITERIA ESSENTIAL FOR BUYERS, ANALYST SAYS

SOUTHAMPTON, Bermuda-Buyers that turn to rating agencies to ascertain the financial strength of insurers they deal with first need to know how those agencies arrive at their conclusions.

Several agencies rate the claims-paying ability and solvency of insurance companies, and each approaches the business in slightly different fashion and produces different types of ratings.

"We think that ratings are important because buyers deal with a lot of companies, and it's fair to know what's on our minds," said Alan Levin, managing director of Standard & Poor's Corp.'s Insurance Ratings Group in New York.

Risk managers need to ensure that the companies they deal with are secure, and one way to do that is to look at ratings, he said during a session at the Bermuda Insurance Symposium III, Feb. 18-21 in Southampton, Bermuda.

"Your chartered responsibility is making sure that you do not pay premiums, or fees, to these people and find out 10 years later that you have an uncollectible balance," he said.

Mr. Levin said that of the approximately 2,000 companies that S&P reviews, 63% are in the "secure" rating categories of BBB to AAA, with 14% in the AAA and AA categories and 49% carrying ratings of A to BBB.

The remainder are in lower rating categories.

However, even those companies in the "vulnerable" categories with less than BBB ratings are not necessarily at high risk of defaulting on claims, he said.

When we look at the history, "companies with a BB rating have a default rate that is twice as bad or twice as high as the default rate of BBB securities," Mr. Levin said. "But still, the default rate of BB securities is in the high teens, 16% to 17% after about eight or 10 years. Clearly that means that more than 80% of the BB securities that we consider vulnerable, or non-investment grade, will pay off, will not default and in insurance terms will be there to meet their obligations," he said.

Mr. Levin noted that many insurance market observers have focused in recent years on industry competitiveness, reduced profit margins and poor returns as indicative of weakness among insurers. But S&P in 1996 issued nearly twice as many upgrades as downgrades, he said.

In analyzing why, S&P found that the companies that earned a ratings upgrade focused on a narrow niche, either in product or geographic terms, that gives them a competitive advantage, he said. By contrast, companies with downgrades have little or no competitive advantages in the marketplace, significant expense issues or inadequate loss reserves.

Risk managers can look at several factors that rating agencies examine to determine the strength of their insurers, Mr. Levin said. Those include quantitative factors such as profitability, capital adequacy and loss reserves.

"Loss reserves are the great leveler in the industry. Companies need to be able to demonstrate that they can reserve their losses adequately," he said.

In addition, there are qualitative measures that are really the keys to determining the financial security of insurers, he said. Those include a company's cost control structure, whether it has competitive advantages in any area and how much control it has over its distribution system.

Keith Buckley, group vp of Duff & Phelps Credit Rating Co. in Chicago, assessed the strengths and weaknesses of the industry.

"The industry is generally well-capitalized, managements are generally knowledgeable about their books of business, we see good investment quality and liquidity in the industry, and the industry historically has been profitable," he said.

Among the weaknesses, according to Mr. Buckley, are that the industry is highly competitive, which is the root of a lot of current problems.

"The industry is also grappling with a number of tough risks, including catastrophes and the A&E issue," he said.

Other weaknesses are a moderate return on equity, and challenges to efficient distribution of their product, he said.

John H. Snyder, senior vp of A.M. Best Co. of Oldwick, N.J., reviewed how insurers are grappling with more persistent catastrophe exposures and how it affects the marketplace.

The rating agency views cat exposures as one of the most important factors in rating insurers, behind their asbestos and environmental exposures, he said.

John L. Ward, CEO of Ward Financial Group of Cincinnati, moderated the session.