First thoughts on how brokers should consider the financial health of insurers
In certain jurisdictions we have seen an increasing regulatory and market focus on the financial health of insurers, increasing the risk that brokers the blame for using an insurer that fails.
In this discussion document, Litmus offers some basic thoughts to help brokers address this across three areas – the use of ratings, the use of unrated carriers, and systems to manage the market security function.
Litmus stresses that we are not lawyers and in providing these thoughts we are not offering any form of legal advice.
Use of Ratings
Whether the use of well rated paper covers a broker’s liability for use of an insurer that subsequently fails is not something we are qualified to say. That said, the major agencies have a profound degree of global knowledge and experience around the quantitative and qualitative issues that drive insurer failure, and large teams of expert insurance credit analysts. Therefore, it seems inherently reasonable that a broker would place weight on a rating from such an agency. However, as with any other expert source a broker chooses to rely on, how they use and understand ratings is surely very important.
The Litmus team’s decades of experience in rating agencies and working with major broker market security teams on their use of ratings suggests to us the following points are issues all brokers should consider when using ratings:
o Ensure that the legal entity you are offering to your client as the carrier is the same as the rated entity. Do not simply accept a statement like “we’re part of XYZ Insurance Group which has an ‘A’ rating” – the rating may not apply to the subsidiary.
o Make sure the rating you are referring to is current. You can check ratings on the rating agency public websites. Ratings are under ‘ongoing surveillance’ – they can change at any time. The assignment of ratings by the major agencies is not an annual event (even if their normal practice is to conduct a formal review annually).
o Understand the fundamental implication of the “tail” of the cover when deciding the rating level you consider to be acceptable. S&P’s research on how frequently rated insurers have failed shows that “BBB” range insurers did so as frequently over 2 years as “A” range insurers have over 4 years (0.73% and 0.77% default rates respectively).
o Understand that ratings are not being assigned on the basis of the risk of an insurer going into run-off, but rather on their prospective ability to pay valid policyholder claims in full.
o Look out for the ratings ‘outlook’ – it can carry an important message about the potential for the rating to change in the short to medium term.
o Understand that ratings are not facts – they are opinions on the future probability of the ability to meet policyholder obligations. Like any view of the future, that cannot and will not always prove to be correct.
For non-life insurers a particular challenge for auditors, boards, regulators and rating agencies is reserve adequacy. Occasionally, fraudulent behaviour by an insurer’s leadership can lead to all these stakeholders simply being given data that is profoundly and deliberately misleading. More commonly the range of variables involved in reserve setting can mean that even taking a prudent view of what is required turns out to be insufficient.
o Consider that you may have important knowledge and insight not readily available to a rating agency – for example, if you see a rated insurer habitually undercutting the rest of the market, or moving into new, risky classes, or clearly displaying poor risk-selection, the rating agency may not know. You may be able to take action before the bad news – in the form of underwriting losses or large holes in their reserves – shows up.
o Finally, learn about ratings. Litmus offers a free ‘Guide To Ratings’ – get in touch and we’ll happily provide you with a copy.
Ratings are a very valuable piece of information, but only an opinion. Being rated even in the “A” range does not mean an insurer will not fail, and neither does being unrated mean that it will, although just observing historical failure suggests that unrated carriers tend to fail more often than well rated carriers. A duty of care to a client may well include some consideration of an unrated insurer that is materially cheaper (for the same cover). Although why it is cheaper is, as noted below, a very important consideration.
In our experience the simple fact of an insurer being regulated is generally not seen (by the regulators themselves) as a “greenlight” for brokers to use them without any further consideration.
Accordingly, we make the following suggestions around broker due diligence on unrated carriers:
o Consider undertaking or commissioning some analysis from a suitably qualified credit professional or company.
o Look at the Solvency and Minimum Capital Requirement ratios published under Solvency 2, but remember that you need to understand properly what they mean and cover (and therefore what they do not). Like ratings these are not a panacea.
o Monitor the amount of exposure you and your client have to each unrated insurer. Consider the extent to which you might want to limit this.
o Consult your E&O insurers in terms of their views on your exposure when using unrated insurers and what you are actually covered for.
Managing market security
The above will have highlighted some basic actions or practices we suggest that you might consider.
In addition, we would suggest that there are some important operational considerations:
o Having a member of staff explicitly responsible for the market security function, with their responsibilities clearly laid out. This individual (or team, in larger organisations) would logically either have the relevant background or have undertaken some training in respect of ratings and the basics of insurer financial analysis.
In medium sized and smaller brokers this may naturally be seen as sitting with the finance director. But, with the greatest respect to broker finance directors, understanding how to interpret an insurer’s accounts for the purposes of assessing their likely creditworthiness is a specialist subject: some may well have the relevant expertise but that would not simply be a function of being a senior accountant working in the insurance industry.
o Having systems in place, including:
- Clear guidelines on your market security processes and documentation that demonstrates your understanding of the effective use of ratings and/or regulatory capital ratios (and any other sources of opinion or assessment).
- A policy on how and why a given rating level is deemed acceptable (and from which rating agencies), with consideration of the rating level by type of business (and hence duration of policyholder exposure).
- A policy on the use of regulatory capital ratios and the nature of reviews of relevant supporting information (such as the Solvency and Financial Condition Report for insurers – SFCR – covered by Solvency 2)
- A regular meeting to consider your clients’ exposures. This should include senior management and be capable of making important decisions about which insurers you should use.
- A policy on, and a defined process for, how you communicate with clients about rating, regulatory capital ratios or other perceived changes to the financial health on the insurer(s) you have placed their business with.
- A method for monitoring ratings and regulatory capital ratios on a regular basis.
- Suitable ongoing training for all personnel involved in carrier selection decisions.
Very interesting article, Peter, and there’s some great advice here.
We do not advocate that insurer security analysis is only about avoiding blame when things go wrong. Rather it is simply good professional broker practice to have regard to the ability of an insurer to do what it implies on the can; to pay claims promptly when they happen.
But when a claim is not paid and the security of the insurer comes into question, the broker that can show how and by whom its diligence in security monitoring is conducted in practice will be in much better shape to protect itself from blame.
Whether we like it or not the customer or client, their professional advisers, regulators, lawyers and ultimately the court , will all expect a competent insurance broker to have taken specific steps as part of its business model, to avoid arranging insurances with insurers that may not meet their financial obligations.
No amount of due care and diligence by a broker will guarantee that the “security” of the recommended (or only available) insurer/s meets its financial obligations. That is unrealistic.
Rather, the fact that the broker can show, when required, how it had due regard for the importance of the underlying security of insurance companies with whom it trades will stand it in good stead to both meet criticism and demonstrate professionalism.
One more tip! If the only insurer available to meet the client’s demands and needs is security you would otherwise NOT recommend, at least make a detailed record of the transaction and correspondence with the client about the risks and their acceptance of the possible consequences, before you use it.