Core elements of difference in A.M. Best and S&P rating criteria
On 10 March 2016 A.M. Best published its draft insurance rating criteria for public comment. The initial comment period closed on 30 June and updated criteria reflecting Best’s reactions to the comments, and a further comment period, are expected later this year, with the stated goal to release and implement the final criteria in early to mid-2017. Best is also revising its non-US capital model (the “Universal BCAR”) in line with changes being made to its US models.
Like S&P, which implemented a revised methodology for rating insurance companies back in 2013, A.M. Best aims to provide greater transparency on how individual rating factors are combined and incorporated into the final rating analysis. Although the methodologies are likely to become more closely aligned, some key differences still exist, in part as the agencies bring together the component parts of their analytical criteria differently. In this article we briefly summarize the key features of A.M. Best’s proposed framework and compare and contrast them with S&P’s rating methodology.
Where They Differ…
Balance Sheet Strength remains the baseline for A.M. Best’s rating
A.M. Best continues to consider an insurer’s balance sheet strength as the foundation for its ability to meet its obligations. Consequently, the analysis of balance sheet strength is the first step of the agency’s proposed methodology, representing the “baseline” to the rating. In effect all other rating factors act as a series of “modifiers” to the balance sheet position (although as noted later that modification can be very considerable). The non-balance sheet factors act, in particular, to provide the prospective view.
By contrast, S&P starts its analysis with an evaluation of a company’s business risk profile (BRP), which it regards as the basis for a company’s future success. The financial risk profile (FRP) is viewed as the result of the decisions a company makes because of its BRP and comes as the second building block. The BRP and FRP combined determine the “anchor” to the rating.
S&P also explicitly focusses on a prospective view (2 year-out) of the capital model as its “base case”for capital adequacy.
A.M. Best ratings have no explicit link with sovereign ratings
One of the key differences between A.M. Best and S&P remains the absence of a specific link to a sovereign’s credit rating under A.M. Best’s methodology, whereas under S&P’s criteria the relevant sovereign rating could constrain the rating if the company failed to pass a hypothetical sovereign default scenario. This is a separate part of S&P’s analysis to the Industry and Country Risk noted later. Best, by contrast, sees Industry and Country risk as the primary source of constraint.
A.M. Best’s maintains a more qualitative approach to evaluating size
Both agencies factor size into the analysis, although in different ways. A.M. Best appears to remain more qualitative and case specific in its approach. Under its proposal it does, however, introduce an explicit cap for rating units with less than $20 million of surplus, which will not be eligible for the highest balance sheet assessment.
S&P’s methodology is more explicit and includes various generic size limits, which could significantly constrain the rating. For example the capital and earnings assessment is generally limited to “moderately strong” if total adjusted capital is consistently below $100 million and limited to “lower adequate” if total adjusted capital is below $25 million.
A.M. Best will maintain operating performance as a separate rating factor
Under A.M. Best’s proposed methodology operating performance remains a separate rating factor reflecting the agency’s view that earnings are a lead indicator for a company’s prospective financial stability and considered to be the most important source for generating capital.
S&P on the other hand abandoned “Operating Performance” as a separate rating factor when it introduced its new criteria. Instead it combined capital and earnings into one rating factor, reflecting its focus on a company’s willingness to retain earnings and effectively employ them. Operating performance is analysed on an absolute basis when determining a forward-looking view of capital adequacy. In addition, relative operating performance – as a quantitative indicator of a company’s ability to outperform the market – is a sub-factor of S&P’s assessment of an insurer’s competitive position.
A.M. Best captures industry and country risk in different parts of the analysis
Both agencies analyse industry and country risk, although in different parts of the analyses (this is a different issue to the sovereign rating constraint noted earlier). A.M. Best methodology (via its “Country Tiers”) includes the evaluation of country risk as an important overlay when determining a company’s balance sheet strength. It is also factored into the analysis of operating performance and together with industry risk in the evaluation of the business profile.
In contrast, S&P introduced the Insurance Industry and Country Risk Assessment (known as IICRA) as a separate rating factor to explicitly address the risk instead of implicitly as was previously the case.Together with the evaluation of a company’s competitive position the IICRA determines an insurer’s BRP.
Business Profile (A.M. Best) is not the same as Business Risk Profile (S&P)
In addition to the different application of industry and country risk through the analysis, Best’s Business Profile review also includes factors such as strategy and management that S&P handles separately within its Management & Governance analysis.
Liquidity is part of Balance Sheet Strength
Under A.M. Best’s proposal the analysis of liquidity is a component of a company’s balance sheet strength, whereas a low liquidity ratio could potentially be a cap to the rating under S&P’s criteria.
…What They Have In Common
Both agencies stress that analytical judgement remains an important part of their respective methodologies, embedded implicitly and explicitly in different parts of the analysis.
A.M. Best is proposing to introduce the so-called “comprehensive adjustment” to capture any strength or weakness which might not have been covered elsewhere in the analysis. Similarly, S&P applies its so-called “holistic analysis” providing the flexibility to adjust the rating if a company consistently out- or under-performs its peers. Both may change the final rating by one notch.
The rating is not simply a function of the capital model
There continues to be a common misperception that the outcome of the capital model equates to the rating. This is neither true for A.M. Best nor for S&P. In fact, the final rating under A.M. Best’s proposal can be as much as ten notches below the balance sheet strength assessment. In the case of S&P, a company with an extremely strong financial risk profile could still only achieve an anchor of “bb-“ if its business risk profile were assessed highly vulnerable. The difference strongly demonstrates how much the more qualitative factors such as the business profile drive the final rating outcome.
ERM as a separate rating factor
A.M. Best has ERM as a separate rating factor underpinning the importance the agency attributes to risk management as a driver for a company’s financial stability. In the proposed criteria, the downside for the rating in case of a negative evaluation can be significant, with a weak ERM assessment potentially decreasing the rating assessment by up to four notches.
S&P maintains ERM as a separate rating factor, but combined it with the evaluation of management and governance when it revised its criteria. The downside potential in case of ERM and management being scored “weak” is even more substantial; for example, an anchor of ‘aa+’ would be revised downwards to ‘bbb’ if ERM and management were scored “weak”.
The last analytical step under both methodologies is an assessment of potential group or government support.
Ratings scale within the criteria
While Best continues to publish insurer ‘financial strength’ (policyholder credit risk) ratings using its unique financial strength rating scale, its criteria are described using its ‘Issuer Credit Rating’ scale, which mirrors that of S&P. Each notch on the Issuer Credit Rating scale maps to a point on the Financial Strength Rating scale. Best therefore derives a financial strength rating outcome from the Issuer credit rating for any given re/insurer.
Karin Clemens, Senior Analyst
Rowena Potter, Senior Analyst
Monday 12 September 2016