Calculated risk

Credit rating agencies are supposed to be the almighty seeing-eye; the ones that brokers can put unwavering faith in when it comes to determining the credit worthiness of insurers.

But with some of these agencies having awarded top ratings to bonds backed by subprime mortgages – and with these same bonds subsequently falling in value and being blamed for the start of the credit crisis – questions have been raised over whether their accuracy can be trusted.

Reputation is everything for brokers; their business model is built on client trust, and when that trust is broken, it can do irreversible damage. So what should a broker do when it comes to rating agencies?

The consensus is that there aren’t any real alternatives to rating agencies. But that doesn’t mean brokers can’t be savvy about choosing the right ones, and also do their own homework on insurers.

“Credit rating agencies are a necessary evil,” says one broker, who does not want to be named. “If they weren’t around, what would you do? We do get their [insurers’] accounts and have a look through them, and keep an eye on what’s in the news from different websites. But if ratings are going to drop, that’s what we are looking at.”

Not all brokers are critical of rating agencies. John Batty, a director of Caunce O’Hara, says his company gets updates from rating agencies every month. “If we want to check the current security rating of any insurer, then we just log on to the internet,” he explains. “We can’t say that we take ratings with a pinch of salt because overall they are probably more accurate than anything else we have.”

Rob Jones, managing director of S&P, adds: “Most of the criticism that has been levelled against agencies has focused on the ratings of structured finance instruments and less so on the ratings of corporates, including insurers.”

Quality control

However, with brokers relying so heavily on ratings, they have to draw the line somewhere. And that line is usually when insurers are rated BBB or less.

“Triple B is the cut-off used by the national brokers, and that is what we use,” Batty says. “What you normally see is a triple A to a triple-A minus. Norwich Union has been downgraded recently, but it wasn’t enough of a swing to cause us any concern.”

But he adds: “If it went from an A to a B, then it’s something we would look at, and try and analyse the reasons for it.”

The Broker Network, which has a securities committee to assess the different ratings and to monitor the stability of all the insurers on behalf of its members, adopts a similar approach.

“We don’t offer risk placements through any insurers that fall below a certain criteria. We won’t let members place business through us if they do,” a spokesman says.

Meanwhile, another option is to improve the quality of rating agencies. And in light of the economic crisis, there have been many calls for agencies to make their calculations more transparent. “The position of rating agencies has been questioned following the banking crisis, and no doubt changes will be made,” Eric Galbraith, chief executive of Biba, says.

A question of ethics

What still sits uneasy for most customers using rating agencies is the way in which agencies are remunerated. Agencies are paid by the companies they are rating, and critics say this creates a conflict of interest.

“The financial crisis has revealed problems with the role of credit rating agencies and that, up to a point, there is a conflict of interest with their business model,” says a spokesman from the European parliament.

Rating agencies have been regulated by the US Securities and Exchange Commission (SEC) since 2005, but the financial crisis has prompted the European Commission (EC) to step in and add further rules. The EC wants to regulate rating agencies and has introduced proposals that are currently being discussed by the European parliament.

The proposals include rules that credit rating agencies may not provide advisory services or rate financial instruments if they don’t have sufficient information to base ratings. Agencies must also disclose their model methodologies and key assumptions on which they base their ratings, and must publish an annual transparency report.

In addition, they need to have three independent directors on their boards whose remuneration does not depend on the financial performance of the agency. When Insurance Times went to press in April, the European parliament was due to vote on the proposals before the elections in June this year.

Some brokers welcome the idea of more regulation. One says: “It would be nice, as everything else is regulated. Agencies give you an overview of their ratings but they don’t get down to how they work it out, with turnover versus assets versus people and loans. Don’t make it overcomplicated; make it relatively simple.”

Until the models are improved and more stringent regulation kicks in, Galbraith suggests that brokers try to minimise their reliance on agencies.

“Rating agencies are one source to obtain information on measuring insurer security in our sector. Other key factors in considering the selection of an insurer should be their willingness to pay claims and the overall service levels provided.”

Ratings Explained

Confusingly, credit ratings come in many forms, and each agency uses different methods to calculate ratings. The most well known are Standard & Poor’s (S&P), A.M. Best, Moody’s, and Fitch Ratings. S&P, for example, rates companies from AAA – its highest rating – down to D, where companies are considered in danger of defaulting. (For explanations of S&P’s ratings categories, see box overleaf.)

Of the brokers Insurance Times talked to, most tended to use S&P and A.M. Best. One source says this was down to preference: “We use these agencies [S&P and A.M. Best] as they are probably the best known and the standard quoted by most of the industry.”

So what exactly are ratings and how do agencies reach their conclusions? On the former, Moody’s describes a rating as “an opinion of credit quality of individual obligations or of an issuer’s general credit worthiness”. But it further warns that “ratings are not recommendations to buy or sell, nor are they a guarantee that default will not occur”. Moody’s says its ratings represent a rank ordering of credit worthiness, or expected loss.

To formulate their conclusions, agencies use multiple sources of information, including annual reports, prospectuses, and market information such as stock price trends. They also rely on economic data from industry groups, articles from academic sources, reports from meetings with the debt issuer, and expert sources in the industry, government or academia.