Feld.RtAgs

Reading: “Rating Agencies,” CAS Study Note, October 3, 2011, pp. 1-7 and 14-19, including Appendix A. Candidates are not responsible for Section 4, Appendices B-D, formulæ, and the endnotes.

Authour: Feldblum, S.

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BA Quick-Summary: Rating Agencies Rating agencies evaluate the financial strength of insurers and other companies, helping policyholders, investors, and regulators assess their ability to meet financial obligations. Agencies analyze both quantitative financial data and qualitative factors like management strategy, risk exposure, and market conditions to determine ratings. Insurers can participate in an interactive rating by providing proprietary data and meeting with rating analysts, allowing for a more detailed evaluation, whereas public ratings rely only on available financial statements.

Pop Quiz

Speaking of financial strength, do you remember the conditions that must be satisfied for an actuary to confirm on an insurer's FCT that they are in good financial position?

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Rating agencies are supposed to provide reliable financial strength ratings for insurers. So people were very P-O'd in 2008-09 when highly rated mortgage-backed securities went up in smoke. A.M. Best, Moody's, and S&P screwed up big-time, and legislation now requires rating agencies to disclose details of their method. FeldBlum's papers are always well-written.

The purpose of rating agencies is tied to a general theme concerning regulation: protection of policyholders. Now, rating agencies are not government bodies, but they contribute to that goal with their financial strength ratings of insurers. Of course, being essentially private companies, rating agencies need to get paid, and one of their major shortcomings is that they are paid by the companies they rate. Even if rating agencies were government bodies, the government is often lobbied by industry groups to create legislation favorable to those groups. Still, this imperfect system is better than nothing. Except when it isn't - like in 2008.

Memorize:

• purpose of financial ratings, consistency (3 items), shortcomings (2 items)
• 5 steps of the interactive rating method + advs/disadvs of interactive method
• details of methods for each of the 3 most common rating agencies

Estimated study time: ½ day (no including subsequent review time)

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• why rating agencies are important to insurers: [Hint: USE]
• identify & describe the capital models: used by the 3 main rating agencies
• miscellaneous facts about interactive ratings and rating agencies

Top Questions ← Questions you absolutely need to know!

Questions held out from Fall 2019 exam: #25. (Skip these now to have a fresh exam to practice on later. For links to these questions, see Exam Summaries.)

reference	part (a)	part (b)	part (c)	part (d)
E (2019.Spring #22)	importance to insurers: - of rating agencies USE	high ratings: - lines where it's important
E (2016.Fall #23)	importance to insurers: - of rating agencies USE	interactive ratings: - ads/disads	rating agencies: - shortcomings
E (2016.Spring #22)	importance to insurers: - of rating agencies USE	rating agencies: - maintaining consistency	capital models: - describe
E (2013.Fall #24)	importance to insurers: - of rating agencies USE	capital models: - identify	capital models: - describe

In Plain English!

Intro

We're getting to the point in the syllabus where you really only need to know the main points. If I'm being honest, I'm getting a bit bored of writing these wiki articles, and I know if I'm getting bored, then you guys must be getting bored too! So even though this isn't a top-ranked paper, it isn't a bad idea to look at the source text. That way, you're not just reading bullet points – you'll get more context for the material. The paper is quite long, 31 pages, but you don't have to read all of it in detail. Feldblum is a great writer, and it's good to become familiar with him.

As an aside, he wrote an interesting opinion piece on the actuarial exam process versus the CFA designation. It's from way back in 2000, but here's the link if you're interested: FeldBlum's Opinion. And here's another interesting opinion piece on the exam process from Gil Student. (Just something to think about.) My personal experience after I left academia in 1995 to start an actuarial carrer was that I took exams for 3 years and was half-way to fellowship. Then I met my significant other and decided to stop taking exams altogether. (I already had my Ph.D. in math and I just didn't feel like studying for exams anymore.) I did, however, continue reading syllabus papers but it was different because I was reading for understanding versus memorization. One of my first projects was coding a suite of reserving software, but that's a story for another day! It wasn't until almost 20 years later that I decided to return and get my ACAS. I got so frustrated with the existing study guide for exam 6 that I invented my own system. And that's the origin story of BattleActs.

Anyway, back to the task at hand. As mentioned in the summary, legislation now requires rating agencies to disclose details of their method. The method for assessing the financial strength of insurers is based on something called an interactive rating. (This is discussed in more detail further on.)

First, why do we bother with financial strength ratings at all?

Financial strength ratings help buyers assess an insurer's ability to pay claims (some buyers MUST place business with highly rated reinsurers)

Now, there are two key points regarding rating agencies:

Consistency: How do rating agencies ensure consistency across insurers? (2016.Spring #22b)

1. There should be consistency in information gathering and assessment guidelines.
2. Ratings should be related to economic capital.
3. The analysis & final rating should be issued by separate bodies.

Shortcomings: It's important to realize that rating agencies are not perfect. If they were, we never would have had the financial crisis in 2008. (2016.Fall #23c)

1. There is a conflict of interest since rating agencies are paid by the companies they rate.
2. There is a history of unreliability. Rating agencies have given high ratings to companies that then went bankrupt. (Example: Enron Scandal)

There are 3 well known rating agencies:

A.M. Best: has the most experience with financial strength ratings of insurers (They're the BCAR people! See BCAR.Cdn & BCAR.Cat)

Moody's: focuses more on debt ratings (versus overall financial strength ratings)

S&P (Standard & Poor's): focuses more on debt ratings (versus overall financial strength ratings)

All of them use interactive rating as an overall methodology but differ in their specific rating model.

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Sections 1-2: Interactive Rating

An interactive rating is defined as follows:

an independent assessment of an insurer's ability to pay claims BASED ON a comprehensive qualitative & quantitative analysis

The interactive rating model has 5 steps: [Hint: RM-PDP]

Research: by ratings analysts (insurer submits proprietary info)

Meeting: between rating analysts & insurer's senior management for presentations

Proposal: the rating analyst leader proposes a rating (insurer may submit further info)

Decision: by ratings committee

Publication: to public & fee-paying subscribers

Note the advantages and disadvantages of interactive ratings have been asked: E (2016.Fall #23b)

Advantages:

• A.M. Best's ratings are widely reviewed so are likely to be reliable (although we know from the 2008 crisis that reliability is not guaranteed)
• Without an interactive rating, an insurer may remain unrated (or be given a public rating where insurer has less control over the info used in the rating)

Disadvantages: [Hint: it TIEs up company resources]

Time-consuming: requires extensive meetings with senior management

Intrusive: insurer must provide detailed operational info

Expensive: insurer must pay for rating agencies to do the interactive ratings

If interactive ratings are intrusive, time-consuming, and expensive, you might wonder why insurers bother with them. Well, there is actually a very good reason.

Question: if interactive ratings are such a royal pain in the ass, why do insurers bother with them??!!!! [Hint: USE]

Unrated insurers: agents are wary of unrated insurers

Solvency assessment: 3rd parties such as regulators or investors may rely on a rating agency's assessment

Efficiency: (agents, U/W, regulators) don't have the expertise to evaluate the financial strength of an insurer

See (2016.Fall #23a), (2016.Spring #22a), (2013.Fall #24a). (Notice that the question was always around #23. This is typical for this exam - the ordering of the questions is always roughly the same.)

High financial ratings are particularly important for certain types of businesses such as:

• reinsurance: because if downgraded to below investment grade, a reinsurer may not be able to renew treaties
• low frequency / high severity lines: because it's harder to assess risk and a high rating is a way of proving that insurer can pay claims (Ex: surety)
• homeowners: because banks may require mortage insurance from a highly-rated insurer

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Sections 3-4: Timbits

Just 2 BattleCards, but pay special attention to the first one...this is the most common question from this paper. It's appeared at least 3 times: (2016.Fall #23a), (2016.Spring #22a), (2013.Fall #24a) Yes, I know I just mentioned that a few lines above, but I'm saying it again so that it sinks into your Battle-Brain!!!!

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Section 5: Details

The final facts you need to know about ratings agencies are some details of their methods. (2016.Spring #22c), (2013.Fall #24c). Just memorize this table. I know it's a pain, but it's been asked twice.

Rating Agency	General Description of Method	Detailed Description	Other
A.M. Best 1	EPD (Expected Policyholder Deficit)	EPD = $P / $V	SELECTION: choose required capital so that EPD = 1%
Moody's	stochastic cash flows to model economic capital	repeated simulations of loss distributions of separate risks	TIME HORIZON: project cash flows until liabilities are settled
Std & Poor's	PB (principles-based) models & ERM practices	evaluate insurer's (ERM, internal capital model)	RATING: weighted avg of (S&P, insurer) capital assessment

¹ $P = pure premium for treaty, $V = market value of reserves (The answer in the examiner's report to (2016.Spring #22c) does not agree with Feldblum's paper. Thx jc2018!)

(ERM = Enterprise Risk Management)

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Appendix D: Exercises

Great News! This appendix has been removed from the syllabus!

Feldblum has included exercises in this reading. If this were a higher ranked reading, I would recommend that you do these exercises as they would be good exam questions. But I think there is only a low probability of any of these exercises appearing on your exam. Take a look at Exercise 1, but beyond that, only if you have extra time before the exam. (This is unlikely!!)

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POP QUIZ ANSWERS

Most important item in the FCT reading!!  →   when can the actuary report that the insurer is in satisfactory financial condition

The following conditions must hold throughout the forecast period:

[1] under the base scenario insurer meets its internal target capital ratio(s) as determined by the ORSA

→ in practice this may be MCT ratio > 180% (180% is just an example and would vary based on insurer and circumstances)

[2] under the going-concern scenarios → insurer meets the regulatory minimum capital ratio(s)

→ in practice this may be MCT ratio > 100% (see related forum discussion)

[3] under solvency scenarios → must have assets > liabilities

Memorize that! That was the most frequently asked question from the old DCAT, now CIA.FCT-1 reading and appeared on many exams.