C - Feldblum Rating Agencies

Question 1

FELDBLUM

2 types of ratings provided by Rating Agencies.
For each, give one example of rating agency.

Answer 1

CREDIT RATING FOR BONDS
Standard and Poor’s, Moody’s

FINANCIAL STRENGTH RATINGS
for life and PC insurers (AM BEST)
-the focus of Feldblum article

Question 2

FELDBLUM

1) Purpose of FINANCIAL STRENGTH RATING?
2) What does it helps to assess?
3) Give example of its uses for REINSURERS?

Answer 2

1) to make insurance market more efficient by reducing information costs

2) ABILITY TO MEET OBLIGATIONS of
insurer

3) Reinsurers may need investment grade ratings TO RETAIN CONSUMERS. Independent agents use ratings TO PLACE POLICIES WITH HIGHER RATED INSURERS

Question 3

FELDBLUM

3 disadvantages of unrated insurers.

Answer 3

independent AGENTS HESITATE TO USE UNRATED insurers

some BANKS DO NOT ISSUE MORTGAGE without property coverage from a rated insurer

insurers who do not pay for interactive ratings MAY RECEIVE PUBLIC RATING, WHICH HAS LESS CONTROL over the information reviewed by the agencies and greater chances of errors.

Question 4

FELDBLUM

2 examples testifying of the public acceptance of insurance ratings.

Answer 4

1) INSURERS are willing to pay large amounts to keep high ratings
2) AGENTS AND INVESTORS base business decisions on these ratings

Question 5

FELDBLUM

discuss INTERACTIVE MEETING by which the rating analysts meet with the sr. mngmnt of the insurer.

Answer 5

Rating analyst will meet officer responsible for U/W, Reserving, Reinsurance, Investments, Risk Management

Rating Agency’s focus is the quality of an insurer’s managers : their knowledge of industry trends, their experience with adverse scenarios, their handling of current problems

Insurer select the info they provide to the rating agency. Agency avoids specifying the data they want. They evaluate their client : DECEPTIVE, MISLEADING, INCOMPLETE INFO may lead to poor rating.

Question 6

FELDBLUM

5 steps of an interactive rating

Answer 6

1. BACKGROUND RESEARCH by rating analyst and SUBMISSION OF DATA by the insurer
2. Interactive MEETINGS between RATING ANALYST and SENIOR MANAGER.
3. Preparation of RATING PROPOSAL by lead analyst and submission of add’t data by insurer
4. DECISION by the RATING COMMITTEE after presentation by the lead analyst.
5. PUBLICATION OF RATING on public web sites and provision of analysis to fee-paying subscribers.

Question 7

FELDBLUM

An insurer with a $200M market value has $800M of bonds with average durations of 6 1/2 years.

Contrast RATING AGENCY vs INVESTORS in their ability to evaluate an insurer, were the interest rates to rise by 200 basis points.

Answer 7

The market value of the insurer would go down.

Investors would quickly offer a lower price for the stock.

Rating agency does not evaluate the insurer as quickly as investors do, and it may wait to downgrade the insurer to see if interest rates reverse.

Question 8

FELDBLUM

3 reasons why an insurer would request rating from more than one agency.

Answer 8

1) The insurer may want to issue debt and seeks a rating from an agency with MORE EXPERIENCE WITH DEBT RATING
2) It may want a rating from an AGENCY BETTER KNOWN TO INVESTORS
3) it may NOT BE SATISFIED with current rating and believes the 2nd rating will be better.

Question 9

FELDBLUM

6 commonly requested information by rating agencies for the initial meeting

Answer 9

Financial statements for the past 5 years.

History of the company (major events, mergers acquisitions, expansions)

Biographies of executives

Investment strategy, policy, guidelines

Org Chart

Product description and business strategy for each line

Question 10

FELDBLUM

3 reasons why almost all insurers are rated by agencies as compared to a small percentage in other industries.

Answer 10

1) agents are CAUTIOUS OF UNRATED INSURERS, since they might be in distress
- it is less expensive to pay for a rating than to demonstrate financial strength individually to others

2) 3rd PARTIES RELIANCE ON RATINGS
- independent agents use ratings to select insurers, insurers use ratings to select reinsurers
- Agents might be sued for providing insurance from a financially weak insurer

3) rating agencies EFFICIENCY at assessing financial strength

Question 11

FELDBLUM

Contrast
Public rating vs interactive rating

Answer 11

PUBLIC RATING rely on public data only, with no input from the insurer

INTERACTIVE RATING rely on proprietary data and meetings with senior managers

Question 12

FELDBLUM

What would happen if the insurer pays for an interactive rating one year but does not want an interactive rating the next year?

Answer 12

The agency may issue a PUBLIC RATING based on public data only

Question 13

FELDBLUM

Why would an insurer refuse an interactive rating? What would happen if this happens?

Answer 13

because insurer expects a downgrade

Agency may proceed with a public rating to inform investors that the previous rating is no longer valid.

Question 14

FELDBLUM

how insurer should disclose information to the rating agency

Answer 14

should not hide potentially damaging data, even though analyst does not request it

bettter to inform rating agencies of adverse events before they become evident. May keep a good rating doing so.

The contrary would lead to downgrade

Question 15

FELDBLUM

what may happen to an exhibit presented to rating agency and not supported by data or if confidential

Answer 15

Exhibit may not be presented to rating committee

If insurer tell rating analysts that the analysis is confidential, the analyst will not demand more information

But will give the rating committee a conservative (wost case) estimate from industry figures

Question 16

FELDBLUM

how insurers can prepare for interactive meetings.

Answer 16

Some insurer use a DRY RUN (REHEARSAL) with a RATINGS ADVISOR, such as an actuarial consulting firm

RATINGS ADVISOR will take the place of RATING AGENCIES, meet with senior managers, and tell them how to improve their presentation.

Question 17

FELDBLUM

top-down approach in rating insurers

Answer 17

Agencies generally use a top-down approach.

They start with an industry forecasts and insurer’s competitive position.

The committee evaluates u/w cycles by LoB and the insurer’s own performance, and management quality.

The industry evaluation is made by senior officers of the rating agency, bringing more consistency to the ratings.

Question 18

FELDBLUM

how rating committee of agency decides rating.

Answer 18

The rating analyst present the insurer’s data to the committee, which then decides the rating by majority vote.

Question 19

FELDBLUM

why agencies hesitate to change ratings too quickly

Answer 19

Erroneous downgrades anger clients, who pay the agency’s fees
Erroneous upgrades ruin the agency’s reputation with investors and agents

Question 20

FELDBLUM

Discuss the disclosures of the agency rating changes.

Answer 20

Agencies delay downgrades by repeating current rating with negative outlooks for several months and reduce only if insurer cannot raise capital.

Question 21

FELDBLUM

Rating agencies have been publishing capital requirements for each rating.

Examples of insurer’s doing to meet these capital requirements.

Answer 21

1) setting high enough prices
2) limiting business expansion
3) avoiding high-risk policies
4) selling block of business
5) structuring reinsurance

Question 22

FELDBLUM

how some reinsurance treaties explicitly link agency ratings and security with clause.

Answer 22

a treaty with a downgrade clause may specify that if reinsurer fails to maintain a certain rating, it must deposit funds covering its obligations or provide letter of credit as security.

Question 23

FELDBLUM

How a downgrade clause benefits both parties (insurer and reinsurer)?

Answer 23

reinsurer: avoids the costs of collateral as long as it maintains its rating

insurer : gets collateral to cover reinsurance recoveries if the reinsurer cannot meet its obligations

Question 24

FELDBLUM

3 rating agency models and who is using them.

Answer 24

1) AM BEST
use of the expected policyholder deficit (EPD) to calibrate risk

2) Moody’s and Fitch
use of Stochastic Cash Flow to model economic capital

3) Standard and Poor’s
use principles-based models and ERM practices.

Question 25

FELDBLUM

What must a rating agency do to succeed against other rating agency?

Answer 25

• Must me better at distinguishing weak and strong insurers
• Identify stable insurers underrated by other agencies (gaining clients who will pay for the rating)
• Identify weak insurers who are overrated by other agencies (strengthening a reputation for accurate rating)

Question 26

FELDBLUM

3 steps in Moody’s and Fitch stochastic CF models to assess capital requirements methodology.

Answer 26

1) the model form distributions of each risk an simulate repeatedly from them
2) cash flows are projected until all current liabilities are settled
3) required capital is set by a VaR or TVaR risk measure.

Question 27

FELDBLUM

Describe principles-based systems in insurers rating.

Answer 27

It bases capital requirement evaluation on insurer ERM’s system and internal capital model

Question 28

FELDBLUM

why Standard and Poors is using a principle based system.

Answer 28

SandP believes that well managed insurers evaluate their capital needs more accurately than a rating agency can (calculating VaR, TVaR, EPD, easier to assess for insurer than rating agency)

Question 29

FELDBLUM

Contrast
bottom-up vs top-down
economic models in insurers rating.

Answer 29

BOTTOM UP
determines capital charges for each risk and LoB and combines them with diversification factor
TOP-DOWN
determines overall capital requirement from a multivariate distribution of all risk and allocates the required capital back to risk and LoB

Question 30

FELDBLUM

State BCAR formula.

What are the components of the formula?

What kind of risk does BCAR include that is not included in NAIC’s PC formula?

Discuss impact on small risk and weight?

Answer 30

sqrt(b1^2 + b2^2 + b3^2 + b4^2 + b5^2 + b6^2) + b7
where
b7 is off-balance sheet risk
b1-b6 are bond, equity, interest rate, credit, reserve, new business risks

Interest rate risk

BCAR uses the expected policyholder deficit (EPD) 1% risk measure

Overall capital is still heavily weighted toward underwriting risk

Question 31

FELDBLUM

Calculate implied interest rate from 2 to 3 years if:
The term structure of interest rates is 5% for one year, 6% for two years, and 7% for three years.

Answer 31

$1 invested now yields $1.05 in one year, $1 × 1.06^2 = $1.12 in two years, and $1 × 1.07^3 = $1.23 in three years. The implied interest rate from 2 to 3 years is $1.23 / $1.12 – 1 = 9%.

Question 32

FELDBLUM

given following info, calculate EPD, EPD ratio (Expected Policyholder Deficit) and required capital:
general liability reserves have a market value of 1,200,000,
aggregate excess-of-loss reinsurance treaty that pays the adverse development above 25,000 have a pure premium of 500
aggregate excess-of-loss reinsurance treaty that pays the adverse development above 1,700 have a pure premium of 12,000.

Answer 32

• Best’s chooses required capital so that the EPD ratio is 1%.
• The EPD ratio is the EPD divided by the market value of held reserves.
• The EPD is the pure premium for unlimited aggregate excess-of-loss reinsurance.

EPD ratio = PP/RMV, meaning that EDP ratio * RMV = PP
1%*12G=12M => for a PP of 12M, required capital is attachment point = 1.7M