Contact: Cary Schneider
212-346-5566
Date: November 12, 2002
Two out of four recent insolvencies in Pennsylvania were likely caused by rating downgrades, according to a panel on the rating agency view of capital adequacy.
Rating agencies are required to assess and tell the public the extent to which a company is a going concern. If they lower a rating beyond a certain level to signal financial problems, the public trust is lost and business goes elsewhere.
Quoting from articles in the trade press, Robert F. Wolf, FCAS, MAAA, principal, Mercer Risk, Finance & Insurance Consulting, and moderator for the program, said that the Pennsylvania insolvencies and similar events had raised questions about cause and effect.
"Did the downgrade prompt regulatory action?" Wolf asked. "Did regulators and rating agencies act too slowly? Are rating agencies becoming scapegoats for regulators who failed to correctly assess capital adequacy? Or did the downgrade shut off future business opportunities, making the rating downgrade itself a factor in the insurer's collapse?"
Responding to these questions, Todd R. Bault, FCAS, MAAA, Senior Research Analyst- Institutional Research, Sanford C. Bernstein & Company said that from his viewpoint as an equity analyst, "rating agencies have a tough row to hoe."
In the context of capital adequacy, he said, rating agencies are charged with assessing the financial strength and creditworthiness of the company.
"Ideally, you would like these assessments to correlate with the so-called real condition of the company," he said "but in practice, of course, we do not know what that is." In addition, Bault continued, we would also like the "assessment not to add new information" that might cause a negative impact on the company.
Bault explained that most financial assessments assume that a company is a going concern - that it will thrive in the future. The role of the regulator and rating agency is to determine whether a company is in danger of ceasing to be a going concern without actually causing this status to end prematurely. "This is a difficult balancing act," he said.
The most significant element of being a going concern is trust. "Once that trust is lost, you get a liquidity crisis and that ends the ability of a company to be a going concern," Bault observed. To avoid precipitating the sequence of events that effectively end the life of the company, he noted, rating agencies have to err on the side of not reacting to deteriorating conditions as quickly as they could.
"Rating companies would like the market to appreciate the differences between small rating changes, like moving from AA to A, but companies aren't bonds," Bault said.
For insurance companies, three levels are important, he suggested: AAA which is needed for some specialized businesses such as financial guaranty; A- and above which is needed to write most commercial business; and below A- "which is effectively a death sentence." A move from A to B, he maintained, could trigger a loss of business and in turn jeopardize a company's status as a going concern. Possibly because of this, ratings below A appear to be declining.
To improve the system Bault suggested that rating agencies might consider sharing information with the SEC and state regulators. He also said that assessments of the business should be more dynamic. For example, there should be more emphasis on the future growth of claims, such as asbestos, and more disclosure about increases in exposure which is not the same as growth in premium, he noted. Finally, companies need to make available better data.
Chester J. Szczepanski, Chief Actuary, Pennsylvania Insurance Department, agreed that the information provided needed to be more complete and reliable but he defended the A..M. Best Company, one of the organizations that rates insurance companies.
Bests Reports is one of the first publications that we turn to when we are about to review a company's financial condition, he said, acknowledging that they're subject to the representations of management, actuaries and others with knowledge about the financial condition of the company. But, he pointed out that sometimes reading between the lines of the reports can give you important information.
Turning to examples of insurance company insolvencies in Pennsylvania, Szczepanski gave an overview of the sequence of events that had led to four insolvencies, two multi- line insurers, Reliance and Legion that were heavily leveraged by reinsurance and two medical malpractice insurers, PIC and PHILCO.
All four were downgraded by rating agencies, he explained. Physicians continued to purchase coverage from the medical malpractice insurers because coverage was cheap but the multi-line companies suffered serious cash flow problems after the downgrade. Reserve deficiencies contributed to all four companies' downfall. They added to the liquidity crisis for the multi-line companies but were the catalyst for the insolvencies of the two medical malpractice insurers.
Were rating agency downgrades the cause or effect of the companies' demise? Szczepanski stressed that the downgrades were both the cause and effect. In the case of Reliance and Legion, he said, the downgrades were coincident with the crises they were going through. Reliance, for example, was heavily leveraged by reinsurance and by holding company debt and was subject to a number of adverse developments on several fronts, including reserves deficiencies and investments, events small in themselves but large in the aggregate.
The rating agencies downgraded the company in the middle of all this and in so doing cut off cash flow. "That downgrade made it impossible for them to survive," he said.
Are the basic measures of capital adequacy working? Like Bault, Szczepanski said the measures are too static in nature, noting that in the calendar year before it became insolvent, Reliance had the highest surplus in its history. Its downward spiral occurred over a span of less than 12 months.
Szczepanski emphasized that rating agencies and regulators need sharper tools. First, he said, actuarial opinions and reports should be clearer. Even though it's management's responsibility to give its best estimate, he said actuaries have a responsibility to present a clear picture so that the rating agency or regulator can understand the risks.
Second, he said, regulators and rating agencies must get a "better handle on measuring reinsurance leverage because this is critical in assessing liquidity risks from a long term perspective."
Third, he observed, "We need better tools to measure liquidity because that's critical in identifying whether the company is going to be viable and healthy and able to weather shocks to its financial well-being along the way." Liquidity was a paramount issue for the two multi-line companies after downgrades slowed cash flow and reinsurers slowed payments once the company's problems became evident, he said.
The Casualty Actuarial Society is an organization dedicated to the advancement of the body of knowledge of actuarial science applied to property, casualty and similar risk exposures.