Predicting Downgrades of A.M. Best's Ratings for Property and Casualty Insurance Companies

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ABSTRACT

With intense competition among property and casualty insurance companies and tougher standards for ratings by A. M. Best Company, property and casualty insurers are very concerned with maintaining the current ratings since downgrades will affect insurer's ability to retain and attract new business. A. M. Best Company groups insurers receiving a letter grade rating into two distinct groups, "secure" and "vulnerable." Occasionally, A. M. Best Company uses quantitative and qualitative information in a confidential analysis process to downgrade previously assigned ratings from secure to vulnerable.

Using a matching sample of insurers whose rating is downgraded to vulnerable as compared to insurers whose rating remains secure, have the same organizational form and are of similar size, we analyze the level of firms' financial ratios prior to a downgrade to predict subsequent downgrades. This study differs from previous research in the focus on the secure and vulnerable ratings. Our results indicate that the complicated and vague process of downgrading a secure rating to a vulnerable rating can often be predicted with a simple model and a small set of ratios that can be calculated from readily available information.

INTRODUCTION

Insurance companies are closely watched by several ratings agencies. The ratings provide an opinion on the financial position of the insurer including its operating performance and its ability to meet its obligations to its policyholders. These obligations often follow the payment for services by several years. With these staggered obligations, the performance of an insurance company is not transparent to policyholders. Understanding the solvency of insurers goes beyond the mere collection of financial data, it requires analysis of existing conditions and anticipation of future obligations. In the preface of the Key Rating Guide published by A. M. Best agency, the rating procedure is explained in terms of general quantitative and qualitative characteristics considered, but not the specific performance expected to maintain a rating. Given the nature of the insurance industry, there is a need for expert opinions about the solvency of insurance companies.

The incentives of consumers to inform themselves about the financial condition of insurance companies may be reduced by the existence of state guaranty funds which compensate policyholders of an insolvent company. However, the compensation is often delayed and incomplete due to specified state limits. Policyholders may benefit if they can anticipate rating downgrades.

Additionally, as insurance companies operate in a competitive, yet regulated industry, the issuing of a rating may affect the position of the insurance company in several ways. The change in a rating may attract the scrutiny of regulatory agencies whose actions may restrict the operations of the insurance company. Also, in a financial service industry, where the quality of the service sold is not immediately apparent, the publicity associated with the issuance of a rating downgrade may alter a firm's competitive position in the industry. For these reasons, insurance ratings are as important to insurance companies as to policy holders.

The ratings are voluntary and in the past insurer rating agencies have been criticized for assigning inflated ratings. However this situation is changing. Until the 1980's, one rating agency, A.M. Best, had a monopoly on ratings. Since then, other agencies with experience rating debt securities have begun rating insurance companies. These agencies include Standard & Poors, Moody's and Duff & Phelps. With increased competition in the issuance of ratings, it may be anticipated that the ratings will more accurately reflect the ability of insurance companies to meet their obligations. The failure of highly rated life insurance companies, such as Executive Life Insurance and Mutual Benefit Life Insurance Companies, generated heavy criticism of the leading rating agencies by the insurance press. …