Insurance company ratings: Should you sell products from B+ rated carriers?
By Roccy Defrancesco
The Wealth Preservation Institute
Because of the recent financial turmoil and downgrading of many insurance company ratings, I’ve been receiving a lot of questions about how the ratings are derived; the lowest rating of a company I will recommend and why.
I've never really thought much about ratings because, for the most part, I always used companies with ratings of A- or better. Frankly, there was no specific reason I never sold a B+ or better rated company; it just so happened that the products I researched and thought were best for the clients happened to be at companies with an A- rating or better.
In the wake of the recent stock market crash, some quality companies with good products have had their ratings slip to B++ or B+. The question is: What’s wrong with selling a B+ or better-rated company, and what does B+ even mean?
Let me start with a question that really has no definitive answer. Why is there a negative stigma in the industry about a B+ rated carrier? I think I know a few reasons why.
1) There is a false rumor that E&O insurance carriers will not cover claims made against insurance agents if the claim has to do with selling a product from a carrier rated lower than A-. Most E&O policies will defend and pay claims, as long as the B+ or better rated carrier is solvent. Therefore, unless the B+ or B++ carrier is going to suddenly become insolvent, your E&O insurance will cover you. (Be sure to check with your current carrier. You may have to add a rider to be fully covered).
2) Many broker/dealers (BDs) do not allow their licensed agents to sell carriers with less than an A- rating. Why? I don't really know, but I’m certain it has to do with avoiding lawsuits. What else is new?
What other reasons might an agent have for not wanting to sell products from a B+ or B++ rated carrier? Their own thoughts about an insurance company’s financial stability and wanting to pick one that will be around and take care of their clients. That makes some sense. However, let’s look at the A.M. Best ratings and see if such a school of thought is really valid.
Most people are familiar with the following A.M. Best financial strength chart:
What jumps out at me are the orange lines. The top one says “secure,” and the second one says “vulnerable.”
It’s great if we can sell clients a product at an A++ or A+ company, but for the most part, unless you are dealing with a narrow band of products (and not indexed products), most of the products issued by these companies are not that great. I’ve always found A or A- rated carriers to have more well-designed life insurance and annuity products (especially indexed products).
But as I said, some A and A- rated carriers that have well-designed and client-friendly products have slipped to B++ or even B+. Does that mean I should no longer recommend or sell these products?
I’ve done my research; and I’ve come to the conclusion that if the company is B+ or higher, and if the financials are still sound (even if they are not as sound as they used to be before the market crashed), I’m still going to offer products from these companies.
The key will be disclosing the ratings to clients and making sure they know of alternative products at A- or better companies so they can choose the one that’s best for their situation. I’ve already beta tested this with one company I like, and what I’ve found is that if I don’t make a B+ or B++ rating a big deal, the client doesn’t think it’s a big deal.
The question you’ll have to answer for yourself is whether you think it’s a big deal.
To help you better understand the A.M. Best Rating system
To help you better understand the ratings at A.M. Best, I put together the following. It’s a little like reading Greek, but if you are going to have a discussion with clients about ratings, I think it is important that you know how they are derived.
A.M. Best’s Capital Adequacy Ratio (its ratings)
A.M. Best, like other rating agencies, has its own proprietary formula called the Best Capital Adequacy Ratio (BCAR).
A ratio of greater than 100 typically corresponds to a securely rated company, while insurers deemed to have a strong balance-sheet strength typically have a BCAR score of 200.
A company’s overall financial strength rating is derived from three components: balance-sheet strength, operating performance and business profile.
Balance-sheet strength forms the starting point for a credit rating, and an assessment of an insurer’s operating performance measures its stability. An insurer’s business profile — which is made up of the lines it writes, the markets it serves and its method of distribution — is an indicator of future balance-sheet strength.
A.M. Best computes the BCAR score by dividing an insurer’s adjusted policyholder surplus by its net required capital. But BCAR also takes an interactive approach that projects capital adequacy through different scenarios. Unlike the NAIC model, the BCAR places much more emphasis on catastrophic and reinsurance risks, and requires a greater portion of capital to support underwriting risks.
For life and health insurers, the model is designed to capture risks inherent to the industry and quantify the level of capital needed to support them. The capital formula computes four broad risk categories:
1) Asset risk — Charges are a reflection of a particular asset’s risk of defaulting or losing value. Asset classes include bonds, common and preferred stock, mortgage loans, and real estate.
2) Mortality and morbidity (insurance risk) — Mortality risks are assessed on volume of insurance and the net of reserves of reinsurance. Charges for morbidity risks are determined by a risk-profile evaluation of each different accident and health business line, since it is A.M. Best’s view that individual and group lines bear different risks, and exposure for hospital and major medical, Medicare, Medicaid and fee-for-service also differ greatly. Reserve levels and annual premium equivalents also are evaluated.
3) Interest rate/market risk — Charges reflect interest rate or market changes and are based on the level of reserves in annuity and life insurance products. The changes vary based on the characteristics of the product.
4) Business risk — These charges represent the numerous general business risks of a life/health insurer, including legal, regulatory and competitive environments. Liabilities may include debt-service requirements, surplus, relief or certain securities.
Financial tests used by A.M. Best
A.M. Best uses six primary tests to come up with the financial rating for a life insurance carrier.
Calculation: Current year’s capital and surplus – (minus) the previous year’s capital and surplus/(divided by) the previous year’s capital = (equals) the percent change.
Each year, A.M. Best looks at the gross change in capital as one of the factors that drives its ratings.
2. Net income to total income — This is a measure of the company’s profitability. Insurers with a higher percentage are more profitable and will have more money left over to spend on other business operations or to pay dividends. Any result less than zero would be considered poor or unusual.
Calculation: Net income/(divided by) total income + (plus) realized capital gains/losses
3) Nonadmitted assets to assets — If an insurer boasts high assets but much of the assets are nonadmitted (assets that are reported separately and may not be applied to support an insurer’s required reserves, like furniture or premiums 90 days past due), then that carrier is low in assets. The usual range is any result less than 10 percent.
Calculation: Nonadmitted assets/(divided by) total admitted assets.
4) Total affiliated investments to capital and surplus — This is an investment risk ratio. Insurers who hold more of their assets in affiliated investments should hold more capital and surplus, because they face a higher investment risk. These investments in consolidated or unconsolidated affiliated companies (basically investments in the company or in its subsidiary companies) generate equity. Any percentage over 100 percent would be considered unusual.
Calculation: Receivables from affiliates + (plus) investments in affiliates/(divided by) total affiliated investments. Then, take the total affiliated investments/(divided by) capital and surplus.
5) Surplus relief — This is a financial leverage ratio that shows the extent to which an insurer relies on reinsurance to maintain surplus strength. The smaller this ratio, the more financially sound the carrier is likely to be.
Calculation: Net reinsurance commissions and expense allowances on reinsurance ceded – (minus) net reinsurance commissions and expense allowances on reinsurance assumed + (plus) change in surplus as a result of reinsurance = (equals) net reinsurance commissions and expense allowances and changes in surplus for reinsurance.
Then, take net reinsurance commissions and expense allowances and changes in surplus for reinsurance/ (divided by) capital and surplus = (equals) surplus relief.
6) Change in premium ratio — This represents the change in premium from the prior year. The usual range for this test is all results less than 50 percent and greater than -10 percent.
Calculation: Current year’s premium + (plus) annuity considerations – (minus) prior year’s premium & annuity considerations/(divided by) change in premium.
Then, take the change in premium /(divided by) prior year’s premiums & annuity considerations = (equals) the percentage change. The previous is not a complete summary of what A.M. Best uses to determine the rating of an insurance carrier, but it's a good summary of most of what's used.
To learn more about A.M. Best ratings, go to www.ambest.com/ratings.