As a key part of the insurance ecosystem, credit rating agencies provide opinions on the creditworthiness of various issuers and securities. But how are these credit ratings decided, what’s assessed and how do actuaries fit into the picture?
To share more about this industry, Patrick Douville – FCIA and Vice President of Global Insurance and Pension Ratings at Morningstar DBRS – provided a few answers.
For those unfamiliar, what exactly does a credit rating measure in the insurance world?
Patrick: At a high level, it’s about creditworthiness, asking: “will the company honour its obligations to policyholders and to creditors?” For insurance, we start our credit ratings process with a financial strength rating, which assesses the ability to pay policyholder claims. This is a credit ratings approach that is unique to the insurance sector, and considers the priority of policyholders over other creditors. As policyholders rank first, the whole structure of insurance credit ratings flows from an insurer’s financial strength rating, an approach also generally taken by other credit rating agencies.
Our insurance credit ratings typically are done at the group level, meaning one financial strength rating for one financial institution, even if it is composed of multiple legal entities. Debt issuances however may be rated differently depending on subordination and other features, as well as which entity of the group issued the security and how far removed it is from operational assets.
What factors do you look at when evaluating an insurer?
Patrick: Our framework for analyzing an insurer’s financial strength uses five interconnected building blocks that address the various elements that underpin their financial strength. These building blocks are:
- Franchise Strength: An insurance organization’s franchise reflects its overall market position and brand, the strength and diversification of its distribution channels, diversification of its businesses and products, its competitiveness, and its strategic and operational excellence.
- Earnings Ability: Insurance companies generate earnings to fund the capital requirements for future business growth, provide a return to participating policyholders, and provide an investment return to investors.
- Risk Profile: In this building block, the credit rating process seeks to evaluate an insurer’s risk exposures and its processes for managing the various types of risk inherent in the insurer’s activities. An insurer’s track record in managing risk through time and its capacity to maintain sound capital levels over the medium term are key credit rating considerations. The analytical framework starts with evaluating an insurer’s product risk profile and how risk is managed. An insurer’s risk management policies, processes, monitoring, and actions to deal with accumulating risks are useful components of the analysis. The analysis then focuses on assessing an insurer’s profile across the major categories of risk—credit risk, counterparty risk, market risk, interest rate risk, and operational risk.
- Liquidity: The liquidity analysis considers the resources available to meet claims and policyholder and contract withdrawals as well as maturing obligations. An insurer can suffer losses if forced to sell marketable assets at a discount to meet policyholder demands.
- Capitalization: The fundamental purpose of an insurer’s capital is to provide a buffer for losses to ensure the timely payment of the insurer’s policyholders’ claims and benefits and other obligations to contract-holders. Strong capitalization is also important for retaining the confidence of policyholders, investors, and counterparties.
Our role is to translate the information presented by an issuer’s management team into a rating that investors can use.
What’s changing in the credit rating world right now?
Patrick: For the insurance sector, in the last few years, accounting changes have been disruptive. We’ve had to redesign how we access financial data and build models. The tools and systems available to gather and process data are also changing fast with new technologies. There have also been new types of debt instruments issued by insurers to meet regulatory capital requirements.
Credit analysts also produce research on industry trends that affect credit ratings. We always have to stay on top of economic events and industry dynamics that could have credit ratings implications. Big themes that have affected the insurance sector in recent years include climate change and catastrophe losses, the growth in private credit markets, and changes in technology including artificial intelligence.
How does your actuarial background help in this role?
Patrick: Coming from an actuarial background helps with being more familiar with the insurance industry, regulatory landscape, and products than those who may have covered other industries before.
Also, actuaries are risk professionals by nature. We’re trained to think about future uncertain events, quantify and model them, and stress test those events. That translates well to credit analysis, where we’re assessing downside risk and hypothetical scenarios.
Having a probabilistic mindset helps differentiate between credit ratings, which are designed to map to default probabilities. You need to be able to process complex information from various sources, think about severe stress scenarios, and translate this information into a credit ratings scale.
Any advice for actuaries who want to move into credit ratings?
Patrick: A few things I’d suggest include:
- If you’re in the insurance industry, get involved in risk, capital or investment roles. It’s a natural bridge to the credit rating industry. Treasury roles, regulatory work, or consulting can also help.
- Attend rating agency events; they’re often free and a great way to learn and network.
- Some people pursue a CFA, but it’s not a requirement.
- Be curious about financial markets, industry trends and other sectors. Insolvencies are rare, but being familiar with them is important in the credit world.
And remember that there are many roles connected to the rating agency world, including internal credit rating teams at banks and insurance companies, so search around to find different opportunities.
Looking back, what accomplishment are you most proud of?
Patrick: It was interesting to be involved in the development of the LICAT solvency framework for the Canadian life insurance sector, prior to my role at Morningstar. My contribution was small, but being part of a LICAT working group was meaningful and it’s something that’s going to stick around for a while, strengthening the industry and protecting policyholders. Overall, I’m proud to contribute to the resilience of the financial sector, both for policyholders and for investors who rely on this industry to achieve their financial objectives.
Any final thoughts?
Patrick: The insurance industry has really come a long way in the last 30 years, with more sophisticated solvency and capital frameworks, but also a shift towards more prudent products less reliant on future investment returns or policyholder behaviors. In general, the business model has shifted toward risk pooling, rather than risk taking, which I think is the right direction. You also see this in the generally positive movement of credit ratings in the sector. Going forward, insurers will have to focus on service and efficiency, to make sure they continue to deliver good value to their customers.
This article reflects the opinion of the author and does not represent an official statement of the CIA, nor does it represent the official views of Morningstar DBRS.