A 5-Minute Primer on Factoring ERM into Credit Ratings for Insurance Companies

An article we published in mid-2017 gave an introduction to how credit rating agencies are factoring ERM into their ratings. For most organizations, the evaluation of ERM is simply folded into the overall review of the firm’s management and governance.

Additional research and other resources (see here and here) shared with me since the original piece explains how the ERM evaluation is a separate, formal process for insurance companies.

According to S&P:

ERM examines whether insurers execute risk management practices in a systematic, consistent, and strategic manner across the enterprise that effectively limits future losses within an optimal risk/reward framework.

In the original piece on this topic, I outlined the four major components of S&P’s evaluation of a company’s ERM process: 1). Risk Management Culture & Governance, 2). Risk Controls, 3). Emerging Risk Preparation, 4). Strategic Risk Management.

Each of these factors receives a positive, negative, or neutral rating. All analysis is evidence-based, so if there isn’t enough information available on a particular factor, S&P will issue a “neutral” rating, at least in the short-term.

There is an additional element for insurance companies. S&P also evaluates risk or capital modeling. 

For insurance companies, modeling plays an important role in measuring risk exposures, quantifying capital requirements, and guiding future business decisions for underwriting practices. S&P’s evaluation looks at all types of risk models, including the insurer’s economic capital models if they are available.

The ultimate score an organization receives for its modeling is based on how well the insurer captures its material risk exposures and the interrelation between risks. Not only does S&P consider the breadth and quality of the models, they also look at methodology, the quality of the data going into the models (…think ‘garbage in, garbage out’), and even how results from modeling are used in decision-making.

Key note: Models receiving a positive score are also ones used extensively in the organization’s ERM process.

Regardless of its purpose, capital modeling shouldn’t be a big deal for insurers since they have been doing risk-based capital (RBC) analysis for at least the last 2 decades. In my previous life as an insurance regulator in Florida, we would do complex evaluations of RBC models based on this statute to ensure they accurately reflected the company’s surplus and risk exposure, which was important to keep track of since these surpluses represent the funds the insurer uses to pay claims in excess of loss reserves.

RBC analysis looks at finances…capital modeling included as part of ERM takes this purely financial analysis and produces results for use by the company’s management.

Once S&P completes its evaluation of all five components, it combines the classifications (positive, negative, and neutral) and gives the organization a score on a 5-point scale ranging from very strong, or most credit-supportive, to weak, or least credit-supportive.

Factoring ERM into the final credit score

Once S&P has the final ERM rating, they combine this score with an assessment of the organization’s management and governance and assign a rating on the same 5-point scale. As you can see in the table below, this combined score does consider the importance of ERM in its final rating.

Courtesy of Insurers: Rating Methodology Guide (S&P)

S&P then matches this score to the company’s anchor rating, which in actuality is a combination of its business and financial risk profiles.

Image courtesy of Insurers: Rating Methodology (S&P)

What impact does the ERM score have on the insurer’s ultimate credit rating?

The impact of ERM on a firm’s final credit score depends on a variety of factors…the impact isn’t uniform, even within the insurance industry.

Again, according to S&P:

The ultimate impact of ERM on a firm’s rating will depend on the risks of the firm, the susceptibility of the firm to those risks, and the capacity of the firm to absorb losses

Extending this to insurance companies, the significance of the ERM score on the final rating depends on the complexity of risks they are covering. The rating’s importance is higher for insurers covering complex risks that lead to either a significant loss of capital in a short amount of time (e.g., high-value property insurance) or risks that are uncertain over the long term (e.g., medical malpractice, workers’ comp).

On the other hand, the significance of the ERM score is low for insurance companies not exposed to these risks or who consistently maintain high levels of capital relative to the risk they are covering.

Is ERM considered a significant factor in your company’s ultimate credit rating? If so, has ERM’s importance on your rating been a motivating factor to further develop processes in your company?

I’m interested to hear your thoughts about ERM and its impact on credit ratings, so please feel free to leave a comment below or join the conversation on LinkedIn. Show others the growing influence of ERM both internally to a company and externally to regulators, ratings agencies, and others.

If your company feels like it needs to improve its ERM process in order to maintain or improve its credit ranking, please contact me to discuss your situation today. And remember, the possibility of an improved credit rating is minor compared to the benefits ERM can provide for addressing threats and opportunities in your organization.

 

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