This is the latest in a series of guest essay by associate members of AAIS. To learn more about associate membership, contact Rick Maka, director of marketing, at rickm@AAISonline.com, or by calling 800/564-AAIS.
An article in The May 2007 issue of the RMA Journal, the lending industry’s journal of Enterprise Risk Management discussed loan agreement covenants. Loan agreement covenants specify what a borrower must and must not do to comply with his or her loan agreement. The covenants are designed to ensure the lender that the borrower will be able to repay the principal and interest due to the lender. The author, Charles S. Zimmerman, suggested that if a situation does not satisfy the five C’s - character, capacity, capital, conditions, and collateral - then a loan should not be made to the borrower.
The article provided an outline for evaluating the five C’s. The author suggested that all borrowers, even qualified borrowers, should be evaluated based upon the five C’s. His concern was that some borrowers might be poor risks for qualitative reasons even though they had acceptable quantitative scores. As a rating service analyzing the insurance industry, it struck me that this was analogous to the assignment of a Financial Stability Rating® at the Stable level, A or better. That is, even financially stable insurance companies need some degree of qualitative evaluation. What follows is my perspective on the application of the five C’s to insurance companies seeking a Financial Stability Rating®.
First, policyholders prepay a premium for insurance coverage. The ability of the carrier to honor its obligations is of paramount importance. Clearly, a lender’s perspective of a borrower’s ability to respond to its contractual obligation is analogous to an insured’s perspective. ‘I gave you money, I expect you to honor your contract, as well.’ The Character of an insurer is more difficult to measure than the character of an individual; however, our assignment of FSRs reflect a measure of corporate character.
Specifically, prior to assigning an FSR, Demotech, Inc. analyzes the representative operating experience of a carrier while simultaneously analyzing its mix of business. If an insurer sticks to its core competency and can report operating results consistent with its historical results, that
carrier demonstrates character. It demonstrates a commitment to producers, consumers, reinsurers and management by staying in its niche(s).
Second, we believe Capacity can be interpreted as the financial capability to write business without leverage while simultaneously processing insurance policies, transactions and claims. Prior to assigning an FSR, we evaluate premium growth and operating effectiveness (combined ratios over an extended period of time.) Stability is a critical consideration.
Capital sufficiency is another critical component of an FSR. Demotech, Inc. needs to be comfortable that the insurer can absorb adverse fluctuation from its typical historical operating result. Policyholders’ surplus and the relative level of loss and loss adjustment expense reserve adequacy provide us with some direction. Has the carrier utilized reinsurance to protect itself or has the carrier stretched itself too thin?
Our interpretation of the fourth C, Collateral is the quality and liquidity of invested assets. Similar to a lender’s evaluation of collateral, Demotech, Inc. reviews the quantity, quality and liquidity of invested assets. Are the insurers’ assets and liabilities properly matched with comparable timing of cash flows? A carrier with an FSR at the stable level has met or exceeded our stringent criterion.
Conditions present a two-fold observation - Should conditions refer to “policy conditions” or to “limitations and conditions?” We opt for the latter. To earn an FSR at the stable level, an insurer must have appropriate financial flexibility. Carriers with substantial debt obligations, pre-existing contractual obligations, existing or impending regulatory constraints require additional scrutiny, evaluation and analysis. At Demotech, Inc., we believe that transparency and simplicity are preferable to complexity.
Those who rely upon FSRs of A or better should realize that we identify carriers that focus on insurance fundamentals - liquidity and quality of invested assets, adequacy of loss and loss adjustment expense reserves and appropriate use of reinsurance.
In sum, lenders must be able to evaluate and trust borrowers. Consumers must be able to trust their insurers.
The five C’s provide a good start to the evaluation process. We were pleased to determine that they are as applicable in the insurance business as they are in the lending industry.
Joseph L. Petrelli is the President and Founder of Demotech, Inc. Organized in 1985, Demotech, Inc. is a Columbus, Ohio based financial analysis and actuarial services company. Demotech, Inc. provides services to regional insurance companies, title underwriters and specialty insurance markets. Financial Stability Ratings® of A or better are accepted by the secondary mortgage marketplace, virtually all mortgage lenders and an increasing number of umbrella insurance markets.
|
