The Strange Case of the Use and Abuse of Insurance Ratings

Are ratings used by the insurance industry accurate?

Probably not.

At least that’s what an opinion piece published in July in contends.

Insurance agencies “certainly don’t always get [ratings] right,” according to the article, and then trouble sets in “from the way many re/insurance practitioners apply ratings” as they make decisions.

Why do practitioners do so?

Because ratings “are merely forecasts” and are “…based on historical information and forward-looking expectations.”

In other words, past performance does not future performance guarantee.

Yet the madness of using ratings continues, with many insurance pros using “ratings as a ‘binary’ selection criteria” (designating a certain rating level as unacceptable or acceptable), without even taking a look at a rating’s “historical default or impairment….”

The article states that there are three problems with this binary type of ratings approach:

  • Disregards the fact that the historic performance of the statistic takes into account different time periods. Paying attention to this would “allow for a much more rational approach” when it comes to evaluating credit risk.
  • Misses agencies’ leading indicators regarding potential rating trends.
  • Steers insurance pros to believe that the rating is, indeed, “a fact.” That somehow an “A-” rating is good while a “B++” rating is “questionable,” which can lead to “angst” when a rating proves to have been too high.

Instead of automatically relying on a binary-like standard, the article recommends that re/insurance professionals “invest” in really understanding what analytical factors ratings reflect, as well as the ratings indicators as provided by agencies, the “observed credit risk” that any rating has historically displayed, and the effect exposure length will have on the credit risk.

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