December 11, 2003Copyright ©2003, GreenwichFinancial Management Inc.

Demystifying Insurance, Part 3:

Assessing Credit Quality

            When you purchase insurance, you are seeking to transfer a risk you face to other people in return for your payment of cash premiums.   To feel protected against risk, you want to be assured that your insurer will pay your valid claims in the future.  The likeliness that a company will meet its liabilities is called credit quality.

            There are two aspects to payment of claims.  The first is willingness to pay, the second, ability to pay.  Willingness to pay is particularly relevant to an insurance policy where there is some room for argument about whether there is a valid claim and for how much.   For example, if you suffer a collision, how much will your insurer pay to repair or replace your car, and how promptly?  In personal insurance, analogous problems come up with disability: are you fully disabled, partially, or not all?  In life insurance, there isn't much dispute about whether the insured is dead or not.  (Although suicide as cause of death can be an issue, when barred from recovery under contract, usually for up to two years after inception; missing person status can be another issue.)  The ability to pay is the key question.

            The longer an insurance policy is likely to stay in force, the longer a view the policyholder must take of an insurer's credit quality.  In a permanent life policy insuring a woman now 30 years old, the event insured against, death, may not happen for 50 or more years.  It's hard to predict how a company will be doing in five years, let alone fifty.  Nevertheless, default by life insurance companies on the claims of policyholders is relatively rare, and there are numerous published measures of insurance company credit quality available.

            The insurance business is regulated by the individual states.  Each state has a Commissioner of Insurance.  One crucial goal of state regulation is to verify the ability of insurance companies operating in each state to pay claims now and in the future.  The key credit measure the states concern themselves with is "regulatory surplus," which is the stated excess of assets over liabilities.  For a variety of reasons, a company may show a significant regulatory surplus even though its solvency is questionable.  A very good resource for state regulation of insurance companies is the Website of the National Association of Insurance Commissioners, www.NAIC.org; with their Consumer Information Service, you can check on the licenses, consumer complaints and financial status of each insurance company operating in your state.  The NAIC's Insurance Regulatory Information System (IRIS) provides analysis that assists the commissioners in detecting insurance companies that may face financial problems.  When an insurance company messes up, and goes into receivership, whether for rehabilitation or liquidation, the claims of insurance policyholders (aside from reinsurance) rank higher in priority than those of general creditors or shareholders, and usually are not impaired.  Also, the different states have "guaranty funds" that protect claims by policyholders in the event of insolvency up to certain maximum amounts.  In egregious cases, though, such as that of Executive Life Insurance and its aggressive junk bond strategy, some policyholders have had their claims impaired. 

            Insurance companies, like other large borrowers, pay fees to have their obligations rated by private agencies.  Unfortunately, each agency has its own rating scale.  With Standard & Poor's (S&P)(www.standardandpoors.com), AAA is the highest rating for long-term obligations, then AA, A, BBB, BB, B,  CCC, CC, C, and D (default); there are plus and minus gradations.  Any rating of BBB- or above is called "investment grade" for bond investors.  I recommend you consider companies with long-term ratings no lower than A equivalent for term life and AA equivalent for permanent life.  Moody's (www.moodys.com; requires registration) three highest ratings are Aaa, Aa, and A, with descending gradations of 1,2,3.  The four highest ratings of insurance company "financial strength" at A.M. Best (www.ambest.com), which specializes in insurance, are A++, A+ ,A and A-.  Finally, Fitch (www.fitchratings.com) has an Insurer Financial Strength rating scaled like S&P.  Generally, you pay more premium to be insured by a higher rated company.  When you purchase insurance, your agent ought to apprise you of the credit ratings of your prospective insurer.

Next: Term Life

Andy Szabo, CFA, is Managing Director of Greenwich Financial Management Inc., a Registered Investment Advisor, which advises individuals and companies on investments, insurance and employee benefits.  Questions or comments welcome by phone (203-531-2877) or e-mail: Szabo@GreenwichFinancial.com.