Are You a Carrier Using Only One Credit Model? Why Kroll Says You Should Think Again
Risk managers already understand why diversifying risk is a smart idea, and we all see the benefits of including diversity, equity and inclusion in our businesses and lives.
But diversity is also critical when using models for credit analysis of insurers.
Relying on just one model can lead to disastrous results. Rating agencies review different criteria, and using just one agency limits the view to only what that agency considers essential. But financial strength is based on many diverse factors and how they interact — oversimplifying the view is a risk.
Kroll Bond Rating Agency (KBRA) released its report “What the Insurance World Needs Less of Right Now: Rating Agency Capital Models,” focusing on the challenges of the overreliance on credit rating models when analyzing insurance companies.
The report highlights two main risks and demonstrates through case studies how insurers and reinsurers can reduce the risks of over reliance on one credit rating model.
The Risks of Overreliance on One Credit Rating Model
A main takeaway from the report is that models can oversimplify credit risk. Insurers and reinsurers have complex and dynamic credit risk profiles, and models can oversimplify credit analysis.
Models may be limited to looking at one moment in time when the reality is that insurers and reinsurers are dynamic, and their exposure to different risks ebbs and flows over time. Using a model to look at a singular time period is risky — the model may show another result when run later.
Instead, KBRA argues more factors need to be included in the rating outcome.
The report states, “Rigorous credit analysis goes beyond performance metrics to factor in relevant qualitative factors such as competitiveness, financial and operational risk appetite, growth strategy, and political/regulatory risk.”
“When it comes to insurance ratings, rating agencies have diverse methodologies and different perspectives. Investors are better served by having multiple views of credit risk,” said Peter Giacone, managing director at KBRA.
Firms may “manage to the model.” Insurers and reinsurers may start to manage their business based on what the model predicts, leading to unintended consequences.
Instead of focusing on sound risk management and mitigation practices, managing to the model could lead an insurer to ignore other consequences and results.
The KBRA report lists other, less tangible factors relevant to credit ratings that traditional models ignore.
“The most effective business plans will come out of management’s view of the (re)insurer’s risk/return appetite, market conditions, and the (re)insurer’s ability to execute. A rating agency capital model is effectively blind to any of these critical considerations, largely useless for any strategic planning, and, to the extent erroneous inputs are forced into such a framework, likely to drive poor decisions,” the report read.
It is tempting to try to optimize business results based on the model, but if the model has provided limited or erroneous information, managing the business to meet the model is a quick road to insolvency.
Over Reliance on One-sided Perspective Causes Chaos
Giacone offered the following cautionary tale of the overreliance on a one-sided perspective with a recent California example stemming from the Camp Fire tragedy.
In this case, Merced Property & Casualty Company was rated by a single agency that changed its rating from “A-” (excellent) to “F” (in liquidation or insolvent) after the company reported massive losses as a result of the 2018 Camp Fire.
At that time, the Camp Fire was the deadliest and most destructive fire in California’s history. The volume of claims Merced saw overwhelmed the company to the point of insolvency.
“KBRA notes that the rating agency capital model applied to this small insurer did not capture the significant event risk exposure as a basic stress test analysis would have revealed that, given the company’s inadequate reinsurance program, it would only take about 30 total residential losses to essentially consume all of Merced’s statutory surplus base,” Giacone said.
“As the Merced example illustrates, these capital frameworks have significant shortcomings, especially when evaluating geographic concentrations and the effectiveness and appropriateness of an insurer’s reinsurance program. This was the first time in decades that the California Insurance Guaranty Association needed to step in to cover claims for a property insurer.”
A Holistic Approach Is Better Suited to the Industry
Instead of relying on one model to capture all risks, insurers and reinsurers may be better served by combining quantitative and qualitative approaches. Using a more holistic approach can pinpoint unique risks that would have been missed using a more limited singular view.
“KBRA’s approach to insurance ratings incorporates both quantitative as well as qualitative elements to provide a holistic view of financial strength. The quantitative component is comprised of a fundamental financial analysis combined with stress scenario tests to assess the resiliency of the balance sheet to adverse economic conditions or severe events,” Giacone explained.
“The qualitative component considers credit risk dimensions such as quality of capital, consistency of results, market position, distribution, management/strategy and, perhaps most important, risk management. Finally, while historical financial results are an important factor, KBRA’s ratings are also forward-looking and consider management strategy and ability to execute on business plans.”
By combining the results from diverse models that measure different factors, insurers and reinsurers can lower the risk of relying on one singular model.
No model is perfect, nor can any individual model capture every potential outcome. Insurance and underwriting continue to be a blend of art and science — the use of models must be enhanced by the people reviewing the results. &