Rating Agencies Are On The Mark, But Reserving Practices Are Way Off

The questions have cropped up before. And recent news of Congressional scrutiny of rating agency responses to Enron have prompted insurance industry commentators to pick up on some of the old rating agency bashing that surrounded the demise of Reliance.

Even our own "NU Online News Service" got into the act recently, questioning the "A" rating of Overseas Partners Ltd. that was in place before that company's heart stopped beating as a result of its own actions. In February, OPL put its reinsurance operation into runoff, saying it didn't have enough capital to compete effectively.

Questions about the timeliness of ratings have merit because of the extent to which users rely on them. Remarks made at a recent meeting of surplus lines brokers serve as a reminder. "On long-tailed business, [an insurer] could be rated 'A' when you bind, but two years later, it's out of business," a broker said, wondering if a brokers reliance on ratings could give rise to E&O exposures.

Of greater concern are the businesses, individuals and professionals who shell out premium dollars for policies from insurers whose ratings assured them that theyd be around to meet their obligations.

Still, we appreciate the difficult and unenviable task that rating analysts face when they grade insurer strength–in many cases, holding the fate of a company in their hands. Lowering an insurer's rating to a "B," after all, might shut off future business opportunities, making the rating action itself a factor in an insurers collapse.

It also seems fair to ask whether rating agencies are increasingly becoming convenient scapegoats for others who are creating, not assessing, insurer failures. With loss reserving issues torpedoing insurer results for 2001, aren't the actions of management teams, auditors and actuaries, those on the front lines, more appropriate to question?

Let's first consider the individual case of the ratings of MRM's insurance operations. The facts we present aren't based on any inside knowledge, but on press statements and publicly-available information about its earnings and ratings. As such, nothing will be said about the actions of managers, auditors or actuaries. More general thoughts on how those three groups behave across the industry will come in a followup commentary next week.

On an encouraging note, we see that Legion and Villanova are in rehabilitation, not liquidation. By its very nature, the rehabilitation process suggests that there's hope for a fix. So it may be that all parties concerned acted just in time.

With some lingering doubts, however, let's probe the question of whether rating agencies acted too quickly in lowering the companies' ratings to "vulnerable" levels. To understand that, we must ask if their actions prompted rehabilitations that wouldn't have happened otherwise.

The answer appears to be no.

Representatives of the Pennsylvania insurance department (quoted in an "NU Online News Service" report and other press accounts), did point to a potential "death spiral" created by downgrades as one reason for its petition to rehabilitate. But they also said that a negative auditors report and reinsurance collectibility issues contributed to the decision.

Recalling that reinsurance recoverability has been a problem for MRM since late 2000, it's appropriate to ask the opposite question: Did raters and regulators act too slowly?

Early last year, MRM issued its first negative earnings announcement, reporting a $5.6 million net loss for 2000. The company's results were hurt by developments in its program business segment–in particular, problems with reinsurance receivables on terminated programs–which prompted a $46.1 million fourth-quarter reserve charge for reinsurance receivables.

"Our program business segment grew rapidly over the last five years, fueled by reinsurers' desire to write more gross premium volume," MRM Chairman Robert Mulderig said at the time. He also said that MRM's insurers would embark on a new strategy, increasing program business retentions to counter the waning appetite of reinsurers.

Rating agencies responded quickly. On the same day that MRM announced its earnings, A.M. Best placed the insurer's "A-minus" financial strength rating under review with negative implications. Pointing out that MRM gave a $50 million capital infusion to Legion in the fourth quarter of 2000, Best believed more was needed.

Mr. Mulderig vowed: "We will get money into Legion in a fairly short time period." He added: "As long as [the ratings] begin with an 'A,' I don't think that will have a great deal of effect" on the group's ability to sell business

Standard & Poor's responded a few days later, putting on "Watch" and downgrading Legion and Villanova to "single-A" from "single-A-plus," saying that operating performance was "significantly below expectations" with and without the reinsurance charge. S&P removed the "Watch" tag in two weeks, but lowered the ratings again, to "single-A-minus."

In April, MRM announced a bailout of sorts, with XL Capital and other investors putting $112.5 million into a new debt offering.

But in mid-December, there was more bad news. MRM prewarned that it would have a fourth-quarter net loss of $6-to-$8 million and that it would add $30 million to reserves. Best and S&P put Legion and Villanova ratings on "Watch" again. Best said that the companies needed more capital as levels of reinsurance recoverables continued to rise. S&P worried about managements ability to cope with the risks of its new business model.

The "A-minuses" stayed in place until mid-February, when S&P dropped its ratings to "triple-B" before MRM's fourth-quarter earnings were officially announced. Two days later, MRM announced a $99.7 million fourth-quarter net loss, a $61.5 million loss reserve charge, a special $63 million reserve to offset deferred tax assets, and the $110 million sale of its mutual fund administration company.

Mr. Mulderig said MRM sold the mutual fund company to raise capital to avoid an A.M. Best downgrade. Best lowered the ratings to "B" anyway, as did S&P–to "double-B."

Don Watson, director of S&P's insurance ratings group in New York, explains the timing of those "vulnerable" ratings assignments.

"The triggering point was the sale of their mutual business," he said, noting that S&P did not previously anticipate that the holding company would sell that business. "This was [an] important, fee-generating business that they had to offset weaknesses in their insurance operation," he added. "I feel good that we lowered the ratings at the point in time they went public that they were selling."

Does that ignore that Legion's operations were potentially threatened before the sale? Mr. Watson said he didn't think so, pointing to resources that the corporate holding company had to support the insurance operations.

"We had XL in there, for instance, and XL's providing underwriting support," he said, noting that XL's presence alleviated some doubts S&P had had about where MRM's insurers would get their underwriting expertise when they changed their business strategy.

It's hard to argue with actions that, even in hindsight, seem to react appropriately to information as soon as it emerges. But, they do, indeed, "react."

Raters recently in the hot seat, testifying before a Congressional committee about their assessments of Enron, have said that debt ratings "ultimately depend on information provided by the issuer." It strikes me that, in the world of insurance, there is an even greater ring of truth to this statement.

While rating agency analysts–and regulators, for that matter–can and do take independent looks at the financial obligations of the companies they review, their ability to dig into the details of insurer loss reserving practices is limited. A comparison of the number of rated insurance companies to the number of rating agency actuaries supports this conclusion.

Why is this important? Because, in the world of insurance, inadequate loss reserves are a key contributor to company downfalls.

For MRM, a $62 million net loss reserve charge was one of several problems. Across the industry, it is clear that reserves charges ruined insurer financials in 2001 and will likely kill more insurers in the coming months.

Even excluding the impact of Sept. 11 losses, we've reported that there have been at least 50 reserve and restructuring charges announced by publicly-traded insurers in 2001, and that A.M. Best expects a total reserve charge of $9.5 billion.

While there is certainly a question about whether those reserves would have been booked without the cloak of 9/11 losses to hide behind, its clear that the reserve positions were still inadequate–by at least that amount and potentially much more.

Next week: a look at the professionals who examine insurance company reserves, and the questions that the Enron debacle suggests we ask about insurers.

NU Senior Editor Susanne Sclafane is a fellow of the Casualty Actuarial Society.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, April 22, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.