A.M. Best Updates Debt Rating Methodology

"For instance, an 'A-plus' financial strength rating would correlate with a 'double-A' or 'double-A-minus' credit market scale. This has been an internal distinction we've been making. And our announcement helps the public connect the dots, so to speak. This really serves as a road map," Mr. Mayewski said.

The revised methodology also clarifies how this new issuer credit category works with other ratings currently assigned by A.M. Best by summarizing the inter-relationship between financial strength, debt and the new issuer credit ratings. "We correlate the financial strength rating with one of the appropriate ICRs, and from there, senior debt ratings for holding companies are notched off from that," said Mr. Mayewski.

The Oldwick, N.J.-based A.M. Best's financial strength ratings, which have been assigned since 1906, are the standard in the insurance industry. Its expansion into debt ratings came a bit later, however, when the firm started assigning them about three years ago.

(In its summary definition, A.M. Best describes its debt ratings as an opinion about issuers' ability to meet its financial obligations to security holders.)

A.M. Best also noted that traditionally, financial strength ratings–which examine insurers' capacity to meet their obligations to policyholders–have been the comparable substitute for issuer credit ratings, since policyholders are usually senior-most creditors for insurers. But sensing the growing interest of non-policyholders in insurer creditworthiness, the ratings agency said it is now "drawing a distinction" publicly between these two ratings.

The ratings agency, however, was careful to point out that this won't alter how the financial strength is measured at A.M. Best: "It is important to note that drawing the distinction with the financial strength and the issuer credit rating of an operating insurer involves no change to A.M. Best's traditional approach to producing or issuing financial strength ratings."

The firm added, "The assignment of an issuer credit rating serves as an integral transition from A.M. Best's traditional financial strength ratings scale to the credit rating scale, which is used in the capital markets."

Steve Dreyer, analyst at Standard & Poor's Ratings Services in New York, noted that the announcement signifies "an expansion of what A.M. Best has been doing for quite some time," and that it's "not really a significant change."

But the biggest revision in the methodology may involve notching guidelines. In this revision, A.M. Best explains, the notching between operating insurance companies' policyholder ratings and ratings for securities issued by holding companies should be wider than it has been in capital markets, especially at lower rating levels.

"This view is supported by the one-year to 20-year cumulative default probabilities constructed from A.M. Best's proprietary database, the actual recoveries of impaired entities at the operating company level and the trend to greater regulatory intervention," added David Brey, an analyst at A.M. Best.

"Previously, the standard notching was two to three levels," said Mr. Mayewski. But with this revision, "at the mid-to-lower rating levels, there will be some impact on securities ratings for holding companies. But at the upper end of the scale, there won't be much change."

Going forward, this new notching difference could be as much as four to five levels for companies that have "double-B" or lower policyholder ratings.

Mr. Mayewski said his firm is still going through the evaluation process, but a "preliminary evaluation shows that, overall, the number of securities rating changes will be modest."

Commenting on changes at A.M. Best, Paul Bauer, analyst for New York-based Moody's Investors Service, noted that his firm has also been widening its notching difference in the past few years.

"At Moody's, we have increased the spread of notching over time. A few years ago, a two-notch spread would have been the most common example. But now, a three-notch spread is the most common example. So over the last few years, we have widened our notching by about one level," Mr. Bauer said.

So now, if Moody's assigns an "Aa3″ financial strength rating, then one can typically expect the senior debt rating to be an "a3″, he explained.

"That's a three-notch difference. But sometimes, the notching can be different from that if there are characteristics of debt that would offer a higher security," Mr. Bauer added. "For example, you might have a large amount of cash resources at the parent company that provides extra security to the debt, so in such a case, you might have only a two-notch spread. But in general, two to three notches are typical."

Mr. Bauer also commented that, in general, while A.M. Best is known for its financial strength ratings, it has not been in the business of debt ratings for a long time.

"A.M. Best has a strong franchise in the insurance sector, but they don't cover a lot of other industries and people who buy debt usually want to be able to compare ratings across multiple industries," he argued.

At Standard & Poor's Ratings Services, for the investment grade of "triple-B" and above, the notching difference has traditionally been three notches from the operating insurance company to the holding company, explained Jay Dhru, director at S&P's insurance division.

"But it's also never as simple as that," Mr. Dhru added. "One needs to analyze from the holding company how diverse the sources of earnings are and how leveraged the company is. And this tells you whether the S&P's starting point–the three-notch difference–is justified or whether you should have wider or narrower notching," he explained.

Mr. Dhru observed that there have been cases where S&P had notching wider than three notches, as well as instances with narrower ones. "It's normally three notches, but it could range anywhere from zero to three, four notches," he said.

And for non-investment grade, it's very difficult to have notching criteria, Mr. Dhru added: "You really have to look at the fundamentals of the holding company. Below the investment grade, you need to look at characteristics of the holding company a lot more closely than what the notching would imply."

Commenting further on changes at A.M. Best's debt rating methodology, S&Ps Mr. Dreyer noted one of the things that the introduction of issuer credit rating does is, "it obviously builds the bridge between the debt rating and the operating insurance company rating for Best."

Mr. Dreyer also observed Best's debt ratings have to be viewed "alongside other ratings like S&P's and Moody's. And my guess is that, for most companies that we rate in common in terms of debt ratings, you will find that Best ratings are pretty close to S&P's."

But on the other hand, Best's operating insurance company ratings are arguably more optimistic than S&P's, he said. "It's hard to make such comparisons, I realize, but they have far more companies rated in the 'A' category or higher than we do," Mr. Dreyer noted.

And this apparent disparity raises an interesting question, he said: "If you are A.M. Best, you want your debt ratings to be similar to those that are already in the market. But if your operating company ratings are higher, how are you going to maintain those two things?"

"Well," Mr. Dreyer added, "the new variable notching difference could help justify that difference."

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, August 4, 2003. Copyright 2003 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.