Feld.RtAgs

Question 1

Types of ratings that rating agencies provide (2)

Answer 1

• Credit ratings for (corporate, municipal, government) bonds
• Financial strength ratings for insurers

Question 2

Cases evoking criticism of rating agencies (2)

Answer 2

• Downgrades of AAA MBSs in 2008-09
• Failures of highly rated firms (Enron, AIG)

Question 3

Legislative response to criticism of rating agencies

Answer 3

Law now requires extensive DISCLOSURE of rating agencies’ methods to help understand ratings

Question 4

Importance of financial strength ratings to buyers of insurance (2 reasons)

Answer 4

• Helps buyers assess insurer’s ability to pay claims
• Some buyers MUST place business with highly rated insurers or reinsurers

Question 5

Measures taken by rating agencies to ensure consistent ratings across insurance companies (3)

Answer 5

• Relate ratings to economic capital measures
• Rating are issued by committees independent from the ratings analyst
• Review ratings periodically

Question 6

Shortcomings of rating agencies (4)

Answer 6

• Conflict of interest: rating agencies are paid by the companies they rate
• Rating agencies hesitate to change rating too quickly
• Agencies prefer to wait until they verify the new information
• Rating agencies often do not respond as quickly as the bond and stock markets

Question 7

Define “interactive rating”

Answer 7

An independent assessment of an insurer’s ability to pay claims based on a comprehensive qualitative & quantitative analysis

Question 8

Broad items covered in interactive ratings (2)

Answer 8

Operating strategy & competitive advantage

Question 9

Do rating agencies enjoy public acceptance?

Answer 9

Yes

Question 10

What responds faster to shocks - Rating agencies or bond/stock market? (why)

Answer 10

• Bond/Stock market responds almost immediately
• Rating agencies may take months - to verify info and verify the shock was real and not just noise

Question 11

Interactive ratings - advantages (3)

Answer 11

• Insurer has some control over information reviewed
• Fewer chances of error
• Agents may be wary of insurers without an interactive rating, since they may be financially distressed

Question 12

Interactive ratings - Disadvantages (3)

Answer 12

• It is time consuming (requires extensive meetings with senior management)
• It is expensive (insurer must pay for rating agencies to do the interactive rating)
• It is intrusive (Insurer must provide detailed operational info)

Question 13

Briefly describe the 5 steps in interactive ratings by rating agencies

Answer 13

1. Research by ratings analysts + insurer submits proprietary info
2. Meetings between rating analysts & insurer’s senior management for presentations
3. Proposal: lead ratings analyst prepares proposal + insurer may submit additional data
4. Decision: by ratings committee after lead analyst’s presentation
5. Publication of rating: to public & fee-paying subscribers

Question 14

Identify examples where a high financial rating is particularly important (3)

Answer 14

1. Reinsurance: an insurer may be required to have reinsurance with a reinsurer of a high rating. This helps to ensure the financial strength of the reinsurer
2. Low Frequency/High Severity type of insurance like surety: these types of lines are particularly difficult to insure because of their nature (harder to risk analyze & manage than high freq/low sev). A high rating may be required to demonstrate an insurer’s ability to pay out
3. Homeowners insurance: Bank often requires mortgage insurance from highly rated insurance

Question 15

Why do insurers maintain credit ratings with rating agencies

Answer 15

1. Agents are wary about unrated insurer, since they might be financially distressed
2. Third party and customers rely on outside assessment of insurer solvency
3. Rating agencies are efficient at assessing financial strength

Question 16

How can a reinsurance treaty link a rating with security of payment

Answer 16

Insert a downgrade clause: IF rating falls below a threshold THEN insurer must deposit funds or provide LOC (Letter of Credit)

Question 17

Interactive meetings: is focus on qualitative or quantitative info

Answer 17

Qualitative

Question 18

Identify (Best, Moody, S&P) rating or capital standard models

Answer 18

• A.M. Best: EPD (Expected Policyholder Deficit) Method
• Moody’s: use stochastic cash flows to model economic capital
• S&Ps: focuses on Principles-based models & Entreprise Risk Management Practices

Question 19

Describe Best’s rating model: expected policyholder deficit

Answer 19

• The EPD represents the average loss for the worst 1% of outcomes (i.e. TVaR at 99%)
• The EPD for each risk depends on the volatility and size of the risk
• The EPD ratio is the pure premium for unlimited aggregate excess-of-loss reinsurance. The EPD ratio is the EPD divided by the market value of held reserves.
• Therefore, choose required capital such that EPD ratio = 1%

Question 20

Describe Moody’s rating model: use stochastic cash flows to model economic capital

Answer 20

• Uses stochastic cash flows to model economic capital (model is based on repeated simlations of loss distributions of separate risks)
• Cash flows are projected until all liabilities are settled
• Required capital is set by a VaR or TVaR measure for the aggregate loss distribution

Question 21

Describe S&Ps rating model: Principal-based models & Entreprise risk managment practices

Answer 21

• S&P focuses on evaluating insurer’s ERM systems and internal capital models
• Uses a weighted average of S&P’s formula and the client’s model to determine the capital requirement
• Reasoning is: S&P believes that well-managed insurers evaluate their capital needs more accurately than a rating agency can.