Credit rating
A measure of creditworthiness of debt issues (securities) and debt issuers (companies) determined by a credit rating agency. Can also be considered as an estimate of how likely a company is to fail.
Properties of credit ratings
- They are long term assessments, considering the position of the firm over an economic cycle
- Varying levels of collateralization and subordination invite different credit ratings
- Typically, all debt from the same issuer has the same rating
Purpose of credit rating agencies
Agencies are hired by firms in order to allow those firms to borrow more cheaply. Any benefits to investors or customers is a by-product.
CRO
- Chief risk officer.
- The executive responsible for providing leadership for ERM, and integrating risk management frameworks across the organization.
Responsibilities of the CRO
- Provide leadership for ERM (like setting risk appetite and risk policies)
- Integrating risk management frameworks across the organization (like implementing KRIs, risk reports, and systems to support risk policies)
- Monitoring compliance with risk policies and regulations
- Communicating the firm’s risk profile to key stakeholders (the Board, regulators, investors, rating agencies)
What qualities should a CRO have
1) Leadership skills to hire and retain talented risk professionals
2) Skills to overcome resistance from business units
3) Ability to safeguard the company’s financial and reputational assets
4) Technical skills in strategic, business, credit, market, and operational risks
5) Ability to educate the board, senior management, and business units
FCT
Financial condition testing. A stress testing process, part of the firm’s overall risk management
Purpose of FCT
- Help management understand business plan implications on capital
- Identify main threats (risks)
- Determine actions to mitigate the frequency and/or severity of the risks
Components of FCT
1) Development of a base scenario
2) Analysis of the impact of adverse scenario
3) Identification and analysis of the effectiveness of various corrective actions
4) Results and recommendations
5) Appointed Actuary’s opinion and sign off
How to perform FCT
1) Review recent and current financial position
2) Develop a base scenario
3) Use sensitivity testing and/or Stress Testing to determine which risks are needing further analysis
4) Develop adverse scenarios and select the scenarios to be tested across business and product lines.
5) Identify and analyze the effectiveness of corrective management actions to mitigate risks
6) Report on the results and give recommendations to management
7) Get the appointed actuary’s opinion and sign off
8) Deliver report with presentation to Board and regulators with Q&A portion
Properties of adverse scenarios in FCT
1) There should be at least 2 solvency scenarios, 1 going concern scenario, and 1 integrated scenario
2) Liabilities should be revalued at each year in each scenario to test that the financial condition stay satisfactory throughout the projection
3) The forecast period is usually 3-5 years. Needs to be long enough to incorporate the vast majority of ripple effects and assess the recovery period of corrective management actions.
Why might FCT and ORSA be combined into one report and process?
- The AA’s opinion is required in FCT, and the ORSA-defined internal target capital ratios are a key contributor
- ORSA is useful for assessing the solvency nature of adverse scenarios, so it can help develop adverse scenarios for FCT
- Operational efficiencies like consistent timing, collection of data, analysis, management discussions, production and review of reports, and comprehensive scenario testing
- A comprehensive view of regulatory and own capital requirements can promote more informed decision making
Why might FCT and ORSA be kept as separated reports and processes?
- Oversight of FCT lies with the appointed actuary while ORSA accountability lies with senior management (with oversight provided by the board)
- FCT follows a prescribed regulatory basis while ORSA reflects own models and assumptions. Integration of models and processes may be difficult
- Areas of the org responsible for FCT may be different from those for ORSA, increasing cost of coordination and change management
FSR
Financial strength rating. A rating that Morningstar DBRS assigns to insurers
How to calculate an FSR
Evaluate the 5 building blocks with assessments ranging from weak to exceptional.
1. Financial strength
2. Risk profile
3. Earnings ability
4. Liquidity
5. Capitalization
Components of the financial strength portion of the FSR
- Market position
- Distribution channels
- Diversification of business and/or products
- Strategic and operational excellence
Components of the risk profile portion of the FSR
- Product risk
- Credit risk
- Market risk
- Operational risk
- Risk management
Components of the earnigns ability portion of the FSR
- Revenue generation and profitability
- ROE
- Income Stability
Components of the liquidity portion of the FSR
- Key asset and liability classes
- Claims frequency and severity
- Collateral posting
- Credit downgrade risk
- Limits and stress tests
Components of the capitalization portion of the FSR
- Capital cushion
- Financial leverage
- Fixed-Charge Coverage Ratio
- Capital Flexibility
- Capital Generation
Importance of the financial strength portion of the FSR
Market position directly affects the firm’s ability to attract and retain customers
Diversification of business and products has the following benefits:
- Reduces volatility of earnings
- Provides opportunity to rebalance products and market exposure to manage risk and optimize capital
- Allows the firm to better service clients throughout their changing lifecycle
Importance of the risk profile portion of the FSR
Assess reserve development history because if a firm continuously or frequently strengthens reserves, it may indicate that there are continuous estimation errors or unforeseen developments (like a large liability settlement)
Importance of the earnings ability portion of the FSR
Earnings are used to fund capital requirements, for future business growth, and to provide returns to participating policyholders and shareholders.
Importance of the liquidity portion of the FSR
Insurers can suffer losses if forced to sell marketable assets at a discount to meet policyholder demands.
