GCR's Criteria For Rating Short Term, Life and Composite Insurance Companies

Introduction

Global Credit Rating Co. (“GCR”) is the leading rating agency in Africa , with particular expertise in claims paying ability ratings. Overall, GCR accounts for approximately 81% of all claims paying ability ratings accorded on the African continent and boasts a ratings coverage ratio of up to 95% in certain markets.

GCR's rating approach employs analytical techniques that incorporate quantitative and qualitative factors. Our rating reflects an evaluation of the company's current financial position as well as how the financial position may change in the future. GCR examines the ability of the insurer to meet its obligations under reasonable and stressful scenarios. In effect, GCR ratings are a measurement of the probability of default on policyholder obligations.

A brief overview of GCR's rating process is outlined below:

The following guidelines provide a general overview of the qualitative and quantitative factors that GCR considers when analysing the claims paying ability of an insurance company.

1. Qualitative Analysis

Fundamental analysis is the basis for ratings assigned by GCR. GCR's opinions are based on a clear understanding of the fundamentals of the rated company and the industry in which it participates. These guidelines are intentionally broad in scope, recognising that assigning credit ratings is a dynamic process and each company possesses unique characteristics and assumes varying levels of risk. Overall, GCR's ratings are based on a detailed analysis of an insurer's current financial position, as well as an assessment of how future operations and developments will either positively or negatively affect that position.

GCR's analytical process focuses on the following areas:

1.1. Competitive positioning

1.2. Risk exposures

1.3. Defensive characteristics

1.4. Affiliated relationships

1.5. Management quality

A strong competitive position represents a significant barrier to entry for new competitors or, on the other hand, a weak competitive position represents a significant barrier to success. Insurers that have strong balance sheets and acceptable risk exposures can show high short term financial strength. However, for the levels of financial strength to be maintained over the long term, the company must possess a sustainable competitive advantage.

Size can clearly be a competitive advantage in the insurance industry. The benefits of size include economies of scale and improved negotiating leverage with service providers. Furthermore, several fundamental characteristics are usually aided by size, including: financial flexibility, ability to influence pricing, diversification and market positioning.

However, while recognising that small insurers can be disadvantaged (given the financial flexibility, diversification and critical mass available to large insurers), GCR believes that market niches remain for smaller companies that are able to provide superior service and support that is not economically feasible in larger insurers. Smaller companies tend to be less bureaucratic and more nimble than larger companies.

In addition, the ability to build and maintain viable networks and alliances are also critical to maintaining a company's customer base and expanding market share.

The following areas can affect an insurer's competitive advantage:

1.2 Risk Exposures

Insurers assume varying degrees of risk in the normal course of business, depending on their product lines, target market and funding arrangements. When evaluating risk exposures, an assessment of the likelihood that an adverse loss situation will occur is undertaken. Such risks must be understood and supervised by management, both individually and in aggregate.

The following represent the most significant sources of risk assumed by all insurance companies:

The underwriting risk that companies assume relates to a number of factors, including:

In terms of the relative importance of these risk exposures, it would vary by product mix of the company. Typically, important risk exposures by product type in terms of life insurance companies are:

a. Fixed Annuities

In analysing an annuity carrier, exposure to interest rate and disintermediation risk, high-risk investments and liquidity risk, as well as the tax/regulatory climate are the most important. Slow growth might be less of an issue because annuity carriers earn returns on the product on a spread basis and issue product opportunistically. High growth during adverse market conditions can be problematic.

b. Life Insurance

For a life insurance carrier the most important risks would be slow growth or sales declines (because it would not be building strong renewal profits and would be eroding its competitive position), inadequately controlled rapid growth (because of related high acquisition costs), mortality exposure (particularly given the high prevalence of AIDS), high-risk investments and liquidity risk, and the regulatory and legal environment. Asset/liability risk is important for companies that issue interest-sensitive life insurance.

c. Variable Products

A separate-account annuity company would have negligible investment and asset/liability risk and some mortality risk in the guaranteed death benefit. The primary issues would be the tax climate, critical mass, ability to meet expense targets and uncontrolled growth or no growth.

1.3 Defensive Characteristics

This represents the third area of analysis. Companies with strong defensive characteristics are best able to both preserve and build their assets and capital. The assessment of an insurer's risk exposures and defensive characteristics is done in unison. The level of risk that an insurer is exposed to is critical in determining the required defensive characteristics, since the two should move in tandem. The following are key defensive characteristics:

1.4 Affiliated Relationships

This area of analysis determines the insurer's relationship with its affiliates and how this relationship impacts on the company's financial strength. Although all companies are evaluated on a stand-alone basis, ratings may be adjusted based on affiliated relationships.

Factors to consider include:

Without significant upfront capital funding, start-up insurance companies or those in the early stages of growth will usually not, all other things being equal, exhibit the characteristics necessary to attain a high level of financial strength in their own right. However, the presence of a powerful controlling shareholder can mitigate this.

Management represents the final area of analysis, although all areas of analysis discussed above in some way reflect an evaluation of management's strengths and capabilities.

In other words, success or failure in the previously discussed areas often represents the best “report card” on management. GCR evaluates management's strategy in relation to the company's overall strengths and the current market environment.

Our specific evaluation of management focuses on the following:

2. Quantitative Analysis

Although fundamental analysis of the insurer forms the cornerstone of our assessment, it is important to stress that GCR does not subscribe to a ‘box' approach. This implies that we do not simply infer a rating based on our fundamental analysis. Rather, the approach is to integrate our fundamental and qualitative analysis with quantitative analysis.

In essence, our aim is to gain an understanding of the insurer's financial, administrative and operating capabilities. In common with many other areas of analysis, the entity's statistics are compared with relevant benchmarks, including national and international norms, and business cycles.

GCR's quantitative analytical process focuses on the following areas:

2.1 Efficiency Ratios

2.2 Liquidity

2.3 Solvency

Efficiency analysis focuses on the source of premiums, particularly in terms of diversification and volatility. The type of premium income for a life insurance company is particularly relevant, where single premium business is becoming an important driver of top line growth. However, given that 70% of life insurers' costs are fixed, recurring premium income therefore remains a key component of efficiency.

When assessing a short term insurer's mix of business and relative quality of gross underwriting, retention levels (net premium income to gross premiums) and loss ratios (claims incurred to net premiums earned) are used.

When assessing a long term insurer's mix of business and relative quality of gross underwriting, the book multiple (premiums to claims) provides a good indication. This ratio also provides an indication of the growth prospects for the industry (identifying periods of contraction and expansion).

Furthermore, expenses are analysed in order to determine if there are any undue inefficiencies in both long and short term insurance companies. The assessment of costs revolves around management expenses and commissions paid, whilst taking into account the relationship between fixed and variable costs and the insurer's ability to rationalise these costs if they are out of line with industry norms. At all times, a comparison is made with historical trends, peers and industry norms. Ratios used include management expenses to net premium income and commissions paid to net premium income.

Overall, the management and administration capacity of an insurer can directly impact the entity's efficiency, in tandem with the composition of revenue and expenses. As such, these areas are all evaluated concurrently.

Asset and liability liquidity factors are very important in the analysis of the claims paying ability of an insurer. From a cash flow perspective, GCR reviews the operating cash flow characteristics of an insurance company and how these may change in certain economic and underwriting environments. Liquid assets in relation to liabilities give an indication of the portion of a company's liabilities that are covered by cash and other liquid assets. This is particularly relevant to a short term insurer's business.

GCR evaluates the level of capital in relation to an insurer's risk exposures, which include investments, underwriting, business and reinsurance. In the case of short term insurers, this is measured by the international solvency margin (shareholders funds as a percentage of net premium income) and the financial base ratio (which includes technical reserves). Investing technical reserves, capital reserves and capital is a key activity of a general insurance company's operations. GCR analyses investment mix and compares it to peer companies and to the characteristics of the liability portfolio. Furthermore, GCR assesses concentration risk in terms of asset class, geographic region, size of investment and source of investment. Historical investment performance is important to determine the insurer's track record in specialty asset types. Foreign currency management and the ability of the portfolio to protect against inflation is also a critical part of the GCR analysis, particularly in certain markets.

The actuarially determined excess of assets over liabilities (or free asset reserve) is used to determine whether a life insurer's capital adequacy requirements (“CAR”) are adequately covered. The CAR provides a buffer against experience worse than that assumed in the financial soundness valuation.

As noted, claims paying ability ratings are a measure of the strength and variability of the margin by which assets are expected to exceed liabilities on a sustainable basis. Accordingly, existing capital plays a critical role in the evaluation of a short term/ life/health insurer's claims paying ability. However, there is often confusion concerning the extent existing capital levels influence a rating, especially when a company is overcapitalised. In the absence of a healthy block of business, manageable risk exposures and quality management, a company is not likely to achieve a high rating regardless of its existing capital strength. An otherwise reasonably strong company that maintains extraordinarily large capital balances can, however, potentially achieve a higher rating than its profile may otherwise imply. The extent that overcapitalisation improves a rating depends on GCR's comfort that the company will remain overcapitalised, especially if overcapitalisation makes the return on capital subpar. Except in extreme cases, overcapitalisation may improve a rating by not more than one or two ratings categories.

Conclusion

While thorough quantitative analysis is important, the qualitative characteristics of our analysis cannot be overemphasised. It is critically important to look “beyond the numbers” to evaluate the intangible strengths and weaknesses of a company. An important aspect of GCR's analysis is an understanding of the strategic characteristics of a company and the quality of management. Our emphasis is on determining how these strategic aspects will affect the insurer's claims paying ability.