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Preparing for Your Rating Agency Visit Physicians Insurance Association of America (PIAA) CEO/COO Session March 13, 2008 10:30 – 11:45 AM Westin Kierland Hotel Scottsdale, Arizona Presented by Herbert E. Goodfriend Senior Vice President 1 2 Agenda Ratings: Holy Grail? Preparing for the Ratings Presentation The Presentation Itself After the Presentation Conclusion Questions 3 Where Do You Fit In? Already involved with the rating agency process? Preparing for your first visit? Don’t think you need a rating, but … 4 Why Do It? Holy Grail Many financial institutions, regulators, policyholders, distribution systems may require it For marketing reasons – i.e., a high rating encourages policyholder, investor and public confidence in your company Some of the disciplines involved in preparation can be quite instructive and useful in your internal management – ownership assessments Process provides: Valuable perspective on company’s business plan and strategy Encourages greater transparency 5 Are There Pitfalls? Experience can be unpleasant: Adversarial Generational gap High cost in terms of time and money – not a one-off phenomenon Once on the path, it’s difficult to get off unscathed 6 What is a Rating? Rating is an opinion about the financial strength of your company Rating is based on publicly available data, often supplemented with confidential interviews with rating agency staff (“insiders”) A high rating does NOT mean your company will survive and thrive; it simply means that there’s a greater likelihood it will Rating firms are not perfect; opinions inter alia may differ Criteria change as do the people involved in setting and applying them 7 Who are the Leading Rating Firms? A.M. Best Company Duff & Phelps Fitch Ratings Moody’s Investor Service Standard & Poor’s Weiss Ratings, Inc. - Different Category 8 What are They Looking For? Rating scales tend to fall into two major categories: Secure Vulnerable The common denominators among all ratings: Solvency Relative Performance 9 Summary of the Rating Process: A 3-Legged Stool with Moving Parts Capital Business profile Operating efficiency and profitability Enterprise Risk Management (ERM) and Dynamic Financial Analysis (DFA) rising in relative importance, but still in nascent stages for most companies 10 A.M. Best Company Founded in 1899; oldest, independently-owned rating agency Broadest coverage Two types of ratings: Public data only – extracted from available statutory and reportable documents Interactive Consultation with company management Quantitative analysis of financial data (“SRQ”) provided by the company Evaluation of the company’s balance sheet strength and operating performance Qualitative analysis of several factors including management experience Comprehensive review including quantitative/qualitative mix of meetings, conference calls, written correspondence and business plan Process not driven solely by ratio analysis; evaluation includes organization(s) as whole including holding companies and pools as well as statutory and GAAP regimens Rated companies can request that rating not be published (classified as “NR-4”) 11 Duff & Phelps (D&P) Founded in 1932; independently owned Claims-paying ability rating Companies request to be rated; can request rating not be published Relatively few insurance companies rated 12 Fitch Ratings Majority-owned subsidiary of Fimlac S.A., headquartered in Paris Fitch assigns two types of ratings: • Requested ratings - a variety of public and non-public data plus meeting with Fitch analysts • Not requested ratings - designated “q” (quantitative) and based on publicly available information Very fixed income asset and capital oriented Relatively few insurance companies monitored Proprietary capital adequacy scoring (“PRISM”) for 99 insurance groups o 63% of non-life industry with $284 bill NWP o e.g. Range AAA – BBB+; Average Rating 2005-2006 AA 13 Moody’s Investors Service Founded in 1900; independently owned “Solicited ratings” are based on public and non-public 14 information as well as meetings with Moody’s analysts The company does almost no unsolicited ratings Financial strength rating Companies cannot request that rating not be published Major force in public and private capital markets Tend to be more conservative Standard & Poor’s (S&P) - part 1 Founded in 1860; acquired in 1966 by The McGraw–Hill 15 Companies Claims-paying ability rating Quantitative ratings (“q” qualifier) based solely on publicly available information Companies may request to be rated or may be rated involuntarily Companies can request that rating not be published – except for quantitative rating Has expanded coverage significantly in last decade = 48 U.S. groups in all, for the most part oriented to insurers tapping capital markets Standard & Poor’s (S&P) - part 2 New risk-based insurance capital model Higher charges for P-C companies but few downgrades to date Focus is on volatility Ratings trend positives and negatives in equilibrium: 2007 = 1 up and 1 down Stable outlook 77% of the total 2006 = 5 up and 5 down 2005 = 3 up and 4 down Median financial strength is “A” 16 Weiss Ratings, Inc. Independently owned and operated at one location (Florida) “Safety” rating Companies cannot request ratings No interview, formal meetings or personal relationships (“Black Box”) Companies are rated based on publicly available information – i.e., formula-driven (companies are invited to provide additional information) Companies cannot insist that rating not be published Dominated by life insurance coverages and health care companies; P-C companies get less attention but on the rise Genesis was spin-off of “John Doe” life and annuity inquiries 17 Preparing for the Presentation You should consider the rating agency an “insider” Use rating agency questionnaire to prep yourselves Select a “point” person who knows his/her craft, is well organized in such proceedings as to data selection, collection and presentation; being an articulate, succinct speaker would help too Pull together mission statement, business plans, projections, GAAP-statements, as well as use of outside consultants inputs, actuaries, counsel and portfolio managers Determine who should attend formal meetings and who should contribute on site; add or subtract one person from each presentation annually 18 The Presentation Itself - part 1 What to expect re: rating agency staff – personnel, experience and modus operandi for decisions Prepare a timetable for delivery of written and oral presentations; live up to schedule! Put your best foot forward without hyperbole; avoid predictable negative surprises, especially if they are called to the agency’s attention by a third party Address their previously articulated concerns head-on, with courses of action taken and/or planned near term Best case, modal case, worst case: 3-5 year projections The “short leash” syndrome Don’t knock your competition by name 19 The Presentation Itself - part 2 Get outside help if needed – it’s expected and a common practice before, during and after Practice, practice, practice Take notes of all questions, who asked them, who replied and especially, agency calls for action Ask for the rating you want and MERIT The letter grade is important but don’t forget the “Outlook”; it could well be pre-cursor to letter grade rating change Stable Positive Negative Under Review Penalty Box 20 After the Visit – part 1 Circulate notes among all participants Set time frame for responding to call to action As agency time for decision-making approaches, call agency counterpart to inquire if additional data are needed Check galley proof carefully BEFORE signing If decision is adverse, clarify issues carefully with possible additional visit Prospect for overturning adverse rating is not high. Agency loathe to overturn its analysts and “committees” 21 After the Visit - part 2 Submit operational and financial data on a regular, consistent basis supplemented by comments where appropriate If special issues arise such as financing, recapitalization, key ownership and management changes, alert agency ASAP to likely impact Similarly, if projections change materially from previously submitted ones, give agency heads up as to why, so as to maintain confidence 22 Hot Buttons - part 1 Industry risk - ERM Too much capital accretion vs. need for more capital Financial flexibility (capital requirements and capital sources) Management and corporate strategy Parental commitment as to resources. Leverage – access to capital Business review – underwriting results Capitalization Liquidity 23 Hot Buttons - part 2 Outsourcing – quality control; cost savings vs. give-ups Unique exposures Financial market dependency Regulatory and judicial room for maneuver Materiality of change since last meeting Reinsurance stress tests 24 Hot Buttons - part 3 Competitive situation Distribution Traditional Avant Garde/New Age Demutualization/Mutual Holding Company Structure Use of captives and RRGs: Some are being rated Managed care links Expense ratios 25 Hot Buttons - part 4 Investing in a low-interest rate environment; policy vs. reality; asset liability matching (ALM); sub-prime exposure Reserves – releases: 2004 and prior accident years – modestly redundant or on 26 target since then Regulatory developments Profitability; the cyclical phase of declining margins is at hand Group inter-relationships Parent company and subsidiaries issues “Micro” Issues Can you have and do you enjoy a sustainable advantage in a keenly competitive business? Balance sheet strength Statutory NAIC risk-based capital (RBC) and parochial measurements Investment portfolio 27 Proprietary – i.e., Best’s Capital Adequacy Ratio (BCAR); Fitch and S&P Risk measurements – stress tests and ERM Quality Liquidity Income Flows New Internal Revenue Service opinions on RRGs and captives Enterprise Risk Management - part 1 What is it? Risk and capital needed Diversification Accumulation and aggregation correlation Mitigation measures Return on adjusted capital Who likes it and sponsors it? Consultants, Ernst & Young, Wall Street; Standard & Poor’s Origins were in other businesses Only now getting footprints; likely to rise in relative importance 28 Enterprise Risk Management - part 2 What can it mean to you? Cost/benefit analysis – frees up capital but only a few do it well Culture unto itself Competitive differentiation Benchmarking: S&P codes 125 companies: “Excellent (6)”; “Strong (11)”; “Adequate (105)” and “Weak (3)” Drivers of change and challenges 29 Med Mal Insurance Trends – part 1 2006 was peak earnings year; rate declines accelerating in GL 30 standard lines, down 71%; NWP growth slowing Skeptical view of industry category affects rating agency collective judgments Reinsurance - more available here and abroad; at lower cost Slower new growth in units and dollars expected More consolidation, mergers and poolings in emerging softer market -- it's started already Stock buy-backs, where pertinent Med Mal Insurance Trends - part 2 Agency overview not limited to carriers - TPAs, claims organizations and advisory- medical consultative enterprises are in the swim too More problematic growth in RRGs and captives, especially start- ups IRS is on the loose again looking for revenue founts from RRGs and captives Continuing relatively high medical-hospital and pharmaceutical costs, unlike inflation in overall terms 31 Med Mal Insurance Trends – part 3 Loss ratios to hover around 75%, ex-LAE Good combined ratios at + or - 90% for first half 2008 Pressure on cash flows in 2008 due to lower or flat fixed income securities yields, and slowing volume growth with lowered premium rates Ergo - must not depend on investment returns to buoy slackening operating profitability Reasonably healthy reserves for accident and calendar years 32 Long Term Rating Agency Concerns Volatility Pricing and reserving adequacy Regulatory and legislative changes Populism - the election syndromes, aided and abetted by the media focus on “booboos”; consumerism 33 Long Term Rating Agency View Pluses Emerging tort reform: mixed trends in such jurisdictions as 34 Illinois, Maryland, Pennsylvania and West Virginia Claims frequency moderation Adequate reserves pro tem Present premium rates good (albeit for how long?) Big med-mal claims at hospitals on the wane as to frequency and severity, but still too long at 33 months on average What You May Anticipate from Rating Agencies - part 1 Some “movement on the beach”: Ratings upward but not too many Outlooks likely to remain “stable” to “cautious”, especially after mid year 2008 Recommendation to diversify lines and geography Expand only if infrastructure can handle it, before the fact Pay more attention to the media coverage of your business and region 35 What You May Anticipate from Rating Agencies - part 2 Notable exception to rational behavior in the market place: New York where its pool has large deficit Concern as to where and who are the new doctors, especially surgeons More self-discipline of the medical profession clearly needed, says the public Greater use of special law courts and administrative proceedings 36 Questions? 37