However, despite improved balance sheets and sustained operating profits from self-imposed underwriting discipline, coupled with benign frequency and severity trends during this period, the sector remains prone to market cyclicality, reserve missteps, and the vagaries associated with changes in judicial and legislative rulings.
AM Best’s perspective on the heightened challenges facing the MPL sector today is impacting the agency’s prospective view of the companies’ financial strength, thereby jeopardizing ratings. These challenges include declining premiums, increasing claim severity, shrinking reserve margins, and emerging risks in the delivery of healthcare. A company’s rating will ultimately be determined by its ability to manage headwinds, sustain and deploy capital,
and the perceived prospects for its growth and profitability. Companies that have recent profit trends lagging the performance benchmarks of their peers will encounter rating pressure.
In an industry where business can be materially altered by changes in state tort reform law, jury verdicts, and loss cost trends, AM Best keeps a close eye on the road ahead rather than the road behind. Analysts incorporate as much prospective analysis as possible, placing greater emphasis on market challenges and opportunities, trend analysis, and potential changes to the judicial, regulatory, and legislative landscape. AM Best analysts will conduct accident- year analysis to recognize reserving behavior and the embedded redundancies that may be harvested later. This requires that AM Best have a more open dialogue with company management and focus on rating outlooks.
As they adopt a more forward-looking approach for assessing the risks inherent in the MPL sector and attempt to recognize more of the recent trends, AM Best may be assigning ratings on MPL companies that show a downward shift.
Elements in a rating
AM Best’s ratings are derived from the evaluation of a company’s building blocks (evaluation areas), as part of a rating scorecard. The building blocks include balance sheet strength (BSS), operating performance, business profile, and enterprise risk management (ERM). Balance sheet strength holds considerable weight within the evaluation, and the BCAR capital model remains vital to this assessment. However, the agency has always made it clear that ratings were not based on BSS alone and that within the rating scorecard, the BSS assessment was not based solely on BCAR.
Therefore, despite median BCAR scores for MPL companies that are well above the minimum AM Best thresholds required, companies rarely achieve the highest available BSS ICR (issuer credit rating) of “a+.” This is a noteworthy target, since the BSS ICR is the anchor rating in the scorecard, which is notched higher or lower based on AM Best’s evaluation of the other building blocks. The influence of other balance sheet factors in the BSS assessment cannot be ignored when roughly three-quarters of MPL insurers’ BCAR scores (expressed as percentages) are in the mid-60s, at the highest confidence level in the
model. Aside from other balance sheet factors, such as leverage, reinsurance, and financial flexibility affecting BSS, another factor impacting the BSS for MPL companies is the connectivity of their building blocks.
The connectivity of the building blocks in the scorecard is evidenced by how business profile impacts the BSS assessment. A healthy and vibrant market typically leads to good business prospects and growth, continued deployment of capital, and enhanced stakeholder value. In situations where market opportunities are limited or restricted, AM Best believes that this is likely to adversely affect future financial strength, limiting a company’s eligibility for the highest BSS assessment levels.
For many MPL insurers, the rating agency recognizes the robustness of their balance sheets. However, that assessment is tempered by the impact of their limited business profile, coupled with challenges and adverse conditions in the current market and the constraints of putting capital to work to foster growth and diversification. As such, many companies cannot attain the maximum “a+” ICR for BSS, due in large part to the diminishing prospects for their balance sheet.
In the rating evaluation, excess (BCAR) capital does not compensate for below-average business profile trends. Nor does it compensate for below-average operating performance. AM Best measures the operating performance of a company on both an absolute and relative basis, and the agency has developed benchmark reports that assess a company’s results against the ratios achieved by its peers, at each assessment level. Benchmarking used in the context of the appropriate peer group is more meaningful, and the analyst should understand the external factors affecting trends. Companies need to understand where they stand relative to their rated peers since the use of benchmarking allows the analyst, along with the rating committee, to see how well a company is performing on a percentile basis. Highly rated companies need to recognize that if they are profitable, yet their key performance ratios remain at or near MPL sector averages, they are likely to be viewed as merely “Adequate” in regard to operating performance assessment. This
assessment provides no positive notching in the scorecard.
A majority of MPL insurers are still realizing sizeable amounts of
investment income. Companies that are reporting hefty investment income should continue to see the benefits of it in their operating returns. Drivers of rating-outlook changes for highly rated companies with large quantities of invested assets are therefore likely to be based on more recent, and expected, trends in operating returns. AM Best’s view of prospective results will also include an assessment of accident year (AY) loss trends, reserve development, and the value of ultimate AY loss ratios. With the MPL sector experiencing weakening AY loss ratios and diminished reserve cushions, future calendar-year ratios will benefit less from favorable development, potentially leading to pressure on rating outlooks.
The business-profile evaluation of a company in the MPL sector is impacted mainly by its market position, geographic, business diversification, and judicial risks, on a state-by-state basis. A “limited” business profile may inhibit prospective operating results and balance sheet strength. Market challenges posing a risk of uncertainty for rising claim costs include healthcare reform and delivery changes, legislative/tort reform changes, migration of solo physicians to groups or hospitals,
and an influx of insureds into the healthcare system.
Role of innovation
Going forward, AM Best will provide a more focused review of a company’s extent of innovation. The rating agency sees innovation as a competitive advantage for companies, which leads to greater financial strength. Innovation is now one of the subcomponents considered in the business profile; it can be positive, neutral, or negative to the assessment.
At their annual meeting with AM Best, companies should be prepared to discuss their innovation process. Ultimately, the rating agency will look for evidence of a sound innovation process regarding lower expenses, higher revenue, higher customer retention, improved brand, better data analytics, and implementation strategies, including time horizons.
ERM and the assessment
The rating agency evaluation of ERM is tied to the rating assessment and is no longer focused solely on checking the box for compliance purposes. The practical application of a company’s ERM framework has become more prominent in discussions with the rating agency and, if it is presented well, can make a difference in maintaining a rating. MPL companies would benefit from enhanced economic capital modeling and stress testing around risk appetite and risk tolerance, but the ideal evidence for a strong ERM program is still a prudent level of capital coupled with positive, stable performance.
AM Best is clearly concerned about the MPL sector due to market trends. In the MPL space, market headwinds such as a shrinking base of insureds, soft pricing, declining reserve redundancies, and rising AY loss ratios all contribute to Best’s negative outlook for the sector. Insurers that can successfully navigate these headwinds, take advantage of new opportunities to deploy capital that increase stakeholder value, find ways to foster growth, and produce profits in line with the profit targets expected by AM Best, will maintain their ratings.