Introducing Morningstar's Insurance Credit Ratings

In late 2009, Morningstar announced the launch of corporate credit ratings, and, in July, we announced the launch of corporate credit ratings for banks. Since then, we've published ratings on more than 500 firms in a variety of industries. We are now adding insurance to the roster of companies for which we provide ratings, with an insurance-specific rating methodology.

While our system for rating insurance companies is similar to the methodology used for banks and nonfinancials--emphasizing economic moats, competitive analysis, and the uncertainty surrounding a firm's prospects--there are some important differences. For example, we've developed a Financial Risk Score using ratios specific to insurance companies. We also incorporated an insurance Debt Cushion score. Four separate scores fold into a final credit rating, which we believe provides a thorough perspective on an insurer's financial health.

• We evaluate a firm's moat and other core business characteristics in a Business Risk Score.
  
• The Financial Risk Score measures a company's leverage against reserves and premiums. Debt-to-capital is also considered in this pillar. Finally, we perform sensitivity analysis on the insurer's investment portfolio. Combined, these measures give us a good picture of the strength of the company's balance sheet and its sensitivity to unexpected claims or investment losses.
  
• The Debt Cushion Score measures an insurer's capacity to service its debt, based on our analysts' projections. While leverage factors into this ratio, earnings power also influences this score.
  
• Our market-driven Distance to Default Score uses option pricing theory to evaluate the risk that the value of an insurer's assets will turn out to be less than the sum of its liabilities, denying it the benefit of a minimum capital cushion.

I. Insurance Business Risk Score
The Business Risk Score is based on multiple elements, each evaluating a different aspect of the risk associated with a particular insurer.

Country
No matter how solid an insurer's balance sheet, if it operates in an unstable political or economic environment, it deserves a lower credit rating than a similar firm operating under more benign conditions.

Size
We believe that size is relevant in assessing the credit quality of insurers, as large insurers generally have better access to capital markets and more parties interested in their survival.

Economic Moat Rating
An essential part of our company analysis is the economic moat rating, which encapsulates our view of a company's competitive advantage and its ability to earn excess returns on capital.

Uncertainty Rating
Morningstar's uncertainty rating represents our estimate of the predictability of future cash flow to equityholders. Because equity is the residual value of a firm after satisfying creditors, it represents a cushion against losses for bondholders.

Stewardship
Our analysts assign companies a Stewardship Grade, which captures our view of corporate-governance practices and management's skill. The Morningstar Equity Stewardship Grade is adjusted as necessary to reflect a management team's concern for the interests of bondholders.

Regulatory Environment
Our analysts assess the regulatory environment surrounding each insurer. For example, insurers with concentrated operations in states where the insurance commissioner is elected rather than appointed run a higher risk of negative regulatory outcomes to appease public opinion.

Underwriting Profitability
To assess underwriting profitability, we measure an insurer's combined ratio (a ratio of 100% means the insurer breaks even on underwriting). We use a modified combined ratio that includes fee income to make the measure relevant to life insurers, which typically generate a substantial amount of fee income.

Underwriting Volatility
We assess the range of an insurer's modified combined ratio to further gauge its underwriting practices and potential magnitude of losses.

Overall Level of Underwriting

We assess the overall level of underwriting risk of an insurer, applying baseline scores for each sub-industry (life, P&C, and reinsurance). Analysts and the credit rating committee may adjust away from these baseline scores for any relevant firm-specific considerations.

 

II. Insurance Financial Risk Score
This score centers on the balance sheet structure. We look at four measures to assess the leverage of the company to the unexpected claims or investment losses.

Reserves to Capital
Reserves-to-capital gauges the exposure of the firm's capital base to unexpected claims losses.

Premiums to Capital
Premium-to-capital measures the insurer's exposure to underwriting mistakes.

Debt-to-Capital
This traditional metric captures the company's financial leverage.

Investment Portfolio Sensitivity Analysis
For each asset class that an insurer may carry in its investment portfolio, we assign a potential loss rate based on the volatility of the historical returns of that asset class. For example, Treasuries would carry the lowest assumed loss rate, and equities the highest. This allows us to gauge the relative riskiness of the insurer's portfolio. We then take the total loss rate for the portfolio and compare it to the company's capital base. This allows us to measure both the riskiness of the company's asset allocation and the sensitivity of the balance sheet to investment losses.

III. Insurance Debt Cushion Score
The Debt Cushion Score measures the insurer's ability to cover its debt load and future interest payments with its balance sheet surplus and future profitability. It is forward-looking and not only takes into account both earnings power and leverage, but also allows its individual components to be dissected and analyzed.

• The lower the balance sheet leverage, the higher the score.
  
• The higher the future profitability ("earnings power"), the higher the score.
  
• The lower the debt level, the higher the score.
  
• For insurers with volatile claims exposure, analysts typically include a high loss year in future projections, so the lower the claims volatility, the higher the score.

IV. Distance to Default
Distance to Default ranks companies on the likelihood that they might encounter financial distress. The more likely the value of a company's assets is to fall below the sum of its liabilities and a small capital cushion, the greater the likelihood of financial distress. The measure treats a company's equity as a call option on the company's assets, with the total liabilities being the strike price. The Distance to Default expresses how many standard deviations separate the current value of assets from the strike price.

The Final Credit Rating
When combined, these four factors create a ranking system for measuring an individual corporation's financial strength against that of other firms in our coverage universe. All of these factors are then reviewed by a Morningstar credit rating committee made up of senior members of the research staff, where additional adjustments to rankings may be made--for example, by incorporating outside factors such as the potential for government assistance. The committee then decides on the final rating--AAA through C--to award the company.

Our credit ratings are issuer ratings, meaning they apply to the corporate issuer, not to any specific bond. We define the ratings, however, to apply to any senior unsecured debt of the company in question, which covers the bulk of corporate debt outstanding. Also keep in mind that a credit rating is not an investment rating--it's not our opinion on whether a company's bonds or other securities are "buys" or "sells."

Even if credit ratings do not translate directly to buy or sell recommendations, the ratings do have direct relevance for bond investors. By comparing bond issues from companies we consider to be of comparable credit quality, we can identify individual bond issues that appear potentially overpriced or underpriced. These investment ideas, along with weekly credit updates on our coverage list and all the underlying assumptions that go into the credit ratings, are available through our institutional service.

Where to Learn More
We think it's important to be as transparent as possible about how we arrive at the ratings for individual firms. Click here to go directly to a more detailed explanation of our methodology.