How Secure is Your Security Blanket?

How Secure is Your Security Blanket?

Too often, when shopping for insurance, consumers will focus most of their attention on the amount of the premium they will have to pay rather than on the financial strength of a prospective insurance company. Unfortunately, those who focus primarily on premium rates may find that they have “backed the wrong horse,” so to speak, and could wind up suffering big losses.

Although the cost of insurance is certainly an important factor when seeking coverage, the financial strength of an insurance company can prove to be the most significant factor of all, especially in instances when a financially weaker insurance company is chosen over a stronger one. After all, an insurance company that becomes insolvent or bankrupt will likely not be able to pay the claims of its policyholders; if you are one of those policyholders, then your insurer’s insolvency may have serious implications for you or your business.

Conceptually, an insurance company’s ability to pay the claims of its policyholders is fundamental to the underlying purpose of insurance. The significance of premiums, deductibles, coverage limits, policy terms, and exclusions virtually vanish when the prospect of insurer insolvency surfaces. After all, what difference does the amount of the deductible make if there is no money to pay a claim?

Although it is always important to evaluate the financial strength of an insurance company, doing so takes on even greater significance during periods of national economic contraction because insurance companies face considerable obstacles during recessionary periods. Insurance companies are, after all, businesses like any other.

A business is considered insolvent when it is unable to pay its debts as those debts become due. And the debts of insurance companies are generally the claims of policyholders. Thus, when viewed from this perspective, it becomes clear that not only shareholders are injured when an insurance company becomes insolvent. Policyholders with claims may also be left holding the bag for any losses that they assumed their insurers would cover.

Although there are no guarantees that a particular insurance company will remain solvent, it is commonly understood that financially strong insurance companies are more likely to meet their ongoing obligations to policyholders than financially weak ones. That’s why a company’s solvency, in the context of being able to pay claims as they become due, is critical.

An insurance company may become insolvent for a number of different reasons, such as mismanagement, undercapitalization, poor underwriting standards, ill-advised investments of premium reserves, or overexposure to a specific risk. The existence of one or more of these conditions may increase the risk of insurer insolvency.

For example, an insurance company that elects to sell an inordinate number of wind insurance policies in coastal communities, when compared to the insurance company’s overall risk exposure, would be susceptible to a large loss in the event of a single catastrophic hurricane. In this example, the imprudent risk is that of aggregation. This is why insurers typically favor limiting their exposure to loss from a single event to a small percentage of their overall capital base. However, an insurance company that operates contrary to this logic by overexposing itself to a specific risk faces the very real possibility of being wiped out financially in the event that risk comes to pass.

Given the severity of the consequences that usually flow from insurer insolvency, there is a benefit to knowing whether or not a prospective insurance company possesses one or more of the conditions that may lead to insolvency. Unfortunately, conducting the requisite investigatory due diligence may be difficult, if not impossible, for the average insurance consumer. However, there are resources available to assist consumers with this task.

A.M. Best®, a company that evaluates and rates the financial health of insurance companies, conducts independent evaluations to form an opinion regarding an insurance company’s financial strength. Based on an evaluation of an insurance company’s balance sheet, operating performance, and business profile, A.M. Best issues its “Financial Strength Ratings,” which have been recognized as a benchmark for assessing an insurance company’s financial strength.

The Financial Strength Ratings assign letters to convey A.M. Best’s opinion as to the financial strength of a particular insurance company. Similar to academic report-cards, a higher rating suggests that, in A.M. Best’s opinion, a particular insurance company is more likely to meet its ongoing obligations to policyholders as opposed to an insurance company with a lower rating. “Secure” insurance companies are graded as Superior (A++, A+), Excellent (A, A-), and Good (B++, B+). “Vulnerable” insurance companies are graded as Fair (B, B-), Marginal (C++, C+), Weak (C, C-), Poor (D), Under Regulatory Supervision (E), In Liquidation (F), and Suspended (S).

In addition to A.M. Best, there are other rating agencies available for those wishing to investigate the financial health of prospective insurers. However, consumers should understand that each rating agency may use different standards, processes, and methods to rate insurance companies. Despite the fact that many such agencies may use some form of alpha-rating methodology, not all “A” ratings are necessarily created equally. Consumers should investigate not only the methodology used by their rating agency of choice but also its reputation in the insurance and financial industries. As usual, the more information insurance consumers obtain at this stage of the purchasing process, the better off they will likely be.

Regardless of which system is used, it is important to note that a rating is not intended to be a guarantee of an insurance company’s financial strength. The ratings merely reflect opinions based on detailed evaluations. Consequently, a higher rating does not guarantee solvency, nor does a lower rating necessarily demand insolvency. This is because the ability to predict an insurance company’s future solvency falls short of mathematical precision. Insurance companies must rely on probabilities, not absolutes when underwriting risks and setting premiums. When calculating such probabilities, insurance companies generally apply a mathematical theorem known as the law of large numbers. If the predicted probability of a loss is high, then the insurance company will either charge a higher premium or reject the risk outright.

However, unknown or unanticipated risks may compromise the predictability provided by the law of large numbers. Since these risks were unknown, the actuarial science initially used to calculate the risk is undermined. In such cases, even insurance companies with the highest ratings may not be able to survive a deluge of unanticipated claims for which premiums have not been collected and reserves have not been allocated.

Given the inherent imprecision of insurance underwriting, it is unlikely that forecasting the likelihood of continued solvency will ever be sufficiently predictable so as to warrant a guarantee. Nevertheless, the wisdom of considering a prospective insurance company’s financial strength should never be dismissed, and at least a cursory review of the insurer’s financial rating should be undertaken.

It is worth noting that insuring with a highly rated insurance company is not always a viable option. One reason is that the security provided by a highly rated company often comes at a price, usually in the form of higher premiums. For many consumers operating on a fixed budget, going with an A-Rated insurance company may be cost prohibitive.

Another obstacle that consumers may encounter is the fact that many A-Rated companies are simply not offering the type of insurance coverage being sought. For example, in light of the devastating hurricanes of a few years ago, many homeowners living in coastal communities have experienced great difficulty finding insurance companies willing to insure against wind damage. In such cases, many consumers simply do not have the option of going with a highly rated insurance company.

Despite any obstacles that may stand in the way of obtaining insurance from a highly rated company, consumers should nonetheless add the financial strength of prospective insurers to their list of factors to consider when purchasing insurance. By doing so, you may increase the likelihood that the insurance company that is always there to collect your premiums will also be there to pay your claims.