What it means
When you buy an insurance policy, you are trusting the insurer to be around and solvent years later when a claim happens. A claims paying ability rating gives an outside view on that trust.
The agency looks at the insurer's capital, earnings, investments, the quality of its management and the risks in the policies it has written. The scale runs from AAA at the top through AA, A, BBB and lower grades.
Insurers rated BBB or above are generally seen as secure, while those rated BB or lower are seen as vulnerable to adverse conditions. Plus and minus signs fine tune the grade within each letter.
The rating applies to the insurer's obligations to its policyholders and is not a view on its debt or its share price. A different set of ratings covers the bonds the insurer itself issues.
Mixing the two up is a common source of confusion. Businesses use the rating when choosing insurers, especially for long-term or large cover such as workers' compensation, liability and surety bonds.
Many contracts, loans and government tenders state a minimum rating for any insurer they will accept. A rating downgrade can therefore force a company to move cover at short notice.
Ratings are opinions, not guarantees, and they can change. Smart buyers check the rating at purchase and again at renewal, and for large exposures they spread risk across several insurers rather than rely on one.
Reinsurance plays a part in the grade too. Insurers pass some of their risk to other insurers, and the agency considers how strong those partners are and how much the insurer relies on them.
A company with heavy exposure to a weak reinsurer may receive a lower grade than its own balance sheet suggests.
In practice
Real-world examples.
Example
A construction firm is bidding for a public contract that requires its surety bond to be issued by an insurer with a rating of A or better. The firm's broker confirms the insurer's grade before the bid is submitted.
Example
A finance director reviewing a workers' compensation policy sees that the insurer has been downgraded from A to BBB. She asks her broker for quotes from stronger insurers before renewal, and she compares the extra premium against the risk of an unpaid claim.
Example
A landlord requires every tenant to carry liability cover from an insurer with a minimum rating. The rule protects the landlord if a claim arises years after the incident, and it avoids arguments about whether a small insurer can really pay.
Case study
Seen in the real world.
Harlow Marine Supplies is an entirely fictional importer that insures its warehouse with a low-priced insurer. In this illustrative story, the policy is $2,000,000 cheaper over five years than the alternatives offered.
The company's broker points out that the insurer has a weak financial strength grade, which means there is a higher chance that it could struggle to pay a large claim. The finance director weighs the saving against the risk of an uninsured loss at the worst possible moment.
She moves the cover to a stronger insurer at a higher premium. The illustrative lesson is that an insurance policy is only as good as the insurer's ability to pay, and that a lower price can hide a higher risk. She wrote the decision into the company's procurement policy, so future renewals would automatically check the insurer's grade and compare it against a minimum. The broker also arranged for the board to receive an annual one-page summary of each insurer's rating and outlook. Two years later the cheaper insurer is downgraded after heavy losses on another line of business, and the company is relieved that it did not have to scramble for replacement cover in the middle of a claim. The finance director now reports insurer grades to the audit committee every year.
Watch out
Common mistakes.
- Choosing an insurer on price alone, without checking its financial strength.
- Confusing the insurer's claims paying ability rating with the rating on its bonds.
- Assuming a high rating at purchase will last for the whole life of a long-term policy.
Questions
People also ask.
What is the difference between a claims paying ability rating and a credit rating?
The first assesses the insurer's ability to pay policyholders, while a credit rating assesses a borrower's ability to repay debt.
What rating counts as secure?
Insurers rated BBB or higher are generally considered secure, although many buyers prefer A or better for long-term or high-value cover such as liability and workers' compensation.
Is the term still used today?
It has largely been replaced by insurer financial strength rating, but the idea is the same, and older contracts may still use the earlier wording.
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