Is Your Life Insurance Policy Money Good? Part 1: Assessing the Credit Quality of Insurers

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

In the present harsh credit environment, I have received inquiries about the claims paying ability of life insurance companies.

To understand insurance policy credit risk, we need to look at three basic questions. First, what is the credit quality of my life insurer? Second, what is the nature of ownership of any assets held in the policy as “cash value”? Third, what backstop protection do I have from my state insurance fund? We will start this week with the first issue.

The longer an insurance policy is likely to stay in force, the longer a view the policyholder must take of an insurer's credit quality. In a permanent life policy insuring a woman now 30 years old, the event insured against, death, may not happen for 50 or more years. It's hard to predict how a company will be doing in five years, let alone fifty. Nevertheless, default by life insurance companies on the claims of policyholders is relatively rare, and there are numerous published measures of insurance company credit quality available.

There are several ways of measuring the credit quality of insurance companies. The least sophisticated way is by looking at their so-called “regulatory capital”—essentially a book value measure of the excess of stated book assets minus stated liabilities. This measure is important because insurers must maintain certain regulatory capital limits to stay in business. Each state has a statute regulating insurance companies domiciled there; the State Insurance Department and its Commissioner oversees insurance company capital adequacy.

A more sophisticated measure is called “economic capital.” If a company has adequate economic capital, security analysts believe it holds adequate reserves to meet probable real world challenges; this requires evaluation of the probable market value of both its assets and liabilities under various stress scenarios.

Third party credit agency evaluations of long-term debt obligations provide another important perspective. Insurance companies, like other large borrowers, pay fees to have their obligations rated by private agencies. Unfortunately, each agency has its own rating scale. With Standard & Poor's (S&P)( www.standardandpoors.com ), AAA is the highest rating for long-term obligations, then AA, A, BBB, BB, B, CCC, CC, C, and D (default); there are plus and minus gradations. Any rating of BBB- or above is called "investment grade" for bond investors. I recommend you consider companies with long-term ratings no lower than A equivalent for term life and AA equivalent for permanent life. Moody's (www.moodys.com ; requires registration) three highest ratings are Aaa, Aa, and A, with descending gradations of 1,2,3. The four highest ratings of insurance company "financial strength" at A.M. Best ( www.ambest.com ), which specializes in insurance, are A++, A+ ,A and A-. Finally, Fitch ( www.fitchratings.com ) has an Insurer Financial Strength rating scaled like S&P. See "What You and Your Family Need to Know About Personal Insurance," from GreenwichFinancial.com Website.

Generally, you pay more premium to be insured by a higher rated company. When you purchase insurance, your agent ought to apprise you of the credit ratings of your prospective insurer; you should stay informed of significant changes. Caveat: the ongoing subprime lending fiasco has highlighted the foibles and conflicts of interest endemic to such rating agencies; critics say they are often the last to recognize serious financial difficulty.

When an insurance company fails, and it goes into receivership, whether for rehabilitation or liquidation, the claims of insurance policyholders (aside from reinsurance) rank higher in priority than those of general creditors or shareholders, and usually are not impaired. In egregious cases, though, such as that of Executive Life Insurance and its aggressive junk bond strategy, some policyholders have had their claims at least partially impaired.

For a variety of reasons, a company may show a significant regulatory surplus even though its solvency is questionable. A very good resource for state regulation of insurance companies is the Website of the National Association of Insurance Commissioners, www.NAIC.org; with their Consumer Information Service, you can check on the licenses, consumer complaints and financial status of each insurance company operating in your state. The NAIC's Insurance Regulatory Information System (IRIS) provides analysis that assists the state commissioners in detecting insurance companies that may face financial problems.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.