The Critical Importance of Rating Agencies: Joseph Petrelli, CEO of Demotech (AoB S1E3)

Insurance company Rating Agencies perform a critical and yet, under-appreciated function to society. As an impartial 3rd party, Rating Agencies evaluate insurance companies for their ability to pay future claims and remain solvent.

Now the ability to pay future claims depends on a large part to the amount of assets and surplus an insurer has on their balance sheet. The larger the surplus, the more risk an insurer can take. Rating Agencies are highly focused on surplus as it relates to some probability threshold of loss. Here is an example.

• Taylor Swift Insurance Company has $100 Million (or should it be billions of $$$) in surplus.
• A fictional rating agency that computes their rating based on say the 1-in-100 year expected hurricane loss will want to see forecasts of hurricane loss under different probabilities.
• If $100M in surplus is greater than the 1-in-100 year threshold used by the rating agency, then Taylor Swift Insurance Company is likely to pass
• But, If $100M in surplus is LESS THAN the 1-in-100 year threshold used by the rating agency, then Taylor Swift Insurance Companies may need to go on tour again to build up that surplus.

The actual rating is a complicated, month's long process. Each rating agency has their own unique quantification weightings and philosophies on what an insurer needs to have for assets and how that insurer runs their operations for the rating agency to assign it a rating that will allow the insurer to conduct business.

Rating Agencies look at

• The management of the company (has it conducted itself with integrity?)
• The history of management and the company (a history of excellence is weighted more positively versus a startup with no history)
• The marketing and source of business of the company (does the company have a strategic angle on distribution? What is the expense to obtain that business?)
• It's investment strategy (can it generate income from it's investable assets that can offset underwriting losses? Is the strategy conservative or aggressive, prudent or risky?)
• What is it's claims practices? (does it get have a mature and effective claims management team and process? How does it handle catastrophic events?)
• Finally, what is the ability of the insurer to pay claims under attritional and catastrophic conditions? (Does the insurer have the balance sheet to cover a 1-in-100 year, a 1-in-200 year (or worse) event? Can the insurer handle multiple events in a single season? Does the insurer have access to reinsurance capacity in the extreme cases where their balance sheet isn't substantial enough?)

It is the last scenario that allowed an actuarial firm such as Demotech an opening to become on of the most important and influential rating agencies for insurers.

Small insurers and startups generally lack the balance sheet necessary to make a dent in the marketplace. In most states, an insurance license can be had for $5-10 million in paid-in capital. But even if that carrier wrote small ticket items, that capital will quickly be accounted for.

Enter reinsurance. Reinsurance is insurance that insurance companies buy. For smaller firms, startups and regional players, reinsurance is an essential component to their business model. Startup carriers do not have much going for them in the early days. Small balance sheet, no brand, no reputation. But with reinsurance, a small firm can have the claims paying ability of a larger firm. In 2023, the US P&C industry has over $1 trillion in claims paying surplus, and amazingly State Farm has over 10% of this total. But with the backing of reinsurance companies, even startups can go head to head with the big players. Global reinsurers such as Munich Re, Swiss Re, Scor and Berkshire Hathaway have hundreds of billions of dollars of surplus they use to back smaller insurers. Before Demotech came along, it was "impossible" for rating agencies to rate small, regional or startup insurers.

In this episode of Assignment of Benefits, Nick spoke with Joseph Petrelli , CEO of Demotech, Inc. , about Rating Agencies and their role in society. Demotech understood that the solvency of a small insurer was correlated with their reinsurance and less about their balance sheet. Their balance sheet was adequate to get them in the game, but it's the reinsurance that allows them to compete. In CAT prone areas such as Florida, the market is dominated by domestic insurers who for the most part got their start as startups backed by Bermudian and global reinsurance (a large part of this is due to the reduction of uncertainty of losses due to the ubiquity of CAT Models...a topic for a later time).

The importance of this can NOT be understated.

Mortgage lenders want to know that their loans are going to get paid back in the event of a catastrophic event. A third party rating is crucial to the mortgage market. NO rating - NO access to properties with federally secured mortgages (which is the majority of them). States like Florida could not exist in its current form with real estate funding from banks. That real estate funding can not be secured unless it has insurance coverage on it that is rated by an impartial third party rating agency. So what we have is trillions of dollars of Florida real estate (not just Florida) that would be uninsurable if it weren't for a company like Demotech finding a methodology to analytically quantify the claims paying ability of smaller insurers backed by high quality reinsurance. Yes, you could say Demotech is a crucial stakeholder to the US property market.

Listen Here: (soon to be available on Apple, Google, Spotify, and all major podcast players)

Watch Here: