Insurance Rating
Companies are rated according to their risk of defaulting credit. Credit rating agencies such as S&P and Moody use many criteria to assess the likelihood that a company will default on its debt payment. The ratings of these companies are important because it gives valuable information to potential investors, issuers and the corporations themselves. A good credit rating enables a company to raise money easily in the financial market. S&P assesses a lot of criteria before giving a rating to any company. Some of the criteria used to evaluate the companies include micro and macro regulations, ERM and the Capital structure of the individual corporations. The highest rating a company can get is AAA whereas the lowest rating possible is D (Cole, Cooley, & National Bureau of Economic Research, 2014).
Micro-regulation involves the risk assessment carried out by an individual company. These regulations are instituted by the various companies to enhance the safety of the company as a financial institution. The evaluation is done by assessing the business's position in its industry and the risks from competition in the area. The two primary areas of concern when it comes to creating a business risk profile are the industry risk assessment and the competitive position of the company. Minimal risk and a great competitive advantage in the industry will allow the company to have a high credit rating. The opposite is also true.
Macro regulation involves the analysis of the overall financial capabilities of the company. The whole process involves going through the company’s financial profile which includes capitals and earnings, risk position and the financial flexibility of the company. A corporation’s capital and earnings are the amount of money that the business can generate and keep. The capital of a company includes its revenues, fixed and liquidated assets. The company with more capital will be given a higher credit rating than one with a low capital because they are in a better position to pay off debt. The risk position is determined by the history established by the company concerning the way it handles its debt. A company may have a large capital base, but the amount of debt that it has incurred over time may deem it too big a risk for investors and creditors. Financial flexibility is another important aspect in rating a company since a more flexible company can pay off debt more quickly when compared to one with a lot of bureaucracy.
Basel I, II and III
Basel 1 is a set of guidelines that establish the capital requirements for financial institutions. The first Basel rules were established in 1988 and were used as a measure of credit risk for the various institutions. The main role of these rules was to standardize banking habits across all countries. Basel II was established in 2004 to make up for the shortcomings of the first set of rules. Basel II set guidelines for risk management, financial accountability and asset management. External agencies such as S&P could use these measures to assess the risk of an institution. Basel III is a newer model that focuses on five major aspects: capital, funding, liquidity and leverage. Tracking a company’s operation along these four measures is crucial in coming up with a fair score.
ERM
Enterprise Risk Management is the methods and procedures that a business sets up to control risk and align operations to achieve the set goals. S&P and other rating agencies carry out an ERM of the companies to determine whether they get a high score or not. The risk management process typically involves establishing the context, identifying risks, quantifying, prioritizing and treating the risk. Constant monitoring and reviewing are necessary to uphold the integrity of the framework (Fraser & Simkins, 2010).
Rating agencies have realized the important of ERM in the rating process of companies. Firms that have a more refined infrastructure in place are often more risk-averse and can, therefore, receive a high score. Enterprise Risk Management aims at taking a more holistic approach to the assessment of a company's risk portfolio. After a careful review of the risks that the company faces, it can come up with strategic plans to counter the same. ERM helps companies increase their valuation and ensure good returns to the clients and investors. ERM is usually carried out at the same time as an analysis of governance by rating agencies. These two aspects of the business ensure that a proper and fair rating is given.
Capital Structure
Business' capital structure often refers to the ratio of debt to equity of its finances. In a general term, capital structure is the ways in which a company finances its operations by using different sources of capital. The factors that are considered most fundamental in the capital structure include the long-term and short-term debts that the company has. Rating agencies often note the capital structures of a firm before giving it an appropriate rating (Pettit, 2007).
Rating agencies are most concerned about the ability of a company to take assets and liquidate them to get cash. A company that takes up debt in any form, be it a bond or a bank loan, needs to be in a financial position to pay back the debt without causing harm to its operations. The companies with an extensive and reliable capital structure are often given high credit ratings since they can assure payment of debt. Smaller companies with little assets are not rated highly because their capital structure cannot accommodate large loans.
S&R also considers the sovereign risk involved for investors. Sovereign risk is the possibility that if a country changes its exchange rates, investors risk losing the value of foreign investments.
Securitization
Securitization is the process of the converting a liquid asset into a financial security. The security can be in the form of a mortgage for example. This strategy is employed by companies in order to minimize risks on assets. a company that has more securities is able to get a higher score because it has a stronger financial position.
Challenges and possibilities
The challenges facing the architecture used by insurance rating agencies are the constant changes in the parameters of measurement. Micro and macro regulations are always changing making them unreliable measures independently. Micro-regulations has evolved with the introduction of Basel I, Basel II and the newest model Basel III, which is currently not even in use. ERM also has the risk of not being all inclusive, and the agencies run the risk of missing something important. In conclusion, it is evident to see that all the factors used by rating agencies to assess the credibility of business are interconnected and need to be evaluated together to come up with the fairest rating possible.
References
Cole, H. L., Cooley, T. F., & National Bureau of Economic Research. (2014). Rating agencies. Cambridge, MA: National Bureau of Economic Research.
Fraser, J., & Simkins, B. J. (2010). Enterprise risk management. Hoboken, NJ: Wiley.
Pettit, J. (2007). Strategic corporate finance: Applications in valuation and capital structure. Hoboken, NJ: John Wiley & Sons.
