Is your life insurance safe?

To find out, look beyond financial-strength ratings

Standard advice on selecting a life-insurance policy or annuity is to buy only from companies that have high marks for financial soundness from the major ratings agencies. But insurer financial-strength ratings are not always easy to interpret, and grading systems vary from agency to agency.

Worse, in many cases, insurers pay agencies for ratings, creating conflicts of interest. And three agencies—Fitch, Moody's, and Standard & Poor's—have damaged credibility because they earned billions in fees rating mortgage-backed securities that started as "investment grade" but later were downgraded to "speculative."

At the same time, steep declines in the investment markets have damaged life insurers' income, investment portfolios, and capital reserves. There is a state-mandated life-insurance "safety net," but policyholders and beneficiaries of failed insurers might find it weak. Most states' death-benefit "protection" limits can result in payouts that are 30 to 50 percent less than what insurers say a median-income family might need.

So it's more important than ever to do business with a financially strong insurance company. Following are four key questions to ask about the safety of your life insurer and the answers you should look for.

1. Can you trust the ratings?

Performance studies have demonstrated the basic validity of a life-insurer financial-strength rating system. Companies with the highest grades are least likely to become insolvent. As an insurer slips down the rating scale, it has an increasingly greater chance of trouble. In a study spanning 1977 to 2007 by rating agency A.M. Best, only 0.06 percent of insurers with a top-tier A++/A+ grade were impaired one year later, on average, compared with 2 percent of B/B- companies and 6 percent of C/C- carriers. That's 33 to 100 times the risk of top-tier insurers.

But we found credibility problems with how ratings are used. For one thing, they've become marketing tools. Insurance companies pay for most ratings and use them to tout their supposed financial strength. The symbols that most ratings agencies use to communicate financial strength tend to make weaker insurers look better than they are. For example, an insurer with an A+ rating from Fitch is the best there is, right? Wrong. Fitch's AA-, AA, AA+, and AAA are higher. Moody's A group employs a jumble of upper- and lower-case letters and numbers.

Getting what appears to be a top grade is almost as easy as showing up for class. Fitch, Moody's, and S&P each uses seven variations of A, and a large percentage of rated life insurers get some version of an A rating—47 percent of Fitch's, 81 percent of S&P's, and 89 percent of Moody's. A.M. Best uses four variations of A, and TheStreet.com uses three—A+, A, and A-.

B grades are even more vexing. Fitch, Moody's, and S&P each uses nine versions of B, defined as everything from "good," "adequate," and "marginal" to "weak," "questionable," and "poor."

To assess whether the ratings are the result of worthy students or easy graders, the Money Lab analyzed 2,097 ratings awarded to 809 life insurers as of early February by Fitch, Moody's, S&P, A.M. Best, and TheStreet.com (formerly Weiss Ratings).

Moody's and S&P say their rating scales aren't necessarily directly comparable with other agencies' because of differences in data, rating criteria, and scoring models. Fitch does map its rating scale to Best's, but something gets lost in the translation: Fitch says its B+ rating is comparable to Best's C++, not Best's B+. TheStreet.com, meanwhile, says its C- equals Best's B++, S&P's A+, Moody's Baa3, and Fitch's A-.

To make sense of the differing rating scales, we threw out the letter grades and grouped the ratings by each agency's word descriptions. All of the scales had one thing in common: various letter ratings that they describe as "good." We bundled those into one tier. All grades above that were grouped into a single "excellent" tier; all grades below were assigned to tiers representing fair, weak, and poor.

We found TheStreet.com was the most conservative grader overall. Only 11 percent of its 625 ratings were "excellent" on our scale compared with 81 percent of S&P's 282 grades (see Top grades or easy graders?).

2. Does it matter how ratings are financed?

We found a significant difference in scores based on whether or not ratings were sponsored by insurers. TheStreet.com is the only agency that doesn't accept payment from any of the companies it rates. Its research is financed through sales of guidebooks and reports to investment advisers and libraries. By contrast, 100 percent of Best's and Moody's ratings we studied were paid for by insurers. Fitch and S&P ratings are hybrids; 44 and 82 percent of their financial-strength grades studied, respectively, were sponsored by insurers.

Generally, financial-strength ratings are determined by analyzing an insurer's balance sheet, capital and reserve ratios, and other financial vital signs. The data come primarily from reports that insurers file with state regulators, plus market data from independent sources. All five rating agencies use this objective data in their proprietary "quantitative" analytical models.

TheStreet.com analysis ends there. The other four agencies meet with an insurer's management team and learn about the company's plans, which they might then use to adjust their ratings. This relationship between rater and rated produces "interactive" or "qualitative" ratings. That adds subjectivity to the assessment and creates a potential conflict when the insurer pays the rating agency.

"Subjectivity can override the objective work you just did," says Melissa Gannon, vice president for insurance and bank ratings at TheStreet.com. "If you have a meeting with the insurer and you like the person, or if the management team is charismatic, that could sway you."

The other agencies say they employ safeguards to prevent problems. We examined the scores to see if the added subjectivity or fact that they sponsor, or pay for, ratings appears to give insurers any scoring advantage. Our findings:

  • Best's and Moody's sponsored ratings, all of which included subjective analyses, averaged a 4.4 and 4.1 rating, respectively, on our scale, on which 5 is the top score. TheStreet.com's independent ratings, based on objective analyses, averaged up to a full point lower grade of 3.4.
  • For Fitch and S&P, which used both rating methods, insurers rated using the independent and objective method received an average score of 3.7; companies rated using the sponsored and subjective method got a better average score of 4.5.
  • TheStreet.com was the toughest grader with independent and objective ratings; Moody's was the toughest with sponsored and subjective ratings.

3. Are life insurers at risk?

The industry has sent confusing signals on this score in recent months. On the one hand, the American Council of Life Insurers says the industry "remains well-positioned to withstand the crisis," and "policy and annuity owners should remain fully confident in the ability of their insurance companies to honor all their obligations." But this same group implored state regulators in January to relax "overly conservative" rules on capital reserves, the liquid assets insurers must hold to assure the payment of claims.

"Nobody knows where the bottom of this crisis is right now," Patrick Baird, president of the insurer Aegon USA and chairman of the ACLI board, told regulators. "There are companies all over the place in terms of their solvency."

The economic crisis has put life insurers under extreme pressure by attacking their $5 trillion investment portfolios—primarily bonds, but also stocks and troubled mortgage-backed securities. Life insurers watched a whopping $75 billion, or 24 percent of their capital surplus and reserves, disappear last year, according to estimates by Conning Research and Consulting, which follows the industry.

More losses are expected this year. Best, Fitch, Moody's, and S&P all went negative in their outlooks of the life-insurance industry last fall, which means they expect to downgrade financial-strength ratings in the future. "It doesn't get a whole lot worse and still has yet to fully play out," says Joel Levine, senior vice president of Moody's US Life Insurance Group.

But you might never guess there was any trouble by looking at those agencies' financial-strength ratings. Among life insurers owned by the 10 largest U.S. life/health insurance groups, with some $2.5 trillion in assets, the ratings from those four agencies were all As as of early March. TheStreet.com, which doesn't produce outlooks, gives those same insurers a mix of mostly Bs, fewer As, and a handful of Cs. Most notable disparities: TheStreet.com gave only C or C+ (fair) to Prudential Annuities Life Assurance, Pruco Life Insurance of New Jersey, Genworth Life Insurance, and Genworth Life Insurance of New York, while the other agencies handed out nothing but As, meaning "good," "strong," "very strong," or "superior." On their Web sites, Genworth and Prudential tout the A ratings but exclude the Cs.

4. What if your insurer goes under?

State guaranty associations provide some protection to their residents, but it generally falls short of the $400,000 to $600,000 in coverage that the industry says a median-income family should buy. Death benefits are protected only up to $300,000 in most states, so consumers with larger policies could be left out in the cold.

Guaranty associations covered only 82 percent of all life-insurance liabilities from 1991 through fall 2008, and in recent insolvencies, those limits left one in 10 policyholders short, according to the National Organization of Life & Health Insurance Guaranty Associations. Most states provide only $100,000 coverage for cash surrender or withdrawal value of whole life policies and annuities.

Before payouts kick in, state regulators try to rehabilitate or liquidate the company. When that happens, you might lose coverage and have to buy a replacement that costs more—if you qualify—or your policy might be sold to another insurer with less favorable terms. If you die during this period, the payment of benefits, up to state limits, might be delayed months or years.

This article appeared in the May 2009 issue of Consumer Reports Money Adviser.

Posted: May 2009 — Consumer Reports Money Adviser issue: May 2009