May 2002

Evaluating the Financial Health of Your Insurer

By JAMES S. ANCHIN, CPA

We recently wrote about the difficulties in securing bonding in a hardening surety market. Insurance coverage, from property to workers comp, is also becoming just as difficult to obtain. The tough insurance market is likely to be a fact of life for the foreseeable future, as insurers grapple with losses from the Sept. 11 attacks, the Enron scandal and two years of economic doldrums.

Contractors who have managed to get insurance have experienced enormous increases in premiums. The bad news doesn't end there. In addition to shrinking alternatives and more expensive insurance options, contractors are faced with insurance companies whose financial health is sometimes questionable. Today more than ever, it's imperative to do your homework on the fiscal fitness of an insurance company before committing your company's dollars.

The best place to start is with the ratings agencies. A.M. Best is the most widely used by insurance brokers. However, since no rating agency is infallible Ñ and all have their pros and cons Ñ it's often advisable to take a look at several rating agencies to get a broad perspective on candidate insurers. Weiss Ratings, Inc., provides high-quality data, though it can be expensive. Other rating options for contractors include: Standard & Poor's, Moody's Investors Services and Fitch Ratings.

Be cautioned not to fall into the trap of relying solely on the insurer's current rating. Because ratings change over time, it's advisable to track a company's record over a three- to five-year period. A company on its way to a higher rating is a much safer bet than one whose rating has been losing altitude. If you've purchased coverage from an insurer who is then downgraded, quick action is key. Monitor the developing situation while you initiate a search for replacement coverage. It's also advisable to earmark some funds or secure a line of credit to head off a potential financial crisis.

The National Association of Insurance Commissioners (NAIC) has developed a series of ratios to determine the financial soundness of insurance companies. Known as the Insurance Regulatory Information System (IRIS), the four ratios and 11 financial statistics measure the vital signs of an insurer in much the same way a doctor's physical exam gives a good indication of a patient's health. While they can be time consuming to conduct for all the insurers you are considering, in this economic environment, it's well worth the time and effort to run the IRIS tests. Because they can identify red flags early on before serious problems arise, IRIS tests taken as a whole constitute a valuable diagnostic tool in the construction financial manager's little black bag. More information on the IRIS system is available at www.naic.org.

In the quest to differentiate the strong from the weak, don't discount your insurance broker. Many brokers have a "security committee" that keeps tabs on the financial status of insurers that they recommend. In some cases, brokers have a client sign a waiver to do business with a less than top-rated insurer, and later have been sued for placing coverage with an insurance company that goes into bankruptcy. But by the same token, brokers are well aware of the professional liability and errors and omissions exposures they face if an insurer they have recommended goes under. As a result, insurance brokers should exercise due professional care in steering their clients to insurers.

In a hardening insurance market, the price versus security issue should be considered from all angles. Should contractors obtain insurance only from A+ rated firms? That depends. Past performance is no guarantee of future success, and sometimes today's highest rated firms are tomorrow's lowest; while the lower B-rated insurers keep on covering claims with regularity. Rather than pay a premium for A-rated companies, contractors looking to shave costs may find lower rated insurers a viable option. In certain situations, contractors may have no choice in the matter and may be forced to go with a certain insurer simply because no one else is willing to provide the insurance.

Specifying minimum financial ratings in construction contracts will almost certainly be a more widespread practice in this insurance market. Contractors will be faced with several thorny questions that must be determined on a case-by-case basis. How stringent should contractors be if subs have insurers that miss the ratings only slightly? Should top ratings be required for insurers across the board, or can the rating requirements be relaxed somewhat for specialty lines?

In this financial environment, contractors must keep attuned to the strength and stability of current and prospective insurers. Rely on the expertise of your professional advisors, but in the end, rigorous independent analysis is critical.

About the author: Mr. Anchin is managing partner of Anchin, Block & Anchin, LLP, a New York City certified public accounting firm that specializes in meeting the needs of contractors in the tri-state area.