Is Efficiency an Important Determinant of A.M. Best Property-Liability Insurer Financial Strength Ratings?

Insurance regulators, policyholders, and investors are interested in the ability of insurers to fulfill their financial obligations. Economic and finance theory suggests that, all else equal, more efficient firms should be financially stronger firms. Efficiency scores represent a quantitative measure that summarizes in a single value the relative effectiveness of a firm in achieving a stated objective, such as cost minimization. However, efficiency scores do not explicitly measure firm risk. Efficiency scores compare firms with similar inputs and outputs whereas insurer financial strength ratings compare insurers within a particular segment of the industry, such as property liability insurance, even though inputs and outputs may differ greatly. The purpose of this study is to examine the relation between insurer efficiency and insurer financial strength ratings. We find firm efficiency scores are a weak predictor of financial strength ratings in that they do not provide significant incremental predictive power over a model with even a few widely recognized rating determinants. Further, efficiency scores perform no better at predicting ratings than simply predicting ratings based on the modal rating category. These results suggest that users of efficiency scores should not use these measures to make inferences regarding insurer financial strength