In August 2018, AM Best surveyed its universe of rated entities to gauge where the insurance industry stands as a whole with regard to innovation. Although we received a wide range of responses to questions on the challenges, opportunities and need for innovation, the answer to one question was largely consistent and abundantly clear: Innovation is critical to the overall success of an organization.

With the pace of innovation accelerating, and given its implications on insurers’ future credit quality and financial strength, AM Best is adding criteria to its rating methodology to score and assess the innovation initiatives of every rated entity. The second comment period for the new draft criteria procedure and the corresponding changes to existing methodology concluded at the end of October. AM Best expects to implement the criteria in 2020.

Market participants are asking: What should insurance executives know about AM Best’s innovation criteria, and how will it affect their company’s rating?

Executives should know that AM Best expects few, if any, rating movements following implementation of the new criteria, for the simple reason that AM Best already has been implicitly assessing each rated company’s innovation efforts for years. Anyone familiar with AM Best’s building-block approach to assigning credit ratings is aware of the four major assessment categories: balance sheet strength operating performance, business profile and enterprise risk management.

The business profile assessment comprises eight components: market position; degree of competition; distribution channels; pricing sophistication and data quality; management quality; product/geographic concentration; product risk; and regulatory, event and country risks. Innovation had traditionally been taken into account in the analysis of these eight components; however, in light of the accelerating pace and growing importance of innovation, AM Best is making innovation a ninth component in the business profile as of the effective date of the new criteria. As with the other components, AM Best analysts will evaluate innovation in the context of an entity’s product lines, circumstances and overall need, to assess whether the company’s initiatives, or lack thereof, provide it with a tangible benefit, a neutral impact or a disadvantage.

In addition to adding innovation to the business profile assessment, AM Best will also be taking a deeper dive into companies’ innovation initiatives to score, rank and identify the leaders in the insurance industry. Executives should note that, in contrast to the addition of innovation to the business profile assessment—which considers a company’s innovativeness relative to its particular circumstances—the innovation ability score will be more of an absolute assessment of the level of a company’s innovativeness in comparison with the entire industry. This score will not be explicitly correlated with the business profile assessment, although AM Best expects some natural correlation, as most entities scoring highly in the innovation assessment will likely have substantial innovation strategies in place and hence will likely already have a favorable business profile assessment.

The innovation ability score will be determined by adding a company’s innovation input score to its innovation output score. The score can range from a minimum of 8 to a maximum of 32; a descriptor is assigned based on the score outcome. A score of less than 12 indicates “minimal” innovation; 12-17 indicates “moderate” innovation; 18-22 indicates “significant” innovation; 23-27 indicates “prominent” innovation; and a score of 28 or higher indicates an innovation “leader.”

Executives striving for a higher score need to understand that AM Best’s definition of innovation was purposely written in a broad manner to encompass multiple forms of innovation and not just focus on technology. AM Best defines innovation as a multistage process that transforms ideas into new or significantly improved products, processes, services or business models that have a measurable positive impact over time and enable an organization to remain relevant and successful, and that can be organically grown or adopted from external sources.

With this definition in mind, the innovation input score is made up of four components, each scored 1-4, for a total possible input score of 16. The four components consist of leadership, culture, resources, and processes and structure.

• For leadership, AM Best analysts will be looking for proof of buy-in at the senior management level; alignment between a company’s mission/vision and innovation strategy; proactive initiatives that have a solid rationale behind them; and a leadership team that has the expertise to develop, implement and encourage innovation.

• For culture, analysts will assess the following: the levels of participation from employees and any incentives provided; the embeddedness of innovation projects throughout the organization; how a company handles and gains knowledge from failures or setbacks in the innovation process; the robustness of internal and external communication on innovation; and a company’s ability and speed to meet changing market conditions or consumer behaviors.

• Resources will be scored based on a company’s external and internal technical, creative and financial resources and how they are allocated and managed under the innovation strategy.

• Finally, a company’s processes and structure will be scored by evaluating the innovation strategy and development process to assess if it is replicable and determine if innovations are integrated with mainstream operations.

AM Best’s innovation output score comprises two components that are also scored 1-4, the sum of which is multiplied by two to give more weight to the innovation output components in the overall score. The maximum score for input and output is 16 each. The two output components are results and the level of transformation. The results component considers whether innovation initiatives have resulted in any competitive advantage or in a tangible measurable impact. The level of transformation component takes into account how unique or industry leading a company’s innovation initiative is with regard to incremental changes.

The key message that executives should take away from AM Best’s innovation criteria can be summed up quite concisely: Innovation is critical to the success of an organization, and the pace of change is accelerating; therefore, executives should be prepared to speak on how their company is progressing on innovation and, at a minimum, how their company is not falling behind peers and the industry as a whole. The impact of obsoleteness on a company’s future creditworthiness may be mitigated if an innovation strategy specific to the company’s particular circumstances is in place.