Spring 2004 CAGNY Meeting How do Rating Agencies Determine Insurance Company Ratings

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Spring 2004 CAGNY Meeting How do Rating
Agencies Determine Insurance Company Ratings
John Andre Vice President Property/Casualty
Ratings June 3, 2004
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Discussion Topics

• The Rating Process
• Importance of Capital Adequacy
• Bests Evaluation of Capital
• Current Future State of the Market

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A.M. Best Mission Statement
To perform a constructive and objective role in
the insurance industry toward the prevention and
detection of insurer insolvency
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Bests Rating Evaluation Rating Components
Balance SheetStrength
Operating Performance
Business Profile
Operating Issuer Credit Rating
Financial Strength Rating
Debt Ratings
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Rating ConsiderationsSuccess Factors
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Balance Sheet Strength Rating Evaluation

• Leverage
• Capital structure / holding company
• Quality appropriateness of reinsurance program
• Adequacy of loss reserves
• Quality and diversification of assets
• Liquidity
• Risk-adjusted capital (BCAR)

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Operating Performance Rating Evaluation

• Profitability
• Revenue composition
• Business plan expectations
• Risk appetite
• Management experience objectives

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Business Profile Rating Evaluation

• Market risk
• Competitive market position
• Spread of risk
• Event risk
• Regulatory risk

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Bests Rating Perspective

• Capital Strength is Most Important
• Sustained, Stable Operating Profitability Ensures
  Future Strength
• Well-Diversified, Strong Business Profile Ensures
  Stability
• Considerations
• Claims Tail
• Excess Capital Strength
• Minimum Capital Requirements

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Why Market Profile and Operating Performance?
Strong Market Profile and Operating Performance
Weak Market Profile and Operating Performance
Date of last balance Sheet
Today
Time
4
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BCAR Considerations Many Issues

• Leverage
• Capital structure / holding company
• Quality appropriateness of reinsurance program
• Adequacy of loss reserves
• Quality and diversification of assets
• Liquidity
• Profitability
• Growth Rate

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Fundamentals of A.M. Bests Capital Adequacy
Model

• Interactive
• Dynamic
• Consolidated Approach
• Capital Factors Calibrated to a 1 EPD
• Reserve and Premium Adequacy
• Correlation and Diversification of Risk
• One of three parts of an integrated rating
  approach

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BCAR Model Structural Overview
BCAR Ratio Economic Surplus / Net Required
Capital

• Economic Surplus
• Reported Surplus (PHS)
• Equity Adjustments
• Unearned Premiums
• Loss Reserves
• Assets
• Debt Adjustments
• Surplus Notes
• Debt Service Requirements
• Stress Test Adjustments
• Future Operating Losses
• Potential Catastrophe Exp.
• Other
• Economic Surplus (APHS)

• Net Required Capital
• Gross Required Capital (GRC)
• (B1) Fixed Income Securities
• (B2) Equity Securities
• (B3) Interest Rate
• (B4) Credit
• (B5) Loss and LAE Reserves
• (B6) Net Premiums Written
• (B7) Off-Balance Sheet
• Covariance Adjustment
• Net Required Capital (NRC)

NRC Ö (B1)²(B2)²(B3)²(0.5B4)²
(0.5B4)B5)²(B6)² B7
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• Calculation of BCAR Score

• Company BCAR Score APHS / NRC
• APHS Adjusted Policyholder Surplus
• NRC Net Required Capital
• BCAR gt 100 gt Secure Capitalization

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B1 B2 Investment Risk

• Fixed Charges applied to Assets
• 100 Charge to Non-PC Affiliates
• Asset Concentration Charge

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B3 Interest Rate Risk

• Stress Tests Exposure To a Rise in a 120BP
  Interest Rates
• Liquidity Risk During the Year
• Annually Mark Bonds to Market in APHS
• Impact of Short-Term Cash Need
• Considers All Assets

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B4 Credit Risk

• Other than Invested Assets
• Reinsurance Charge
• Charge Based on Quality
• Additional Dependence Charge

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B5 Reserve Risk

• Statutory Discount Treated as Deficiency
• Reserves Adjusted for Adequacy Disc.
• Reserve Equity Included in Adj. Surplus
• Risk Factors
• Industry By Line
• Company Stability
• Size
• Reinsurance Impact
• Growth Charge
• Diversification Credit

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B6 Premium Risk

• Based On Net Written Premium
• Risk Factors
• Industry By Line
• Company Profitability
• Size
• Reinsurance Impact
• Underwriting Cycle
• Growth Charge
• Diversification Credit

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Frequently Made Adjustments

• Reserve Adequacy (Core AE)
• Reinsurance Charges
• Catastrophe Exposure
• Affiliated Charges
• Stop Loss Reinsurance
• Reinsurance Terms
• Loss Sensitive Business
• Projected Capitalization

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• Calculation of BCAR Score

• Company BCAR Score APHS / NRC
• APHS Adjusted Policyholder Surplus
• NRC Net Required Capital
• BCAR gt 100 gt Secure Capitalization

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Minimum Capital Requirements

• Rating Level BCAR Score
• A 175
• A 160
• A 145
• A- 130
• B 115
• B 100
• B/B- 80
• C/C 60
• Exceptions Based on Overall Analysis

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Key P/C Financial Indicators
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Affect on P/C Combined Ratio
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Financial Trends Commercial Lines
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Financial Trends Personal Lines
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Financial Trends Reinsurance