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Jennifer Marshall Senior Financial AnalystProperty/Casualty DivisionFebruary 12, 2009
Treatment of Investments in the A.M. Best Rating
Process
NYIA Educational Seminar
Discussion Topics
• Rating Process Overview
• Capital Model Overview
• Treatment of Investments in the
Capital Model
• 2008 Review / 2009 Preview
Rating Process Overview
Objective of A.M. Best’s Financial Strength
Ratings
To perform a constructive and
objective role in the insurance
industry toward the prevention
and detection of insurer
insolvency
A.M. Best’s Rating Evaluation
Key Components
Balance Sheet Strength
Operating Performance
BusinessProfile
Best’s Rating
A.M. Best’s Rating Evaluation
Rating ConsiderationsSecure
A++ B+Vulnerable
B D
Balance SheetStrength
OperatingPerformance
BusinessProfile
Outstanding
Very Stable/Strong
Strong /Sustainable AdvantagesWell-Diversified
Weak
Volatile/Poor
Questionable ViabilityCompetitive Disadvantages
Concentrated Risk
A.M. Best’s Rating Evaluation
Balance Sheet Strength• Leverage• Capital structure / holding company• Quality & appropriateness of reinsurance• Adequacy of loss reserves• Quality and diversification of assets• Liquidity• Growth• Risk Adjusted Capitalization (BCAR)
A.M. Best’s Rating Evaluation
Operating Performance• Level of Profitability
- Historical- Prospective
• Stability/Volatility of Earnings• Revenue Composition/Quality of
Earnings• Ability to Meet Plan
A.M. Best’s Rating Evaluation
Business Profile
• Market risk• Spread of risk• Event risk• Competitive advantages• Management
Capital Model Overview
Best Capital Adequacy Ratio - BCAR
• Comprehensive Tool to Evaluate Risk Components Simultaneously
• Generates Overall Estimate of Required Level of Capital to Support Risks
Economic (Adjusted) Surplus
Reported Surplus (PHS)Equity Adjustments:
Unearned PremiumsLoss ReservesAssets
Debt Adjustments:Surplus NotesDebt Service Requirements
Stress Adjustments:Future Operating LossesPotential Catastrophe Exp. Other
Net Required Capital
Gross Required Capital (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
BCAR Model Overview
Economic (Adjusted) Surplus
Net Required CapitalBCAR =
Capital Model Treatment:Net Required Capital
Net Required Capital
Investment Risk Bonds Equities
Interest Rate Risk Other Issues
Single Large Asset Spread of Risk Common Stock Leverage
Investment Risk (B1): Bonds
• Grouped by NAIC SVO Class• US Treasury Bonds separate
from other Class 1 bonds• Risk Factor varies from 0% to
30% for unaffiliated bonds, based on SVO class
Bond Risk Charges
US Treasury (Cl. 1) 0.0%
Class 1 1.0%
Class 2 2.0%
Class 3 4.0%
Class 4 4.5%
Class 5 10%
Class 6 30%
Security Type/Class Risk Charge
Investment Risk (B1): Other
• Cash Risk Charge: 0.3%• Mortgage and Contract Loans
Risk Charge: 5%• Short-term investment Risk
Charge: 1%
Investment Risk (B2): Equities
• Publicly-traded equities have a 15% risk charge
• Private equity generally carries a 100% risk charge due to limited liquidity
• Preferred and common equities generally treated the same
Investment Risk (B2): Other
• Real Estate Risk Charges• Company Occupied: 10%• Investment: 20%
• Other Investments: 20%• Title Plants: 10%• EDP & Other Tangibles: 20%• Foreign Exchange Rate Asset: 20%• Aggregate Write-Ins: 20%
Additional Asset Considerations
• Single Large Asset• Spread of Risk Adjustment• High Common Stock Investment
Leverage
Interest Rate Risk (B3)• Identifies potential stress for
companies that maintain a high exposure to short-term cash needs
• Often greatest for companies with a high gross catastrophe PML
• Estimates impact of a 120 point increase in interest rates on market value of bonds
• Multiplies by ratio of gross PML to liquid assets, with a minimum charge of 10% of the decrease in market value
Capital Model Treatment:Adjusted Policyholder Surplus
Fixed Income Equity Adjustment
Reflects Difference between Market and Book Value of Bonds
Based on General Interrogatory #28 – reported only in year-end statement
If difference is: Positive, capped at 10% of surplus Negative, capped at 15% of surplus
This adjustment has been positive (e.g., it has increased surplus) for the industry overall and for most companies individually
Fall, 2008 Investment Survey
Credit market issues had significant negative impact on market price of bonds
Reviewed fixed income adjustment with caps in place and without the caps (stress scenario)
Recalculated BCAR with revised FI equity adjustment and under stress scenario
Fall, 2008 Investment Survey
Reviewed the recalculated BCAR in the context of each company’s Overall liquidity and cash flows Operating fundamentals Business profile, including exposure to
shock losses Contacted companies with potential
rating concern
Review of 2008/Preview of 2009
2008 In the Rear-View Mirror
Capital Adequacy Remains Adequate Soft Market Conditions Underwriting Losses Investment Market Turmoil Financial Flexibility in Hibernation
2009 Market Expectations
• Modest stabilization in pricing• Underwriting results rebound, but
remain negative• Continued uncertainty in financial
markets • Limited growth in investment
earnings
Questions?
For More Information:
http://www.ambest.com/ratings/methodology.asp Financial Strength Methodology for P/C Insurers Understanding BCAR for P/C Insurers
Contact your company’s rating analyst
Contact me: [email protected]