Spring 2004
CAGNY Meeting
How do Rating Agencies Determine
Insurance Company Ratings
John Andre
Vice President
Property/Casualty Ratings
June 3, 2004
Discussion Topics

The Rating Process

Importance of Capital Adequacy

Best’s Evaluation of Capital

Current & Future State of the Market
A.M. Best Mission Statement
To perform
a constructive and objective role in
the insurance industry
toward the prevention and
detection of insurer insolvency
Best’s Rating Evaluation— Rating
Components
Balance Sheet
Strength
Operating
Performance
Business
Profile
Operating Issuer Credit Rating
Financial
Debt
Strength
Ratings
Rating
Rating Considerations
Success Factors
Management
Business
Profile
Operating Performance
Balance Sheet Strength
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)

Operating Performance: Rating
Evaluation
Profitability
 Revenue composition
 Business plan & expectations
 Risk appetite
 Management experience & objectives

Business Profile: Rating Evaluation
Market risk
 Competitive market position
 Spread of risk
 Event risk
 Regulatory risk

Best’s 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
Why Market Profile and Operating
Performance?
Financial Strength
Leading Indicators of the Future Balance Sheet
Strong Market Profile and
Operating Performance
Weak Market Profile and
Operating Performance
Date of
last
balance
Sheet
Today
Time
~4~
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

Fundamentals of A.M. Best’s
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
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
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)*
Economic Surplus (APHS)
*NRC=  (B1)²+(B2)²+(B3)²+(0.5*B4)² +[(0.5*B4)+B5)]²+(B6)² +B7
Calculation of BCAR Score

Company BCAR Score = APHS / NRC
APHS = Adjusted Policyholder Surplus
NRC = Net Required Capital

BCAR > 100 ==> Secure Capitalization
B1 & B2 Investment Risk
Fixed Charges applied to Assets
 100% Charge to Non-PC Affiliates
 Asset Concentration Charge

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

B4 Credit Risk
Other than Invested Assets
 Reinsurance Charge

 Charge Based on Quality
 Additional Dependence Charge
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
B6 Premium Risk
Based On Net Written Premium
 Risk Factors






Industry By Line
Company Profitability
Size
Reinsurance Impact
Underwriting Cycle

Growth Charge

Diversification Credit
Frequently Made Adjustments








Reserve Adequacy (Core & A&E)
Reinsurance Charges
Catastrophe Exposure
Affiliated Charges
Stop Loss Reinsurance
Reinsurance Terms
Loss Sensitive Business
Projected Capitalization
Calculation of BCAR Score

Company BCAR Score = APHS / NRC
APHS = Adjusted Policyholder Surplus
NRC = Net Required Capital

BCAR > 100 ==> Secure Capitalization
Minimum Capital Requirements
Rating Level
A++
A+
A
AB++
B+
B/BC++/C+

BCAR Score
175
160
145
130
115
100
80
60
Exceptions Based on Overall Analysis
Key P/C Financial Indicators
2002
14.9
-1.4
107.4
2003
9
22.2
100.1
Inv. Income Growth (% )
Investment Yield
POI to NPE (% )
After-Tax ROS (% )
2.9
4.9
2.2
3.1
0.9
4.3
8.8
9.5
NPW to Surplus
1.3
1.2
NPW Growth (% )
Surplus Growth (% )
Combined Ratio
Affect on P/C Combined Ratio
2002
2003
Combined Ratio (Reported)
107.4
100.1
Less: Catastrophe Losses
Less: A&E Losses
Combined Ratio (Normalized)
1.6
2.4
103.4
3.2
1.8
95.1
Combined Ratio (Accident Yr)
99.4
93.3
Financial Trends– Commercial Lines
Change in NPW (%)
Change in Surplus (%)
Combined Ratio
Change in Net Inv. Income (%)
Investment Yield
After-tax Return on Surplus (%)
NPW/PHS (Reported)
2002 2003
19.9 10.5
19.9 21.8
107.7 101.8
0.6
1.1
5.0
4.2
6.6
1.3
9.9
1.3
Financial Trends – Personal Lines
Change in NPW (%)
Change in Surplus (%)
Combined Ratio
Change in Net Inv. Income (%)
Investment Yield
After-tax Return on Surplus
NPW/PHS (reported)
2002
11.5
-5.6
104.8
-4.5
4.5
2003
11.0
18.3
98.3
0.8
4.0
1.0
1.5
10.1
1.3
Financial Trends – Reinsurance
Change in NPW (% )
Change in Surplus (% )
Combined Ratio
Change in Net Inv. Income (% )
Investment Yield
After-tax Return on Surplus
NPW/PHS (reported)
NPW/PHS (Excl National Indemnity)
2002
20.1
4.7
122.9
38.0
5.4
2003
5.4
33.9
100.4
-8.3
4.3
1.4
0.6
1.0
6.3
0.5
1.0