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: jennifer.marshall@ambest.com