Spring 2004 CAGNY Meeting

How do Rating Agencies Determine Insurance Company Ratings

John Andre Vice PresidentProperty/Casualty RatingsJune 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 SheetStrength

Operating Performance

Business Profile

Operating Issuer Credit Rating

Financial Financial

StrengthStrength

RatingRating

DebtDebt

RatingsRatings

Balance Sheet StrengthBalance Sheet Strength

Operating PerformanceOperating Performance

Business Business ProfileProfile

ManagementManagement

Rating ConsiderationsSuccess Factors

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?

Leading Indicators of the Future Balance Sheet

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h Strong Market Profile and Operating Performance

Weak Market Profile and Operating Performance

Date of last

balance Sheet

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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

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

Economic SurplusReported Surplus (PHS)Equity Adjustments:

Unearned PremiumsLoss ReservesAssets

Debt Adjustments:Surplus NotesDebt Service Requirements

Stress Test Adjustments:Future Operating LossesPotential Catastrophe Exp. Other

Economic Surplus (APHS)

Net Required CapitalGross 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)*

BCAR Ratio = Economic Surplus / Net Required Capital

*NRC= (B1)²+(B2)²+(B3)²+(0.5*B4)² +[(0.5*B4)+B5)]²+(B6)² +B7

BCAR Model — Structural

Overview

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 BCAR ScoreA++ 175

A+ 160

A 145

A- 130

B++ 115

B+ 100

B/B- 80

C++/C+ 60

Exceptions Based on Overall Analysis

Key P/C Financial Indicators

2002 2003NPW Growth (%) 14.9 9Surplus Growth (%) -1.4 22.2Combined Ratio 107.4 100.1

Inv. Income Growth (%) 2.9 0.9Investment Yield 4.9 4.3POI to NPE (%) 2.2 8.8After-Tax ROS (%) 3.1 9.5

NPW to Surplus 1.3 1.2

Affect on P/C Combined Ratio

2002 2003

Combined Ratio (Reported) 107.4 100.1

Less: Catastrophe Losses 1.6 3.2Less: A&E Losses 2.4 1.8Combined Ratio (Normalized) 103.4 95.1

Combined Ratio (Accident Yr) 99.4 93.3

Financial Trends– Commercial Lines

2002 2003Change in NPW (%) 19.9 10.5Change in Surplus (%) 19.9 21.8Combined Ratio 107.7 101.8Change in Net Inv. Income (%) 0.6 1.1Investment Yield 5.0 4.2

After-tax Return on Surplus (%) 6.6 9.9

NPW/PHS (Reported) 1.3 1.3

Financial Trends – Personal Lines

2002 2003Change in NPW (%) 11.5 11.0

Change in Surplus (%) -5.6 18.3Combined Ratio 104.8 98.3Change in Net Inv. Income (%) -4.5 0.8Investment Yield 4.5 4.0

After-tax Return on Surplus 1.0 10.1NPW/PHS (reported) 1.5 1.3

Financial Trends – Reinsurance

2002 2003Change in NPW (%) 20.1 5.4Change in Surplus (%) 4.7 33.9Combined Ratio 122.9 100.4Change in Net Inv. Income (%) 38.0 -8.3

Investment Yield 5.4 4.3

After-tax Return on Surplus 1.4 6.3NPW/PHS (reported) 0.6 0.5NPW/PHS (Excl National Indemnity) 1.0 1.0