• For institutional investor and registered representative use only. Not to be shared with the public.

Impact of AM Best’s New Rating Methodology and BCAR on Investment Portfolios

Ken Johnson, CFA, CAIA, FRM Senior Director, AM Best

Americas Insurance Gathering March 28, 2019

Agenda

3

Revised BCAR and Its Role in Ratings4

The Building Block Structure3

What is the New Methodology (BCRM)2

AM Best Overview 1

Investment Treatment Within the BCAR5

AM Best Overview

4

• Established in 1899 by Alfred M. Best with the mission to report on the financial stability of insurers and the insurance industry

• Oldest and most widely recognized provider of ratings, financial data and news with an exclusive insurance industry focus

• Ratings are issued on approximately 3,400 companies in more than 90 countries • Cover 16,000 insurance companies globally through a wide range of analytical

resources, references, directories and periodicals • Offices in the U.S., London, Hong Kong, Dubai, Mexico City and Singapore

US Life Insurance Outlook

5

• Outlook• Factors

– Strong Risk Adjusted Capital– Improved Company-wide Liquidity– Tailwinds from equity markets– Evolving regulatory issues– Benign Credit Environment– Continually Evolving ERM Capabilities

US Health Insurance Outlook

6

• Outlook• Factors

– Strong Performance in All Lines – Growth in Capital and Surplus – Decline in Near-Term Regulatory Uncertainty – Prospects for Supplemental Product Growth

US PC Insurance Outlook

7

• Outlook• Factors – Personal Lines

– Improving Underwriting Performance in PP– Lower Catastrophe Experience– Favorable Investment Returns

• Factors – Commercial Lines– Robust Risk-Adjusted Capital– Profitability in Workers Compensation– Improving Interest Rate Environment– Stable Reinsurance Market

The New BCRM

8

An Updated BCRM

9

• Not a fundamental change to rating analysis

• Key rating drivers will remain the same

– Balance Sheet Strength

– Operating Performance

– Business Profile

– Enterprise Risk Management

• Discrete Assessment for each building block

Why the Change?

10

Transparency & consistency

A move towards best practices

A way to integrate new tools

11

The Building Blocks

Best’s Credit Rating Methodology – Building Blocks

12

Balance Sheet Strength

Baseline

Balance Sheet Strength

Baseline

Operating Performance

(+2/-3)

Business Profile

(+2/-2)

Enterprise Risk Management

(+1/-4)

Comprehensive Adjustment

(+1/-1)

Rating Lift/Drag

Issuer Credit Rating

Country Risk

Maximum + 2

Balance Sheet Factors

13

Country Risk

Rating UnitBalance Sheet

Strength Assessment

Holding Company

Impact Assessment

Balance Sheet

Strength

Baseline (e.g., bbb+)

• BCAR – Starting Point• Qualitative Factors• Other Quantitative Factors • Consolidated BCAR

• Leverage & Coverage• Financial Flexibility• Quality of Capital

• Country Risk Evaluation• Country Investment Class

Other Balance Sheet Strength Factors

14

Stress Tests

Quality & Appropriateness of Reinsurance Program

Reinsurance Dependence

Quality & diversification of assets

Financial & Operating Leverage

Liquidity

Quality & Fungibility of Capital

Internal Capital Models

Asset Liability Matching

Financial Flexibility

Strength of Reserves

Balance Sheet Strength = Rating Baseline

15

Bal

ance

She

et S

tren

gth

ICR Range

CRT 1 CRT 2 CRT 3 CRT 4 CRT 5

Strongest a+/a a+/a a/a- a-/bbb+ bbb+/bbb

Very Strong a/a- a/a- a-/bbb+ bbb+/bbb bbb/bbb-

Strong a-/bbb+ a-/bbb+ bbb+/bbb/bbb- bbb/bbb-/bb+ bbb-/bb+/bb

Adequate bbb+/bbb/bbb- bbb+/bbb/bbb- bbb-/bb+/bb bb+/bb/bb- bb/bb-/b+

Weak bb+/bb/bb- bb+/bb/bb- bb-/b+/b b+/b/b- b/b-/ccc+

Very Weak b+ & below b+ & below b- & below ccc+ & below ccc & below

Source: A.M. Best data and research

Operating Performance & Business Profile

16

17

Revised BCAR

What is BCAR?

18

Best’s Capital Adequacy Ratio (BCAR)

• A comprehensive quantitative tool that evaluates many of the risks to the balance sheet simultaneously

• Generates an overall estimate of the required level of capital to support those risks and compares it with available capital

• Current model calculates BCAR at 5 VaR Levels

BCAR and the Building Blocks

19

• Not the sole determinant of balance sheet strength• Not the sole determinant of the rating

BCAR is a key tool in the assessment of balance sheet strength

• Identify companies with tail risk• Promote discussions of how companies identify, monitor,

manage, measure, and protect policyholders from that risk

BCAR is also being usedin ERM assessment

New Metric

20

VaR99.0

VaR99.5

VaR (Value at Risk)

VaR does not tell us about what’s in the tail so we need to look at more than one VaR

BCAR Scores and VaR Levels

21

Using Value at Risk (VaR) metricVaR levels: 95, 99, 99.5, 99.6

Return Period (Years) Annual Probability (%) Confidence Level (%)

20 5.0 95.0

100 1.0 99.0

200 0.5 99.5

250 0.4 99.6

VaR 99.8 also modeled but not included in balance sheet assessment VaR 99.8 included in ERM assessment

Overview of Available Capital & Risk Categories

22

Available Capital (AC)

Reported Capital (C&S)Equity Adjustments:

AVR ReservesIMRUnearned Premiums

Debt Adjustments:Surplus NotesDebt Service Requirements

Other Adjustments:Future Operating LossesGoodwill & Intangible AssetsOther (Dividends, Off B/S, etc.)

BCAR Ratio = (Available Capital – Net Required Capital)/Available Capital x 100

Net Required Capital

Gross Required Capital (GRC):(C1) Asset Risk(C2) Insurance Risk(C3) Interest Rate/Market Risk(C4) Business Risk

Covariance Adjustment

Net Required Capital (NRC)*

VaR levels: 95, 99, 99.5, 99.6

*NRC= SQRT [ (C1 NonEq + C3 Interest)²+ (C1 Eq + C3 Market)²+(C2)²] + C4

Overview of Available Capital & Risk Categories

23

Net Required Capital = + (B7)(B1)2 + (B2)2 + (B3)2 + (.5 * B4)2 + [(.5 * B4) + (B5)]2 + (B6)2 + (B8)2

Available Capital (AC)

Reported Capital (PHS)Equity Adjustments:

Unearned Premiums (DAC)AssetsLoss ReservesReinsurance

Debt Adjustments:Surplus NotesDebt Service Requirements

Other Adjustments:Future Operating LossesGoodwill & Intangible AssetsOther

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) Business Risk(B8) Potential Catastrophe Loss

Covariance Adjustment

Net Required Capital (NRC)*

BCAR = ( Available Capital - Net Required Capital) x 100Available Capital

BCAR Guidelines

24

BCAR is the starting point of the balance sheet strength assessment …

VaR Level (%) BCAR BCAR Assessment

99.6 > 25 at 99.6 Strongest

99.6 > 10 at 99.6 & ≤ 25 at 99.6 Very Strong

99.5 > 0 at 99.5 & ≤ 10 at 99.6 Strong

99 > 0 at 99 & ≤ 0 at 99.5 Adequate

95 > 0 at 95 & ≤ 0 at 99 Weak

95 ≤ 0 at 95 Very Weak

* Companies with < 20 million USD in capital & surplus cannot score in strongest category

BCAR and the Balance Sheet Assessment

25

53.7

37.2

24.818.5

-11.1-20

-10

0

10

20

30

40

50

60

VaR 95 VaR 99 VaR 99.5 VaR 99.6 VaR 99.8

BCAR

ERM

10<BCAR<25 at VaR 99.6

Now that you have a BCAR assessment, need to review the other components of balance sheet strength…

BCAR ≠ Balance Sheet Assessment

26

66.7%

27.3%

15.8%

38.8%

11.3%

19.0%

6.3% 10.6%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

BCAR Assessment Balance Sheet Assessment

Strongest Very Strong Strong Adequate

27

BCAR and Investments

Investment Risks

28

Fixed Income Securities –Default Risk

Bonds

Mortgage Loans

Preferred Stocks

Equities – Market Value Volatility

Publicly Traded Common Stocks

Real Estate

Hedge Funds

Affiliated and Private Investments

Receive 100% risk charge

Investment Risks - Bonds

29

Bonds – Default Risk

• Based on ESG• Updated bond default risk factors

• Reflect maturity of company’s bond portfolio (SRQ)• Reflect asset quality of company’s bond portfolio (SRQ)• Only defaults occurring in first 10 years are considered• Offset default with recovery on defaults (vary by rating)• Net defaulted amounts are present valued

Investment Risks – Common Stocks

30

Common Stocks – Market Value Volatility– Based on ESG– Updated publicly traded common stock risk factors

• Reflect volatility of stock market (stochastic portion) uses 1yr time horizon• Can adjust to reflect volatility of company’s portfolio (Beta)• Credibility of company Beta based on degree of fit (R-squared)• Adjusted Beta= (Co. Beta * Co. Rsquared) + ( 1.0 * (1.0 – Co. Rsquared))

Industry Baseline Risk Factors (YE 2017)

Publicly Traded Common Stock VaR 95 VaR 99 VaR 99.5 VaR 99.6 VaR 99.8

United States 25.0% 38.0% 43.0% 44.0% 48.0%

Canada 27.0% 41.0% 46.0% 47.0% 50.0%

United Kingdom 26.0% 39.0% 45.0% 46.0% 51.0%

Japan 29.0% 43.0% 48.0% 49.0% 54.0%

Other 25.0% 39.0% 45.0% 46.0% 51.0%

Investment Risks – Other Asset Classes

31

Hedge Funds – Market Value Volatility– Update Other Invested Assets risk factors

• Reviewed volatility in over 30 different hedge fund indices in ESG• Selected baseline risk factors = 1.10 times common stock risk factors• Companies can share greater details of portfolio for potential reduction in factors (investment working group)• Using 1 year time period

Industry Baseline Risk Factors (YE 2015)

PC Current BCAR VaR 95 VaR 99 VaR 99.5 VaR 99.6 VaR 99.8

Other Invested Assets(Unaffiliated)

20.0% 27.5% 41.8% 47.3% 48.4% 52.8%

32

Investments

Asset Allocation By Segment

33

2017L/A P/C Health*

Bonds 73.2 58.5 53.7Stocks 2.6 24.1 16.7Mortgage Loans 11.6 1.0 0.1Real Estate 0.6 0.7 2.5Cash & Short-Term 2.6 6.8 21.5Contract Loans 3.1 0.0 0Derivatives 1.4 0.0 0BA 4.3 8.1 5.1All Other 0.7 0.6 0.4

100.0 100.0 100.0

* Health Excludes California-domiciled DMHC filing companies

Source: AM Best data and research

Bond Distribution By Sector

34

Source: AM Best data and research

2017L/A P/C Health

U.S. Gov't 7.1 12.0 15.8Foreign Gov't 3.1 1.7 0.5Foreign Other 17.1 7.7 7.2US State/Special Revenue 13.0 40.7 33.9Ind. & Misc. 58.6 37.4 42.6Affiliated 1.1 0.4 0.0

100.0 100.0 100.0

* Health Excludes California-domiciled DMHC filing companies

Commercial Mortgage Loans

35

Source: AM Best data and research

-4

-2

0

2

4

6

8

10

12

14

0

100

200

300

400

500

600

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

% of Invested A

ssets & G

rowth R

atesS

ch B

and

BA

Mor

tgag

es ($

Bill

ions

)

Sch. BA Mortgages Sch. B Mortgages % of Invested Assets Growth %

Schedule BA

36

Source: AM Best data and research

($ Billions)Life/Annuity

Total BA Assets Private Equity Hedge Funds2013 150.8 45.0 11.42014 167.6 44.1 13.12015 161.3 43.0 14.22016 164.7 44.1 8.32017 181.8 50.1 7.0

Property/CasualtyTotal BA Assets Private Equity Hedge Funds

2013 122.6 12.2 8.92014 131.7 12.9 10.22015 132.3 13.5 10.22016 144.0 12.9 9.12017 155.5 14.2 8.8

HealthTotal BA Assets Private Equity Hedge Funds

2013 6.3 1.0 0.72014 6.5 1.0 1.62015 6.6 1.4 0.72016 8.0 1.7 0.62017 8.8 2.2 0.6

37

Investments Working Group

Common Types of Investment Reviewed by IWG

38

• Investment Working Group at AM Best was established to review non-traditional investments and to provide RBC guidance for analysts.

40 Act Funds, UCITS Funds, ETFs Private Co-Mingled Investments Concentrated Alt- Strategy (HFR)

Default RBC Factors

VaR 95 27.5% 35.8%(L/H)/100%(PC) 55.0%

VaR 99 41.8% 49.7%(L/H)/100%(PC) 83.6%

VaR 99.5 47.3% 54.1%(L/H)/100%(PC) 94.6%

VaR 99.6 48.4% 56.1%(L/H)/100%(PC) 96.8%

TreatmentLook-Thru for Fixed Income Assets, or Market Risk Analysis for Equity Type Assets

Look-Thru for Fixed Income Assets, or Market Risk Analysis for Equity Type Assets

Full Scope Analysis (including on site due-diligence)

Risks Considered Market Risk/Default Risk Market Risk/Default Risk and Liquidity Risk

Market Risk, Liquidity Risk andOperational Risk

Example of IWG Analysis –Commercial Mortgage Fund

39

• A life insurance company held shares in an open-end comingled fund investing in commercial mortgages.

– The fund is managed by an asset manager affiliated to another insurer X.– Average credit quality of underlying mortgages is CM2.– Redemption on a quarterly basis with 90 days written notice after lock-up period. Insurer X

received special redemptions terms.• Default RBC factor at VaR 99 would be 49.7%. • After review, the recommended factor for the insurance company is 4.9% at VaR 99(CM3). Insurer X’s

factor is 3.4% at VaR 99 (CM2).

Example of IWG Analysis – Private Fund Look-thru

40

• A PC insurance company invested in a private high-yield bank-loan fund.

– The fund is managed by a third partyasset manager.

– 30 day redemption notice.

Portfolio Distribution RBC at VaR 99%

BBB 8.30% 4.25%

BB 35.70% 9.87%

B 48.30% 22.28%

Below B 4.00% 44.16%

NR 3.70% 50.00%

Weighted Avg. 18.3%

Liquidity Charge 7.5%

Total RBC factor after Look-Thru 25.8%

Default RBC factor for Private Fund 100%

41

Questions?

Disclaimer

42

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