Spring 2002CAS Meeting

Modeling Capital Adequacy

Matthew C. Mosher, FCAS Group Vice PresidentProperty/Casualty RatingsMay 21, 2002

Discussion Outline

Importance of Capital Adequacy

Best’s Evaluation of Capital

Future Changes

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

Best’s FSR Rating

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 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

Why Market Profile and Operating Performance?

Leading Indicators of the Future Balance Sheet

Fina

ncia

l Str

engt

h Strong Market Profile and Operating Performance

Weak Market Profile and Operating Performance

Date of last

balance Sheet

Today Time

~4~

Best Rating EvaluationUpdate

In the Overall Rating Assignment Consideration of Claims Tail Consideration of Excess Capital Minimum Capital Requirements

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 Considered 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 Being Reviewed

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

Growth Charge Diversification Credit

B6 Premium Risk

Based On Net Written Premium Risk Factors

Industry By Line Company Profitability Size

Growth Charge Diversification Credit

Frequently Made Adjustments

Reserve Adequacy (Core & A&E) Reinsurance Charges Catastrophe Exposure Affiliated Charges Stop Loss Reinsurance Loss Sensitive Business Projected Capitalization

Why Market Profile and Operating Performance?

Leading Indicators of the Future Balance Sheet

Fina

ncia

l Str

engt

h Strong Market Profile and Operating Performance

Weak Market Profile and Operating Performance

Date of last

balance Sheet

Today Time

~4~

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

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

Value at Risk

Currently a Separate Model in Testing

Potential Enhancements Consistency of Risk Factors Updated Investment Risk Charges Improved Interest Rate Risk Covariance Treatment Diversification Calibration

Best Capital Adequacy Issues

BCAR Remains Best’s Standard for Measuring Capitalization Domestically

No Major Changes to BCAR in 2002 Likely to be Changes for 2003

Spring 2002CAS Meeting

Modeling Capital Adequacy