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Spring 2004 CAGNY Meeting How do Rating Agencies Determine Insurance Company Ratings

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

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Spring 2004 CAGNY Meeting How do Rating Agencies Determine Insurance Company Ratings

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  1. Spring 2004 CAGNY Meeting How do Rating Agencies Determine Insurance Company Ratings John Andre Vice President Property/Casualty Ratings June 3, 2004

  2. Discussion Topics • The Rating Process • Importance of Capital Adequacy • Best’s Evaluation of Capital • Current & Future State of the Market

  3. A.M. Best Mission Statement To perform a constructive and objective role in the insurance industry toward the prevention and detection of insurer insolvency

  4. Best’s Rating Evaluation— Rating Components Balance SheetStrength Operating Performance Business Profile Operating Issuer Credit Rating Financial Strength Rating Debt Ratings

  5. Management Business Profile Operating Performance Balance Sheet Strength Rating ConsiderationsSuccess Factors

  6. 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)

  7. Operating Performance: Rating Evaluation • Profitability • Revenue composition • Business plan & expectations • Risk appetite • Management experience & objectives

  8. Business Profile: Rating Evaluation • Market risk • Competitive market position • Spread of risk • Event risk • Regulatory risk

  9. 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

  10. Why Market Profile and Operating Performance? Strong Market Profile and Operating Performance Weak Market Profile and Operating Performance Date of last balance Sheet Today Time ~4~

  11. 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

  12. 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

  13. 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 Economic Surplus (APHS) 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)* BCAR Model — Structural Overview BCAR Ratio = Economic Surplus / Net Required Capital *NRC= Ö (B1)²+(B2)²+(B3)²+(0.5*B4)² +[(0.5*B4)+B5)]²+(B6)² +B7

  14. Calculation of BCAR Score • Company BCAR Score = APHS / NRC APHS = Adjusted Policyholder Surplus NRC = Net Required Capital • BCAR > 100 ==> Secure Capitalization

  15. B1 & B2 Investment Risk • Fixed Charges applied to Assets • 100% Charge to Non-PC Affiliates • Asset Concentration Charge

  16. 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

  17. B4 Credit Risk • Other than Invested Assets • Reinsurance Charge • Charge Based on Quality • Additional Dependence Charge

  18. 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

  19. B6 Premium Risk • Based On Net Written Premium • Risk Factors • Industry By Line • Company Profitability • Size • Reinsurance Impact • Underwriting Cycle • Growth Charge • Diversification Credit

  20. Frequently Made Adjustments • Reserve Adequacy (Core & A&E) • Reinsurance Charges • Catastrophe Exposure • Affiliated Charges • Stop Loss Reinsurance • Reinsurance Terms • Loss Sensitive Business • Projected Capitalization

  21. Calculation of BCAR Score • Company BCAR Score = APHS / NRC APHS = Adjusted Policyholder Surplus NRC = Net Required Capital • BCAR > 100 ==> Secure Capitalization

  22. Minimum Capital Requirements Rating LevelBCAR Score A++ 175 A+ 160 A 145 A- 130 B++ 115 B+ 100 B/B- 80 C++/C+ 60 • Exceptions Based on Overall Analysis

  23. Key P/C Financial Indicators

  24. Affect on P/C Combined Ratio

  25. Financial Trends– Commercial Lines

  26. Financial Trends – Personal Lines

  27. Financial Trends – Reinsurance

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