1. A tough row to hoe C19: Rating agency view of capital adequacy Todd R. Bault, FCAS Senior Research Analyst Sanford C. Bernstein & Co., LLC Copyright 2002, Sanford C. Bernstein & Co., LLC, a subsidiary of Alliance Capital Management L.P. ~ 1345 Avenue of the Americas ~ NY, NY 10105 ~ 212/486-5800. All rights reserved. This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of, or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Sanford C. Bernstein & Co., LLC, Sanford C. Bernstein Limited or any of their subsidiaries or affiliates to any registration or licensing requirement within such jurisdiction. This report is based upon public sources we believe to be reliable, but no representation is made by us that the report is accurate or complete. We do not undertake to advise you of any change in the reported information or in the opinions herein. This research was prepared and issued by Sanford C. Bernstein & Co., LLC and/or Sanford C. Bernstein Limited for distribution to market counterparties or intermediate or professional customers. This report is not an offer to buy or sell any security, and it does not constitute investment, legal or tax advice. The investments referred to herein may not be suitable for you. Investors must make their own investment decisions in consultation with their professional advisors in light of their specific circumstances. The value of investments may fluctuate, and investments that are denominated in foreign currencies may fluctuate in value as a result of exposure to exchange rate movements. Information about past performance of an investment is not necessarily a guide to, indicator of, or assurance of, future performance. Sanford C. Bernstein & Co., LLC, Sanford C. Bernstein Limited, or one or more of its or their officers, directors, members, affiliates or employees, or accounts over which they have discretion, may at any time hold, increase or decrease positions in securities of any company mentioned herein. Sanford C. Bernstein & Co., LLC, Sanford C. Bernstein Limited, or its or their affiliates may provide investment management or other services for such companies or employees of such companies or their pension or profit sharing plans, and may give advice to others as to investments in such companies. These entities may effect transactions that are similar to or different from those mentioned herein. To our readers in the United States: Sanford C. Bernstein & Co., LLC is distributing this report in the United States and accepts responsibility for its contents. Any U.S. person receiving this report and wishing to effect securities transactions in any security discussed herein should do so only through Sanford C. Bernstein & Co., LLC. To our readers in the United Kingdom: This report has been issued or approved for issue in the United Kingdom by Sanford C. Bernstein Limited, regulated by the Financial Services Authority and located at Devonshire House, 1 Mayfair Place, London W1J 8SB, +44 (0)20-7170-5000. To our readers in member states of the EEA: This report is being distributed in the EEA by Sanford C. Bernstein Limited, which is regulated in the United Kingdom by the Financial Services Authority and holds a passport under the Investment Services Directive.

2. First, we kill all the analysts… 1) The two main questions of this session: 1) Do rating agency downgrades prompt subsequent regulatory actions? 2) Are rating agencies too slow to act on developing problems? 2) And you were wondering why we have no rating agency representative on this panel? 3) At least we’re not criticizing sell-side analysts…

3. A tough row to hoe The task of any regulator (or quasi-regulator like a rating agency) is extremely difficult, particularly in the US No one likes a watchdog Americans really don’t like watchdogs American financial types really REALLY don’t like watchdogs  Until something bad happens to them, of course Unfortunately for financials types, Americans, and humans generally, some level of regulation is needed in most financial endeavors Our fight over how much is called politics

4. Preliminaries In the context of capital adequacy, rating agencies are charged with assessing the financial strength and credit worthiness of the company Ideally, these assessments would be perfectly correlated with the “real” underlying condition of the company Also, the assessments ideally would not add new information, but simply reflect “reality” In practice, this doesn’t always happen  Ratings may not exactly line up with condition  Ratings may also “create” a financial condition

5. Going concerns Most financial assessments assume that the company in question is a going concern--it will exist in the future and generate future profits The essential regulatory, and rating agency, task is to: Determine when a company is in danger of ceasing to be a going concern, but… Do so without actually ending the going concern status incorrectly Example: capital markets trading companies The most significant element of being a going concern in the capital markets is market confidence & trust Once lost, a liquidity crisis can result and ends the ability of the company to be a going concern

6. The rating agency game So agencies risk two errors, like Type I and II errors from statistics: Type I: Rating agency downgrades company below that needed to be a going concern when not justified Type II: Rating agency maintains a high rating when not justified, and company ceases to be a going concern In our view, the Type II error is the more serious, and rating agencies probably try to keep this as small as possible Putting health companies out of business should be avoided Cost is letting some companies go on for longer than they should Side effect: rating agencies generally demand companies to be “overcapitalized”

7. Insurers highly capitalized vs. other financials It’s hard to compare insurance balance sheets to other financials, but some simple comparisons show that insurers hold a lot of capital Assets/equity are some 3-5 times lowers than for other financials Source: FactSet, Bernstein analysis

8. Can ratings create a financial event? Some rating agencies have expressed frustration (S&P in particular) at the market’s lack of appreciation for the “granularity” of ratings i.e. AA ought to be worth more in the market than A In practice, market simply doesn’t view ratings as that meaningful at fine levels of detail--companies aren’t bonds For insurance companies, 3 levels seem important: AAA (or A++): Needed for certain kinds of businesses, like financial guaranty A- and above: Needed to write commercial business, particularly long-tail business Below A-: Effectively a death sentence--buyers will flee So yes, ratings can create a loss of customers at some hard trigger, which threatens the going concern status

9. Can ratings create a financial event? The A rating barrier seems to have some credence in the ratings themselves: While Best’s Vulnerable ratings (B and lower) have risen slightly in recent years, ratings below A- have declined Small changes, but it provides additional evidence that A ratings matter Source: Best’s, Bernstein analysis

10. Do ratings reflect financial condition? There is some relationship between ratings and various financial condition metrics, as a Moody’s 2002 study shows, but the relationships aren’t perfect Moody’s grouped ratings by Aaa, Aa, A, Baa, and below Baa, looked at 1998 and 2000 results (soft market) Key rating to us is Baa--does it look more like A or more like below Baa? Our assessment:  NO statistics had Baa looking more like below Baa  Financial statistics like leverage and cash flow had Baa looking more like A; i.e. not very predictive  Profitability and reserve development appeared transitional between A and below Baa, so these may be most useful for prediction Conclusion: underwriting discipline matters!

11. What duties do rating agencies have? Being a rating agency is an odd business: The company being rated pays, not the users of the rating  In contrast, investment analysts are paid by investors, the users of the information In exchange for the rating, agency gains proprietary access to information, often confidential  In contrast, investment analysts gain no such access (or aren’t supposed to at any rate) Might this not be a conflict of interest?  Possibly, but market require some function like this, and don’t seem to trust pure regulators to do it  In the long-run, abusing their privileged status would destroy their business model Possible duty: rating agencies should share information with the SEC and state regulators (not markets until public)

12. Are rating agencies too slow or missing something? Not in our view: Biggest risk to rating agency is killing a healthy company--requires more caution in downgrading than upgrading Other analysts, like equity analysts, can play the role of “canary in the coal mine”  As we don’t have privileged access, our speculation carries a bit less weight As for missing something, there are never enough hours in the day for any analyst Very easy to second guess risky decisions

13. Where could ratings agencies improve? Biggest area for potential improvement in dynamic assessment of business: Some analyses seem to be in response to past trends, not identifying future ones  Asbestos, for example Some key statistics need enhancement:  High growth from pricing not the same as high growth from exposure  Companies need to disclose better data in exchange