Spring 2002 CAS Meeting Modeling Capital Adequacy Matthew C. Mosher, FCAS Group Vice President Property/Casualty Ratings May 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 Sheet Strength Operating Performance Business Profile Best’s FSR Rating

Balance Sheet Strength Operating Performance Business Profile Management Rating Considerations Success 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? Strong Market Profile and Operating Performance Weak Market Profile and Operating Performance Date of last balance Sheet TodayTime ~4~

Best Rating Evaluation Update  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 l l Interactive l l Dynamic l l Consolidated Approach l l Capital Factors Calibrated to a 1% EPD l l Reserve and Premium Adequacy Considered l l One of three parts of an integrated rating approach

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 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 u u Company BCAR Score = APHS / NRC APHS = Adjusted Policyholder Surplus NRC = Net Required Capital u u 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? Strong Market Profile and Operating Performance Weak Market Profile and Operating Performance Date of last balance Sheet TodayTime ~4~

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 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 u u Company BCAR Score = APHS / NRC APHS = Adjusted Policyholder Surplus NRC = Net Required Capital u u BCAR > 100 ==> Secure Capitalization

Minimum Capital Requirements Rating LevelBCAR Score A++175 A+160 A145 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 2002 CAS Meeting Modeling Capital Adequacy