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  Current & Future State of the Market

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 Operating Issuer Credit Rating FinancialStrengthRatingDebtRatings

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  Business plan & expectations  Risk appetite  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  Considerations  Claims Tail  Excess Capital Strength  Minimum Capital Requirements

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~

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 u 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

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

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  Reinsurance Impact  Growth Charge  Diversification Credit

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

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

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

Key P/C Financial Indicators

Affect on P/C Combined Ratio

Financial Trends– Commercial Lines

Financial Trends – Personal Lines

Financial Trends – Reinsurance