a.m. best · uidity and market-value declines in both equi-ty and fixed-income securities.a.m....

The objective of A.M. Best Co.’s ratingsystem is to provide an opinion of aninsurer’s financial strength and ability

to meet ongoing obligations to policyholders.The assignment of an interactive rating isderived from an in-depth evaluation of a com-pany’s balance-sheet strength, operating per-formance and business profile, as comparedwith A.M. Best’s quantitative and qualitativestandards.

For A.M. Best’s interactive ratings, the bal-anced approach of evaluating a company onboth quantitative and qualitative levels pro-vides a better analysis of a company andmakes possible a more discerning and credi-ble rating opinion.

A.M. Best’s quantitative evaluation is basedon analysis of more than 100 key financial testsand supporting data.These tests, which under-lie the evaluation of balance-sheet strength andoperating performance, vary in importance,depending on a company’s characteristics.

A company’s quantitative results are evalu-ated on their own merits and also are com-pared with industry composites as establishedby A.M. Best. Composite standards are basedon the performance of other insurance com-panies with comparable business mixes andorganizational structures. These industrybenchmarks are adjusted to reflect changes inunderwriting, economic and regulatory mar-ket conditions.

Balance-Sheet StrengthIn determining a company’s ability to meet

its current and ongoing obligations to policy-holders, balance-sheet strength is the mostimportant area to evaluate, since it is the foun-

dation for policyholder security. Performancethen determines how that balance-sheetstrength will be enhanced, maintained oreroded over time. Balance-sheet strength mea-sures the exposure of a company’s surplus toits operating and financial practices. An analy-sis of a company’s underwriting, financial andasset leverage is very important in assessingoverall balance-sheet strength.

Underwriting leverage is generated fromcurrent premium writings, reinsurance recov-erables and loss reserves.To assess whether acompany’s underwriting leverage is prudent, anumber of factors unique to the company aretaken into account, including the types ofbusiness written, the quality and appropriate-ness of its reinsurance program and the ade-quacy of loss reserves.

Financial leverage is created through debtor debt-like instruments—including financialreinsurance—and is reviewed in conjunctionwith a company’s underwriting leverage. Ananalysis of financial leverage is conducted atboth the operating company and holding com-

Structural Overview: A.M. Best's Capital Adequacy RatioBCAR = Adjusted Surplus

Net Required Capital

Adjusted Surplus Components Net Required Capital (NRC) Components(B1) Fixed-Income Securities

Reported Surplus (B2) Equity SecuritiesEquity Adjustments (B3) Interest Rate

Unearned Premiums (B4) CreditAssets (B5) Loss and Loss-Adjustment-Expense ReservesLoss Reserves (B6) Net Written PremiumReinsurance (B7) Off Balance Sheet

Debt AdjustmentsSurplus NotesDebt Service Requirements

Other Adjustments CovariancePotential Catastrophe Losses Future Operating Losses

Source: A.M. Best Co.

A.M. BESTMETHODOLOGY NOVEMBER 24, 2003

Copyright © 2003 by A.M. Best Company, Inc.All rights reserved. No part of this report may be reproduced, stored in a retrieval system or transmitted in any form or by any means; electronic, mechanical, photo-copying, recording or otherwise.

Understanding BCARA.M. Best’s Capital Adequacy Ratio for Property/Casualty Insurersand Its Implications for Ratings

Questions regarding A.M.Best’s BCARmethodology can be directed to ThomasMount, ACAS, MAAA, managing seniorfinancial analyst, in A.M.Best Co.’s proper-ty/casualty division.

NRC = (B1)2+(B2)2+(B3)2+(0.5*B4)2+[(0.5*B4)+B5]2+(B6)2 + (B7)

Methodology November 24, 2003

pany levels, since debt at either level couldplace a call on the insurer’s earnings and strainits cash flow, leading to financial instability.

Asset leverage measures the exposure of acompany’s surplus to investment, interest rateand credit risks.The volatility and credit quali-ty of the investment portfolio, recoverablesand agents’ balances determine the potentialimpact on the company’s balance-sheetstrength.

A company’s underwriting, financial andasset leverage also are subjected to an evalua-tion by Best’s Capital Adequacy Ratio (BCAR),which allows for an integrated review of theseleverage areas. BCAR calculates the netrequired capital to support the financial risks ofthe company associated with the exposure ofassets and underwriting to adverse economicand market conditions, and compares it witheconomic capital. Some of the stress tests with-in BCAR include above-normal catastrophes, adecline in equity markets and a rise in interestrates.This integrated stress evaluation permits amore discerning view of a company’s balance-sheet strength relative to its operating risks.

A company’s BCAR result is extremely use-ful in evaluating a company’s balance-sheetstrength, but it is only one component of thatanalysis. In addition, balance-sheet strength isonly one component of the overall financialstrength rating, which also includes operatingperformance and market profile. BCAR veryoften is a minimum requirement to support arating, but other factors driving expectationsof future balance-sheet strength drive the rat-ing as well. All of these factors are importantto the overall rating process. This article willdescribe the methodology used in the BCARmodel and how market issues are treatedwithin the model.

Overview of BCARStructurally, A.M. Best’s capital formula

resembles the National Association of Insur-ance Commissioners’ risk-based capital calcu-lation, whereby required capital is computedto support three broad risk categories: invest-ment risk, credit risk and underwriting risk.Like the NAIC model, the A.M. Best formulacontains an adjustment for covariance, reflect-ing the statistical independence of the indi-vidual components.A company’s adjusted sur-plus is divided by its net required capital,after the covariance adjustment, to determineits BCAR.

Shown in the exhibit, “A.M. Best’s CapitalAdequacy Model,” the distribution of grossrequired capital by risk category is generatedby applying the BCAR capital model to theproperty/casualty industry in 2002. In contrastto the NAIC model, a significantly greater pro-portion of capital is required to support thepremium component, reflecting A.M. Best’smore stringent risk factors.

While BCAR is designed very similarly to theNAIC’s risk-based capital calculation, it alsoincludes several critical risk components notconsidered in the risk-based capital calculation.

Total investment risk—which includesthree main risk components: (B1) fixedincome securities, (B2) equities and (B3) inter-est rate—applies capital charges to differentasset classes based on the risk of default, illiq-uidity and market-value declines in both equi-ty and fixed-income securities. A.M. Best’smodel has incorporated an interest-rate riskcomponent that considers the market-valuedecline in a company’s fixed-income portfolioas a result of rising interest rates.Additionally,

2

A.M. Best Co.Methodology

November 24, 2003

PUBLISHER, PRESIDENT AND CHAIRMANArthur Snyder

EXECUTIVE VICE PRESIDENT/CHIEF OPERATING OFFICERArthur Snyder III

EXECUTIVE VICE PRESIDENT/CHIEF RATING OFFICERLarry G. Mayewski

EXECUTIVE VICE PRESIDENT/CHIEF INFORMATION OFFICERPaul C. Tinnirello

SENIOR VICE PRESIDENTShaun Flynn, International

GROUP VICE PRESIDENTSManfred Nowacki, Life/Health

Matthew Mosher, Property/CasualtyCopyright © 2003 by A.M. Best Company, Inc., Ambest Road, Oldwick,New Jersey 08858. ALL RIGHTS RESERVED. No part of this report ordocument may be distributed in any electronic form or by any means, orstored in a database or retrieval system, without the prior written permissionof the A.M. Best Company. For additional details, see Terms of Use avail-able at the A.M. Best Company Web site http://www.ambest.com.

Best’s Ratings reflect the A.M. Best Company’s opinion based on a compre-hensive quantitative and qualitative evaluation of a company’s balance sheetstrength, operating performance and business profile and, where appropri-ate, the specific nature and details of a rated debt security. These ratingsare not a warranty of an insurer’s current or future ability to meet its contrac-tual obligations, nor are they a recommendation to buy, sell or hold anysecurity. Further, any and all information herein is provided “as is,” withoutwarranty of any kind, expressed or implied. A.M. Best Company receivescompensation for its interactive financial strength ratings, from the insurancecompanies it rates. In compliance with the Securities Act of 1933, A.M. Bestalso discloses that it receives rating fees from most issuers of the debt secu-rities it rates. Those fees fall within a range of $ 7,500 to $ 500,000.

BBeessttWWeeeekk ssuubbssccrriibbeerrss can download a printed copy of the full24-page methodology, ““UUnnddeerrssttaannddiinngg BBCCAARR”” from our Website, www.bestweek.com.


higher capital charges are ascribed to affiliatedinvestment holdings, real estate, junk bondsand nonaffiliated common stocks.

The credit risk category (B4) applies capitalcharges to different receivable balances toreflect third-party default risk. Capital chargesare ascribed to recoverables from all reinsur-ers, including foreign and domestic affiliates.Required capital for credit risk might be modi-fied after taking into account any collateraloffsets for reinsurance balances; the quality ofthe reinsurers that participate in the compa-ny’s domestic reinsurance program; and thecompany’s dependence on its reinsuranceprogram.Also included in the credit risk com-ponent are charges for agent balances andother miscellaneous receivables.

The largest risk category, which typicallyaccounts for two-thirds of a company’s grossrequired capital, is underwriting risk.This cate-gory encompasses both loss and loss-adjust-ment expense reserves (B5) and net premi-ums written (B6).The loss-reserve componentrequires capital based on the risk inherent in acompany’s loss reserves, adjusted for A.M.Best’s assessment of its reserve equity.The netpremiums written component requires capitalbased on the pricing risk inherent in a compa-ny’s mix of business. In addition, required cap-ital for the reserve and premium componentsmay be increased to reflect an additional sur-charge for “excessive” growth in exposure.Finally, there is credit for a well-diversifiedbusiness, but this credit is limited for thosecompanies that maintain small books of manylines of business and might not necessarilyhave expertise in all of these lines.

Collectively, these six risk components gen-erate more than 99% of a company’s grossrequired capital, with the business risk com-ponent (B7) generating minimal capitalrequirements for off-balance-sheet items. Acompany’s gross required capital, which is thesum of the capital required to support itsseven risk components, reflects the amount ofcapital needed to support all risks were theyto develop simultaneously. These individualcomponents then are subjected to a covari-ance calculation within the BCAR formula toaccount for the statistical independence ofthese components.This covariance adjustmentessentially says that it is unlikely for all sevenrisk components to develop simultaneouslyand serves to reduce a company’s overallrequired capital by about 35% to 45%.

A.M. Best has adopted a covariance calcula-tion that is very similar to the NAIC’s risk-based capital calculation. The A.M. Best calcu-lation recognizes the distortions caused bythis “square root rule” covariance adjustment,whereby the more capital-intensive underwrit-ing risk components are accentuated dispro-portionately, while the less capital-intensiveasset risk components are diminished in theirrelative contribution to net required capital.Nevertheless, by using other distinct capitalmeasures, A.M. Best can counterbalance thisapparent shortcoming.

Unlike other models, A.M. Best’s capitalmodel makes a number of adjustments to acompany’s reported surplus to provide a moreeconomic and comparable basis for evaluatingcapital adequacy.These adjustments are relatedlargely to equity, or economic values, imbed-ded in unearned premium reserves, loss andloss-adjustment expense reserves, and fixed-income securities.They serve to even the play-ing field and compensate for certain economicvalues not reflected in the statutory financials.Surplus is adjusted further to reflect other non-balance-sheet risks, including catastropheexposures and debt-service requirements.

In addition, the model can be adjusted inresponse to various market issues. Some exam-ples that can impact capitalization includerate changes; the stage of the underwritingcycle; changing reinsurance products; anddependence on reinsurance.The ability of themodel to respond to these market issuesmakes it a robust tool that assists in the evalu-ation of the company’s balance-sheet strength.

For a detailed discussion of the key fea-

3

A.M. Best's Capital Adequacy ModelComposition of gross required capital for 2002 industry aggregate.

Investments31%

PremiumsWritten

32%

Loss/LAE Reserves27%

Credit10%

All Other Investments 5%

Nonaffiliated Stocks 6%

Interest Rate 4%

Investments in Affiliates 16%



tures, adjustments and issues related to theBCAR model, please refer to “TechnicalReview of the BCAR Formula,”on page 6.

Interpretive GuidanceThe basis of risk measurement for A.M.

Best’s property/casualty BCAR model isexpected policyholder deficit. A.M. Bestadopted the concept of expected policyhold-er deficit to better calibrate the model’s loss-reserve and premium risk factors, as well asother risk factors throughout the model.Although this calibration isn’t absolute, it hashelped to measure more consistently the riskthat companies face.

Expected Policyholder DeficitThe expected policyholder deficit concept

allows risk charges to be calibrated to a specificlevel of insolvency risk, producing a consistentassessment of insolvency risk throughout thecapitalization model. Many other capital ade-quacy models, including those based on value-at-risk concepts, tend to be based solely on theprobability of ruin,or insolvency.Expected poli-cyholder deficit also takes into considerationthe expected cost,or severity,of insolvency.

The table, “Expected Policyholder DeficitIllustration,” shows the difference in riskbetween two companies that have the same10% probability of insolvency. Under the firstscenario, neither company defaults or pro-duces a deficit. Under the second scenario,while both companies default and producedeficits, Company B produces a deficit of$2,000, but Company A produces a deficit ofonly $1,000.

In calculating the expected policyholderdeficit for the two companies, the probabilityof each scenario is multiplied by the deficit

produced by the scenario. Based on this calcu-lation, Company A produces an expected poli-cyholder deficit of $100, or 1% of expectedloss amount. Company B produces an expect-ed policyholder deficit of $200, or 2% ofexpected loss amount. While both companieshave the same 10% probability of failure, Com-pany B presents the greatest risk to insuredsbecause of the additional costs of its insolven-cy relative to the same capital position.

Since Company B is showing a larger expect-ed policyholder deficit, it would generate alower BCAR than Company A. The larger riskfor Company B needs to be supported by agreater amount of capital than the amountneeded to support Company A’s risks. Thegreater required capital to support CompanyB’s risks, relative to the same asset base as Com-pany A, results in a lower BCAR for Company B.

Formula DriversMore than two-thirds of a company’s gross

capital requirement within A.M. Best’s capitalmodel usually is generated from its lossreserve (B5) and net premiums written (B6)components. Consequently, a company’sabsolute BCAR value reflected in A.M. Bestpublications is influenced largely by the capi-tal required to support its net underwritingcommitment, which in turn is largely a func-tion of a company’s mix of business, size ofsurplus, stability of loss development, prof-itability, loss-reserve adequacy and length ofclaims payout. All things being equal, a compa-ny’s absolute BCAR value will be lowerbecause of higher capital requirements associ-ated with higher underwriting leverage,greater indicated reserve deficiencies andunstable or unprofitable business.

While only one-third of the gross capitalrequirement is generated from investment risk(B1/B2), interest rate risk (B3) and credit risk(B4) components, a company that maintains amore aggressive investment portfolio, dependsheavily on pyramided capital, has excessivecredit risk or depends excessively on reinsur-ance will likely generate a lower BCAR value.

Sensitivity CalculationsA.M. Best analysts may supplement their ini-

tial assessment of a company’s baseline capitalposition by performing various sensitivity cal-culations. These analyses can quantify the cap-ital required to support future business plans,reflect the effect of pro forma transactions or

4

Expected Policyholder Deficit IllustrationAsset Loss Capital Claim

Company A Amount Amount Amount Probability Payment DeficitScenario 1 $13,000 $9,556 90% $9,556 $0Scenario 2 13,000 14,000 10% 13,000 1,000Expectation 13,000 10,000 3,000 9,900 100Expected Policyholder Deficit (Expected Deficit/Expected Loss Amount) 1%

Company BScenario 1 $13,000 $9,444 90% $9,444 $0Scenario 2 13,000 15,000 10% 13,000 2,000Expectation 13,000 10,000 3,000 9,800 200Expected Policyholder Deficit (Expected Deficit/Expected Loss Amount) 2%



reflect the current quarter-ending capital posi-tion. Finally, these calculations can reduce acompany’s reported surplus to incorporate anumber of stress scenarios. These sensitivitycalculations would quantify the extent of capi-tal cushion or shortfall relative to the compa-ny’s current rating level.

A.M. Best’s minimum capitalization stan-dards, which have been established for individ-ual rating levels, generally correspond with 10%to 15% increments of a company’s net requiredcapital. If a company’s capitalization were todeteriorate after a reasonable stress test suchthat its capital position slipped more than onefull rating level or suggested a vulnerable ratingof B (Fair) or lower, the sensitivity analysiswould contribute to downward pressure onthe company’s rating. The extent of sensitivityanalysis performed on a company’s capitaliza-tion will vary by company and situation.

Integration of BCAR in the RatingProcess

Clearly, BCAR is an important quantitativetool that helps A.M. Best differentiate financialstrength between companies and indicatewhether a company’s capitalization is appro-priate for a rating. However, BCAR by itself isinsufficient as the sole basis for determiningthe final rating. In many cases, companies withsimilar capital positions might be assigned dif-ferent ratings based on the integration ofother important considerations unique to

each insurance company: operating perfor-mance and business profile.

In addition, the quality of capital is becom-ing another issue that will qualitatively differen-tiate one rating from another, even though twocompanies might have similar BCAR scores.Many soft capital transactions are admitted assurplus under statutory accounting rules butultimately drain cash, place a drag on earningsor only provide contingent capital, therebycompromising policyholder security and nega-tively impacting financial strength ratings.

However, for companies that maintain capi-tal near or below the secure/vulnerable BCARlevel of 100, BCAR becomes an important rat-ing component. Additionally, companies thatare expecting material changes over the nextyear are evaluated on both an “as is” and an “aswill be” basis to better gauge the direction inwhich capital adequacy is moving.

Availability of BCAR OutputBecause of the sensitive nature of the

underlying adjustments and qualitative infor-mation incorporated in a company’s BCAR cal-culation, detailed BCAR output for a particularcompany is made available only to that compa-ny’s management. Often, a discussion of A.M.Best’s capital model is included in rating meet-ings when capitalization is an important ratingissue.A.M. Best’s analysts generally are availableto run a limited number of scenarios to aidmanagement in understanding the impact of

5

Although BCAR originally wasdesigned as a relative measureof balance-sheet strength, the

modifications made since its introduc-tion allowed the BCAR model to pro-duce absolute measures of capital ade-quacy. A company’s absolute capitaladequacy ratio indicates whether itscapital strength aligns with A.M. Best’s“Secure” or “Vulnerable” rating cate-gories and is based on the specific riskof a company’s operation. In determin-ing whether a company’s capitalstrength is secure or vulnerable, a com-pany’s absolute BCAR is comparedwith the secure/vulnerable cutoff of100%. An absolute ratio below 100%would be considered vulnerable, mean-

ing the company’s indicated expectedpolicyholder deficit is greater than 1%.

BCAR provides an integrated evalua-tion of a company’s investment, creditand underwriting risk as it compareswith the company’s level of economicsurplus. Within this evaluation, A.M.Best includes many adjustments thatrecognize the company’s specific riskand economic surplus. Because of thisintegrated evaluation of operating risk,BCAR is an important tool in evaluatinga company’s balance-sheet strength.

Given standard operating issues,the following chart provides a reason-able guide for the minimum BCARlevels needed to support FinancialStrength Ratings:

BCAR Is an Absolute Measure

Minimum BCAR LevelsImplied Balance-Sheet Minimum Strength Rating BCARSecure:A++ 175A+ 160A 145A- 130B++ 115B+ 100

Vulnerable:B 90B- 80C++ 70C+ 60C 50C- 40D 0


their decisions on their BCAR and ultimatelyon A.M. Best’s view of capital strength.

The Technical Review of the BCAR Formula

Below are summaries of key features andissues related to adjusting policyholder sur-plus and each of the seven distinct risk com-ponents (B1 through B7) within the BCARmodel. The following exhibits illustrate thekey aspects of the BCAR calculation for twohypothetical insurers with different businessprofiles.This two-company example highlightsthe factors that drive their BCAR results, pro-vides examples of company-specific adjust-ments and gives an indication of their impliedcapital strength ratings based on their capitalpositions.

Treatment of Key Risk ComponentsIInnvveessttmmeenntt RRiisskk ((BB11//BB22))

NNoonnaaffffiilliiaatteedd BBoonnddss: A.M. Best looks at thequality distribution of an insurer’s bond port-folio and assigns risk charges for default riskthat are modestly higher than those appliedby the NAIC, with no capital charged for U.S.government bonds.

CCoommmmoonn aanndd PPrreeffeerrrreedd SSttoocckkss:: A.M. Bestcontinues to apply its historical investmentleverage approach, which assumes a 15%reduction in the market value of publicly trad-ed common stocks held.This charge is consis-tent with A.M. Best’s goal of calibrating thebaseline capital factors to a 1% expected poli-cyholder deficit. A.M. Best continues to treatpreferred stocks consistently with commonstocks.

RReeaall EEssttaattee aanndd OOtthheerr IInnvveessttmmeennttss: Giventhe greater volatility of real estate investmentsand their risk of being valued improperly, A.M.Best applies higher risk factors to this assetclass. Separate risk charges of 10% and 20%are applied to real estate occupied by thecompany and real estate held for investmentpurposes, respectively. In addition, a 20% base-line factor is applied to Schedule BA assets,which typically include some speculative,higher-risk assets.These charges are broadly inline with the NAIC’s risk factors.

CCaasshh:: The 0.3% risk charge applied to cashbalances represents the risk that cash deposit-ed in a banking institution might be uncol-lectible if the bank becomes insolvent.

IInnvveessttmmeenntt iinn PPrrooppeerrttyy//CCaassuuaallttyy IInnssuurreerrss::A.M. Best takes a consolidated approach that

recognizes the importance of affiliated rela-tionships within a domestic property/casualtygroup.This is different from the NAIC’s single-company approach, in which the requiredcapital of the domestic affiliate is charged tothe parent. A.M. Best’s consolidated approachapplies to all affiliates included in the ratingunit through reinsurance or group rating con-sideration. Separately rated subsidiaries alsoare consolidated upward and included in theirparents’ rating analyses. This consolidationprovides a better view of the overall operatingfundamentals and capitalization of the operat-ing unit.

IInnvveessttmmeenntt iinn LLiiffee//HHeeaalltthh IInnssuurreerrss:: Similarto the NAIC model, the required capital of thedomestic life/health affiliate within A.M. Best’sformula is charged to the property/casualtyparent. A.M. Best’s formula is designed toallow the excess of a life/health subsidiary’sadjusted surplus over the required capital nec-essary to support its current rating category toaccrue to the parent.

SSppeecciiaall PPuurrppoossee SSuubbssiiddiiaarriieess:: The requiredcapital to support the underlying assets andliabilities of a special purpose affiliate ischarged to the parent company. For example, adownstream holding company that holds spe-cial-purpose real estate investments wouldreceive a 20% capital charge rather than abaseline charge of 100% afforded “otherinvestment affiliates.”

IInnvveessttmmeenntt iinn NNoonniinnssuurraannccee AAffffiilliiaatteess::There are a number of issues consideredwhen determining the appropriate risk chargefor investments in noninsurance affiliates. Ifthe investment is publicly traded, it mightreceive a lower risk charge than a privatelyplaced investment, because privately placedinvestments generally are viewed as being lessliquid. However, if the company owns a largeproportion of a publicly traded affiliate, itmight require regulatory or shareholderapproval to sell it, making it less liquid. Lastly,the sale of an affiliated investment in a stresssituation could give the buyer leverage duringthe negotiation of the sale price, resulting in arealized value for the asset that is lower thanthe reported value.

These issues make these types of assets lessliquid than other publicly traded investments,and the risks resemble those of a privatelyheld subsidiary.

A.M. Best charges the full statutory carryingvalue of the noninsurance affiliate to the parent.

6


Unless a property/casualty insurer is committedactively to selling a noninsurer,with proceeds tobe reinvested in the property/casualty opera-tions, the baseline treatment is a 100% capitalcharge. In this regard, A.M. Best presumes thatthe net asset value of the affiliate is needed tosupport its own operations and isn’t available tosupport the property/casualty operation.

AAsssseett CCoonncceennttrraattiioonn AAddjjuussttmmeenntt:: A.M. Bestdoubles the asset risk charge for single, largeinvestment holdings that are greater than 10%of surplus.This additional capital requirementapplies to amounts in excess of the singleinvestment limit, with the baseline charge forthat investment type applying to the amountless than 10% of surplus.

SSpprreeaadd ooff RRiisskk FFaaccttoorr AAddjjuussttmmeenntt:: A.M.Best’s model generates additional required cap-ital to support investment risk relating to diver-sification of the portfolio, using a size factorrelated to the spread of risk among all majorasset classifications. Generally, no additionalcapital is generated from this adjustment forinsurers with more than $500 million in invest-ed assets, while insurers with less than $5 mil-lion in invested assets could receive as muchas a 50% surcharge that is added to their base-line investment capital requirement.

HHiigghh IInnvveessttmmeenntt LLeevveerraaggee:: The recent, dra-matic declines in the equity markets haveshown that companies with high investmentleverage in common stocks are subject togreater volatility in their reported surplus. Inresponse,A.M. Best will stress the capital withhigher risk charges for those companies withhigh investment leverage in common stocks.The current, baseline risk charge of 15% willbe increased to 20% or 30% when commonstocks are more than 50% or 100% of reportedsurplus, respectively.

IInntteerreesstt RRaattee RRiisskk ((BB33))Companies that maintain a high level of

exposure to short-term cash needs—most like-ly those with a high gross catastrophe proba-ble-maximum loss (PML)—are the mostexposed to interest-rate risk. A.M. Best uses aninterest-rate stress test of 120 basis points onmarket value. The 120-basis-point test comesfrom the American Academy RBC Task Force’sstudy and is consistent with a 1% expectedpolicyholder deficit.

The interest rate risk calculation includes acompany’s gross PML for catastrophes as themaximum exposure a company has to interest

rate risk. This is done by relating the compa-ny’s gross PML to its liquid assets and thenrelating this factor to the company’s decline inmarket value following a 120-basis-point risein interest rates. By relating the company’sPML to all liquid assets first,A.M. Best assumesa company is no more likely to liquidate afixed-income asset at a loss than it is likely toliquidate any other investment at a loss. How-ever,A.M. Best has established a minimum 10%catastrophe exposure percentage appliedagainst the company’s decline in market valueafter a 120-basis-point rise in interest rates,recognizing that there are other reasons for acompany to have a short-term need for cash.

The exhibit, “Interest Rate Risk” (B3) illus-trates a case in which Company B maintained ahigh gross PML exposure and, therefore, wassubject to a potential need to sell liquid assetsin a short period.As shown, the company’s cata-strophe exposure percentage—gross PML toliquid assets—is 30%. Based on A.M. Best’sassumption that asset sales would be distrib-uted evenly across the portfolio of liquid assets,this company would need to sell 30% of itsfixed-income portfolio. As a result, A.M. Bestonly charges for 30% of the $13,280 in poten-tial market depreciation, to which the fixed-income securities are exposed, resulting in acapital charge of $3,943.

A key assumption in the calculation comesfrom A.M. Best’s process of marking bonds tomarket as an adjustment to reported surplus.Because A.M. Best adjusts fixed-income securi-ties to market each year through its re-evalua-tion of capitalization, only the incremental riskthat a capital loss will be realized over thenext year needs to be considered. Any risk oflost future income will be reflected at subse-quent evaluations.Therefore, only a company’sshort-term cash needs—such as the occur-rence of its PML—would trigger a decline incapitalization over the next year.

CCrreeddiitt RRiisskk ((BB44))AAffffiilliiaatteedd RReeiinnssuurraannccee:: In most situations,

A.M. Best will use a baseline charge of 10% forreinsurance due from domestic affiliates and abaseline charge of 10% for reinsurance duefrom foreign affiliates. This charge may beadjusted, based on an assessment of the affili-ates’ creditworthiness.

NNoonnaaffffiilliiaatteedd RReeiinnssuurraannccee:: A.M. Best’s capi-tal model, which starts with a fixed 10%charge for nonaffiliated reinsurance recover-

7


ables, allows the analyst to assign variable riskcharges based on a reinsurer’s Best’s Rating,which can range from a low of 2% for an A++(Superior) reinsurer to charges in excess of50% for suspect reinsurers. In addition, A.M.Best will consider funds withheld or otherforms of collateral as an offset to reinsurancerecoverable balances. Offsets that require cer-tain conditions before the collateral is postedmight not receive an offset credit until the col-lateral option is exercised, since there is noaccess to the collateral until the threshold hasbeen triggered.

Most importantly, however, A.M. Bestincludes an additional capital requirement, orsurcharge, for insurers that analysts believe areexcessively dependent on unaffiliated reinsur-ance, given their lines of business and financialresources. For these insurers,A.M. Best increas-es the overall credit risk charge for their recov-erable balances, regardless of underlying creditquality. This additional charge ref lects theincreased exposure to reinsurance disputes andcash-flow problems the insurer might face as aresult of the higher dependence on reinsur-ance.

This increased exposure to dispute risk canhave a severe impact on surplus. A companywith recoverables equal to five times its sur-plus could lose 50% of its surplus if 10% of itsrecoverables are disputed successfully by thereinsurer. In an effort to recognize this expo-sure to dispute risk, A.M. Best employs tworeinsurance dependence tests. The first testcompares the company’s recoverable-to-sur-plus ratio to an industry benchmark. The sec-ond test examines the company’s total cededleverage to thresholds of five, seven and 10times surplus, resulting in risk charges of 15%,20% and 25% of nonaffiliated recoverables.The company’s total ceded leverage is definedas its nonaffiliated recoverables plus nonaffili-ated ceded written premium.This total cededleverage test is forward looking, since itincludes not only the existing recoverablesbut also the potential exposure to be added inthe upcoming year.

CCrreeddiitt EEnnhhaanncceemmeennttss ttoo RReeiinnssuurraanncceeRReeccoovveerraabblleess:: With the increased reliance onreinsurance, the ceding company facesincreased credit or dispute risk exposure. Inan effort to offset this increased exposure,ceding companies traditionally have requiredreinsurers to deposit funds with ceding com-panies, set up trust accounts or obtain irrevo-

cable letters of credit. Recently, ceding compa-nies have investigated the purchasing of creditenhancements that protect the ceding compa-ny’s recoverables against the possibility ofbeing uncollectible. If these recoverables areinsured by an unaffiliated third party,A.M. Bestwill reduce the risk charges to ref lect thereduced credit risk. However, the reinsurancedependence factor might not change if thecontract doesn’t cover uncollectibility result-ing from a dispute.

PPoooollss aanndd AAssssoocciiaattiioonnss:: A.M. Best’s baselinemodel applies a 10% charge to pools and asso-ciation balances. These balances might beadjusted based on the evaluation of the credit-worthiness of the pool and the state’s regula-tory environment. For ceded reinsurance asso-ciated with risk-free servicing-carrier business,A.M. Best doesn’t charge for credit risk.

AAggeennttss’’ BBaallaanncceess aanndd OOtthheerr RReecceeiivvaabblleess::A.M. Best applies a 5% capital charge foragents’ balances in course of collection anddeferred agents’ balances, as well as a 10%charge for accrued retrospective balances,although these balances will be reduced byvalid collateral and contractual offsets. Otherreceivable balances generally are assessed a5% charge and represent a minor overall capi-tal requirement.

Underwriting Risk Capital FactorsThe baseline capital factors for each line of

business are based on risk, as measured by aninternal A.M. Best study that replicated theAmerican Academy of Actuaries’ Property/Casu-alty RBC Task Force’s Report on Reserve andUnderwriting Risk Factors. Both reserve-riskfactors and premium-risk factors were calculat-ed using this process.

For reserves, A.M. Best looked at the vari-ance in incurred loss development betweenaccident years, as well as the variance withinan accident year between companies. Thesetwo measures of variance provided an indica-tion of the volatility of loss development foreach line of business. Similar calculations weremade to measure the volatility in premiumadequacy using a discounted underwritingprofit, which was calculated by subtractingcompany expenses and discounted lossesfrom earned premiums.

A.M. Best modifies both premium andreserve baseline capital factors based on acompany’s size. A.M. Best’s analysis foundgreater variation within smaller companies

8


than in larger companies for both premiumand reserves. This difference was much moreevident within reserve variation than in premi-um variation. Based on this differential, A.M.Best continues to vary its capital charges bycompany size.

The variation of capital factors by size isbased on adjusted policyholder surplus andcan be as much as a 35% reduction to theindustry baseline reserve-risk capital factorsand a 25% reduction to the industry baselinepremium-risk capital factor. This reductionreflects the inherent flexibility and diversifica-tion of a larger company to better monitor itsreserves and pricing programs. Full credit forthis size differential isn’t awarded in calculat-ing the reserve-risk factor, as the part of thisbenefit is considered in calculating each com-pany’s by-line stability factor.

Underwriting risk factors for both premi-ums and reserves can be impacted by variousreinsurance products. The treatment of thesereinsurance products varies by type of con-tract. By focusing on the amount of risk trans-ferred, the analyst may increase the underwrit-ing risk charges to reflect the disproportionateamount of risk retained vs. the amount of pre-mium retained.

Finite quota-share contracts with loss ratiocaps, corridors, sublimits and sliding-scalecommissions are examples of reinsuranceproducts that transfer away more premiumthan risk.This results in underwriting risk fac-tors that are higher than the baseline factorsbut are applied to the reduced net premiumsor reserves.This usually generates a reductionto required capital, but not as much as origi-nally anticipated based on the reduction inpremium leverage.

Retroactive adverse development coverscould benefit loss and loss-adjustment expensereserve capital factors, but the available limitsfrom the contract must be viewed in relationto any reserve deficiencies. If reserve deficien-cies exist, the contract limits are applied to thedeficiency first, and any remaining limit thencan be applied to the capital factors.

Prospective stop-loss contracts create theneed for numerous adjustments to the model,depending on where the coverage layers andlimits occur relative to historical ultimates.Any loss and loss-adjustment expense layersceded away that occur below the expectedultimate won’t reduce capital factors butmight reduce indicated deficiencies.

For each of the above types of reinsuranceproducts, adjustments may be made to sur-plus, deficiency factors or reinsurance recov-erables in addition to the modifications to theunderwriting capital factors. Furthermore, ifthere are clauses in the contracts that threatento cancel the contract and appear likely to beinvoked, the contract may be viewed as havingno risk transfer in BCAR. Although the adjust-ments made under these types of contractsnumerically might result in a desirable BCAR,the lower quality of the company’s reinsur-ance-enhanced surplus will be viewed nega-tively, resulting in a lower rating of its balance-sheet strength.

Loss and Loss-Adjustment ExpenseReserve Risk (B5)

To a large extent, A.M. Best’s loss and loss-adjustment expense reserve risk componentemphasizes adjusted reserve leverage and sta-bility in loss development as gauges of a com-pany’s exposure to reserving errors in its bookof business. Consequently, all other factorsbeing equal,A.M. Best’s capital model will gen-erate a greater reserve capital requirement foran insurer that is more leveraged or morevolatile, after adjusting for our view of itsreserve adequacy, than its peer companies andvice versa.

Required capital for loss-reserve risk isgenerated by applying capital factors to aninsurer’s adjusted loss reserves for 20 dis-tinct lines of business. To ensure equitablecapital treatment among insurers,A.M. Best’smodel places considerable weight on a com-pany’s adjusted reserves, which emphasizesreserve adequacy and the time value ofmoney imbedded in those reserves. Aninsurer that historically has under-reservedwill be penalized for maintaining lowerreported loss reserves. A.M. Best’s by-linereserve-risk factors are based on an integra-tion of the stability of a company’s loss-development pattern, the size of the compa-ny and the risk inherent in the particularline of business. Consequently, a company’srequired capital for loss reserve is driven bythese key factors:

RReesseerrvvee EEqquuiittyy AAddjjuussttmmeennttss:: On a line-by-line basis, a company’s carried loss reservesare adjusted to an economic basis that reflectsA.M. Best’s view of an insurer’s ultimatereserves, which are discounted to their pre-sent value, recognizing the time value of

9


money. By-line carried loss reserves are adjust-ed to an economic basis through two compa-ny modification factors: the reserve-deficiencyfactor and the discount factor.

The reserve-deficiency factor reflects A.M.Best’s view of an insurer’s reserve deficiencyexpressed as a fraction of its original reserveplus 1.0. The initial determination of reservedeficiency is based on a number of actuarialtechniques used within A.M. Best’s proprietaryloss-reserve model, including paid and case-incurred development. In addition to thereserve model, a diagnostic analysis of Sched-ule P and a qualitative assessment of the com-pany’s operating environment and historicalreserve development are used to arrive at A.M.Best’s view of reserve deficiency. Generally,unseasoned insurers with less than five yearsof loss experience are compared with indus-try experience, while the reserves of seasonedinsurers are determined relative to their ownhistorical experience.

A number of issues can affect A.M. Best’sview of a company’s reserve position, includ-ing the number of reserve adjustments; thesize of the adjustments; the lines of businessinvolved; the accident years generating theadverse development; and whether the adjust-ment was anticipated or unexpected. For com-panies of concern, a minimum deficiency fac-tor of 10% above the actuarial best estimatewill be used in the model. In addition toassessing the company’s core reserves, A.M.Best performs a separate analysis of itsasbestos and environmental reserves liabili-ties. Any deficiency in mass-tort reserves isadded to the core deficiency. For asbestos andenvironmental reserves, A.M. Best uses a sur-vival ratio method, a premium market sharemethod and a paid-loss-share method to gener-ate an initial assessment of these reserves. Dis-cussions with company management and acurrent, third-party, ground-up review then areused to supplement the initial analysis.

A discount factor, based on the payout pat-tern of the individual company’s reserves anda 5% discount rate, is applied to the estimatedultimate loss reserves.The resulting deficiencyand discount factors are applied to a compa-ny’s reported by-line loss reserves to derivethe company’s adjusted reserves.To maintain aconsistent treatment of the time value ofmoney, all statutory discounting is treated asreserve deficiency, and credit is given throughthe discount factor.

RReesseerrvvee CCaappiittaall FFaaccttoorrss:: Once adjustedreserves have been determined by line of busi-ness, they can be multiplied by company-spe-cific reserve capital factors to determine acompany’s reserve capital requirement. By-linereserve capital factors are based on the riskinherent in each line of business, scaled by thesize of the company and the volatility of acompany’s loss development for that line.

Stability factors are used to differentiate thevolatility in a specific company’s loss reserves.The stability factors are calibrated around1.00—ranging from 0.70 to 1.30—and are cal-culated by line, based on the stability of thecompany’s loss-development pattern relativeto the rest of the industry. The measurementused to judge the stability of a line of businessis the coefficient of variation for loss-develop-ment factors at each stage of developmentthrough 72 months. Companies with less thaneight years of loss experience are penalizedfor their lack of loss experience and loss-development history.

A.M. Best views the variation in a compa-ny’s loss-development pattern as a strong indi-cator of the risk inherent in its loss reservesand of the company’s ability to make accurateprojections of ultimate losses.

To calculate a company’s final reserve capi-tal factors for each line of business, the stabili-ty factors are applied to the industry baselinecapital factors, adjusted to reflect the compa-ny’s size. These capital factors are applied tothe company’s adjusted loss reserves to pro-duce required capital charges by line of busi-ness. It should be noted that, unlike the Ameri-can Academy of Actuaries study, A.M. Bestdidn’t reduce its reserve capital factors toreflect the time value of money, as is done inthe risk-based capital calculation. This isbecause A.M. Best already accounts for thetime value of money in its calculation ofadjusted loss reserves.

In addition, through a number of supple-mental data sources, A.M. Best obtains addi-tional by-line information for certain statutorylines that are too broad, such as the other lia-bility line, which may have a multitude of riskclasses.To the extent that an insurer providesa more detailed breakout of its loss reserves,A.M. Best will apply more appropriate reservecapital factors. Furthermore, a company’sreserve-risk factor may be adjusted within thecasualty lines for loss-sensitive business.

RReettrrooaaccttiivvee RReeiinnssuurraannccee:: Any time-value-of-

10


money gain on retroactive reinsurance isremoved from surplus, because the model hasalready credited the gain to surplus throughthe reserve-equity adjustment. The reserve-equity adjustment represents the embeddedvalue in reserves because of the discountingof those reserves for the time value of money.Failure to remove the surplus gain booked bythe company would result in a double count-ing of the embedded equity.

Because BCAR already gives credit for loss-reserve equity, retroactive reinsurance pro-vides little benefit unless it also includesadverse-development protection. There is notrue economic gain other than the risk protec-tion awarded for stop-loss protection abovethe expected ultimate, and that benefit isreflected with a risk factor adjustment. In fact,in some cases where investment yields abovethose earned by the company are guaranteedto the reinsurer, these contracts can be puni-tive in A.M. Best’s view of capitalization.

GGrroowwtthh CChhaarrggee:The reserve growth chargeref lects the additional risk that typicallycomes from growth and is based on thegrowth in a company’s exposures.The growthcharge applied to the loss reserve aggregaterequired capital reflects the substantial risk acompany faces in the claims and reservingareas during a time of significant growth.

A growth charge is applied when growth inexposure is more than 8%.The basis for deter-mining the level of growth is the greater ofthe one-year and three-year annualized growthrate and can be based on growth in policycount as disclosed in A.M. Best’s SupplementalRating Questionnaire or based on company-supplied exposure information.

Even though the growth charge is intendedto be based on exposure growth, this informa-tion isn’t available in the annual statement.Therefore, the model initially calculates thecompany’s growth charge based on thegrowth in unaffiliated gross premiums writ-ten.The initial calculation compares the mostrecent year’s growth to a threshold and alsocompares the three-year annualized premiumgrowth rate to a different threshold.Whichev-er comparison generates the higher growthcharge is used. These thresholds are chosenbased on rate changes in the industry duringthose time periods plus an allowance for mod-erate growth in exposure.

The table, “High Premium Growth Exam-ple,” shows the impact that rate changes can

have on calculating the growth factor. In thisexample, the premiums grew at a substantial50% during the most recent year, generating agrowth charge of 1.30. However, subsequentexamination of policy counts shows that theexposure really only grew at a rate of 10%,which only generates a growth charge of1.02. This 1.02 growth factor is the growthcharge to be used in the model for this exam-ple.

DDiivveerrssiiffiiccaattiioonn CCrreeddiitt:: The diversificationfactor reflects the reduction in overall reserverisk within a well-diversified portfolio of lossreserves. This factor is calculated similarly tothe NAIC’s risk-based capital formula.The finalrequired capital charge is multiplied by a fac-tor of (.70 + .30 times % reserves in the largestline of business). However, in the case where acompany has operations that are spread thinlyacross many lines of business with smallamounts of reserves, this diversification bene-fit is reduced.

Net Premiums Written Risk (B6)Required capital for premiums written risk

within A.M. Best’s capital model is generatedby applying premium capital factors to aninsurer’s premiums written for 20 distinctSchedule P lines of business. Premium risk cap-ital factors are based on the integration of therisk inherent in a particular line of business,the company’s profitability in that line and thecompany’s size. The company’s profitability isreflected in premium adequacy factors.

To calculate the company premium capitalfactors for each line of business, the companypremium adequacy factors are applied to theindustry baseline premium capital factors,

11

High Premium Growth Example($ Thousands)

GrossPremiums Policy

Calendar Year Written Count1999 $100,000 1,0002000 100,000 1,0002001 100,000 1,0002002 150,000 1,100

One-Year Growth Rate: 50.0% 10.0%Three-Year Average Growth Rate: 14.5% 3.2%

Indicated Growth Factors One-Year Growth Rate: 1.300 1.020Three-Year Average Growth Rate: 1.045 1.000



adjusted to reflect the company’s size. Thesecapital factors then are applied to the compa-ny’s net premiums written to produce requiredpremium capital charges by line of business.

The premium adequacy factors are calibrat-ed around 1.00—ranging from 0.80 to 1.20—and are calculated by line, based on the prof-itability of the company’s business relative toother companies that have written that Sched-ule P line of business. The measurement usedto judge the profitability of a line of businessis a three-year reported accident-year com-bined ratio, using the company’s overall under-writing expense ratio. Adjustments may bemade to the premium adequacy factors toref lect reserve-adequacy levels within theaccident-year results.

To account for any changes in current marketpricing, the model uses an underwriting cycleadjustment that reflects the impact current pric-ing has on underwriting risk.The underwritingcycle factor is applied to the premium adequacyfactor, and the result can increase or decreasepremium capital factors by as much as 10% toreflect the current market conditions.

A.M. Best believes the profitability of acompany’s business and the overall industrypricing levels are good indicators of the levelof risk margin expected within a company’sfuture business. Those companies with betterhistorical profitability are expected to main-tain a greater risk margin in the pricing andunderwriting of future business and, there-fore, require a lower premium capital factor.

Similar to the loss-reserve component,A.M.Best may apply more appropriate capital fac-tors for certain broad-line captions that con-tain a multitude of risk classes. Furthermore, acompany’s premium risk factor may be adjust-ed within A.M. Best’s model to reflect reducedcharges within the casualty lines for loss-sensi-tive business.

Two final adjustments are made to the aggre-gation of the by-line required premium capitalcharge. These adjustments include a charge toreflect the additional risk that typically comesfrom growth and the benefit derived from amore diversified book of business.

GGrroowwtthh CChhaarrggee:: This charge reflects thesubstantial risk a company faces when bring-ing in substantial new business based onweaker underwriting and pricing standards orlack of market knowledge. The calculation ofthe premium growth charge is identical to thecalculation of reserve growth charges and is

applied directly to the aggregate required cap-ital for premium risk.

In the case of both the premium and reservegrowth charges, adjustments are made toreflect issues within growth such as substantial,historical control of the book of business.

DDiivveerrssiiffiiccaattiioonn CCrreeddiitt:: The diversificationfactor reflects the reduction in overall premiumrisk within a well-diversified book of business.This factor is calculated similarly to the NAIC’sRBC formula. The final required premiumcharge is multiplied by a factor of (.70 + .30times % premium in the largest line of busi-ness). However, in the case where a companyhas operations that are spread thinly acrossmany lines of business with small amounts ofpremium, this diversification benefit is reduced.

Business Risk (B7)Like the NAIC, A.M. Best applies a nominal

1% capital charge to several off-balance-sheetitems, including balances associated with non-controlled assets, guarantees for affiliates, con-tingent liabilities, long-term lease obligationsand interest-rate swaps.This charge represents astarting point for business risk capital chargesassessed based on qualitative assessments of off-balance-sheet liabilities that might encumber acompany’s surplus growth or preservation.

After gaining an understanding of the inher-ent risk relating to off-balance-sheet items, theanalyst will modify the capital charge toreflect the appropriate level of risk. An exam-ple of this is the risk associated with creditdefault swaps, for which the analyst will assessthe credit quality of the underlying portfolioof counterparties to determine the appropri-ate capital charge. In such an example, thecapital charge could be increased to as high as100% if recovery is unlikely from the variouscounterparties.

Although many of these items are classifiedappropriately in the business risk component,adjustments for these items may alternatively beincluded in the adjusted surplus component.

Adjusted Surplus (APHS)A.M. Best makes a number of adjustments

to a company’s reported surplus within thecapital model to provide a more economicand comparable basis for evaluating capitaladequacy.These adjustments even the playingfield and compensate for certain economicvalues not reflected in the statutory financials.Reported surplus is modified for equity adjust-

12


ments related to unearned premiums, lossreserves and fixed-income assets on an after-tax basis, based on a three-year-average effec-tive tax rate.

UUnneeaarrnneedd PPrreemmiiuumm EEqquuiittyy:: In the case ofunearned premiums, A.M. Best increasesreported surplus to include an estimated assetfor deferred acquisition costs similar to thatref lected in GAAP (generally acceptedaccounting principles) financials. This equityadjustment enables A.M. Best to place a grow-ing company, which is penalized for heavyprepaid acquisition costs, on a comparablebasis with a mature company, which has flator declining acquisition costs.

To the extent that a company’s book ofbusiness generates a discounted accident-yearloss and loss-adjustment-expense ratio inexcess of 100%, A.M. Best won’t recognize anyequity in unearned premiums. For companieswith discounted accident-year loss and loss-adjustment-expense ratios below 100%, butstill higher than their prepaid underwritingexpense structure will allow, A.M. Best willrecognize only a pro rata share of the deferredacquisition costs as equity.

A risk charge is applied to the unearnedpremiums to reflect the pricing risk inherentin the rates charged for business written lastyear, but still unearned as of the current yearend, and the charge is subtracted from theunearned premium equity. This pricing risk isseparate from the risk charged on the premi-um risk page, which attempts to capture thepricing risk associated with the business thatwill be written in the upcoming year. Themodel uses the current-year written premiumas a proxy for the upcoming year’s writings.

LLoossss RReesseerrvvee EEqquuiittyy:: A.M. Best adjusts sur-plus to reflect the net equity embedded with-in loss reserves.This equity represents the dif-ference between a company’s economicreserves, which reflects A.M. Best’s view ofultimate reserves on a discounted basis, andcarried reserves. The adjustment, which canbe sizable for a casualty insurer, enables A.M.Best to even the playing field and better differ-entiate companies that have historicallyunder-reserved from those that have strongloss-reserve positions.

Any reserve equity gain from reinsurancetransactions is removed from surplus, sincethe equity already is awarded through the cal-culation of loss-reserve equity. This is consis-tent with A.M. Best’s treatment of statutory dis-

counting and with efforts to treat loss-reserveequity consistently.The best example of this isretroactive reinsurance through a loss-portfo-lio transfer in which a company often pays thereinsurer assets equal to the present value ofthe loss-reserve portfolio plus a risk marginand then cedes the full-value loss reserves,producing a gain to surplus. However, becauseof accounting procedures, these loss reservesremain on the primary company’s books, andthe ceded reserves are treated as a negativeliability.

Since the ceded reserves remain within thebalance-sheet reserves, some form of adjust-ment is needed. Otherwise, the time value ofmoney would be credited twice—once withinsurplus and once within the calculation ofloss-reserve equity. In this case, A.M. Bestremoves the surplus gain from surplus, andthe equity within these reserves is awardedthrough the discount factor within the calcu-lation of reserve equity. A reserve risk chargestill applies to these reinsured losses. Withoutadditional stop loss, the primary companyremains exposed to any potential adverse lossdevelopment on these reserves.

FFiixxeedd IInnccoommee AAsssseettss:: Surplus also is adjust-ed to reflect an insurer’s fixed-income securi-ties’ market value.This allows for a better viewof a company’s current economic capital posi-tion. The pretax benefit of this adjustment islimited to caps of +10% and -15% of surplus,and the result is then tax affected.

DDeebbtt aanndd SSuurrpplluuss NNootteess:: A.M. Best’s capitalmodel emphasizes permanent capital and con-sequently will reduce a company’s reportedsurplus for encumbered capital, whichincludes surplus notes and future debt-servicerequirements of an affiliated holding company.This reduction, in whole or in part, depends onthe magnitude and dependence an insurancegroup has on debt-like instruments and theirassociated repayment features.

Both quantitative and qualitative factors areconsidered in the evaluation of debt. As part ofthe quantitative analysis, A.M. Best uses a sepa-rate model to assist in the determination of theamount of surplus credit given to surplus notesand debt instruments.The primary issue, whichdetermines the level of credit given, is the termof the debt as compared with the length oftime needed to pay the bulk of the policy liabil-ities.Usually,more credit is given to longer-termdebt than to short term. Another key determi-nant is the company’s rate of return compared

13


with the interest rate charged on the debt. Acompany should be earning more than its costof capital to receive credit for the debt.

On a qualitative basis, issues such as wherethe debt is held vs. where the cash is used; theexistence of other sources of income to offsetthe cost of debt; fixed-charge coverage; andthe overall level of debt relative to the organi-zation’s total capital all are considered.

OOccccuurrrreennccee ooff aa CCaattaassttrroopphhee:: A standard-ized incorporation of a company’s PML in themodel highlights A.M. Best’s concern that cata-strophes are the No. 1 threat to solvency inthe industry because of the significant, rapidand unexpected impact that can occur. Whilemany other exposures can affect solvency, nosingle exposure can affect policyholder securi-ty more instantaneously than catastrophes.

To reflect this concern, all companies aresubjected to a reduction in their reported sur-plus based on the higher of either a 100-yearwind net PML or a 250-year earthquake netPML within the calculation of BCAR. The netPML exposure also is tax-affected with a 35%tax rate.The determination of these losses willbe provided through A.M. Best’s SupplementalRating Questionnaire database and throughdiscussions with management.

The information filed by companies withinthe Supplemental Rating Questionnaire is crit-ical to the assessment of their capital strength.However, like any other component withinBCAR, the PML response can be adjusteddownward to reflect additional informationprovided by management. The PML responsealso can be adjusted upward if A.M. Best deter-mines additional conservatism should betaken into consideration based on a review ofthe catastrophe study.

TTeerrrroorriissmm:: A.M. Best has surveyed compa-nies about their terrorism exposure throughthe use of its terrorism questionnaire. Begin-ning in 2004, this topic will be included in thesupplemental rating questionaire. The resultsare reviewed with the company, and a qualita-tive assessment of the company’s capitalizationis made. In the future, it is possible that a ter-rorism PML would be usable in the BCARmodel in much the same manner as a naturalcatastrophe PML. In the near term, however, itis more likely that a deterministic approachmight be used to determine exposure.

SSttrreessss TTeesstt AAddjjuussttmmeennttss:: A.M. Best mayreduce a company’s reported surplus furtheras part of its sensitivity analysis to reflect a

number of stress-test scenarios. This analysismeasures an insurer’s prospective capitalneeds stemming from a number of off-balance-sheet items, including commitments or guar-antees to affiliates; outstanding litigation;excessive catastrophe losses not containedwithin an insurer’s reinsurance program; andcontinued operating losses.

Companies with a high catastrophe expo-sure on a gross basis and a low exposure on anet basis will be subjected to additionalstress tests related to the occurrence of suchan event. Assuming an event occurred, rein-surance recoverables would increase by thedifference in the gross and net PML, so thisdifference will be added to reinsurancerecoverables. This adjustment also mightincrease the reinsurance dependence factor.In addition, in determining the appropriaterisk charge for these recoverables, A.M. Bestwill assume the ratings of the reinsurers havebeen lowered two rating levels as a result ofthe event. The last adjustment to be madewill be the addition of the net PML to theloss reserves.

Although these stress-tested BCAR resultsaren’t published, they do impact A.M. Best’sview of capitalization.

A.M. Best’s Capital AdequacyModel: Two-Company Illustration

The BCAR summary section shown in thetwo-company illustration is intended to reflectthe components of a company’s net requiredcapital generated by A.M. Best’s BCAR model.Using Company A’s BCAR output, the followingobservations can be made about its net capitalrequirement, adjusted surplus and BCAR ratio.

Company ANNeett RReeqquuiirreedd CCaappiittaall

In total, before the covariance adjustment,Company A’s gross required capital generatedfrom A.M. Best’s capital adequacy model is$44.1 million; consisting of 68% related tounderwriting risk, 32% related to asset riskand less than 1% related to business risk.

Asset risk capital consists of total invest-ment and credit risk capital. Total investmentrisk capital of $10.1 million consists of: (B1)fixed-income security capital of $3.0 million;(B2) equity security capital of $6.0 million; and(B3) interest rate capital of $1.2 million. Thecredit risk component (B4) is $3.9 million.Typ-ical of most insurers, Company A’s equity secu-

14


rity capital requirement is the largest risk com-ponent with the asset risk category.

Underwriting risk capital consists of lossreserve risk (B5) and net written premiumrisk (B6) with capital requirements of $20.5million and $9.5 million, respectively. Typicalof most insurers, underwriting risk generatestwo-thirds to three-quarters of the company’stotal gross required capital.

Business risk capital (B7) consists of off-bal-ance-sheet risks and typically generates nominalcapital requirement.Although not capital inten-sive, the off-balance-sheet components of busi-ness risk can have a material impact on surplus.

Consistent with the NAIC risk-based capitalmodel,A.M. Best uses a covariance adjustmentrecognizing that each of the underlying risksaren’t going to develop simultaneously andaren’t fully interdependent or correlated. Com-pany A’s net required capital of $25.4 millionreflects a 42% covariance reduction to its grossrequired capital. Covariance reductions gener-ally range from 35% to 45% for most insurers.

Net required capital, which is calculated asthe square root of the sum of the requiredcapital for each of the risk componentssquared (excluding business risk), is substan-tially less than the simple sum of the compo-nent capital charges.

AAddjjuusstteedd SSuurrpplluussCompany A’s adjusted surplus of $32.6 mil-

lion used within A.M. Best’s capital modelreflects a 32% increase to the reported surplusposition after considering the three equityadjustments related to its unearned premiums,loss reserves and fixed-income securities onan after-tax basis.

BBeesstt’’ss CCaappiittaall AAddeeqquuaaccyy RRaattiiooThe BCAR ratio is simply adjusted surplus

divided by net required capital. Company A’sBCAR ratio of 128.1 represents the value thatwould be reflected within each of A.M. Best’spublications, including Best’s Key RatingGuide and Best’s Insurance Reports.

Company A’s BCAR result is used for inter-preting Company A’s implied rating from acapitalization perspective only. On a purelyquantitative basis, A.M. Best’s capitalizationstandards suggest Company A’s BCAR ratiosupports a rating up to B++ (Very Good).

SSppeecciiffiicc CCoommppaannyy CCoommmmeennttaarryyCompany A, which is a small commercial

casualty insurance company, focuses its cur-rent underwriting on midsized manufacturingbusiness written on a loss-sensitive basis.Thecompany maintains marginally secure capital-ization with a BCAR of 128.1, which lagsmany of its commercial-lines peers but sup-ports its current B++ rating. The company’scapital position reflects its much higher thanaverage reserve leverage; heavy use of reinsur-ance; and aggressive investment portfolio,which are tempered considerably by its less-risky, retrospectively rated business and the

15

A.M. Best's Capital Adequacy Model—Two Company Illustration($ Thousands)

Recap of Net Required Capital (NRC) Company A Company B

Required RequiredCapital % Gross Capital % Gross

Risk Component Amount Capital Amount CapitalAsset Risk:

(B1) Fixed Income Securities $2,955 7 $2,521 1(B2) Equity Securities 5,989 13 27,722 16

Subtotal 8,944 20 30,243 17(B3) Interest Rate 1,245 3 3,943 2

Total Investment Risk 10,189 23 $34,186 19(B4) Credit 3,942 9 4,091 2

Total Asset Risk 14,131 32 $38,277 21

Underwriting Risk:(B5) Loss & LAE Reserves 20,488 46 59,829 34(B6) Net Premiums Written 9,508 22 79,351 45

Total Underwriting Risk 29,996 68 139,180 79(B7) Business Risk 16 0 9 0Gross Required Capital (GRC) 44,143 100 177,466 100Less: Covariance Adjustment 18,733 42 72,960 41Net Required Capital (NRC) $25,410 58 $104,506 59

Recap of Adjusted Policyholder Surplus (APHS)% to % to

Reported ReportedSurplus Adjustment Amount Surplus Amount SurplusReported Surplus (PHS) $24,650 100 $109,900 100Equity Adjustments:

Unearned Premium Reserve Equity 2,835 11 10,100 9Loss Reserves Equity 4,603 19 5,093 5Fixed Income Equity 473 2 953 1Subtotal 32,561 132 126,046 115

Other Adjustments:Surplus Notes 0 0 0 0Off-Balance-Sheet Losses 0 0 0 0Future Dividends 0 0 0 0Potential Losses (incl. Catastrophes) 0 0 19,500 18Adjusted Surplus (APHS) $32,561 132 $106,546 97

Effective Tax Rate = 20.0%

A.M. Best's Capital Adequacy Ratio Company A Company B BCAR (APHS/NRC) 128.1 102.0



16

Investment Risk (B1/B2)

Company A Company B(1) (2) (3) (1) (2) (3)

Asset AssetRisk (1)*(2) Risk (1)*(2)

Statement Factor Required Statement Factor RequiredInvestments Value (%) Capital Value (%) CapitalBonds:

U.S. Government $21,410 0.0 $0 $88,700 0.0 0Investment Grade (Class 1-2) 97,280 1.0 1 973 226,300 1.0 1 2,263Below Investment Grade (Class 3-6) 18,790 3.9 1 733 0 3.0 0Afffiliated 1,000 20.0 2 200 0 100.0 0

Total Bonds 138,480 1.4 $1,906 315,000 0.7 $2,263

Preferred Stocks:Nonaffiliated 1,650 15.0 248 0 15.0 0Affiliated 0 100.0 0 0 100.0 0

Total Preferred Stocks 1,650 15.0 248 0 0.0 0

Common Stocks:Nonaffiliated 25,220 15.0 3,783 400 15.0 60Affiliated 0 100.0 0 35,400 70.1 3 24,815

Total Common Stocks 25,220 15.0 3,783 35,800 69.5 24,875

Mortgage Loans 12,750 5.0 638 0 5.0 0Real Estate 5,260 18.6 1 978 500 20.0 100Cash 1,040 0.3 3 2,800 0.3 8Other Investments 770 20.0 154 0 20.0 0Total Investments $185,170 4.2 $7,710 $354,100 7.7 $27,246 Spread of Risk Factor x 1.16 x 1.11Investment-Risk Required Capital $8,944 $30,243

Notes:1 Reflects a blended capital factor because of multiple captions that were collapsed for presentation.2 Reduced bond affiliate charge from 100% to 20% to reflect special-purpose nature of investment in affiliate.3 Reduced affiliated common stock charge from 100% to 70.1%, reflecting "excess" capital in downstream life/health affiliate.


Interest Rate Risk (B3)

Company A120 B.P. Potential Interest-

Estimated Market Interest- Market % Catastrophe Rate RiskFixed Income Security Duration Value Rate Rise Depreciation Exposure CapitalBonds 6.5 $138,970 1.20% $10,840 10% $1,084 Preferred Stocks 7.6 1,675 1.20 153 10 15Mortgage Loans 9.5 12,826 1.20 1,462 10 146Totals $153,471 $12,455 $1,245

Catastrophe Exposure Percentage CalculationGross PML $0 Liquid Assets $179,140 PML/Liquid Assets 10%

Company B120 B.P. Potential Interest-

Estimated Market Interest- Market % Catastrophe Rate RiskFixed Income Security Duration Value Rate Rise Depreciation Exposure CapitalBonds 3.5 $316,191 1.20% $13,280 30% $3,943 Preferred Stocks 4.3 0 1.20 - 30 - Mortgage Loans 6.5 0 1.20 - 30 - Totals $316,191 $13,280 $3,943

Catastrophe Exposure Percentage Calculation:Gross PML $105,000 Liquid Assets $353,600 PML/Liquid Assets 30%



absence of pyramided capital, with the com-pany affiliates owned directly by a commonholding-company parent. Further, althoughalmost 50% of the company’s gross capitalrequirement is generated from loss reserves, italso receives a larger adjustment to reportedsurplus after considering the buildup of sub-stantial economic value embedded within itslong-tail reserves.

The company maintains an aggressive invest-ment strategy, with holdings in junk bonds,mortgage loans, real estate and common stocksaggregating more than 250% of surplus.Because of its long-tail business, the company’sfixed-income portfolio has been structuredlong term and thus faces greater market-valua-tion sensitivity to rising interest rates. However,given the company’s modest short-term needsfor cash, interest-rate risk is minimal.

Capital required for credit risk is higherbecause of the company’s large amount of rein-surance recoverables.These have been collater-alized partially by letters of credit in connectionwith risk-free servicing-carrier business, or gen-erally are placed with high-quality domestic par-ticipants. Despite these adjustments, the compa-ny still is very dependent on reinsurance, withadjusted recoverables representing more than

200% of surplus and consequently generating areinsurance dependence surcharge.

Loss-reserve leverage of four times surplusis 50% higher than companies of a similar sizeand mix of business. The company’s lossreserves have an indicated overall deficiencyof 14%, which is impacted heavily by its otherliability business that has experienced consid-erable emergence of environmental andasbestos claims in its pre-1984 reserves. Thecompany’s overall reserve deficiency, howev-er, is more than offset by the buildup of sub-stantial economic value within its long-tailreserves. Further, the company’s overallreserve capital charge has been tempered con-siderably, reflecting significant adjustmentsmade for its substantial, loss-sensitive national-account business. The company’s capitalrequirements for premium are much less thanthose of its peers because its comparable pre-mium leverage of 1.5 times surplus is tem-pered by its substantial block of less-risky loss-sensitive business.

Company BCompany B, a large, personal-lines insur-

ance company, focuses its current underwrit-ing on personal automobile and homeowners

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Credit Risk (B4)

Company A Company B(1) (2) (3) (1) (2) (3)

Asset AssetRisk (1)*(2) Risk (1)*(2)

Statement Factor Required Statement Factor RequiredValue (%) Capital Value (%) Capital

Receivable Balances:Gross Agent Balances $919 5.0 $46 $16,600 5.0 $830

Reinsurance Recoverables:Foreign Affiliates 0 10.0 1 0 0 10.0 0U.S. Insurers/U.S. Branches 37,950 5.0 2 1,898 17,600 10.0 1,760Pools & Associations 4,990 10.0 3 499 0 10.0 0All Other Insurers 10,070 10.0 4 1,007 3,100 10.0 310Less: Schedule F Provision 2,430 10.0 243 100 10.0 10Less: Funds Held by Company 1,100 10.0 110 0 10.0 0

Reinsurance Totals 49,480 6.2 3,051 20,600 10.0 2,060Reinsurance Dependence Factor x 1.25 x 1.00Adjusted Reinsurance Recoverables 3,813 2,060

All Other Receivables 1,809 4.6 1 83 27,300 4.4 1 1,201Total Credit Risk Required Capital $52,208 7.6 $3,942 $64,500 6.3 $4,091

Notes:1 Reflects a blended capital factor because of multiple captions that were collapsed for presentation.2 Reduced reinsurance recoverable charge from 10% to 5% to reflect A+/A rating among domestic reinsurance participants.3 Reduced $10 million of recoverables due from pools and associations in connection with risk-free servicing carrier business.4 Reduced $5 million of foreign recoverables to reflect 90% credit for letter of credit offsets.



18

Loss & Loss-Adjustment Expense Reserve Risk (B5)($ Thousands)

Company A(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)

Carried Adjusted Adjusted Baseline Company Company Capital CapitalReserves Deficiency Discount Factor Reserves Capital Size Stability Factor Charge

Schedule P Line % $ Amount Factor Factor (3)*(4) (2)*(5) Factor Factor Factor (7)*(8)*(9) (6)*(10)Homeowners/Farmowners 0 - 1.00 1.00 1.00 0 0.37 0.92 1.00 0.34 0Personal Auto Liability 0 - 1.00 1.00 1.00 0 0.38 0.92 1.00 0.35 0Commercial Auto Liability 11 10,500 1.05 0.89 0.93 9,812 0.38 0.92 1.10 0.39 3,803Workers' Compensation 39.8 38,100 1.10 0.79 0.87 33,109 0.39 0.92 0.85 0.23 7,615Commercial Multiperil 14.9 14,220 1.08 0.85 0.92 13,054 0.40 0.92 0.98 0.36 4,687Medical Mal - Occurence 0 - 1.00 1.00 1.00 0 0.50 0.92 1.00 0.46 0Medical Mal - Claims Made 0 - 1.00 1.00 1.00 0 0.44 0.92 1.00 0.40 0Special Liability 0 - 1.00 1.00 1.00 0 0.45 0.92 1.00 0.41 0Other Liability - Occurence 18.6 17,820 1.35 0.82 1.11 19,727 0.45 0.92 1.15 0.27 5,326Other Liability - Claims Made 15.8 15,110 1.10 0.86 0.95 14,294 0.42 0.92 1.03 0.25 3,574Products Liab - Occurrence 0 - 1.00 1.00 1.00 0 0.50 0.92 1.00 0.46 0Products Liab - Claims Made 0 - 1.00 1.00 1.00 0 0.43 0.92 1.00 0.39 0Property 0 - 1.00 1.00 1.00 0 0.44 0.92 1.00 0.41 0Auto Physical Damage 0 - 1.00 1.00 1.00 0 0.44 0.92 1.00 0.41 0Fidelity & Surety 0 - 1.00 1.00 1.00 0 0.44 0.92 1.00 0.41 0Other 0 - 1.00 1.00 1.00 0 0.44 0.92 1.00 0.41 0International 0 - 1.00 1.00 1.00 0 0.59 0.92 1.00 0.54 0Reinsurance A 0 - 1.00 1.00 1.00 0 0.45 0.92 1.00 0.42 0Reinsurance B 0 - 1.00 1.00 1.00 0 0.51 0.92 1.00 0.47 0Reinsurance C 0 - 1.00 1.00 1.00 0 0.50 0.92 1.00 0.46 0Total 100 $95,750 1.14 0.83 0.94 $89,996 0.28 $25,005

Growth Factor x 1.00Diversification Factor x 0.82Adjusted Reserve Capital $20,488

Company B(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)

Carried Adj. Adjusted Baseline Company Company Capital CapitalReserves Deficiency Discount Factor Reserves Capital Size Stability Factor Charge

Schedule P Line % $ Amount Factor Factor (3)*(4) (2)*(5) Factor Factor Factor (7)*(8)*(9) (6)*(10)Homeowners/Farmowners 15 26,100 1.00 0.95 0.95 24,795 0.37 0.86 0.99 0.32 7,854Personal Auto Liability 73.2 127,700 1.05 0.93 0.98 124,699 0.38 0.86 1.05 0.34 42,848Commercial Auto Liability 0 - 1.00 1.00 1.00 0 0.38 0.86 1.00 0.33 0Workers' Compensation 9.6 16,700 1.10 0.81 0.89 14,880 0.39 0.86 1.10 0.37 5,439Commercial Multiperil 0 - 1.00 1.00 1.00 0 0.40 0.86 1.00 0.34 0Medical Mal - Occurence 0 - 1.00 1.00 1.00 0 0.50 0.86 1.00 0.43 0Medical Mal - Claims Made 0 - 1.00 1.00 1.00 0 0.44 0.86 1.00 0.38 0Special Liability 0 - 1.00 1.00 1.00 0 0.45 0.86 1.00 0.39 0Other Liability - Occurence 0 - 1.00 1.00 1.00 0 0.45 0.86 1.00 0.39 0Other Liability - Claims Made 0 - 1.00 1.00 1.00 0 0.42 0.86 1.00 0.36 0Products Liab - Occurrence 0 - 1.00 1.00 1.00 0 0.50 0.86 1.00 0.43 0Products Liab - Claims Made 0 - 1.00 1.00 1.00 0 0.43 0.86 1.00 0.37 0Property 0 - 1.00 1.00 1.00 0 0.44 0.86 1.00 0.38 0Auto Physical Damage 2.3 4,000 1.00 0.94 0.94 3,760 0.44 0.86 1.00 0.38 1,438Fidelity & Surety 0 - 1.00 1.00 1.00 0 0.44 0.86 1.00 0.38 0Other 0 - 1.00 1.00 1.00 0 0.44 0.86 1.00 0.38 0International 0 - 1.00 1.00 1.00 0 0.59 0.86 1.00 0.51 0Reinsurance A 0 - 1.00 1.00 1.00 0 0.45 0.86 1.00 0.39 0Reinsurance B 0 - 1.00 1.00 1.00 0 0.51 0.86 1.00 0.44 0Reinsurance C 0 - 1.00 1.00 1.00 0 0.50 0.86 1.00 0.43 0Total 100 $174,500 1.05 0.92 0.96 $168,134 0.34 $57,579

Growth Factor x 1.13Diversification Factor x 0.92Adjusted Reserve Capital $59,829

Notes: Tempered reserve and premium capital factors to reflect a credit for loss-sensitive business.



19

Premium Risk (B6)($ Thousands)

Company A(1) (2) (3) (4) (5) (6) (7)

Baseline Company Company Capital CapitalNet Premiums Written Capital Size Profit Factor Charge

Schedule P Line % $ Amount Factor Factor Factor (3)*(4)*(5) (2)*(6)Homeowners/Farmowners 0 0 0.53 0.94 1.00 0.49 0Personal Auto Liability 0 0 0.36 0.94 1.00 0.34 0Commercial Auto Liability 13.9 5,220 0.39 0.94 1.00 0.37 1,932Workers' Compensation 30.7 11,490 0.40 0.94 1.02 0.26 2,987Commercial Multiperil 18.1 6,780 0.40 0.94 0.98 0.37 2,499Medical Mal - Occurence 0 0 0.41 0.94 1.00 0.39 0Medical Mal - Claims Made 0 0 0.35 0.94 1.00 0.33 0Special Liability 0 0 0.41 0.94 1.00 0.38 0Other Liability - Occurence 11.6 4,360 0.44 0.94 0.95 0.29 1,264Other Liability - Claims Made 25.7 9,630 0.37 0.94 1.03 0.26 2,504Products Liab - Occurrence 0 0 0.42 0.94 1.00 0.40 0Products Liab - Claims Made 0 0 0.36 0.94 1.00 0.34 0Property 0 0 0.48 0.94 1.00 0.45 0Auto Physical Damage 0 0 0.33 0.94 1.00 0.31 0Fidelity & Surety 0 0 0.33 0.94 1.00 0.31 0Other 0 0 0.33 0.94 1.00 0.31 0International 0 0 0.59 0.94 1.00 0.55 0Reinsurance A 0 0 0.54 0.94 1.00 0.51 0Reinsurance B 0 0 0.45 0.94 1.00 0.43 0Reinsurance C 0 0 0.53 0.94 1.00 0.49 0Total 100 $37,480 0.30 $11,186

Growth Factor x 1.00Diversification Factor x 0.85Adjusted Premium Capital $9,508

Company B(1) (2) (3) (4) (5) (6) (7)

Net Premiums Baseline Company Company Capital CapitalWritten Capital Size Profit Factor Charge

Schedule P Line % $ Amount Factor Factor Factor (3)*(4)*(5) (2)*(6)Homeowners/Farmowners 13.3 30,600 0.53 0.90 1.06 0.50 15,395Personal Auto Liability 52.9 121,700 0.36 0.90 1.05 0.34 41,155Commercial Auto Liability 0 0 0.39 0.90 1.00 0.36 0Workers' Compensation 4.6 10,500 0.40 0.90 1.00 0.36 3,787Commercial Multiperil 0 0 0.40 0.90 1.00 0.36 0Medical Mal - Occurence 0 0 0.41 0.90 1.00 0.37 0Medical Mal - Claims Made 0 0 0.35 0.90 1.00 0.32 0Special Liability 0 0 0.41 0.90 1.00 0.37 0Other Liability - Occurence 0 0 0.44 0.90 1.00 0.40 0Other Liability - Claims Made 0 0 0.37 0.90 1.00 0.34 0Products Liab - Occurrence 0 0 0.42 0.90 1.00 0.38 0Products Liab - Claims Made 0 0 0.36 0.90 1.00 0.32 0Property 0 0 0.48 0.90 1.00 0.43 0Auto Physical Damage 29.2 67,300 0.33 0.90 1.06 0.32 21,444Fidelity & Surety 0 0 0.33 0.90 1.00 0.30 0Other 0 0 0.33 0.90 1.00 0.30 0International 0 0 0.59 0.90 1.00 0.53 0Reinsurance A 0 0 0.54 0.90 1.00 0.49 0Reinsurance B 0 0 0.45 0.90 1.00 0.41 0Reinsurance C 0 0 0.53 0.90 1.00 0.47 0Total 100 $230,100 0.36 $81,780

Growth Factor x 1.13Diversification Factor x 0.86Adjusted Premium Capital $79,351

Notes: Tempered reserve and premium capital factors to reflect a credit for loss-sensitive business.



business, principally in the mid-Atlanticregion, and recently has been expandingaggressively into the Northeast.The companymaintains thin capitalization with a BCAR of102, which is well below its personal-linespeers and marginally supports its current rat-ing of B+ (Very Good).The company’s weakerrelative capital position reflects its higher pre-mium leverage; aggressive growth of its busi-ness in recent years; and dependence on pyra-mided capital, somewhat offset by itsconservative investment portfolio. In addi-tion, the company’s gross probable maximumloss (PML) from a catastrophe occurrence ishigh.Although its gross PML is tempered by acostly reinsurance program, as well as by asso-ciated tax benefits, its exposure to catastro-phes on a net PML basis remains high at 18%of reported surplus.

The company maintains moderate invest-ment leverage driven by its high quality bondportfolio, which is offset largely by its substan-tial holding in a downstream life/health affiliate,with pyramided capital representing more than30% of surplus.The capital charge for this hold-ing was reduced from 100% to 70% to reflectthe “excess” capital held in this life/health sub-sidiary, above the level required to support thesubsidiary’s current rating. The fixed-incomeportfolio has been structured short term,reflect-ing the company’s short-tail book of business,and thus generates a nominal interest-ratecharge. The company has credit risk chargesreflecting its modest use of reinsurance otherthan for catastrophe coverage, which is consis-tent with its personal-lines book.

Company B’s personal-lines loss reservesappear to be modestly deficient but receivelower capital charges than Company A’s capitalfactors—prior to loss-sensitive adjustments—because Company A is predominantly commer-cial casualty lines. Company B’s heavy capital

requirement for premiums, driven by its higherpremium leverage of 2.1 times surplus, is exac-erbated by a growth surcharge of nearly 15%stemming from its aggressive growth in expo-sure, which has averaged 20% to 25% in recentyears. Finally, the company’s capital position isweakened by its sizable, ongoing net exposureto catastrophe losses.The exposure to catastro-phe losses, which has the effect of reducingthe company’s reported surplus by 18%, wors-ens the company’s capital position and impliedrating by more than one full rating category,and consequently, along with high growth inexposure, contributes to downward ratingpressure on the company.

ConclusionAt a time when most of the industry faces

declining capitalization relative to current rat-ings, the management of that capital is impor-tant. The tools to better allocate capital andunderstand capital strength continue toevolve. These tools often vary in theory, pur-pose and outcome. It is important to remem-ber that, while they can add significant value,they are only tools.

A.M. Best’s proprietary BCAR is one ofthose tools that looks at capital needs wellabove financial solvency. A.M. Best will contin-ue to enhance BCAR to improve its accuracyin measuring balance-sheet and operating risk.

BCAR is important to A.M. Best’s evaluationof both absolute and relative capital strength.Consistent with standards embedded withinthe BCAR model, it’s expected that well-man-aged and highly rated companies will main-tain capitalization levels in excess of the mini-mum amounts required to support theircurrent ratings.

A.M. Best is quick to caution, however, thatalthough BCAR is an important tool in the rat-ing process, it isn’t sufficient to serve as the

20

Business Risk (B7)Company A Company B

(1) (2) (1)*(2) (1) (2) (1)*(2)Statement Asset Risk Required Statement Asset Risk Required

Off-Balance-Sheet Item Value Factor % Capital Off-Balance-Sheet Item Value Factor % CapitalNoncontrolled Assets $0 1 $0 Noncontrolled Assets $8,587 1 $9 Guarantees for Affiliates 0 1 0 Guarantees for Affiliates 0 1 0 Contingent Liabilities 1,465 1 15 Contingent Liabilities 32 1 0 Long-Term Lease 130 1 1 Long-Term Lease 8 1 0 Interest Rate Swaps 0 1 0 Interest Rate Swaps 0 1 0

Totals $1,595 1 $16 Totals $927 1 $9



sole basis of a rating assignment. BCAR, likeother quantitative measures, has some limita-tions and doesn’t necessarily work for allcompanies. Consequently, capital adequacyshould be viewed within the overall contextof the operating and strategic issues sur-rounding a company. Business profile andoperating performance are important ratingconsiderations in evaluating a company’slong-term financial strength and viability, aswell as the quality of the capital that supports

the BCAR result. In addition, any holding-com-pany considerations also will play a key rolein evaluating the financial strength of aninsurance company.

A.M. Best believes that well-managed andhighly rated property/casualty insurers willcontinue to focus on the fundamentals ofbuilding future economic value and financialstability, rather than on managing one, albeitimportant, component of A.M. Best’s ratingevaluation.

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22

Financial Strength RatingsA Best's Financial Strength Rating (FSR) is an opinion of an insurer's ability to meet its obligations to policyholders.

A Best's Rating is an independent opinion, based on a comprehensive quantitative and qualitative evaluation, of a company's bal-ance sheet strength, operating performance and business profile. Best's Ratings are not a warranty of a company's financial strengthand ability to meet its obligations to policyholders.

GUIDE TO BEST’S FINANCIAL STRENGTH RATINGS

Rating Descriptor DefinitionA++, A+ Superior Assigned to companies that have, in our opinion, a superior ability to meet their ongoing

obligations to policyholders.A, A- Excellent Assigned to companies that have, in our opinion, an excellent ability to meet their ongoing

obligations to policyholders.B++, B+ Very Good Assigned to companies that have, in our opinion, a good ability to meet their ongoing

obligations to policyholders.B, B- Fair Assigned to companies that have, in our opinion, a fair ability to meet their current obliga-

tions to policyholders, but are financially vulnerable to adverse changes in underwritingand economic conditions.

C++, C+ Marginal Assigned to companies that have, in our opinion, a marginal ability to meet their currentobligations to policyholders, but are financially vulnerable to adverse changes in under-writing and economic conditions.

C, C- Weak Assigned to companies that have, in our opinion, a weak ability to meet their currentobligations to policyholders, but are financially very vulnerable to adverse changes inunderwriting and economic conditions.

D Poor Assigned to companies that, in our opinion, may not have an ability to meet their currentobligations to policyholders and are financially extremely vulnerable to adverse changes inunderwriting and economic conditions.

E Under Assigned to companies (and possibly their subsidiaries/affiliates) that have been placed by anRegulatory insurance regulatory authority under a significant form of supervision, control or restraint where-Supervision by they are no longer allowed to conduct normal ongoing insurance operations. This would

include conservatorship or rehabilitation, but does not include liquidation. It may also be assignedto companies issued cease and desist orders by regulators outside their home state or country.

F In Liquidation Assigned to companies that have been placed under an order of liquidation by a court oflaw or whose owners have voluntarily agreed to liquidate the company. Note: Companiesthat voluntarily liquidate or dissolve their charters are generally not insolvent.

S Suspended Assigned to companies that have experienced sudden and significant events affecting theirbalance sheet strength or operating performance and whose rating implications cannot beevaluated due to a lack of timely or adequate information.

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Rating Modifiers and Affiliation CodesA rating modifier can be assigned to indicate that a Best's Rating may be subject to near-term change (under review), that a com-pany did not subscribe to Best's interactive rating process (public data) and that the rating is assigned to a syndicate operating atLloyd's. Affiliation codes (g, p, and r) are added to Best's Ratings to identify companies whose assigned ratings are based on group,pooling or reinsurance affiliation with other insurers.

Modifier Descriptor Definitionu Under Review A modifier that generally is event-driven (positive, negative or developing) and is assigned

to a company whose Best's Rating opinion is under review and may be subject to changein the near-term, generally defined as six months.

pd Public Data Assigned to insurers that do not subscribe to Best's interactive rating process. Best's "pd"Ratings reflect qualitative and quantitative analyses using public data and information.

s Syndicate Assigned to syndicates operating at Lloyd's.Affiliation Codes g Group p Pooled r Reinsured

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Not Rated Categories (NR)Assigned to companies reported on by A.M. Best, but not assigned a Best's Rating. The five categories are:NR-1: Insufficient Data. NR-2: Insufficient Size and/or Operating Experience. NR-3: Rating Procedure Inapplicable.NR-4: Company Request. NR-5: Not Formally Followed.

Rating OutlookBest's interactive Ratings (A++ to D) are assigned a Rating Outlook that indicates the potential direction of a company's rating foran intermediate period, generally defined as the next 12 to 36 months. Rating Outlooks, which appear in the rating rationale sec-tion of the company's Best's Company Report, are as follows:Positive Indicates a company's financial/market trends are favorable, relative to its current rating level and, if continued, the

company has a good possibility of having its rating upgraded.Negative Indicates a company is experiencing unfavorable financial/market trends, relative to its current rating level and, if

continued, the company has a good possibility of having its rating downgraded.Stable Indicates a company is experiencing stable financial/market trends and there is a low likelihood that its rating will

change in the near term.

Best's Ratings are distributed via press release and/or the A.M. Best Web site at www.ambest.com, and are published in the RatingMonitor section of BestWeek®. Best's Ratings are proprietary and may not be reproduced without permission.Copyright © 2003 by A.M. Best Company, Inc. Version 071503


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Long-Term Credit RatingsA Best's Long-Term Debt Rating (issue credit rating) is an opinion as to the issuer's ability to meet its financial obligations to secu-rity holders when due. These ratings are assigned to debt and preferred stock issues.

A Best's Rating is an independent opinion, based on a comprehensive quantitative and qualitative evaluation, of a company's bal-ance sheet strength, operating performance and business profile. Best's Ratings are not a warranty of a company's ability to meetits financial obligations.

GUIDE TO BEST'S DEBT RATINGS

Rating Descriptor Definitionaaa Exceptional Assigned to issues, where the issuer has, in our opinion, an exceptional ability to meet the terms

of the obligation. aa Very Strong Assigned to issues, where the issuer has, in our opinion, a very strong ability to meet the terms of

the obligation.a Strong Assigned to issues, where the issuer has, in our opinion, a strong ability to meet the terms of the

obligation.bbb Adequate Assigned to issues, where the issuer has, in our opinion, an adequate ability to meet the terms of

the obligation; however, is more susceptible to changes in economic or other conditions.bb Speculative Assigned to issues, where the issuer has, in our opinion, speculative credit characteristics, gener-

ally due to a moderate margin of principal and interest payment protection and vulnerability to eco-nomic changes.

b Very Speculative Assigned to issues, where the issuer has, in our opinion, very speculative credit characteristics,generally due to a modest margin of principal and interest payment protection and extreme vul-nerability to economic changes.

ccc, cc, c Extremely Assigned to issues, where the issuer has, in our opinion, extremely speculative credit characteristics,Speculative generally due to a minimal margin of principal and interest payment protection and/or limited abil-

ity to withstand adverse changes in economic or other conditions. d In Default In default on payment of principal, interest or other terms and conditions. The rating also is utilized

when a bankruptcy petition, or similar action, has been filed.

A.M. Best's Long-Term Credit Rating scale also is used when assigning a Best's Issuer Credit Rating (ICR), which is an opinionas to the ability of the rated entity to meet its senior-most obligations.Ratings from "aa" to "ccc" may be enhanced with a "+" (plus) or "-" (minus) to indicate whether credit quality is near the top or bot-tom of a category. A company's Long-Term Credit Rating also may be assigned an Under Review modifier ("u") that generally isevent-driven (positive, negative or developing) and indicates that the company's Best's Rating opinion is under review and may besubject to near-term change. Ratings shown as (italicized) denote indicative shelf ratings.

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Short-Term Credit RatingsA Best's Short-Term Debt Rating is an opinion as to the issuer’s ability to meet its obligations having maturities generally less thanone year, such as commercial paper.

Rating Descriptor DefinitionAMB-1+ Strongest Assigned to issues, where the issuer has, in our opinion, the strongest ability to repay

short-term debt obligations. AMB-1 Outstanding Assigned to issues, where the issuer has, in our opinion, an outstanding ability to repay

short-term debt obligations.AMB-2 Satisfactory Assigned to issues, where the issuer has, in our opinion, a satisfactory ability to repay

short-term debt obligations. AMB-3 Adequate Assigned to issues, where the issuer has, in our opinion, an adequate ability to repay short-

term debt obligations; however, adverse economic conditions will likely lead to a reducedcapacity to meet its financial commitments on short-term debt obligations.

Non-Investment GradeAMB-4 Speculative Assigned to issues, where the issuer has, in our opinion, speculative credit characteristics

and is vulnerable to economic or other external changes, which could have a markedimpact on the company's ability to meet its commitments on short-term debt obligations.

d In Default In default on payment of principal, interest or other terms and conditions. The rating also is utilizedwhen a bankruptcy petition, or similar action, has been filed.

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Rating OutlookBest's Credit Ratings (aaa to c and AMB-1+ to AMB-4) are assigned a Rating Outlook that indicates the potential direction of a com-pany's rating for an intermediate period, generally defined as the next 12 to 36 months. Rating Outlooks are as follows:Positive Indicates a company's financial/market trends are favorable, relative to its current rating level, and if continued, the

company has a good possibility of having its rating upgraded.Negative Indicates a company is experiencing unfavorable financial/market trends, relative to its current rating level, and if

continued, the company has a good possibility of having its rating downgraded.Stable Indicates a company is experiencing stable financial/market trends and that there is a low likelihood that its rating

will change in the near term.

Best's Ratings are distributed via press release and/or the A.M. Best Web site at www.ambest.com, and are published in the RatingMonitor section of BestWeek®. Best's Ratings are proprietary and may not be reproduced without permission.Copyright © 2003 by A.M. Best Company, Inc. Version 090203

A.M. Best Co., established in 1899, is the world’s oldestand most authoritative source of insurance company rat-ings. Best’s Ratings are the definitive symbol signifyingthe financial strength and operating performance ofinsurance companies worldwide. For more information,visit A.M. Best’s Web site at http://www.ambest.com, orcontact one of our offices:

AA..MM.. BBeesstt CCoommppaannyyAmbest Road

Oldwick, New Jersey 08858Phone: (908) 439-2200

Fax: (908) 439-3296http://www.ambest.com

AA..MM.. BBeesstt EEuurrooppee LLttdd..1 Minster Court, 11th Floor

Mincing LaneLondon, England EC3R 7AAPhone: 011-44-207-626-6264

Fax: 011-44-207-626-6265www.ambest.com.uk

AA..MM.. BBeesstt IInntteerrnnaattiioonnaall LLttdd..A.M. Best House

264 Northfield AvenueLondon, England W5 4UB

Phone: 011-44-208-579-1091Fax: 011-44-208-566-1789

www.ambest.com.uk

AA..MM.. BBeesstt AAssiiaa--PPaacciiffiicc LLttdd..907, 9/F Shui On Centre

6-8 Harbour RoadWanchai, Hong Kong

Phone: 011-852-2824-1107Fax: 011-852-2824-1833www.ambest.com.hk

a.m. best · uidity and market-value declines in both equi-ty and fixed-income securities.a.m....

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