GEORGIA IASA ASSOCIATIONEDUCATIONAL CONFERENCE

A.M. Best’s Stochastic BCAR model

Updated discussion of potential changes and timeline

October 26, 2015

Raju Bohra, EVPWillis Re Analyticsraj.bohra@willis.com(212) 915-8444

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A.M. Best Rating: Rating Methodology

Balance Sheet

Operating Performance

Business Profile

· A.M. Best looks at three key areas in the rating analysis

· The level of importance of each the three areas to the overall rating can vary depending upon the rating level, and composite

· ERM is the link between these areas

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A.M. Best Rating:Balance Sheet Evaluation

· Capitalization is the foundation for assessing the credit quality

· BCAR (factor based model) considers how well surplus is able to support premium, reserve, & credit risks– Pro: Considers multiple risks

– Con: Difficult to calculate

· Underwriting leverage metrics (e.g. NPW to surplus,

recoverables to surplus)

– Pro: Easy to calculate & understand

– Con: Does not differentiate between the riskiness of the business

Balance Sheet

• Capitalization (BCAR)• Underwriting

leverage• Reinsurance

utilization• Reserve adequacy• Investment

composition• Financial flexibility• Cash flow & liquidity

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A.M. Best’s RatingsBest’s Capital Adequacy Ratio

· BCAR Calculation:

– Economic view of surplus (numerator)· Reported Surplus· Fixed income

equity· Equity in

unearned premium reserves

· DAC Adjustment

– Capital to support risks (denominator)· Investment risk:

Converting to cash· Credit risk:

Converting to cash· Premium risk:

Pricing errors· Reserve risk:

Reserving deficiencies

· Business risk

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A.M. Best’s RatingsBCAR Score

Adjusted Statutory SurplusPolicyholders Surplus 36,651,796

Positive AdjustmentsStatutory UPR Equity (net of taxes) 636,454 Loss Reserve Equity (net of taxes) 2,957,484 Fixed Income Equity (net of taxes) 2,382,367

Subtotal 5,976,305

Negative AdjustmentsSurplus Note 268,872 Base Cat Load 448,985 Subtotal 717,857

Adjusted Statutory Surplus 41,910,245

Net Required CapitalAsset RiskB1 - Fixed Income Risk 1,641,809 B2 - Equity Risk 5,409,130 B3 - Interest Rate Risk 1,421,784 B4 - Credit Risk 1,591,365

Underwriting RiskB5 - Reserve Risk 16,844,371 B6 - Premium Risk 5,159,599

B7- Business Risk 18,238

Gross Required Capital 32,086,296 Covariance (12,770,344) Net Required Capital 19,315,952

Economic View of Surplus (aka Adjusted Surplus)

“How much capital you have”

Capital Needed for Risks (aka Required Capital)

“How much capital you need”

BCAR =

Required capital (denominator) is changing in new BCAR

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A.M. Best’s Stochastic BCAR Goals & Objectives

· Incorporate stochastic (probabilistic simulation) modeling in BCAR– Capital factors more directly tied to probability of default

– More sophisticated approach than currently being used

· Select capital factors on a more consistent basis– Currently based on a variety of risk measures, return periods, and time

frames

·  Maintain the general structure used in the current BCAR model– Economic view of capital: mark-to-market, PV of reserves, & UPR equity

– Risk categories: B1- B7 & catastrophe charge

– Covariance: sum of the squares rule

· Not looking to disrupt the industry overall– However, individual rating units could show a significant change

– New scores will be lower than current but will adjust ratings scale

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While A.M. Best has been clear that no final decisions have been made, companies potentially could see significant shifts in their BCAR score.  Draft criteria and parameters

are expected to be released early next year along with draft BCAR scores.

A.M. Best’s Stochastic BCAR Developing Capital Factors

· Current approaches underlying the capital factors

– Premium & reserves: 1% ‘expected policyholder deficit’ (EPD)

– Fixed income investments: probability of ruin

– Reinsurance recoverables: 5 year default rates

– Catastrophe: Wind 1-100 PML & Quake 1-250 PML (similar to VaR)

· New approach underlying Stochastic based capital factors

– Risk measure: Value-at-Risk, e.g. VaR (have moved away from TVaR)

– Return period: 5 confidence intervals: 1-50yrs, 1-100yrs, 1-200yrs, 1-500yrs, and 1-1000yrs

– Time frame: vary by risk category from 1 year to ultimate

· Confidence levels to vary by rating level

– Capital requirements for higher rating levels will be based on higher confidence levels

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The breadth of proposed changes impacts almost every aspect of the BCAR model. Companies should evaluate their risk profiles to understand significant impacts.

A.M. Best’s Stochastic BCAR Preliminary Changes

· Fixed income investments

– Reflects more granular credit quality, duration, volatility of default, recovery rates, & present value of net defaults

· Common equity investments

– Reflects historic market volatility and company specific portfolio Beta· Interest rate risk

– Test 210 bps to 310 bps change adjusted for liquidity need

· Reinsurance recoverables

– Reflects credit quality, type of recoverable, concentration, duration, recovery rates, & net present value

· Premium & reserves

– Reflects 21 Schedule P lines, 4 size categories, 4 correlation matrices

– Higher charges for WC, GL, MPL, and lower for Auto

· Catastrophe charge

– Occurrence (OEP) all peril (Wind + EQ) VaR basis (similar to PML)

– Will continue stress test approach using second event (e.g. 1-100 for Wind)

– Move charge from adjusted policyholder surplus to net required capital

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Impacts will ultimately depend on the selected risk metric, confidence level (return period), and time horizons A.M. Best promulgates in their final criteria.

A.M. Best’s Stochastic BCAR Potential Impacts

· Willis Re has studied the impacts of the risks that will potentially drive new BCAR required capital for companies

· Risk charges that could significantly increase include:

– Bond default risk for portfolios with longer durations or lower credit quality

– Stock market risk, especially for portfolios with Beta > 1

– Credit risk for long-tail recoverables (e.g., casualty lines) or with a concentration of counter-parties

– UW risks (premium and reserves) for smaller lines of business

– Catastrophe risk in specific perils and zones (e.g., Mid-Atlantic and Northeast windstorm, and Midwest EQ)

· Also companies whose risk profile exhibits greater tail risk at higher confidence levels may have difficulty at the higher end of the rating scale

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Model Capital Factor Impact: Asset Risk Charges

· Bond charges relatively unchanged for Govt and Class 1 but increase for lower quality, however not a great impact due to varying confidence levels

– Table does not show impact of bond duration and granular credit classes

· Proposed stock charges significantly higher and vary by confidence level

– Table does not show impact of company specific portfolio “Beta”

A.M Best updated

Asset Risk charges for bonds and

stocks which are

still subject to change

before finalized

Asset Risk Factor For:Current

PC 1-50Yr

(VaR 98)1-100Yr

(VaR 99)1-200Yr

(VaR 99.5)1-500Yr

(VaR 99.8)1-1000Yr

(VaR 99.9)

US Gov't 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

NAIC Class 1 Bonds 1.0% 1.2% 1.5% 1.7% 2.0% 2.4%

NAIC Class 2 Bonds 2.0% 5.4% 6.2% 6.8% 7.5% 8.4%

NAIC Class 3 Bonds 4.0% 10.0% 11.0% 11.8% 12.8% 13.7%

NAIC Class 4 Bonds 4.5% 23.3% 24.7% 25.8% 27.0% 27.8%

NAIC Class 5 Bonds 10.0% 37.6% 38.3% 38.9% 39.5% 39.9%

NAIC Class 6 Bonds 30.0% 45.5% 46.6% 47.5% 48.3% 49.2%

Total Bonds 1.0% 1.8% 2.1% 2.3% 2.7% 3.1%

Public Common Stock 15.0% 33.9% 39.1% 43.8% 47.3% 48.3%

Average Risk Factors of Sample PC Companies

Source: A.M. Best, reflect average 4 year maturity

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Region 100yr 500yr 1000yr

New Madrid 15% 319% 652%

EQ 250yr VaR Relativity

Region 200yr 500yr 1000yr

Northeast 182% 332% 476%MidAtlantic 190% 374% 562%Southeast 153% 241% 320%

HURR 100yr VaR Relativity

Model Capital Factor Impact: Natural Catastrophes

Source: CrisisHQ.com, RMS v13, and Willis Re

· We modeled the gross industry portfolio using the RMS model

· A.M. Best currently charges EQ at 250yr or Hurricane at 100yr

· EQ risk significantly declines below 250yr

· HURR risk increases above 100yr period

– Particularly Northeast

· Net PMLs may show “cliff” beyond level of reinsurance

– Particularly if only purchase limit to current BCAR requirements

Region 100yr 500yr 1000yr

Alaska 66% 121% 138%Northwest 30% 171% 264%California 66% 127% 158%

EQ 250yr VaR Relativity

Region 200yr 500yr 1000yr

Texas 151% 231% 306%Gulf 145% 217% 287%Florida 139% 208% 273%

HURR 100yr VaR Relativity

Region 200yr 500yr 1000yr

US Personal 124% 167% 211%US Comm'l 126% 171% 216%

SCS 100yr VaR Relativity

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Model Capital Factor Impact: UW & Other charges (using eCCM)

· We studied the potential impact of Stochastic BCAR using Willis Re’s eCCM capital model

· Typically eCCM produces

– Higher capital for equity, interest rate, and catastrophe risk

– Lower capital for fixed income and credit (1yr horizon)

– UW risk for a line of business decreases as size of premium or reserves increases but are very company specific

· Utilizing eCCM, a company can evaluate the potential impacts even before final criteria are released

· eCCM allows companies to assess their “own view” of risk and compare to BCAR requirements

Exposure BCAR Economic Capital CoefficientsAmount Factors 1 in 100 1 in 250 1 in 1000

Asset RiskW1 - Fixed Income Credit Risk 435,007 1.1% 0.6% 0.9% 1.2%W2 - Equity Risk 40,586 20.3% 42.9% 50.9% 70.7%W3 - Interest Rate Risk 443,216 0.7% 2.6% 3.3% 4.5%W4 - Credit Risk Reinsurers 14,614 49.6% 1.6% 2.1% 2.9%

Underwriting RiskW5 - Reserve Risk 177,681 28.6% 17.0% 19.2% 24.3%W6 - Prospective Underwriting Risk 344,339 27.4% 18.6% 21.1% 24.7%W7 - Net Catastrophe Risk 55,180,612 0.0% 0.0% 0.0% 0.1%

Sample eCCM Results (000s)

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The new BCAR scores cannot be interpreted in same manner as current scores. The spread of positive scores will be compressed. Relatively small increases under new scale will represent proportionately stronger capitalization viewed currently.

A.M. Best’s Stochastic BCAR New BCAR Formula

· Current BCAR formula (ratio to Required Capital)

– Available Capital reduced for net catastrophe PML

– Looking for a BCAR score above 100% (range from 0% to 999%)

· Planned new BCAR formula (ratio to Available Capital)

– Net catastrophe PML moved to be part of Required Capital

– Translate as “excess capital as percent of available capital”

– Looking for a BCAR score above 0% (range from -999% to 100%)

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑩𝑪𝑨𝑹=𝑨𝒗𝒂𝒊𝒍𝒂𝒃𝒍𝒆𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒅𝑪𝒂𝒑𝒊𝒕𝒂𝒍

𝑵𝒆𝒘 𝑩𝑪𝑨𝑹=(𝑨𝒗𝒂𝒊𝒍𝒂𝒃𝒍𝒆𝑪𝒂𝒑𝒊𝒕𝒂𝒍−𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒅𝑪𝒂𝒑𝒊𝒕𝒂𝒍 )

𝑨𝒗𝒂𝒊𝒍𝒂𝒃𝒍𝒆𝑪𝒂𝒑𝒊𝒕𝒂𝒍

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A.M. Best is still actively evaluating how the new Stochastic BCAR will fit into their overall Rating Methodology and assignment of ratings. Need to remember that BCAR

scores are one component of ratings evaluation and assignment.

A.M. Best’s Stochastic BCAR Applying to Ratings

· Overall new scores will have higher required capital

– Change in placement of catastrophe risk

– Companies may not currently purchase catastrophe reinsurance to proposed standards

– Generally higher investment charges

· Rating levels will be calibrated to return periods

– Show 5 BCAR scores for various VaR levels

– The BCAR score for a given return period will reflect capital charges for all risks at that level · This will significantly increase required capital

when looking beyond the 1-100 level

– For higher ratings (A+/A++) A.M. Best has currently not defined capital thresholds as those ratings not solely based on capitalization

VaRReturn Period

Potential FSR*

99.9% 1-1000 A (A++)**

99.8% 1-500 A (A+)**

99.5% 1-200 A / A-

99.0% 1-100 B++ / B+

98.0% 1-50 < B+

* Assuming no other strengths or weaknesses related to Holding Company, Operating Performance, Business Profile, ERM or Country Risk issues these are the levels BCAR could support** Willis Re interpretation of scale at higher return periods for A+ and A++ rating

Source: A.M. Best, Insurance Insider, Willis Re

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-50-40-30-20-10

0102030405060708090

100

1-50yr< B+

1-100yrB++ / B+

1-200yrA / A-

1-500yrA (A+)*

1-1000yrA (A++)*

VaR Confidence Levels

NE

W S

toc

has

tic

BC

AR

(%

)

Company A and Company B are rated “A+” with identical current BCAR scores.

However under the new Stochastic BCAR, Company B falls below ZERO after the1-200yr return period. This may “cap” Company B’s rating at the “A-/A” level

A.M. Best’s Stochastic BCAR Applying to Ratings (cont.)

· Potential guidance for calibrating BCAR to ratings

– Old benchmarks not relevant

– Examine new BCAR scores for the various return periods to understand a company’s “tail” risks and drivers

– BCAR score > 0% being considered as a standard· Where is Available Capital

less than Required Capital· May create a cap on

rating depending on other rating factors

Company B

Company A

BCAR 0%

*Willis Re interpretation of scale at higher return periods

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A.M. Best’s Stochastic BCAR Next Steps

· Developing:– Building the various distributions: completed

– Running model simulations: completed – Reviewing the output & setting parameters: completed

· Risk measures: VaR· Confidence levels: 1-50, 1-100, 1-200, 1-500, & 1-1000

– Analyzing the potential for unintended consequences: on-going

– Discussions with subject matter experts: on-going

· Communicating:– Issue draft criteria for public comment: expected release Q1 2016

– Receive & review public comments: 60-90 day comment period

– Release final criteria: depending upon public comment & changes

· Implementing:– Phase 1 roll-out: earliest Q4 2016 based on YE 2015 financials

Raj Bohra, EVP

Raj.Bohra@willis.com

212-915-8444

Douglass Ostermiller, SVP

Douglass.Ostermiller@willis.com

212-915-8266

Ralph Cagnetta, EVP

Ralph.Cagnetta@willis.com

212-915-8412

CONTACTINFORMATION

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