Upcoming Changes to AM Best’s Insurance Rating Methodology

IASA CarolinasAugust 17th, 2017

Biographies

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Nitin Chhabra, FCAS

Senior Investment Strategist

Nitin joined Prime Advisors, Inc. in 2016 as a Senior Investment Strategist. He is responsible for determining the fixed income

investment portfolio positioning of Prime’s insurance company clients based on modeling of company underwriting and investment

financial information. In this capacity, he ensures that the company’s investment portfolio is aligned with its underwriting

obligations, risk tolerance, regulatory/capital requirements, tax positioning, and investment policy. Nitin spent the first 10 years of

his career in traditional actuarial roles at Liberty Mutual and Towers Watson before working on Wall Street for nearly 5 years as a

sell-side equity research analyst covering the P&C industry at Sterne Agee. He is a Fellow of the Casualty Actuarial Society (FCAS) and

graduated from Boston University with a degree in mathematics. He has also held the following securities licenses: Series 7, 63, 86,

and 87.

Dennis Klimes

Senior Vice President, Director of Sales and Business Development

Dennis joined Prime Advisors, Inc. in 2015. His primary responsibility is managing the sales and business development initiatives of the

firm. Serving as the main point of contact to address Primes capabilities, he also leads the strategic marketing mandates. Dennis has over

32 years of experience in the capital markets with an extensive background in institutional fixed income sales, portfolio management and

proprietary trading. Prior to joining Prime, Dennis served 20 years with legacy Morgan Stanley companies developing and servicing middle

market fixed income accounts. His tenure also includes 10 years of domestic and international money center banking trading currencies

and money market instruments along with corporate advisory responsibilities. Dennis graduated from Western Michigan University and

earned a BA in International Business Administration.

Table of Contents

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I. Objectives…………….…………………………………………………………….Pg. 4

II. Current Rating Methodology………….…………………………………..Pg. 5-9

III. New Rating Methodology…………….………………..………………..…Pg. 10-19

IV. Key Changes in the New BCAR Model…………………………….…..Pg. 20-25

V. Benefits of the New Methodology & Key Takeaways….……….Pg. 26-28

Objectives

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In this session, you will obtain a better understanding of the following questions relating to upcoming changes in AM Best’s P&C insurance rating methodology:

What’s Changing? First major methodology change in over 20 years!

What is the current methodology?

How does the new methodology differ?

Why the Change? What are the benefits/improvements?

What do you need to know about the changes? Best’s Credit Rating Methodology (BCRM)

Best’s Capital Adequacy Ratio (BCAR)

Current Rating Methodology

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Current Rating Process

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The goal of AM Best’s rating system is to provide an opinion of an insurer’s financial strength and its ability to meet ongoing obligations to policyholders

Driven by projected future balance sheet strength:

Start by assessing current balance sheet strength

Layer on expected future operating performance and business profile to project future balance sheet strength

Common criticism of the current process is that it lacks transparency

BCAR – What Is It?

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AM Best’s capital adequacy model used to assess current balance sheet strength

Similar to NAIC’s Risk-Based Capital (RBC) model

BCAR = (Adjusted Surplus / Net Required Capital) * 100

Adjusted Surplus =

Balance sheet surplus translated from an accounting basis to an economic basis

Net Required Capital =

The estimated capital required to support the risks inherent in a company’s business profile

BCAR – A Closer Look at Net Required Capital

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Net Required Capital includes the following risks: Investment Risk: Fixed Income (B1) & Equity Securities (B2) Interest Rate Risk (B3) Credit Risk (B4) Underwriting Risk: Loss Reserves (B5) & Net Written Premium (B6) Business Risk (B7)

Net Required Capital (NRC) Formula:

Covariance accounted for by square root function Means that all of the risks are not likely to happen at the same

time For a typical company, roughly 2/3rds of net required capital comes

from underwriting risk

BCAR – Guidelines for Ratings

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BCAR Rating Guidelines

BCAR Implied Balance Sheet Strength Rating Category

>175 A++ Superior

160-175 A+ Superior

145-160 A Excellent

130-145 A- Excellent

115-130 B++ Good

100-115 B+ Good

90-100 B Fair

80-90 B- Fair

70-80 C++ Marginal

60-70 C+ Marginal

50-60 C Weak

40-50 C- Weak

<40 D Poor

Source: AM Best

New Rating Methodology

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BCRM Building Block Approach

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Source: AM Best

Current Balance Sheet Strength

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Primary, but not sole, determinant of current balance sheet strength is BCAR assessment

BCAR is the starting point in the assessment of current balance sheet strength

Source: AM Best

Current Balance Sheet Strength

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Current balance sheet strength, adjusted for country risk, is the foundation for the baseline rating

Assessments of operating performance, business profile, enterprise risk management, and other factors are applied to this baseline rating to arrive at a final rating

Source: AM Best

Adjustment #1: Operating Performance

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AM Best looks at a variety a metrics in order to assess expected future operating performance

Focus is on stability and volatility of earnings stream

Source: AM Best

Adjustment #2: Business Profile

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Qualitative component of the rating process

Some areas of focus include: market position, degree of competition, management quality, product/geographic concentration, and product risk

Source: AM Best

Future Balance Sheet Strength

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So far, we’ve taken estimated current balance sheet strength and applied assessments of operating performance and business profile to arrive at estimated future balance sheet strength

The focus on future balance sheet strength hasn’t changed – it’s just more quantifiable now

Source: AM Best

Adjustment #3: Enterprise Risk Management

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Specific categories of review include: risk identification & reporting, risk appetite & tolerance, stress testing, risk management & controls, governance & risk culture

Source: AM Best

Adjustment #4: Comprehensive Adjustment

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Accounts for situations in which, based on comparison to other companies, the creditworthiness of the rating unit exceeds (or is less than) what was captured through the rating process to this point

Source: AM Best

Building Block Approach – Example

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Source: AM Best

Key Changes in the New BCAR Model

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New BCAR – Change #1: Scale Caps at 100

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BCAR will still be the primary metric used to assess current balance sheet strength, but the scale is changing

New scale provides better alignment with risk appetite/tolerance statements

Net Required Capital now includes potential catastrophe losses

Source: AM Best

New BCAR – Change #2: Four Scores Instead of One

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New approach: stochastic based

New metric: Value at Risk (VaR)

Source: AM Best

New BCAR – Change #3: Investment Risk Charges

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Biggest change to the BCAR model appears to be an increase in the investment risk charges, primarily for common stocks and other invested assets

Other invested assets (Schedule BA) risk charges will be equal to 110% of the risk charges for common stocks

Asset Risk Factor For:

Current

PC BCAR VaR 95 VaR 99 VaR 99.5 VaR 99.6

US Government 0% 0% 0% 0% 0%

NAIC Class 1 Bonds 1% 0.6% 0.9% 1.0% 1.1%

NAIC Class 2 Bonds 2% 3.3% 4.3% 4.6% 4.7%

NAIC Class 3 Bonds 4% 10% 11% 12% 12%

NAIC Class 4 Bonds 5% 21% 22% 23% 23%

NAIC Class 5 Bonds 10% 42% 42% 43% 43%

NAIC Class 6 Bonds 30% 54% 55% 55% 55%

Non-Affiliated Public Common Stock 15% 25% 38% 43% 44%

Source: "Understanding BCAR for US Property/Casualty Insurers", AM Best, 11/14/2016

Upcoming Methodology

New BCAR – Change #4: New BCAR Guidelines

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Source: AM Best

New BCAR – Distribution of Indicated Assessments

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Source: AM Best

Benefits of the New Methodology and Key Takeaways

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Benefits of the New Methodology

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Greater transparency into the rating process

Encourages companies to develop their own internal capital models and compare the results of those models against the results of the stochastic-based BCAR model

Increases focus on ERM

Key Takeaways

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More structured rating process should result in greater transparency and less subjective ratings

Companies with high investment portfolio allocations to common stocks and other invested assets will likely see the biggest impact to their BCAR scores, as will companies with significant net property catastrophe exposure

Overall, AM Best does not expect sweeping ratings changes and the assumption is that current ratings are appropriate

Disclaimer on Behalf of Prime Advisors, Inc.®

Prime Advisors, Inc.® (“Prime”) is a federally registered investment adviser that customizes portfolios for its clients. Accordingly, while the views expressed in this presentation and are a general guide to Prime’s economic and marketplace opinions, these are macro or strategy-level views and do not replace portfolio-level advice. Moreover, they do not constitute legal, tax or investment advice; and they are not intended as an offer to sell or a solicitation to buy investment products or individual securities.

This presentation is current as of August 17, 2017. Some of the views expressed are expectations, and constitute “forward-looking statements.” They also reflect the presenter’s best judgment. Actual results may differ. Neither the presenter nor Prime are under any obligation to update this presentation to reflect changed conditions. Additionally, these views are not intended to predict or guarantee the future performance of any individual security, asset class, market, or the future performance of any Prime account.

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