Thomas M. Mount, ACAS, MAAA A. M. Best Company July 9, 2002 Rating Agency Perspectives DFA-12

Discussion Outline Roles of capital model Best’s Rating Process Prospective vs. Retrospective Analysis Stochastic vs. Limited Scenarios A.M. Best’s Views of DFA A. M. Best’s Interests in DFA Rating Implications of DFA DFA Analyses

Roles of a Capital Model Current and Prospective evaluation of Capital Adequacy Identification/Quantification of Risks facing insurers Scenario testing Robust enough to use on all companies

Current Roles of Capital Models at AMBest BCAR - Major Role in Financial Strength Rating Process VAR - Concepts being reviewed –Just a different approach to measuring risk –VAR risk factors could be placed in BCAR model DFA - Not in used internally in rating process

Current Roles of Capital Models at AMBest BCAR - Major Role in Financial Strength Rating Process because it identifies: –Investment Risk –Interest Rate Risk –Credit Risk –Underwriting Risk (reserve vs NWP) –Some Off-Balance Sheet Risks

Best’s Rating Evaluation— Rating Components Balance Sheet Strength Operating Performance Business Profile Best’s FSR Rating

Balance Sheet Strength Operating Performance Business Profile Management Rating Considerations Success Factors

Capitalization Quantitative vs. Qualitative Best’s Capital Adequacy Model (BCAR) * Ongoing Earnings Stream / Capital Generation * Holding Company / Capital Structure U/W Leverage * Ceded Leverage * Investment Leverage * Financial Flexibility * Quality of Capital Reinsurance Program * * DFA can model these

Operating Performance Quantitative vs. Qualitative Underwriting Profitability * Return on Equity * Return on Premium * Reserve Adequacy Changes Return on Assets * Expense Structure * Quality/Sustainability of Earnings * Management Price Monitoring Reserve Development Operating Flexibility/Efficiency * DFA can model these

Business Profile Quantitative vs. Qualitative Spread of Risk * Market Share Catastrophe Leverage * Market Risk Competitive Market Position Distribution Effectiveness Event Risk * DFA can model these

Why Market Profile and Operating Performance? Strong Market Profile and Operating Performance Weak Market Profile and Operating Performance Date of last balance Sheet TodayTime

Prospective View Most Important Retrospective View Provides Insight –Historical Earnings –Plan vs. Actual Initial Capital Strength Prospective vs. Retrospective

Scenario Testing Only Issues with Stochastic Testing –Resources Required –Specific Management Assumptions Is Limited Scenario Testing an Adequate Trade Off? Stochastic Modeling ==> Management Guide Stochastic vs. Limited Scenarios

Views of DFA Still in Development Stages Value to be Determined by Users Could be an Extremely Useful Management Tool Underlying Assumptions are Key But, Only a Tool Not seen as a rating tool yet

Interest in DFA Not seen as a rating tool yet Interests: –Who is performing DFA analyses? –Is it developed in house or externally? –Accuracy? –Indications for capital strength? –Is management using it in business plan?

Will not Mandate the Use of DFA Value to Rating –Initially in Qualitative Review of Operating Performance –Eventually in Sustainable Advantages and Better Performance? –Better understanding of risks –Value to rating based on value to management’s plan Unlikely to garner an upgrade or prevent a downgrade on its own –just because DFA is used does not guaranty rating Ratings Implications of DFA

Few results shared with us –Poor quality of model? –Poor results projected? –Too complicated? If shared with us, need –Assumptions (loss trend, prem trend, interest rates, distributions, parameters, etc.) –How model works –Results –Alternative assumptions/results –How business plan is derived from DFA - reliance on model DFA Analyses