October 26th, 2014

A.M. Best’s New Analytics Will Broaden and Improve P&C Industry Capital Modeling and Benchmarking of Tolerances

Posted at 1:00 AM ET

snyder_jack_100eric-simpson-smallmark-murry-small-1201Jack Snyder, Managing Director, Business Development and Head of the Rating Agency Practice, Strategic Advisory; Eric Simpson, Managing Director in the Rating Agency Practice and Mark Murray, Senior Vice President in the Rating Agency Practice

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A.M. Best’s rating analytics continue to evolve and the pace of change is accelerating as the industry embraces more analytical tools, emerging best practices, and peer benchmarking.

The rating agency is placing greater emphasis on risk-based analytics in its ratings process and will increasingly focus on management’s ability to execute its business plans and reasonably deliver on its financial projections.

The convergence of ORSA regulatory requirements and A.M. Best’s new emerging risk-based analytics has significant implications in 2015 and beyond. Large and small US P&C insurers will be expected to further develop their financial forecasting, capital modeling and risk tolerance metrics for both capital and earnings. Insurers will need to more tightly link their business plans, with both capital and earnings adequacy assessments from a risk-adjusted perspective, to maintain and enhance their Best’s Ratings while complying with new regulatory requirements.

Insurers need to understand A.M. Best’s evolving criteria with respect to their company’s ratings and business plans, particularly in three areas:

  • Stochastic-Based BCAR (Best’s Capital Adequacy Ratio)
  • Earnings Adequacy & Variability
  • ERM Impact Analysis

A Closer Look at Best’s New Analytics

Stochastic-Based BCAR

A.M. Best plans to refine its capital adequacy BCAR model and upgrade risk factors based on stochastic analysis. The change may negatively impact P&C insurers depending on their risk profile, rating levels, and capital position.

A.M. Best is expected to publish a Draft Criteria Report early next year before implementing its Stochastic-based BCAR sometime in 2015.

Implications of the new model include:

  • Stochastic-Based BCAR will incorporate a consistent TVaR risk metric and become A.M. Best’s risk-adjusted capitalization tool used in its ratings and capital evaluations going forward.
  • Stochastic-Based BCAR will affect strategic risk-based decisions (including reinsurance) and accelerate industry trends of more companies developing their “own” internal financial/capital model, particularly among small to mid-sized insurers.
  • Certain insurers’ cost of capital will increase, especially for outlier companies that operate within industry lines exhibiting higher loss ratio/loss reserve volatility; exhibit above-average company-specific loss ratio/loss reserve volatility; and have concentrated natural catastrophe exposures and asset risks.

P&C insurers will need to understand these changes and how their risk profile and volatility impact their BCAR score and ratings. Negatively impacted companies will need to consider corrective underwriting actions and reinsurance solutions to address unfavorable BCAR scores and align their risk profile and risk tolerances to their desired rating levels.

Earnings Adequacy & Variability

While “capital adequacy” remains important, a company’s ability to sustain acceptable operating performance is even more vital. The vast majority of P&C rating downgrades in recent decades for companies have been driven by “earnings adequacy” issues. Chronic under-performance erodes A.M. Best’s confidence in a company’s ability to execute its business plans and effectively compete. Insurers with sustained underperformance and greater earnings variability will be most at risk.

Companies will need to think beyond “capital preservation” and develop “earnings adequacy” risk tolerance statements as well, given A.M. Best’s increased focus on a company’s earnings variability and financial forecasting.

ERM Impact Analysis

Analysts prepare ERM Impact scoring worksheets for Best’s Ratings Committee to gauge whether a company’s ERM capabilities support its risk profile and rating - and result in a ratings “lift” or “drag.”

Companies will need to demonstrate that their ERM practice is linked to risk decisions, business plans, and financial forecasts. A.M. Best continues to view many insurers’ risk tolerance statements as needing further development and will be probing this topic more in rating meetings.

Companies Will Need to Understand and Act

Highly rated insurers will continue to develop their risk and capital management capabilities to gain a competitive advantage and improve their business performance. ORSA requirements and Stochastic-based BCAR are fast approaching. Together, they will accelerate companies’ need to better understand and “own” their risk profile and capital/earnings risk tolerances. Guy Carpenter is fully prepared to assist our clients with these challenges.

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