Best Explains Canadian P/C BCAR Ratings Criteria

April 5, 2005

A.M. Best Co. has issued a paper explaining its rating methodology, which notes that “the assignment of an interactive rating is derived from an in-depth evaluation of a company’s balance sheet strength, operating performance and business profile as compared with A.M. Best’s quantitative and qualitative standards.” It noted that the objective of its rating system is “to provide an opinion of an insurer’s financial strength and ability to meet ongoing obligations to policyholders.”

Best said its quantitative evaluation is based on an analysis of more than 100 key financial tests and supporting data. “These tests, which underlie the evaluation of balance sheet strength and operating performance, vary in their importance depending on a company’s characteristics.

“A company’s quantitative results are evaluated on their own merits and also are compared with industry composites as established by A.M. Best. Composite standards are based on the performance of other Canadian insurance companies with comparable business mixes. These industry benchmarks are adjusted when needed to reflect changes in underwriting, economic and regulatory market conditions.

“A company’s underwriting, financial and asset leverage are subjected to an evaluation by Best’s Capital Adequacy Ratio (BCAR), which allows for an integrated review of these leverage areas. BCAR calculates the net required capital to support the financial risks of the company associated with the exposure of assets and underwriting to adverse economic and market conditions and compares it with economic capital. Some of the stress tests within BCAR include above-normal catastrophes, a decline in equity markets and a rise in interest rates. This integrated stress evaluation permits a more discerning view of a company’s balance sheet strength relative to its operating risks.”

As applied to Canadian insurers, Best said its “BCAR model is adapted specifically to the Canadian P&C-1 and P&C-2 Annual Statements as well as Canada’s GAAP (generally accepted accounting principles) accounting standards. A.M. Best’s Canadian capital formula takes a risk-based capital approach. Net required capital is calculated to support three broad risk categories: investment risk, credit risk and underwriting risk. However, A.M. Best’s capital adequacy formula contains an adjustment for covariance, reflecting the statistical independence of the individual components. A company’s adjusted surplus is divided by its net required capital, after the covariance adjustment, to determine its BCAR.

“A.M. Best makes a number of adjustments to a company’s reported surplus within the Canadian capital model to provide a more economic and comparable basis for evaluating capital adequacy. Goodwill and other intangible assets are eliminated. Other significant adjustments are related largely to equity, or economic values, imbedded in loss and loss-adjustment expense reserves, fixed-income securities and common stocks. Further adjustments are made to surplus to reflect the pricing risk inherent in unearned premium reserves and nonbalance sheet risks, including catastrophe exposures and debt-service requirements.

“Generally, more than two-thirds of a company’s gross capital requirement within A.M. Best’s Canadian capital model is generated from its loss reserve and net premiums written components. Consequently, a company’s absolute BCAR value is influenced largely by the capital required to support its net underwriting commitment, which in turn is largely a function of its business mix, surplus size, stability of loss development, profitability, loss reserve adequacy and length of claims payout.

“While only one-third of the gross capital requirement is generated from investment risk, interest-rate risk and credit risk components, a company that maintains a more aggressive investment portfolio, is heavily dependent on pyramided capital, has excessive credit risk or is excessively dependent on reinsurance, likely will generate a lower BCAR value.”

To access the BCAR rating methodology for Canadian P/C insurers, please visit http://www.ambest.com/ratings/methodology.

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