In the third part of a regular series, AM Best provides an introduction to best capital adequacy ratio, its way of addressing the shortcomings of the solvency margin

We commented on the limitations of the traditional solvency margin in evaluating an insurer's capital adequacy in the second article of this series (11 April, Insurance Times).

In particular we highlighted the following as key limitations of the solvency margin:

  • Asset risk is not factored into the calculation

  • Reserve risk is not factored into the calculation

  • Catastrophe risk is not factored into the calculation

  • The risk profile of the underwriting book is not factored into the calculation

  • Reported shareholders' funds (surplus) can be a poor proxy for available risk capital.

    This month we provide an introduction to how AM Best addresses these issues in our own risk based capital analysis methodology. Our approach, known as best capital adequacy ratio (BCAR) seeks to factor all of the above issues into our analysis of an insurer's financial strength.

    Given the detail involved in the methodology, the following description can only be an overview.

    Underlying principle
    To help address the limitations of this traditional solvency margin approach, we seek to quantify how much capital is required by the insurer for a prudent level, commensurate with its rating, to be maintained. This involves calculating two things:

    First, the risk profile of the insurer and hence how much capital it needs. This is known as "net required capital".

    Second, the amount of capital actually available to support the risk profile. To do this we adjust reported surplus (shareholder funds) by various factors that we consider either overstate or understate the true amount of risk capital available. This is known as adjusted surplus.

    So, having calculated how much risk capital is required and also how much the insurer appears to have, we compare the two as follows:

    Adjusted surplus x 100 = BCAR net required capital

    This ratio is the best capital adequacy ratio (BCAR). For convenience we multiply this by 100 to express the result as a percentage.

    Clearly, the more an insurer's adjusted surplus exceeds its required capital the better its apparent capital adequacy. Consequently, while a financial strength rating reflects many factors in addition to capital adequacy, the BCAR score is an important input into the overall rating analysis.

    Generally a score of at least 100% would normally be expected for a company rated in the secure range ( B+ or higher), with substantially higher BCAR scores being the norm for insurers rated in the A range or higher.

    The principle behind the calculation is to look at each source of risk to the insurer's capital, and assign an amount of capital considered prudent to support this risk.

    For a non-life insurer, the largest contribution to the total required capital number generally comes from underwriting risk.

    That, in turn, is made up of premium risk (the risk of the current business) and loss reserve risk (the risk of adverse loss reserve development).

    Capital charge
    Thus, for premium risk, the most recent annual net written premium volume for each line of business is multiplied by a risk factor specific to the line of business. For reserve risk (the risk of adverse loss development) the amount of reserves for each line is again multiplied by a specific risk factor. These calculations result in a capital charge (the amount of capital required) for each business line.

    The risk factors for both reserves and premiums typically range between 0.30 and 0.55.

    However, simply to add the resulting capital charges together would overstate the real risk position. This is because of the effect of diversification; the individual capital charges do not reflect the fact that in writing several lines of business an insurer is reducing its overall risk profile.

    So, dependent on the spread of business, a diversification credit is applied, reducing the overall capital charge.

    Other factors are also applied, which can modify the ultimate capital charge (up or down). These primarily reflect the stability and profitability of the insurers results over time, its apparent reserve adequacy, its size and growth rate.

    Reinsurance recoverables
    While underwriting risks usually represent the larger part of required capital, asset risks too can be very significant. These are the risks associated with invested assets falling in value, or the credit risk of business partners, such as reinsurers, being unable to pay.

    For example, a risk factor of 0.15 is applied to the company's holdings of unaffiliated public equities. Other investments, such as real estate and bonds, have their own set of factors and resulting capital charges.

    For credit risk, the largest source of potential problem is usually reinsurance recoverables. Again a risk factor or capital charge approach is employed. The risk factors reflect our ratings of the financial strength of the reinsurers to whom the insurer is exposed.

    As with underwriting risk, various additional factors then modify the asset risk charge result, for example, the degree of investment concentration or diversification.

    As highlighted above, when calculating required capital it is important to factor into the calculation the impact of diversification on the overall risk profile of the insurer.

    While the methodology described above addresses this within each type of risk (equity, premium or reserves), there is also the impact of diversification across the different risk types.

    Consequently, when we bring all the capital charges together to calculate the overall net required capital a further co-variance adjustment is made.

    Loss reserves
    Having established what we believe required capital to be, we now need to address how much surplus (or risk capital) the insurer appears to have. There are two parts to this analysis.

    First, we make adjustments due to the accounting practices used by the insurer (this can reduce or increase the reported number).

    Second, we introduce a specific capital charge to reflect the insurer's potential exposure to a catastrophic loss.

    Among the accounting practice-based adjustments, the most significant will usually reflect the extent to which the company does - or does not - discount its loss reserves, the treatment of equalisation (or catastrophe) reserves and the basis for how assets are valued.

    These differences can exist between insurers partly because of differences in management philosophy, but mainly because of national regulations.

    In summary, we are seeking to arrive at an adjusted surplus level that reflects the present value of reserves (for instance, discounted reserves), market values of assets and one that treats equalisation or catastrophe reserves as a form of risk capital, not as loss reserves.

    The final step in the process is to factor in the company's potential exposure to catastrophic losses.

    This is done using the concept of probable maximum loss (PML), which involves an estimate of the insurer's gross and net losses in the event of the worst catastrophe (relative to the insurer's book) occurring. Some insurers have their own models for calculating this, but many work with the well established specialist catastrophe modelling agencies to evaluate their exposure.

    The most common events that lead to an individual insurer's PML are hurricanes or storms, earthquakes and floods.

    The estimates of exposure are usually based on a one in 100, or one in 250-year event, that is, the worst storm expected in any 100 years.

    For the purposes of BCAR , we take the estimated net loss for the worst scenario (plus the cost of reinsurance reinstatements) and deduct it from the surplus number.

    The effect of this is that we are evaluating the insurer on the basis that a PML event could happen in any given year. While this does not prevent a PML event causing an insurer's rating to be downgraded, it does significantly reduce the potential for this.

    As highlighted above, a financial strength rating involves many factors, not simply capital adequacy.

    Consequently, a capital adequacy analysis technique such as BCAR can only be one part of a larger rating process.

    However, while any quantitative technique, however sophisticated, will have its limitations, we believe BCAR provides an important enhancement to the traditional solvency margin approach to the capital adequacy of insurers.

    Fuller details are available on our website www.ambest.com or www.europe.ambest.com