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A.M. Best "Whole New Ballgame" Explained

new ball game
April 06, 2016

alton-cogertAs discussed in an article last month, A.M. Best has proposed changes to its Best's Capital Adequacy Ratio (BCAR) model. A colleague of ours, Alton Cogert, president of Strategic Asset Alliance, recently posted a blog on the InsurerCIO website discussing his thoughts on the changes, especially concerning the impact on investments.

Mr. Cogert (pictured at right) has granted permission to share with our readers the thoughts he expressed in his blog post, as follows.

It's a Whole New Ballgame at AM Best - Part I: BCAR

By Alton Cogert

Undoubtedly to bolster its standing as a NRSRO (“Nationally Recognized Statistical Rating Organization”), AM Best has embarked upon material changes in its rating methodology. From the perspective of investment professionals, this means you will need not only a better idea of Best’s view of insurer investments, but how those investments impact key areas of scrutiny. Those areas notably include a completely revamped BCAR (Best Capital Adequacy Ratio) and ERM (Enterprise Risk Management) analytical approach.

In the past, we’ve always heard that a strong BCAR is necessary but not sufficient for a strong Issuer Credit Rating (ICR). Under the new rating methodology, BCAR appears to be the starting point for understanding balance sheet strength, which definitely sets the tone for the ICR.  
1 - AM Best Rating Process

From there, key areas such as Operating Performance, Business Profile and any analyst adjustments or rating enhancements serve to move the initial BCAR estimated ICR up or down.  Importantly, though, the one area where the BCAR implied rating can be most impacted downward is ERM, where a very weak ERM process can actually reduce the rating by three or four notches.  Let’s restate the importance of ERM in more concrete terms.

If your company’s risk management capabilities contain severe deficiencies relative to the risk profile of the company, your initial BCAR assumed rating of, say, A- can be moved down to a below investment grade BB+.  Or, from A to barely investment grade at BBB-.  Of course, there would be an upward adjustment if your company’s risk management capabilities are excellent and are more than adequate for the risk profile of the company.  But, that upward adjustment is limited to one notch.  In other words, ERM analysis is slanted to reduce your company’s potential rating instead of increase it.

This blog will focus on BCAR and its impact on investments, while the next blog entry From the Northwest Quadrant, will discuss ERM.

First, BCAR is calculated differently, so that it is now basically a measure of how much your company’s available capital is above or below required capital, as a percentage of its available capital.
 4 - New Structure - LH BCAR
 5 - Example Impact to LH Score

So, a positive number says you’ve got ‘excess required capital’ and a negative number means the opposite.  However, there will no longer be one BCAR score and this is where things get interesting and controversial, as you will now have five BCAR scores.  (If one BCAR score is good, why not five?).  These five will be based upon a simulation of required capital at various statistical confidence levels, focusing on the negative ‘tail’ of the simulated distribution at the 95th (1 in 20), 99th (1 in 100), 99.5th (1 in 200), 99.8th (1 in 500) and 99.9th (1 in 1,000) levels.

And, how will BCAR be simulated to determine these levels?  We will not comment on the parts of BCAR outside of investments, as we will leave that to those more trained in the nuances of reserving, reinsurance, etc.  However, for investments, BCAR is simulated using an Economic Scenario Generator (ESG).  What is behind the ESG?  How often is the ESG updated?  Who developed the ESG and how?  What are the basic assumptions behind the ESG?  Did the ESG predict the 08/09 event in financial markets and the economy?  How often is the ESG recalibrated?  These and many other questions dog ESG’s generally and this is where the well thought out structure of BCAR begins to show a potentially material inherent flaw.

But, Best has also gone deeper in its inclusion of investment risks in BCAR, with the most material for most companies being:

Default Risk

Bond default risk will be based upon the ESG, reflecting both the maturity and the credit quality of the portfolio.  To this we say, “It is about time!”  For nearly two decades, SAA has provided its clients with a graphical report called, ‘Credit Duration,’ which combined credit risk and duration.  This is because the other major NRSRO’s appear to care little about corporate bond maturity when they rate a bond.  In other words, you will see the same credit rating for a 1 year IBM bond as for a 30 year IBM bond…and we all know that IBM’s industry, technology, is very stable and unchanging, posing little increased credit risk for longer dated issues (we think not). 

Best uses the next 10 years of projected losses, offsets defaults with expected losses and then performs a present value calculation.  Thus, your company’s default factor for its bond portfolio will be different from your competitors, dependent upon how factors like maturity, credit quality and the all-powerful ESG interact.

Common Stock Market Volatility

This factor will be based upon the ESG, but will also reflect the volatility of the S&P 500 adjusted for your company’s equity portfolio beta (how its volatility compares to the S&P 500).  Best will review correlation coefficients to determine how credible that beta adjustment is.  Amazingly, they will use a one year time period in calculating volatility, despite the fact that, for most companies, equity investments (like most Risk Assets) are seen as a long term commitment.
Interestingly, the 1 in 1000 level of BCAR revealed a factor of 50% as a baseline – much higher than the incongruously inconsistent factors of 15% for P&C insurers and 30% for life insurers.  As we all remember, the Great Recession that began in 08/09 provided about a 50% drop in the S&P 500.  So, to say that is only a 1 in 1000 event may be a bit optimistic.  Perhaps better to just call it a ‘reasonable’ worst case and move on.

Interest Rate Risk

Based upon the ESG, Best simulated 10,000 potential changes in rates over a one year period and produced varying interest rate shocks ranging up to 310 basis points.
From there, Best will estimate the company’s liquidity needs based upon a specific measure (P&C) or a more stochastic approach (L/H).  For PC insurers, liquidity needs are assumed to be the greater of gross PML or 10% of surplus, while for Life insurers, factors such as surrender charge protection, duration mismatch, portfolio mix, payout period and market value adjustments would be considered in a stochastic framework.  So, assume large liquidity needs based upon this formula (P&C) or stochastic analysis (L/H), add in a swift increase in rates, mix heavily and determine the ‘unexpected’ realized loss that would result in the bond portfolio.

There are other asset classes and less common investment risks included in Best’s BCAR, but these three above probably are the most common for most insurers.

What Now?

Good question.  With all due respect, we would expect Best’s now separate publishing company to provide the ESG (at a fee), in order to allow insurers to follow the logic behind BCAR and better understand their strategies in light of this new rubric.

We’ve been told that the new BCAR will be implemented over the coming year and will typically not impact an insurer’s rating.  However, we’ve also been told that companies whose rating might be ‘at risk’ from the new Rating Methodology, including BCAR, will receive a letter from Best in advance and be given an opportunity to discuss with their analyst.

Undoubtedly, there will be more discussions to come from Best’s new, more structured rating methodology and BCAR calculations.   And, we have little doubt that the NAIC is watching these developments very closely.  Going back about two decades, it was the NAIC that pre-dated Best’s efforts in developing a measure of Risk Based Capital.  But, now it appears that AM Best has leapfrogged the regulators in this key area.  We sincerely doubt that this game of leap frog will stop any time soon.

(Photo of Alton Cogert, above right, is courtesy of Mr. Cogert.) 

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