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By MATTHEW BRODSKY, senior editor/Web editor of Risk & Insurance®

It only took a few years, but the Oldwick, N.J.-based ratings agency A.M. Best Co. finally relaxed its stress test for carriers' catastrophe exposure and risk management.

Now the "bar" has been relaxed, he said. At the same time, the new Best methodology is designed to create more appropriate distinctions between seasoned companies with a fair amount of liquidity and strong risk management practices, and those without.

"Companies that are behind the eight ball and do not have access to contingent capital, lack strong risk management, and lack good data quality and validation procedures, they're keeping the bar high," said Simpson.

A company's risk management practices determine how much it can benefit from Best's relaxed methodology.

"Underlying all these factors is A.M. Best's assessment of each company's catastrophe risk management capabilities," the ratings agency wrote in its report on the new methodology, released July 20. "A.M. Best believes companies that possess strong catastrophe risk management focus on data quality, continually monitor exposures and have specific controls in place to manage their exposure on an ongoing basis."

CAPITAL REQUIREMENTS

When it comes to how it crunches numbers, Best made a big change in the way it handles reinsurance recoverables. They are now only increased by 40 percent of the difference between gross and net pretax probable maximum loss. Before, they could be increased up to 80 percent.

No longer will A.M. Best assume that reinsurers get knocked down a notch in their ratings level after a large catastrophe. The new assumption is that reinsurance payouts occur faster.

"This reduces the required capital for loss reserves," Scott Lohman, managing director at Guy Carpenter & Co., explained.

The new guidelines also provide additional clarity on how Best views an insurer's financial flexibility, its historical performance and its exposure to multiple CAT events.

Overall, the Best methodology will remain the same. Its main tool for evaluating a carrier is the Best's Capital Adequacy Ratio, or BCAR, which applies a "risk-adjusted view of capitalization" by modeling what would happen to a carrier if a 100-year hurricane or 250-year earthquake hit its books. Then "to truly understand a company's financial position after an actual event," the ratings house does its catastrophe stress test to examine the carrier's reinsurance recoverables and risk management.

VERSUS OTHER AGENCIES

Guy Carpenter's Lohman does not want to compare what Best now does with the other ratings agencies' policies. What Best does is "unique," he said, with the big difference being that the other major insurance ratings house, Standard & Poor's, tests its insurers with an all-perils, aggregate, 250-year loss (versus Best's single 100-year hurricane and 250-year earthquake).

Simpson, however, noted an important distinction between S&P and Best: their clients. S&P's ratings coverage is largely focused on bigger, more sophisticated carriers, whereas Best is oftentimes the only ratings agency scrutinizing midcap and smaller insurers.

It might be no coincidence, then, that Best has further institutionalized and made explicit its views on catastrophe risk management in its BCAR stress test.

"As de facto regulators, Best is challenging many insurers on the CAT risk management front," he said, "and pushing smaller carriers to continually improve their CAT risk practices."

July 27, 2009

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