Treatment of Investments in the A.M. Best Rating Process

1. NYIA Educational Seminar Treatment of Investments in the A.M. Best Rating Process Jennifer Marshall Senior Financial Analyst Property/Casualty Division February 12, 2009

2. Discussion Topics • Rating Process Overview • Capital Model Overview • Treatment of Investments in the Capital Model • 2008 Review / 2009 Preview

3. Rating Process Overview

4. Objective of A.M. Best’s Financial Strength Ratings To perform a constructive and objective role in the insurance industry toward the prevention and detection of insurer insolvency

5. A.M. Best’s Rating EvaluationKey Components Balance Sheet Strength Operating Performance BusinessProfile Best’s Rating

6. Secure A++ B+ Vulnerable B D Balance Sheet Strength Outstanding Weak OperatingPerformance Very Stable/Strong Volatile/Poor Strong / Sustainable Advantages Well-Diversified Questionable ViabilityCompetitive DisadvantagesConcentrated Risk BusinessProfile A.M. Best’s Rating Evaluation Rating Considerations

7. A.M. Best’s Rating Evaluation Balance Sheet Strength • Leverage • Capital structure / holding company • Quality & appropriateness of reinsurance • Adequacy of loss reserves • Quality and diversification of assets • Liquidity • Growth • Risk Adjusted Capitalization (BCAR)

8. A.M. Best’s Rating Evaluation Operating Performance • Level of Profitability • Historical • Prospective • Stability/Volatility of Earnings • Revenue Composition/Quality of Earnings • Ability to Meet Plan

9. A.M. Best’s Rating Evaluation Business Profile • Market risk • Spread of risk • Event risk • Competitive advantages • Management

10. Capital Model Overview

11. Best Capital Adequacy Ratio - BCAR • Comprehensive Tool to Evaluate Risk Components Simultaneously • Generates Overall Estimate of Required Level of Capital to Support Risks

12. Economic (Adjusted) Surplus Reported Surplus (PHS) Equity Adjustments: Unearned Premiums Loss Reserves Assets Debt Adjustments: Surplus Notes Debt Service Requirements Stress Adjustments: Future Operating Losses Potential Catastrophe Exp. Other Net Required Capital Gross Required Capital (B1) Fixed Income Securities (B2) Equity Securities (B3) Interest Rate (B4) Credit (B5) Loss and LAE Reserves (B6) Net Premiums Written (B7) Off-Balance Sheet Covariance Adjustment BCAR Model Overview Economic (Adjusted) Surplus BCAR = Net Required Capital

13. Capital Model Treatment:Net Required Capital

14. Net Required Capital • Investment Risk • Bonds • Equities • Interest Rate Risk • Other Issues • Single Large Asset • Spread of Risk • Common Stock Leverage

15. Investment Risk (B1): Bonds • Grouped by NAIC SVO Class • US Treasury Bonds separate from other Class 1 bonds • Risk Factor varies from 0% to 30% for unaffiliated bonds, based on SVO class

16. Bond Risk Charges Security Type/Class Risk Charge

17. Investment Risk (B1): Other • Cash Risk Charge: 0.3% • Mortgage and Contract Loans Risk Charge: 5% • Short-term investment Risk Charge: 1%

18. Investment Risk (B2): Equities • Publicly-traded equities have a 15% risk charge • Private equity generally carries a 100% risk charge due to limited liquidity • Preferred and common equities generally treated the same

19. Investment Risk (B2): Other • Real Estate Risk Charges • Company Occupied: 10% • Investment: 20% • Other Investments: 20% • Title Plants: 10% • EDP & Other Tangibles: 20% • Foreign Exchange Rate Asset: 20% • Aggregate Write-Ins: 20%

20. Additional Asset Considerations • Single Large Asset • Spread of Risk Adjustment • High Common Stock Investment Leverage

21. Interest Rate Risk (B3) • Identifies potential stress for companies that maintain a high exposure to short-term cash needs • Often greatest for companies with a high gross catastrophe PML • Estimates impact of a 120 point increase in interest rates on market value of bonds • Multiplies by ratio of gross PML to liquid assets, with a minimum charge of 10% of the decrease in market value

22. Capital Model Treatment:Adjusted Policyholder Surplus

23. Fixed Income Equity Adjustment • Reflects Difference between Market and Book Value of Bonds • Based on General Interrogatory #28 – reported only in year-end statement • If difference is: • Positive, capped at 10% of surplus • Negative, capped at 15% of surplus • This adjustment has been positive (e.g., it has increased surplus) for the industry overall and for most companies individually

24. Fall, 2008 Investment Survey • Credit market issues had significant negative impact on market price of bonds • Reviewed fixed income adjustment with caps in place and without the caps (stress scenario) • Recalculated BCAR with revised FI equity adjustment and under stress scenario

25. Fall, 2008 Investment Survey • Reviewed the recalculated BCAR in the context of each company’s • Overall liquidity and cash flows • Operating fundamentals • Business profile, including exposure to shock losses • Contacted companies with potential rating concern

26. Review of 2008/Preview of 2009

27. 2008 In the Rear-View Mirror • Capital Adequacy Remains Adequate • Soft Market Conditions • Underwriting Losses • Investment Market Turmoil • Financial Flexibility in Hibernation

28. 2009 Market Expectations • Modest stabilization in pricing • Underwriting results rebound, but remain negative • Continued uncertainty in financial markets • Limited growth in investment earnings

29. Questions?

30. For More Information: • http://www.ambest.com/ratings/methodology.asp • Financial Strength Methodology for P/C Insurers • Understanding BCAR for P/C Insurers • Contact your company’s rating analyst • Contact me: jennifer.marshall@ambest.com