Thomas M. Mount, ACAS, MAAA A. M. Best Company July 9, 2002

1. Rating Agency Perspectives DFA-12 Thomas M. Mount, ACAS, MAAA A. M. Best Company July 9, 2002

2. Discussion Outline • Roles of capital model • Best’s Rating Process • Prospective vs. Retrospective Analysis • Stochastic vs. Limited Scenarios • A.M. Best’s Views of DFA • A. M. Best’s Interests in DFA • Rating Implications of DFA • DFA Analyses

3. Roles of a Capital Model • Current and Prospective evaluation of Capital Adequacy • Identification/Quantification of Risks facing insurers • Scenario testing • Robust enough to use on all companies

4. Current Roles of Capital Models at AMBest • BCAR - Major Role in Financial Strength Rating Process • VAR - Concepts being reviewed • Just a different approach to measuring risk • VAR risk factors could be placed in BCAR model • DFA - Not in used internally in rating process

5. Current Roles of Capital Models at AMBest • BCAR - Major Role in Financial Strength Rating Process because it identifies: • Investment Risk • Interest Rate Risk • Credit Risk • Underwriting Risk (reserve vs NWP) • Some Off-Balance Sheet Risks

6. Best’s Rating Evaluation— Rating Components Balance SheetStrength Operating Performance Business Profile Best’sFSR Rating

7. Management Business Profile Operating Performance Balance Sheet Strength Rating ConsiderationsSuccess Factors

8. Best’s Capital Adequacy Model (BCAR) * Ongoing Earnings Stream / Capital Generation * Holding Company / Capital Structure U/W Leverage * Ceded Leverage * Investment Leverage * Financial Flexibility * Quality of Capital Reinsurance Program * Capitalization Quantitative vs. Qualitative * DFAcan model these

9. Underwriting Profitability * Return on Equity * Return on Premium * Reserve Adequacy Changes Return on Assets * Expense Structure * Quality/Sustainability of Earnings * Management Price Monitoring Reserve Development Operating Flexibility/Efficiency Operating Performance Quantitative vs. Qualitative * DFAcan model these

10. Spread of Risk * Market Share Catastrophe Leverage * Market Risk Competitive Market Position Distribution Effectiveness Event Risk Business Profile Quantitative vs. Qualitative * DFAcan model these

11. Why Market Profile and Operating Performance? Strong Market Profile and Operating Performance Weak Market Profile and Operating Performance Date of last balance Sheet Today Time

12. Prospective View Most Important Retrospective View Provides Insight Historical Earnings Plan vs. Actual Initial Capital Strength Prospective vs. Retrospective

13. Scenario Testing Only Issues with Stochastic Testing Resources Required Specific Management Assumptions Is Limited Scenario Testing an Adequate Trade Off? Stochastic Modeling ==> Management Guide Stochastic vs. Limited Scenarios

14. Views of DFA • Still in Development Stages • Value to be Determined by Users • Could be an Extremely Useful Management Tool • Underlying Assumptions are Key • But, Only a Tool • Not seen as a rating tool yet

15. Interest in DFA • Not seen as a rating tool yet • Interests: • Who is performing DFA analyses? • Is it developed in house or externally? • Accuracy? • Indications for capital strength? • Is management using it in business plan?

16. Will not Mandate the Use of DFA Value to Rating Initially in Qualitative Review of Operating Performance Eventually in Sustainable Advantages and Better Performance? Better understanding of risks Value to rating based on value to management’s plan Unlikely to garner an upgrade or prevent a downgrade on its own just because DFA is used does not guaranty rating Ratings Implications of DFA

17. Few results shared with us Poor quality of model? Poor results projected? Too complicated? If shared with us, need Assumptions (loss trend, prem trend, interest rates, distributions, parameters, etc.) How model works Results Alternative assumptions/results How business plan is derived from DFA - reliance on model DFA Analyses