Jun 1

Don’t Get Your BCAR in an Uproar


By Alton Cogert

There are Big Changes coming for your AM Best rating.

AM Best continues in their efforts to improve the rating process.  Yes, I know insurers have misgivings about whatever Best may do or have planned.  I also know that insurers will probably only state those as part of a group, in order for any single insurer to stay generally ‘anonymous.’  That is completely understandable.

However, it is important to be prepared on key AM Best initiatives. One of those is a complete revision to their BCAR (Best’s Capital Adequacy Ratio) calculation.  BCAR has been described by some Best analysts as a necessary, though not a sufficient, condition for a given rating level.  And, despite Best’s position that BCAR is just ‘one of many tools’ they use.  “Me thinks they protest too much” when they tend to downplay BCAR’s importance.

It is still early days in this BCAR revision.  But, there have been a couple of webinars you can view on AMBest.com plus at least one presentation made at their Review/Preview Conference.  Changes being considered impact many aspects of your business, but I will focus on a few key investment and structural changes under consideration.

“BCAR will now be a confidence game.”

Well, not exactly.  But, the BCAR model is contemplated to produce numbers for five levels of confidence (e.g. 95% confident that BCAR is at least x).  This will be possible because BCAR is going stochastic instead of deterministic.  In other words, in many cases, those familiar risk factors applied to balance sheet and income statement numbers will be replaced by modeling.  What will be the assumptions and how will the model be structured?  To be announced.

However, what we do know is that there will be changes on the investment factors.

As long as the overall BCAR calculation structure does not change, if you are a PC company, you may want to immediately look at the last few paragraphs of this blog that address changes to the SRQ (Supplementary Rating Questionnaire).  The covariance factor, which makes changes in investment risk have very little impact on BCAR, remains in the formula.  At least that is the case, so far…

“Life insurers, welcome to the jungle.”

 You already know that investment factors directly impact BCAR.  But, did you know that the duration and credit rating of your bond holdings will now interact to produce credit risk factors?  Well, actually duration and credit rating ALWAYS work together to impact credit risk.  Your investment manager probably never emphasizes this and, of course, BCAR has never considered this.

However, at Strategic Asset Alliance, we have constantly monitored this via our Credit Duration graph.

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Properly used, this graph can spot trends where the investment manager is ‘doubling down’ by taking both credit and interest rate risk, or perhaps not taking advantage of the interplay between the two.  (Both SAA and InsurerCIO clients benefit from viewing Credit Duration.)

And, now AM Best will consider this obvious relationship.  For example, an IBM bond with a year to maturity does not have the same credit risk as an IBM bond with a thirty year maturity.  You can have a fairly good handle about technology over the next year, but the next thirty years?

Yes, you can always sell both IBM bonds within the year, but given that most insurer portfolios are not actively traded, it is likely most corporate bonds will be held for a while.  And, AM Best will now model this interrelationship in their BCAR model.  A very initial analysis has shown that these revised credit risk factors are expected to be much greater than those currently used.

Of course, most insurers sell bonds before they completely default, so there has already been some criticism of this methodology.

And AM Best has been very, very careful to say that they don’t want ‘unintended consequences’ from their BCAR revisions.  So, perhaps the final risk factors and how they are implemented will be a non-event.

But, we do not see it that way.

“AM Best has been very, very careful to say they don’t want ‘unintended consequences’…we do not see it that way.”

At SAA, we think that AM Best is laying the groundwork for discussion and changes at how risk is viewed at any insurer, whether rated by them or not.  Once the Best BCAR model is finalized, we fully expect the NAIC and other rating agencies to reconsider their own models in excruciating detail.

How important is BCAR?  We all know that answer to that.

Related to this, of course, is the latest change to AM Best’s SRQ which requests the insurer to:

Please state any overall risk appetite and risk tolerance statement(s) that have been established or approved by a Board or senior management that apply to the rating unit and provide guidance in providing policyholder security and creating stakeholder value. The risk appetite and risk tolerance statements may be a mix of qualitative and quantitative statements. If no such statements have been formally approved by a Board or senior management, please answer “None”.

AM Best is delving more into quantifying risk (using BCAR) and asking how you perform that analysis internally.  Successfully answering that SRQ question may include asking your investment consultant and investment manager what they have seen as reasonably good responses.

Meanwhile, Best is very careful to say that these possible changes to BCAR are under discussion, attempting to get opinions from the industry.  Why do I think those will not necessarily be happy conversations?

There are Big Changes coming for your AM Best rating.  It is time to consider how you can prepare and not get your BCAR in an uproar.