A Review of Best’s Insurance

A Review of Best’s Insurance-Linked Securities & Structures Methodology (BILSM)

Emmanuel Modu – Managing Director, AM Best

Definition of Insurance Structures & Securities

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Insurance-Linked Structures

Entities that act as intermediaries between the insurance industry and the capital markets

Insurance-Linked Securities

Securities whose interest and principal payments primarily depend on insurance-related assets or events

Purpose of BILSMBILSM Is Used With Two Groups of Ratings Criteria*

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ILS Structures

• Evaluating Reinsurance/Insurance Transformer Vehicles• Rating Sidecars

ILS Securities

• Rating Natural Catastrophe Bonds• Securitization of Annuities• Rating Surplus Note and Insurance Trups CDOs • Rating Life-Related Premium Financing Loan Securitizations• Rating Closed-Block Monetizations• Life Settlement Securitization• Securitization of Period-Certain and Life-Contingent

Structured Settlements

* You can access the complete list of the criteria procedures here: BILSM and Associated Criteria Procedures

http://www3.ambest.com/ambv/ratingmethodology/bilsm.aspx

Best’s Idealized Default Matrices

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Best’s Idealized Default MatricesBILSM Contains Two Idealized Default Matrices

• Best’s Idealized Issuer Default Matrix (Based on AM Best’s Insurance Company Default* Data)

• Best’s Idealized Issue Default Matrix (Based on Best’s Idealized IssuerDefault Matrix)

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* Insurance companies under specific forms of regulatory supervision are classified as being in default for the purposes of this presentation.

• Best’s Idealized Issuer Default Matrix

- Based on Best’s Impairment Rate and Ratings Transition Study

- Currently covers over 40 years of insurance company ratings

• 5,212 companies rated and experienced 746 defaults*

- We smooth the data to make sure defaults are monotonically non-decreasing for each of the 21 rating categories over time

- We also adjust the data to make sure there is no default intersection between our 21 rating categories over time

- Broadly speaking , we apply regression, extrapolation and fitting techniques to preserve some qualities in the historical data

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* Insurance companies under specific forms of regulatory supervision are classified as being in default for the purposes of this presentation.

Best’s Idealized Default MatricesBest’s Idealized Issuer Default Matrix

Best’s Idealized Issuer Default Matrix

1 Year 3 Years 5 Years 10 Years 15 years

aaa 0.08% 0.14% 0.23% 0.58% 1.04%

aa+ 0.14% 0.28% 0.43% 0.88% 1.43%

aa 0.20% 0.41% 0.64% 1.31% 2.14%

aa- 0.22% 0.62% 1.04% 2.24% 3.64%

a+ 0.28% 0.96% 1.65% 3.45% 5.35%

a 0.35% 1.26% 2.18% 4.50% 6.88%

a- 0.45% 1.56% 2.67% 5.48% 8.33%

bbb+ 0.84% 2.90% 4.94% 10.00% 15.06%

bbb 1.23% 4.68% 7.98% 15.65% 22.63%

bbb- 1.56% 6.02% 10.18% 19.50% 27.78%

bb+ 3.73% 10.80% 17.60% 33.58% 48.23%

bb* 4.77% 13.08% 20.77% 38.23% 53.67%

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Best’s Idealized Default MatricesBest’s Idealized Issuer Default Matrix

Unique to AM Best Used for rating Transformers, Sidecars, and other insurance-related entities that are not full-fledged insurers.

*Here we show only 12 rating categories but the BILSM shows the 21 rating categories – 9 more after the “bb” rating: bb-, b+, b, b-, ccc+, ccc, ccc-, cc, c

Excerpt from Best’s Idealized IssuerDefault Matrix in the BILSM

• Best’s Idealized Issue Default Matrix

- This table reflects AM Best’s view of defaults of senior unsecured debt ratings

- AM Best’s senior unsecured debt ratings are notched from operating insurance company ratings*; 0-5 notches typically applied.

- This matrix is similar to the idealized default table produced by other rating agencies for the purposes of rating structured securities

• The seminal data used by these rating agencies for their idealized default tables are primarily from default studies associated with corporate and financial institution debt

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*See Table 3 (Notching From Issuer Credit Rating to Issue Rating) in the BILSM.

Best’s Idealized Default MatricesBest’s Idealized Issue Default Matrix

Best’s Idealized Issue Default Matrix


aaa 0.03% 0.11% 0.19% 0.42% 0.68%

aa+ 0.08% 0.14% 0.23% 0.58% 1.04%

aa 0.11% 0.17% 0.28% 0.69% 1.25%

aa- 0.14% 0.28% 0.43% 0.88% 1.43%

a+ 0.16% 0.33% 0.52% 1.09% 1.82%

a 0.20% 0.41% 0.64% 1.31% 2.14%

a- 0.22% 0.62% 1.04% 2.24% 3.64%

bbb+ 0.28% 0.96% 1.65% 3.45% 5.35%

bbb 0.35% 1.26% 2.18% 4.50% 6.88%

bbb- 0.45% 1.56% 2.67% 5.48% 8.33%

bb+ 0.84% 2.90% 4.94% 10.00% 15.06%

bb* 1.23% 4.68% 7.98% 15.65% 22.63%

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Best’s Idealized Default MatricesBest’s Idealized Issue Default Matrix

Used for rating structured securities backed by insurance assets or obligations: cat bonds, Trups CDOs, and other ABS transactions.

Excerpt from Best’s Idealized IssueDefault Matrix in the BILSM


Insurance-Linked Structures

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Insurance-Linked StructuresHallmarks of Insurance-Linked Structures

Broad Hallmarks of Insurance-Linked Structures

• They operate like insurance companies

• The structures often transact through segregated cells

• They generally don’t have permanent capital – allowing for contraction or expansion of business, if necessary

• They generally have stated maturity terms or specific conditions under which the structure can be terminated and obligations extinguished

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Insurance-Linked StructuresExample: A Transformer

Simplified Diagram of Transformer

RatedTransformer

Assets/PaymentsAssociated with

Financial Contract

Protection Buyer(Ex: Reinsurer)

Protection Seller or Investor

(Ex: an ILS Fund)

Assets

Protection for Losses Per

Reinsurance Agreement

Release of Assets Pursuantto Reinsurance Agreement

or Financial Contract

Redemptions/ReceiptsAssociated with

Financial Contract

Premiums Per Reinsurance Agreement

Asset Deposits Backing Reinsurance Agreement

or Financial Contract

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12

3

4

5

6

7

All other legal agreements amongst all parties

A transformer is an example of an insurance-linked structure – shown here is a simplified diagram of a transaction involving a transformer.

Insurance-Linked StructuresExample: Elements of the Transformer

1. Protection buyer – typically a reinsurer

2. Protection seller – typically an ILS fund

3. The Transformer – the lightly regulated entity entering into agreements with the protection buyer and seller

4. Trust Account – a trust with assets (normally provided by the protection seller) to support the insurance obligations of the transformer

5. Liabilities – the obligations taken on by the transformer through the reinsurance agreement with the protection buyer

6. Conditions for Collateral Release – the mechanism for releasing assets to cover the obligations or releasing assets back to the protection seller

7. Legal Documents – documents that cover all interactions with the transformer

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Insurance-Linked StructuresExample: Simple Transformer Containing Liabilities & Assets

• In our transformer example, we assume:

• Reserves calculated to the full maturity of obligations

• Reserves are recalculated annually

Liabilities

Example: a Non-cat Line of Business

• In our transformer example, we assume:

• Assets are periodically mark to market to eliminate credit/market risk

• Asset returns are swept out periodically to risk sellers

Assets

Example: Highly Rated Assets

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Insurance-Linked StructuresExample: BILSM Broadly Describes How To Determine Transformer Liabilities

Reserve Calculation Principles (Associated with Liabilities)

• Assume the entity is in run-off

• Stochastically simulate future losses for entire term of the exposures

• Present value the future losses for the entire term of the exposures with an appropriate discount rate

• Arrange all the present values from highest to lowest

• Choose the appropriate loss reserve related to confidence level of losses associated with a target rating level

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Insurance-Linked StructuresExample: Reliance on Modeling Results from Sponsors

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The Use of Modeling Results

• AM Best may rely on sponsors to provide data and modeling results for some structures

• Information from sponsors can be sourced from:

- Professional peril modelers

- Actuarial firms

- Brokers

- Their own internal risk assessment models (assuming they have been deemed to be reliable)

Insurance-Linked StructuresExample: Analytical Rating Threshold for the Transformer

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Main Rating Consideration* – Sufficiency of Assets to Cover Liabilities

• Check sufficiency of assets to cover reserves at VaR level commensurate with target Issuer Credit Rating

(Assets** – ReservesVaR ) >=0?

• Best’s Idealized Issuer Default Matrix provides the rating level commensurate with the VaR level at which assets exceed reserves.

**In this example, we assume assets are of the highest quality and are periodically marked to market

*Other considerations may include the structure of the transformer transaction, the review of the legal documents, etc.

Best’s Idealized Issuer Default Matrix

1 Year VaR

aaa 0.08% 99.92 Assets – ReservesVaR99.92 >= 0 ? No

aa+ 0.14% 99.86 Assets – ReservesVaR99.86 >= 0 ? No

aa 0.20% 99.80 Assets – ReservesVaR99.80 >= 0 ? No

aa- 0.22% 99.78 Assets – ReservesVaR99.78 >= 0 ? No

a+ 0.28% 99.72 Assets – ReservesVaR99.72 >= 0 ? No

a 0.35% 99.65 Assets – ReservesVaR99.65 >= 0 ? Yes

a- 0.45% 99.55 Assets – ReservesVaR99.55 >= 0 ? Yes

bbb+ 0.84% 99.16 Assets – ReservesVaR99.16 >= 0 ? Yes

bbb 1.23% 98.77 Assets – ReservesVaR98.77 >= 0 ? Yes

bbb- 1.56% 98.44 Assets – ReservesVaR98.44 >= 0 ? Yes

bb+ 3.73% 96.27 Assets – ReservesVaR96.27 >= 0 ? Yes

bb* 4.77% 95.23 Assets – ReservesVaR95.23 >= 0 ? Yes

Initial rating for this simplified example is the rating at the point when assets are greater than reserves when starting the test from “aaa” down; Here, that point is at the “a” ICR level.

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Insurance-Linked StructuresExample: Use of Issuer Default Matrix for Rating a Transformer


Assuming that we are only concerned about a 1-year risk period, the VaR for any ICR level is = 1-Default

Insurance-Linked StructuresExample: Other Analytical Considerations for Rating a Transformer

Other Quantitative Considerations

• Asset quality – assets may not be of the highest quality so transaction may have to account for credit and market risks

• Some transactions may allow for asset top-ups

• Some transactions may allow for retention of asset returns or premiums before sweeps back to investors – thus building up more equity in the transactions

• Liabilities may be periodically re-evaluated (for example, every quarter) by a third party

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Insurance-Linked Securities

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Insurance-Linked SecuritiesExample #1: Asset-Backed Securities (ABS) Transaction

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Broad Hallmarks of Asset-Backed Securities Structures

• Securities are generally issued from bankruptcy-remote Special Purpose Vehicles

• Securities have fixed maturities

• Assets (which may be of mixed quality) are generally self-liquidating

• Transactions have well-defined “waterfalls” for the payment of interest and principal

• Performance of the transaction broadly depends solely on the performance of the assets

Insurance-Linked SecuritiesExample #1: ABS Transaction

Credit Enhancement

Originator

Investors

Assets

Proceeds

Special Purpose Vehicle

Interest & Principal Based on a “Waterfall”

Cash

Examples: TruPS CDOs, Structured Settlement Securitizations, Life Settlement Securitizations

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1

2

3

4

5

6


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1. Special Purpose Vehicles (SPVs) – A bankruptcy-remote entity that either owns the assets or has beneficial interest in the assets

2. Originator – The entity that accumulates the assets for sale/transfer to the SPV

3. Assets – Typically self-liquidating assets sold/transferred to SPV by originator

4. Waterfall – The priority of payments of principal and interest to the investors

5. Investors – Noteholders who provide funding for the acquisition of the assets

6. Credit Enhancement – Any credit enhancements to the cash flows or the rated securities

7. Legal Documents – Documents that cover all interactions

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• AM Best’s Performs its Own Monte Carlo Simulation In Some Cases

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Transactions that depend on defaults of insurance carriers

or other types of issuers

Transactions that depend on mortality or other well-defined behavioral aspects of

insurance, such as lapses or longevity

Transactions that rely on combinations of defaults, mortality,

and other well defined risks

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• AM Best Applies Deterministic Modelling in Some Cases

‒ Some asset-backed securities transactions cannot be modeled using Monte Carlo Simulation techniques:

• For example, sometimes there are millions of insurance policies involved and too many random variables

‒ Deterministic approach is sometimes appropriate, such as stressing:

• Asset defaults

• Mortality to reflect potential epidemics

• Lapse/persistency reflecting several standard deviations of such elements

• Interest rates for severe and sudden spikes

• Catastrophe frequencies

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The Use of Modeling Results Provided by Sponsors

• AM Best may rely on sponsors to provide data and modeling results for some securitizations

• Sponsors can source data and modeling results from:

- Professional peril modelers

- Actuarial firms

- Brokers

- Their own internal risk assessment models (assuming they have been deemed to be reliable)

Insurance-Linked SecuritizationsExample #1: ABS Transaction

Insurance-Linked SecuritizationsExample #1: ABS Transaction

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Main Rating Considerations

The structure of the transaction

The default/attachment probability (i.e., first dollar of loss) associated with the securities; or the results of the deterministic stresses

The ratings of the entities that directly provide credit support to the transaction

The quality of the assets originated by third parties

Best’s Idealized Issue Default Matrix


aaa 0.03% 0.11% 0.19% 0.42% 0.68%

aa+ 0.08% 0.14% 0.23% 0.58% 1.04%

aa 0.11% 0.17% 0.28% 0.69% 1.25%

aa- 0.14% 0.28% 0.43% 0.88% 1.43%

a+ 0.16% 0.33% 0.52% 1.09% 1.82%

a 0.20% 0.41% 0.64% 1.31% 2.14%

a- 0.22% 0.62% 1.04% 2.24% 3.64%

bbb+ 0.28% 0.96% 1.65% 3.45% 5.35%

bbb 0.35% 1.26% 2.18% 4.50% 6.88%

bbb- 0.45% 1.56% 2.67% 5.48% 8.33%

bb+ 0.84% 2.90% 4.94% 10.00% 15.06%

bb* 1.23% 4.68% 7.98% 15.65% 22.63%

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Example: 15-year Trups CDO transaction; If the security is modeled to have a default probability of 3.64%, the initial rating will be “a-”


Insurance-Linked SecuritiesExample #2: Catastrophe Bonds

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Broad Hallmarks of Catastrophe Bonds

• Cat bonds are generally issued from bankruptcy-remote Special Purpose Vehicles (SPVs)

• Cat bonds have fixed maturities

• Assets are generally of the highest quality and there to collateralize the full limits of obligations to the sponsor (the reinsured).

• Transactions have well-defined “waterfalls” for the payment of interest and principal to cat bond investor

• The performance of a cat bond broadly depends on the occurrence (or non-occurrence) of natural catastrophe events


Investors(Qualified

Institutional Buyers)

Sponsor/Originator

(Re)insurance Company

IssuerBankruptcy Remote

Special Purpose Vehicle

Trust AccountHighly Rated Short Term Investments

PremiumsInterest =

LIBOR + Premiums

Principal at maturityand liquidation

Note Proceeds/Funding

NoteProceeds

Interest & Remaining

Funds atMaturity or

Loss Event

Investment Income

21 3

4

5

Protection for Losses Per

Reinsurance Agreement

6

Sponsor seeking excess-of-loss insurance on a cat line of business.


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1. Sponsor – typically an insurer seeking multi-year excess-of-loss reinsurance coverage

2. Investors – typically capital market participants (especially ILS funds)

3. The SPV— this is actually a transformer that is the intermediary between the sponsor (protection buyer) and the investor (protection seller)

4. Trust Account – the assets in trusts are there to support the full limit of the insurance obligation of the SPV

5. Liabilities – the full limit of the SPV’s reinsurance obligations

6. The interest and principal to the securities we are actually rating

7. Legal Documents – documents that cover all interactions with the transformer

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Main Rating Considerations

The structure of the transaction

The default/attachment probability (i.e., first dollar of loss) associated with the securities – normally provided by 3rd party modelers like AIR, RMS, etc.;

Because we are dealing with binary risk, the ratings of the bonds are normally below investment grade (“bb+” or less) unless the bonds are triggered by multiple cat events

The quality of the assets in the collateral trust

Insurance-Linked SecuritizationsExample #2: Catastrophe Bonds

Summary

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Summary

• BILSM covers both insurance-linked structures and securities – it is used along with various criteria procedures.

• Best’s Idealized Issuer Default Matrix, based exclusively on insurance carrier defaults, is used to rate insurance structures.

• Best’s Idealized Issue Default Matrix, is used for rating securities, and is a derivative of Best’s Idealized Issuer Default Matrix.

• Rating of insurance-linked structures often hinges on establishing the point at which assets are sufficient to cover obligations in a structure within defined VaR levels.

• Rating of insurance-linked securities often hinges on establishing the probability of the first dollar of loss but can be moderated based on the nature of the risk.

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For questions, please contact:

[email protected]

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