Property/Casualty EditionInsurance Ratings Criteria www ... · standardandpoors.com. We will continue to update our property/casualty insurance ratings criteria ... It was then that

Insurance Ratings CriteriaProperty/Casualty Edition

Standard & Poor’s55 Water StreetNew York, NY 10041

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Standard & Poor’s

Insurance Ratings C

riteria – Property/Casualty E

dition

Insurance RatingsCriteria

Property/CasualtyEdition

Published by Standard & Poor’s, a Division of The McGraw-Hill Companies, Inc. Executive offices: 1221 Avenue of the Americas, New York, NY 10020.Editorial offices: 55 Water Street, New York, NY 10041. Subscriber services: (1) 212-438-7280. Copyright 2004 by The McGraw-Hill Companies, Inc.Reproduction in whole or in part prohibited except by permission. All rights reserved. Information has been obtained by Standard & Poor’s from sourcesbelieved to be reliable. However, because of the possibility of human or mechanical error by our sources, Standard & Poor’s or others, Standard & Poor’sdoes not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or the result obtainedfrom the use of such information. Ratings are statements of opinion, not statements of fact or recommendations to buy, hold, or sell any securities.Standard & Poor’s uses billing and contact data collected from subscribers for billing and order fulfillment purposes, and occasionally to inform subscribersabout products or services from Standard & Poor’s and our parent, The McGraw-Hill Companies, that may be of interest to them. All subscriber billing andcontact data collected is processed in the U.S. If you would prefer not to have your information used as outlined in this notice, or if you wish to reviewyour information for accuracy, or for more information on our privacy practices, please call us at (1) 212-438-7280. For more information about TheMcGraw-Hill Companies Privacy Policy please visit www.mcgraw-hill.com/privacy.html. Standard & Poor’s receives compensation for rating obligations and other analytic activities. The fees generally vary from US $5,000 to over US$1,500,000.While Standard & Poor’s reserves the right to disseminate the rating it receives no payment for doing so, except for subscriptions to its publications. TheStandard & Poor’s ratings and other analytic services are performed as entirely separate activities in order to preserve the independence and objectivity ofeach analytic process. Each analytic service, including ratings, may be based on information that is not available to other analytic areas.

Letter to Readers

Standard & Poor’s Ratings Services is pleased to present this edition of Insurance Ratings

Criteria: Property/Casualty Edition. This guide provides a comprehensive presentation of

the criteria used in our rating process and should serve as a reference in understanding

our methodology.

We maintain an active criteria development process for evaluating insurers in order to stay

abreast of industry trends and developments. It is our belief that Standard & Poor’s ratings have the

most value if our users are able to see the thought processes and methodologies used in making our

judgments. Over the years, we have developed and refined our rating process, employing both quan-

titative and qualitative analyses, to help make the best overall evaluations for our rating decisions

and opinions.

Standard & Poor’s regularly publishes its new and revised insurance ratings criteria. For the

most complete and up-to-date ratings criteria, please visit RatingsDirect, Standard & Poor’s Web-

based credit research and analysis system, or Standard & Poor’s Web site at www.pccriteria.

standardandpoors.com. We will continue to update our property/casualty insurance ratings criteria

as part of our commitment to provide the most timely and comprehensive insurance rating

information available.

MARK PUCCIA

Managing Director(1) 212-438-7233

GRACE OSBORNE

Director(1) 212-438-7227

Standard & Poor’s � Insurance Ratings Criteria Property/Casualty Edition 3

IntroductionAbout Standard & Poor’s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

Standard & Poor’s Insurance Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

Credit Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

The Rating Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10

Applying the Rating ProcessInitiating the Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

Information Request List . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13

Proposed Meeting Agenda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

Rating Revisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

Interactive Rating MethodologyRating Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18

Evaluating Insurers’ Competitive Positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19

Management and Corporate Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25

Accounting and Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28

Operational Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29

Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33

Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34

Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42

Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

Financial Flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

ReinsuranceManagement and Corporate Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52

Competitive Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53

Operating Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54

Investments and Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55

Financial Flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55

Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .56

Evaluation of Loss Reserves Enhanced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .56

Property Catastrophe Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .59

4 www.pccriteria.standardandpoors.com

Table of Contents

Captive AnalysisRating Captive Insurers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62

Group MethodologyApplying the Group Methodology Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .66

Group Financial Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .67

Maintenance-of-Net-Worth Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .72

Guarantee Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .73

Rating Interaffiliated Pools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .75

Holding Company AnalysisHolding Company Rating Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .80

Evaluating Management’s Financial Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .81

Ratios Used To Evaluate Holding Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82

Operating Leverage Versus Financial Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85

Off-Balance-Sheet Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .88

Equity Credit for Preferred Stock and Hybrid Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .89

Preferred Stock Rating Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93

Conversion Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .94

Trust Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .94

Surplus Notes in Insurers’ Capital Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .95

Commercial Paper and Confidence-Sensitive Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .97

Liquidity Backup Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .98

Guaranteed Commercial Paper and Other Parent and Subsidiary Arrangements . . . . . . . . . . . . . .101

Frequently Asked Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .101

Counterparty Credit Ratings and the Credit FrameworkIssue Credit Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .106

Sovereign Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .106

Counterparty Credit Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .106

Frequently Asked Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .110

Governing Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .112

Special Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .112

Criteria For Rating Start-UpsCriteria for Rating Start-Ups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .116


Alternative Capital Market or Structured Solutions to Insurance RiskIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .117

Rating Catastrophe Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .118

Optimizing Capital Through a Regulatory Closed Block . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .124

Dynamic Financial Analysis and Rating Agency Models: Room for Both . . . . . . . . . . . . . . . . . . .129

Evaluating the Effect of Regulation XXX on Insurers’ Capital . . . . . . . . . . . . . . . . . . . . . . . . . . .132

AppendixI. Ratings Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .138

II. Sample Guarantee Language . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .148


Introduction

About Standard & Poor’s

Standard & Poor’s dates back to 1860, whenrailroads were the driving force in the industrialrevolution. It was then that Henry VarnumPoor began publishing financial assessments ofrailroad companies through his company, Poor’sPublishing. Investors in the U.S. and Europewere quick to rely on these reports because oftheir accuracy, impartiality, and integrity.

In 1906, another company, StandardStatistics, was the first to publish financialinformation on U.S. industrial companies. Itbegan rating bonds in 1922. Poor’s Publishingand Standard Statistics merged in 1941 to formStandard & Poor’s.

In 1966, Standard & Poor’s became a divi-sion of The McGraw Hill Companies-publisherof Business Week and other leading internation-al business publications and supplier of infor-mation services to business, education, and gov-ernment. In credit analysis and ratings,Standard & Poor’s Ratings Services operatesindependently of The McGraw-Hill Cos.

We provide and publish analytical informa-tion under the basic principles of:

� Excellence.� Integrity.� Impartiality.

We operate with no government mandateand are independent of any regulatory body,investment-banking firm, bank, or similarorganization.

Standard & Poor’s has maintained a long-standing policy of publicly distinguishing rat-ings based on meetings with companies’ man-agements that provide full analytical access(interactive ratings) from those that are basedsolely on public information (designated with a“pi” subscript). Because our reputation as a rat-ing agency ultimately depends on users’ willing-ness to accept our judgment, we believe it isimportant that our users understand how wearrive at our ratings. We regularly publish rat-

ings definitions and detailed reports on ratingscriteria and methodology. See RatingsDirect,Standard & Poor’s Web-based credit researchand analysis system, or our Web site atwww.standardandpoors.com for the most com-plete and up-to-date ratings criteria.

Standard & Poor’s Insurance Ratings

Standard & Poor’s began rating the financialsecurity of insurance companies in 1971. Thisincludes life, health, property/casualty, reinsur-ers, title, mortgage, and bond insurers.

With an experienced staff of specializedinsurance analysts working in offices aroundthe globe, Standard & Poor’s remains at theforefront of originating new ratings criteriaand methodologies.

Our direct access to national and interna-tional insurance and financial markets, theirconditions, and development support the high-est-quality rating information.

We maintain reports and ratings on morethan 3,000 insurance entities in approximately70 countries across all market sectors. Standard& Poor’s is a respected source of informationon global insurance and reinsurance through itsindustry publications, seminars, teleconferencesand frequent participation in conferences andon task forces.

As always, our primary concern is servingclients’ risk-assessment needs locally and global-ly, with the finest analytical talent and reportingtechniques.

Despite the changing environment, Standard& Poor’s core values remain the same: helpingpeople around the world make well-informedfinancial decisions by providing impartial,value-added, analytically driven solutions.

Credit Ratings

Standard & Poor’s began rating the debt of cor-porate and government issuers more than 75


Introduction

years ago. Since then, credit-rating criteria andmethodology have grown in sophistication andhave kept pace with the introduction of newfinancial products. For example, we were thefirst major rating agency to assess the creditquality of and assign credit ratings to the finan-cial strength of insurance companies (1971),financial guarantees (1971), mortgage-backedbonds (1975), mutual funds (1983), and asset-backed securities (1985).

A credit rating is Standard & Poor’s opinionof the general creditworthiness of an obligor orits creditworthiness with respect to a particulardebt security or other financial obligation,based on relevant risk factors. A rating is not arecommendation to purchase, sell, or hold afinancial obligation, inasmuch as it does notcomment as to market price or suitability for aparticular investor.

Standard & Poor’s has developed creditratings that may apply to an issuer’s generalcreditworthiness or to a specific financial obli-gation. Standard & Poor’s Insurance Ratingsprovide financial strength ratings that areprospective evaluations of an insurer’s finan-cial security to its policyholders. Over theyears, these ratings have achieved wideacceptance as easily usable tools for differenti-ating credit quality because a Standard &Poor’s credit rating is judged by the market tobe reliable and credible.

Long-term credit ratings range from ‘AAA’,reflecting the strongest credit quality, to ‘D’,reflecting the lowest. Long-term ratings from‘AA’ to ‘CCC’ may be modified by the addi-tion of a plus (+) or minus (-) sign to show therelative standing within the major rating cate-gories. An ‘R’ rating means regulatory actionhas been taken.

A short-term credit rating is an assessmentof an issuer’s credit quality with respect to aninstrument considered short-term in the rele-vant market. In the U.S., for example, thatmeans obligations with an original maturityof no more than 365 days. Short-term ratingsrange from ‘A-1’ for the highest-quality obli-gations to ‘D’ for the lowest. The ‘A-1’ ratingmay also be modified by a plus sign to distin-

guish the strongest credits in that category.All our studies have found a clear correla-

tion between credit quality and the probabili-ty of default: the higher the rating, the lowerthe probability of default, and vice versa. Asthe charts demonstrate, no matter what thetime horizon, higher ratings generally corre-spond to lower default ratios.


AAA A BB B CCC/C0

10

20

30

40

50

60

70

(%)

Average Cumulative 23-Year Rates

Data Source: Standard & Poor's Risk Solutions.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

Years

0

10

20

30

40

50

60

70

(%)

Average Cumulative Default Rates (1981 - 2003 )

Data Source: Standard & Poor's Risk Solutions.

AAA A BB B CCC/C

The Rating Process

Standard & Poor’s utilizes two approacheswhen rating the financial strength of insurers:interactive ratings and ‘pi’ ratings. The differ-ence between the two reflects the amount andtype of information our analysts are expectedto receive. These two types of ratingsapproaches employ the same rating scale; how-ever, ‘pi’ ratings differ from interactive finan-cial strength ratings based on the ratingsmethodology utilized.

Interactive ratings—with the full cooperation of the insurer.Interactive financial strength ratings are pub-lished only after an insurer has voluntarily sub-mitted to a thorough review, including anextensive interview with senior management.This provides our analytic staff with a clearerunderstanding of how an insurer’s business andits operating and financial strategies affect itsfinancial strength. Standard & Poor’s reviewsthe ratings for accuracy and timeliness on anongoing basis. These ratings and reports aredistributed worldwide.

‘pi’ ratings—based primarily on public information. The ‘pi’ subscript indicates that the insurer hasnot voluntarily subjected itself to Standard &Poor’s most rigorous rating review. Therefore,our analysis for the rating is based on an insur-er’s published financial information and otherdata found in the public domain. The ‘pi’ ratingis not based on in-depth meetings with an insur-er’s management. As a result, the rating is basedon less-comprehensive information thanStandard & Poor’s ratings without the ‘pi’ sub-script. Because the ‘pi’ rating does not involvediscussions or meetings with an insurer’s man-agement, it is possible that a comprehensivereview might indicate a level of financialstrength that is higher or lower than onederived only from public information.

This type of rating is reviewed annuallybased on a new year’s financial statements, butit may also be reviewed on an interim basis if amajor event occurs that may affect the compa-ny’s financial standing.

I N T R O D U C T I O N

1 0 www.pccriteria.standardandpoors.com

Applying the Rating Process

Initiating the Process

Insurers interested in obtaining an interactiverating initiate the process by sending a writtenrequest for a rating to us. We will then send theinsurer an agreement letter outlining the termsof the rating process, fees, and other relevantinformation. The insurer will be asked to signthis agreement letter and return it to us alongwith the name of a primary contact within thecompany. Typically, this contact will be thechief financial officer, treasurer, controller, orsomeone working closely with these individuals.The contact’s responsibilities are:

� To process the analyst’s requests for informa-tion and ensure a prompt and coordinatedresponse to the analyst.

� To coordinate all management meetings andother communication between Standard &Poor’s analysts and the company.

� To maintain open lines of communicationand ongoing dialog with Standard & Poor’sand to apprise us of any significant companydevelopments in a timely manner.When we have processed the signed agree-

ment letter, a primary analyst will be assigned.The analyst will contact the company to estab-lish a date for a management meeting, discussan appropriate format or structure for themeetings, and request information to preparefor the meeting.

A management meeting typically takes a fullday, and we will work with the company con-tact to organize a structure with which theinsurer will be comfortable. At least two insur-ance analysts attend these meetings; analystsfrom Standard & Poor’s other departments mayalso participate if their expertise in a particularsector (i.e., financial institutions, sovereigns,real estate, structured finance, or corporate) willprovide critical insight into certain aspects of aninsurer’s profile.

Standard & Poor’s likes to meet with theindividuals responsible for the major operations

of the company-the chief investment officer,chief actuary, controller/chief financial officer,line of business managers, etc.—as well as staffwho may be responsible for other significantnoninsurance activities. We also like to meetwith the chief executive to get a top-level per-spective on strategies and performance philoso-phy toward managing the company and theoutlook for the future.

To facilitate the rating process and preparefor these discussions, our analysts will requestthat certain information be sent before themanagement meeting. The amount of materialprepared in advance is at the company’s dis-cretion, but access to this information beforethe meeting allows analysts to develop famil-iarity with the company and enables a moreefficient use of management’s time in the meet-ing. The items below list the basic material ouranalysts will expect; additional informationmay also be requested.

� An agenda for the meeting outlining the for-mat, who will be participating in the discus-sions, and their areas of responsibility. Briefmanagement biographies are also useful.

� Copies of reports and accounts for the pastfive years and current and interim-yearresults.

� An organization chart by legal entity and byreporting/structural lines.

� Market share information for the company’smain products/lines.

� A description of major products and distri-bution channels.

� Premiums and operating results for majorproducts or business lines for the past five years.

� Financial projections (income statement, bal-ance sheet) for the next three to five yearsand, where relevant, an analysis of majorlines of business or business segments.Information on the company’s longer-termstrategic plans is also useful.


Applying the Rating Process

� Details on the investment portfolio to provide information on investment guide-lines, asset quality, maturity, diversificationby sector, concentrations, market versusbook values, indications/benchmarks ofinvestment performance, and information onasset/liability management processes.

� Information about the structure of the com-pany’s reinsurance programs.Wherever possible, analysts try to use a com-

pany’s existing reports and internal documents,rather than request creation of special reportsor documents. This enhances our understandingof the quality and timeliness of information thatmanagement relies on in running the business.

Once the management meeting has beenheld, the primary analyst constructs a detailedanalysis of the insurer, drawing on both publicand nonpublic information. The analysis is pre-sented to a rating committee of experiencedinsurance (and noninsurance, as required) ana-lysts who, after thorough discussion, assign arating. The time between the managementmeeting and a rating committee meeting is gen-erally about three weeks. This could change,however, if the analyst requests additionalinformation—based on the management meet-ing discussions or as a result of workingthrough the analytic process—and how quicklythe material can be obtained.

The rating decision will be communicated bythe analyst to the insurer. The analyst will notmerely convey the rating itself but will explainin detail how Standard & Poor’s reached itsopinion: the key rating factors-both positiveand negative-driving the rating and, perhapsmost crucially, our expectations for the insurerand how these expectations are factored intothe rating. If the insurer feels information influ-encing the rating was incomplete or misinter-preted by the committee, an appeal meeting atStandard & Poor’s offices may be arranged.The appeal process is designed to address spe-cific points relating to the rating decision, andhence, the appeal meeting should be tightlyfocused. The analyst will incorporate new infor-mation into the analysis, which then is recon-sidered by a rating committee. The committee

Standard & Poor’s � Insurance Ratings Criteria Property/Casualty Edition 1 3

Information Request ListYear-end1. Past five years of annual statements filed with

state insurance department or regulatory body.a) Include most recent triennial exam report

from regulators.b) Include Insurance Expense Exhibit.

2. Past five years of year-end balance sheets-GAAP basis (if available).a) Include copy of auditor’s report to board of

directors.3. Past five years of year-end income statements-

GAAP basis (if available).4. Management discussion and analysis (normally

accompanies statutory filings).5. Past five years of cash flow statements.6. Any independent reserve studies from the past

two years.7. Past five years of consolidating balance sheets-

year-end and consolidated statements.8. Past five years of consolidating income state-

ments-year-end and consolidated statements.9. Projections-summary balance sheet and income

statement for next three years.10. Property/casualty insurance survey.11. Income statements and balance sheets for past

five years of subsidiaries whose investment constitutes 10% or more of capital and surplus.

12. Investment guidelines and policy document.13. List of top 20 equity exposures, by issuer.14. List of top 20 customer relationships.15. List of reinsurers, ordered by dollar value of

reserve credit taken, along with descriptions oftype of coverage.

16. Past five annual reports or reports to policyholders.

17. Legal organization chart.18. Management organization chart.19. Any peer comparisons.

Quarterly1. Financial report.2. Financial forecast.3. Statement filed with state insurance department

or regulatory body (if filed).4. Balance sheets-GAAP basis (if available).5. Income statements-GAAP basis (if available).6. Cash flow statements.

may decide the new information warrants a rat-ing change or it may stand by its original ratingdecision. The rating decision on appeal is final.

Once the rating has been assigned, if aninsurer declines the rating, it may withdraw itsrequest. Standard & Poor’s will keep all infor-mation about the insurer’s involvement in therating process strictly confidential. If the rating

is accepted, the insurer should acknowledge thisin writing to us, at which time the rating will bepublished, first (almost immediately) in a shortpress release, and then generally within three tofour weeks as a more detailed report as part ofour subscription service. The text is shown tothe insurer before publication whenever possi-ble to ensure that it is factually correct and no

A P P LY I N G T H E R AT I N G P R O C E S S


1. Management and corporate strategy:a) Introduce meeting members and current senior

management team.b) Discuss legal organization and management

organization charts.c) Discuss corporate strategy and structure:

historical, present, and prospective.d) Discuss market advantages derived from

corporate structure, corporate culture and operating philosophies.

e) Review the criteria for new acquisitions.

2. Business review/operating performance/underwriting:a) Describe lines of business and competitive

advantages/disadvantages versus peer groupcompanies.

b) Review current market conditions and expecta-tions as they relate to both new premium and profit opportunities in your markets.

c) Briefly review most recent year-end and interimstatutory and generally accepted accounting prin-ciples (GAAP) financial results, including perform-ance of the company’s underwriting and invest-ments operations.

d) Comment on growth plans and prospective under-writing/investment focus; provide and discuss projections for the next three to five years in as much detail as possible, including capital projections, premium growth, and profits by business unit.

3. Investments:a) Comment on portfolio strategy and asset-

allocation strategy.

b) Discuss quality, liquidity, and investment yields bytype of security and overall.

c) Review investment performance.

4. Capitalization: a) Discuss short- and long-term capital needs in

relation to corporate strategy, as well as bench-marks for operating and financial leverage.

b) Review structure and terms of any proposed debt transaction.

c) Discuss debt tolerance.d) How is capital allocated between various

subsidiaries?e) What is the policy regarding shareholder dividends

and dividends from subsidiaries?

5. Liquidity:a) Comment on liquidity of investments compared

with liability structure, as well as expected cashflows from underwriting, investing, and financing.

6. Reinsurance:a) Synopsis of current reinsurance program and the

rationale behind it.b) Comment on rate changes, placement percent-

ages, and the use of any financial reinsurance.c) Discuss security requirements for selecting

reinsurers.

7. Reserves:a) Discuss methodology/procedures regarding

establishment of reserves.b) Discuss role of external consultants in reserve

setting and rate making.

Proposed Meeting Agenda

confidential information has been disclosed.Acceptance of the rating means the companywill be under ongoing surveillance by Standard& Poor’s, during which we will review interimand annual results, regulatory filings, pressreleases, and other company developments andmay reevaluate the rating at any time if suchaction is warranted. In addition, rated compa-nies are subject to formal review, normally onan annual basis. If a rating revision is necessary,we will discuss our concerns with managementprior to taking any rating action.

Rating Revisions

As a result of the surveillance process, it some-times becomes apparent that changing condi-

tions require reconsideration of the financialstrength rating or debt rating. When thisoccurs, the analyst undertakes a preliminaryreview that may lead to a CreditWatch listing.This is followed by a comprehensive analysis,communication with management, and a pres-entation to the rating committee. The ratingcommittee evaluates the matter, arrives at a rat-ing decision, and notifies the company, afterwhich Standard & Poor’s publishes the new rat-ing. The process is exactly the same as rating anew debt issue. Reflecting this surveillance, thetiming of rating actions does not depend on thesale of new debt issues or on Standard & Poor’sinternal schedule for reviews.


Interactive RatingMethodology


Standard & Poor’s Ratings Services ratingmethodology measures the financial risks ofentities undertaking a wide range of businessactivities. For property/casualty insurance com-panies, these analytical techniques evaluate thefinancial risks associated not only with histori-cal business activities but with new business ini-tiatives as well. A key factor in the effectivenessof Standard & Poor’s methodology is its atten-tion to qualitative factors and risks facing aninsurer. Through discussions with management,Standard & Poor’s can better understand howan organization’s business, operating, andfinancial strategies affect its financial strength.Standard & Poor’s uses projections in assigningits ratings after extensive discussions with man-agement to understand the underlying factors.

Standard & Poor’s can gain insight intofuture financial performance by looking at cur-rent and historical performance. However, theevaluation of a management’s strategies, opera-tions, efficiencies, and risk tolerance—as well asthe insurer’s competitive advantages in the mar-ketplace—will most influence Standard &Poor’s opinion of future financial performance.

Ultimately, the rating decision is a synthesisof important issues that are unique to eachcompany and will drive future financial per-formance. Even highly rated companies mightnot score well in some categories of analysis. Arating is not so much a scorecard that showshow well a company did in each analytical cate-gory as it is a judgment made about the mostimportant rating factors that will affect a com-pany. The decision about an insurer’s futurefinancial strength is based on Standard &Poor’s evaluation of the key issues.

Standard & Poor’s rating methodology pro-file is used for all insurance rating analyses andis uniform across all types of insurance compa-nies. The profile covers competitive position,management and corporate strategy, opera-tional analysis, investments, capitalization, liq-uidity, and financial flexibility.

In applying its rating methodology for theproperty/casualty and reinsurance sectors,Standard & Poor’s evaluates the types of insur-ance written (line of business or sector) by acompany and its geographic profile. Standard& Poor’s also considers how national and localfactors could affect the insurer’s operations. Inaddition, for insurance companies that are partof a larger, more diversified group, Standard &Poor’s looks at non-insurance-related activitiesto assess how favorable or unfavorable theseindustry conditions might be and the potentialeffect on the group’s overall operations.

Key points Standard & Poor’s considers in itsanalysis of insurance company industry risk are:

� The potential threat of new entrants into the market.

� The threat of substitute products or services.� The sector’s competitiveness and volatility.� The potential tail of liabilities (i.e., ease or

difficulty in exiting a market) or risk of largelosses. In some cases, it might not be possi-ble to exit certain lines of business becauseof state regulations that require approval orimpose penalties for doing so.

� The bargaining power of insurance buyersand suppliers.

� The strength of regulatory, legal, andaccounting frameworks in which the insureroperates.Broadly speaking, the lower the industry

risk, the higher the potential rating on compa-nies in that sector or line of business. Althougha high industry risk profile does not automati-cally limit a rating, it is more difficult for com-panies with this profile to demonstrate the earn-ings strength and stability that characterizehighly rated companies.

As a sector of the overall global economy,property/casualty insurance is intrinsically morevolatile than most other industries. For preciselythis reason, the ratings process at Standard &Poor’s begins with a determination of the inher-

Interactive Rating Methodology

ent risk in the type of insurance or reinsurancebusiness being underwritten. Each significantinsurance industry sector is subjected to ananalysis of competitive factors that influence thecurrent and potential supply and demand forcoverage. Standard & Poor’s evaluates thethreat of substitute products—such as finite riskand alternative risk products in the reinsurancesector—as the line between insurance and finan-cial products has become increasingly blurred.

Perhaps a more quantifiable indicator of riskis the length of a company’s insurance portfoliotail for claims reporting and settlement. Themagnitude of the time lag between writing ofpremium and payment of final claims is at theheart of industry risk. Relatively long-tail busi-ness is more risky because of, among other rea-sons, the effects of inflation on casualty lossreserves and the additional opportunity for pos-sible adverse loss reserve development. Shorter-tail business provides ultimate results sooner butoften at the expense of greater loss potential.

Industry risk is also a creature of its politicalenvironment. The landscape of both overall andcompany-specific risk could easily be altered byadoption or potential adoption of regulatory orlegislative changes. Such changes can either beproblems or opportunities depending on theflexibility of insurers to adapt quickly to thenew rules of the game.

Evaluting Insurers’ Competitive Positions

In assessing future financial strength, it is criti-cal to identify an insurer’s fundamental charac-teristics and its source of competitive advantageor disadvantage. Competitive position canprove to be one of the decisive factors underly-ing a final rating decision, as the analyst definesthe key characteristics of organizational struc-ture and activity that constitute competitivestrengths and weaknesses. These strengths andweaknesses are intricately tied to the insurer’sstrategy and operational effectiveness and willstrongly influence its financial profile. It isthrough Standard & Poor’s Ratings Servicesreview of a company’s competitive position in

each major line and region of activity that itdetermines whether there is solid potential forsatisfactory performance. At the same time,such a review will also likely highlight whetherany significant diversification into new activitiesor new regions has added to or diminished thelevel of risk within the company relative to like-ly returns.

Evaluating a company’s competitive posi-tion involves substantial subjective interpreta-tion of the basic facts and data associated withlines of business, premium volumes, marketshares, and technical performance. Large sizesuggests economies of scale but does not guar-antee conspicuous success. Small scale suggestsa lack of diversification but could be offset bycompelling competitive strengths that renderniche status both profitable and defensible intothe foreseeable future. In other words, aninsurer’s strengths and weaknesses in the mar-ketplace are often vital to the company’sfuture performance. The relative strength ofthe competitive review can frequently offsetother positive or negative factors used inStandard & Poor’s analysis.

Standard & Poor’s assesses the success of acompany’s portfolio of business units and prod-uct lines, distribution systems, degree of busi-ness diversification, and appropriateness ofniche strategies. Standard & Poor’s analysisincludes aspects of the business that affect theabsolute level, growth rate, and quality of therevenue base. Ultimately, to demonstrate com-petitive advantage, an insurer must show supe-rior operating performance to the industry,strong growth characteristics, or both. Standard& Poor’s ratings also incorporate an evaluationof the financial strength and business strategiesof important subsidiaries and affiliates.

Standard & Poor’s is often asked, “Howdoes a company’s rate of revenue growth affectthe rating?” Clearly, a strategy of growth forgrowth’s sake can be a road to ruin and is inap-propriate in soft markets, where excess growthcan be obtained only by underpricing business.Nor is size alone equated with credit strength.Over an intermediate to long-term horizon,Standard & Poor’s would expect strong compa-


nies to have good growth prospects. This viewis always balanced against a belief that there aretimes when no growth or slow growth is betterto preserve earnings and capital. In making theevaluation, a clear link exists between thestrength of an insurer’s competitive position andits corporate strategy. On the other hand, aninsurer’s competitive position must be evaluatedin the context of the financial performanceexpected of the company. Standard & Poor’sexpects strong companies to maintain soundlevels of capital and earnings. Companies withsustainable competitive advantages in nichemarkets can receive high ratings if they candemonstrate a record of strong earnings per-formance that is expected to continue.

To illustrate the degree to which a companyenjoys strong, defensible franchises or to whichit is prudently diversified across a variety ofprofitable or potentially profitable sectors,

Standard & Poor’s undertakes an appropriatelydetailed analysis of the company’s businessunits. Standard & Poor’s examines the compa-ny’s ownership structure, market stature, andproduct distribution, even of specific productlines if they are felt to be particularly signifi-cant. In taking a prospective view, Standard &Poor’s also analyzes features and trends in thegeneral market environment, particularly wherethese constitute a possible opportunity or threatto the rated entity.

Market Position and Competitive AdvantageWhen assessing market position, analysts will,in effect, look at what an insurer is actuallydoing and then define each activity anddescribe the company’s business position ineach major line relative to peers. An assess-ment of the overall, consolidated position willthen be made. However, to reinforce theprospective nature of the analysis, the subject

I N T E R A C T I V E R AT I N G M E T H O D O L O G Y


Insurance Company Scoring Guidelines: Competitive Position

Attribute Most Favorable Favorable Least Favorable

I. Distribution Has loyal distribution sys-tem providing high-quality business. Company hasclear control over product distribution.

Uses multidistribution sys-tems and/or has strong con-trol over a distribution sys-tem that has good access toa variety of markets.

Distribution system is highlycost-efficient.

Maintains average controlover distribution, whichprovides good-quality

business. Persistency isaverage, and the companyis usually the preferredprovider of products to thisdistribution system.

Distribution system hasgood access to a couple of markets.

Distribution system does not place company at acompetitive disadvantagedue to high cost structure,nor does it give the insurera competitive advantage.

Distribution system has lowlevel of loyalty to company,often sells competitors’products, and producespoor-quality business lead-ing to poor persistency.

No apparent distributionstrengths in any market.

High cost of distributionplaces company at a competitive disadvantage.

of competitive advantage must also beaddressed. The presence of distinct competitiveadvantages across major lines of business andprincipal markets will likely suggest that cur-rent market franchises will improve or, at thevery least, remain relatively stable in the faceof competition. Meanwhile, the analysis ofoperating performance under a separate sec-tion of the analysis will also help substantiatewhether management is successfully translatingany perceived business strengths into incre-mental earnings. However, for a variety of rea-sons from mutuality to catastrophe and fromperiodic price wars to fluctuating investmentmarkets, Standard & Poor’s recognizes thatthe degree of correlation between competitiveposition and operating performance could varysomewhat over time.

But what is competitive advantage? In prac-tice, it is anything that will help differentiate aninsurance provider in its marketplace in a posi-tive sense and thereby allow it to compete moreeffectively against peers and improve its abilityto write more business or to earn higher mar-gins, or both. In this sense, competitive advan-tage could include a brand name that inspiresgreater customer confidence and loyalty, a costbase that allows competitive pricing at sustain-able and satisfactory margins, or a means ofdistribution that accesses a preferred type ofclient in a cost-effective manner. Similarly, theadvantage could be in product design, with anindividual contract efficiently meeting a marketneed through coverage or flexibility or, alterna-tively, a range of complementary products thattogether attract and retain a class of policyhold-

Standard & Poor’s � Property/Casualty Insurance Ratings Criteria 2 1



II. Market Advantages/Market Share

High market share in significant markets.

Maintains cost advantagesor sustainable productadvantages over competi-tion. Alternatively, maintainsextremely strong competitiveadvantages in niche markets.

Operates in markets thatafford strong financial performance.

Low threat of potential competitors disrupting the insurer’s financial performance.

Favorable regulatory environment.

High market share in smallermarkets or “middle of theroad” competitor in largermarkets.

Competitive product structure.

Operates in competitivemarkets, but still producesgood financial performance.

.Moderate threat of potential competitorsdisrupting the insurer’sfinancial performance.

Moderately favorable to neutral regulatory environment.

Low market share.

No sustainable competitiveadvantages.

Operates in highly competitive or irrationalmarkets.

High threat of potentialcompetitors disrupting theinsurer’s financial perform-ance.

Unfavorable regulatory environment.

er that might not otherwise have been drawn tothe company. Quality of service could also be acompetitive advantage, but it is one that isclaimed by nearly all the insurers that Standard& Poor’s speaks to and could consequently bemore a prerequisite for market success than afacilitator of it. Whatever the case, the analystwill try to identify competitive strengths thatmight exist or be lacking and opine what theeffects of such strengths and weaknesses arelikely to be on the local and overall marketposition of the company or group under review.

Diversification Through Product andGeographic Spread of RiskDiversification is the very essence of insurance,with a pooling of risks so that the lossesincurred by a minority can be settled using thepremiums paid by the majority. At a very fun-damental level, a sufficient degree of size anddiversification at an insurer is essential so as tocover fixed costs, avoid adverse selection, andincreasingly enjoy the benefits of the actuariallaw of large numbers whereby the frequencyand severity of seemingly random eventsbecomes accurately quantifiable. However,beyond this minimum level, there comes a pointin the evolution of any reasonably successfulcompany when it has a realistic choice betweenaiming to maintain a stable, status quo business

strategy or taking the more radical option ofconscious diversification by developing oracquiring new activities or by expanding orbuying into new regions. Neither strategy iswithout risk.

When consciously forgoing diversificationwhile seeking to maintain financial strength,management at a focused, niche insurer must besupremely confident that its company can sus-tain its viability in traditional activities andregions into the long term. Similarly, beforeintroducing new products, new lines of busi-ness, or new, remote operations to justify addi-tional flags on the map, companies must con-sider whether they have the skills, the means,and the infrastructure to achieve a similar levelof ultimate success in the new activity that theycurrently enjoy in their existing principal opera-tions. If the new undertaking risks seriouslyunderperform relative to the traditionally corerange of activities, then arguably management isgambling with its company’s financial strengthby assuming higher levels of exposure in linesor areas where the increased risk is unlikely tobe compensated by sufficiently increased earn-ings. Therefore, in this context, far from beingseen as either positive or even neutral, furtherdiversification and growth risk become signifi-cant and negative risk factors.





III. Product Diversification

Offers multiple productsover a broad range of business lines.

Most product lines maintaincompetitive advantages intheir markets and offerlong-term profitability.

Offers a small range ofproducts over one or twobusiness lines.

Only a couple of productlines offer good prospectsof long-term viability.

One product line accountsfor more than 50% of long-term company profitability.

Narrow product focus overone or two business lines.

The long-term viability ofmost products and lines ofbusiness is in question.

One product line accountsfor more than 80% of long-term company profitability.

Experience suggests that diversification intonew activities is always a challenge, and even ifthe initiative is ultimately successful, it could atthe very least consume disproportionate levelsof management time and energy until opera-tional equilibrium and a reasonably stable trackrecord have been established. Standard &Poor’s has learned to react with instinctive pru-dence in its analysis of start-up and newlyacquired operations, particularly if these newventures appear to be a departure from man-agement’s proven sector or regional strengths.However, to the degree that the passage of timeproves diversification to have been successfuland sustainable, then it will likely be regardedas a distinct strength relative to an otherwisesimilar but nondiversified peer.

Meanwhile, specific to the product spread ofrisk, the rating analyst will study the lead prod-uct offerings in a company’s main markets andask questions such as:

� Does the company manufacture or outsourceits products?

� Is it low or high value added?� Is it high or low risk?� Is the company largely dependent on one or

a few products, or does it have a wholerange of diversified product offerings?Although there are no invariably right or

wrong answers to such questions, it is clear thatboth the analyst and the rating committee willtend to feel greater comfort when a company isfound to be selling value-added rather thancommodity products, as long as the added valueis also apparent in the pricing. Similarly, prod-ucts providing stable, long-term revenues orasset accumulation are likely to be preferredover those that are short-term and volatile, thatconsume capital, or that place a potential strainon liquidity. Naturally, the greatest level ofcomfort will be achieved when it is found that acompany is exploiting its competitive strengthsto sell capital-self-sufficient products at margins that are supportive of sustainable,long-term earnings.

DistributionIncreasingly, distribution might itself be the keycompetitive factor in many markets. A goodname, a good product, and a good quoted pre-mium all help, of course. However, the conclu-sion of an actual sale might ultimately rely on


Insurance Company Scoring Guidelines:Competitive Position


IV. Geographic Diversification

Maintains national pres-ence over a broad range of product lines (i.e., competesin 40 to 50 states).

Has developed some signifi-cant international presence.

Top five states representless than 35% of premiums.

Top 10 states represent lessthan 60% of premiums.

No unusual concentrations.

Maintains strong regionalpresence (competes in 20 to 40 states).

Little or no internationalpresence.

Top five states representless than 50% of premiums.

Top 10 states represent lessthan 85% of premiums.

Only minor concentrations.

Local presence only (competes in less than 20 states).

Little or no internationalpresence.

Top five states representmore than 50% of premiums.

Top 10 states representmore than 85% of premiums.

Clear concentration risks exist.



ease of access by the would-be policyholder. Onthis basis, a cost-effective network of profes-sionally trained, tied agents remunerated on thebasis of technical results rather than simple pre-mium volume could well prove a considerablecompetitive advantage where distributionthrough tied agents remains the norm.Meanwhile, in independent broker-driven markets, an insurer’s ability to interact with andfacilitate the task of brokers and independentfinancial advisers could be even more importantthan an ability to communicate easily with thepolicyholder. Similarly, insurers might see a sig-nificant reduction in their operating costs ifthey trained their customers to interact with thecompany by telephone or electronic mail ratherthan through branches and face-to-face contact.

Again, the rating analyst will pose a numberof questions:

� How is the company managing its distribu-tion today as opposed to in the past?

� What changes in distribution could occur inthe future?

� Is distribution high or low cost relative tocompetitors?Finally, and most importantly:

� Is the means of distribution effective?Ultimately, distribution costs are one of the

few variables over which management can exercise some real control. In practice, though,in the field of distribution as elsewhere, there isno panacea. Consequently, most larger insurersappear to be going down the route of multi-dis-tribution, allowing policyholders to choose theirown channel of approach, whether electronic,across the bank counter, or face-to-face with anagent. Whatever the case, the important factoris effectiveness in bringing appropriate productsto the attention of the customer in a cost-effi-cient manner and then converting that momentof attention into a physical sale at an economicpremium level.

Legal OrganizationThe discussion of an insurer’s legal organizationwill succinctly address factual considerations ofwho owns the company under review, what isthe legal structure of the organization, and whoare the significant sister companies and sub-

sidiaries within the group. More significantly,analysts will seek to ascertain whether the legalstructure is effective for meeting the company’sobjectives and, of equal importance, whetherthere are any other associated operations out-side the current analysis that could consumecapital. If so, do these operations risk having anindirect but negative impact on the financialstrength of the company or companies specifi-cally under review?

The following are examples of the type ofinformation used in evaluating a firm’s competi-tive position:

� The degree of competitive advantage enjoyedby the organization because of distributioncapabilities, product structure, investmentcapabilities, quality of service, cost structure,and market-segment dominance. It is vital toa company’s long-term success to differenti-ate itself from its competitors. Companieswithout a sustainable competitive advantageare viewed less favorably.

� Diversification of revenue by business unit,geographic location, product, and distribu-tion channel. The most favorable scenario isto have a national presence and offer multi-ple products over a broad range of businesslines, with each product line maintainingcompetitive advantages in its market, thusoffering long-term profitability. In addition,a significant international presence is oftenviewed favorably.

� Market share of the total firm and bymajor product lines. Certainly, a high mar-ket share in significant markets is mostdesirable. However, high market share thatis sustainable over the long term in productor geographic niches is also consistent withstrong ratings. Equally important is how acompany obtains and maintains its marketshare. Clearly, the more favorable and sus-tainable situation is when market share hasbeen obtained through a company’s com-petitive advantage rather than simplythrough price-cutting.

� Efficiency of distribution system. The typesof distribution channels a company uses areexamined to determine their cost effective-

ness. It is important to use the most appro-priate distribution channel for each productline to maximize sales efficiency. For exam-ple, a direct marketing effort will likelyentail less cost than maintaining an exclu-sive agency force, but given the strong prof-itability and persistency of products soldthrough such agents, the additional cost ofan exclusive agency is likely justified.Failure to fully harness and utilize a chosendistribution channel or channels can be anegative rating factor.

� The markets chosen. If an insurer caters to aparticular niche market, the growth trend ofthat market and the underlying factors driv-ing the growth are examined to determinetheir likely future course. Although main-taining or expanding market share in grow-ing markets is viewed favorably, participa-tion in markets that afford strong financialperformance is also a key consideration.

� Growth of revenue during the past five yearsand projected growth for the next severalyears. An insurer’s growth is evaluated in thecontext of the market or markets in which itoperates. Although long-term growth wouldappear to be consistent with high ratings,growth must be balanced against marketfundamentals when constraining it leads tosound profitability.

Analytic Guidelines for Evaluating theCompetitive ReviewIn evaluating an insurer’s competitive position,Standard & Poor’s has established guidelinesfor the analyst. The guidelines should not beconstrued as a benchmark, given that any com-pany that scores well in some categories mightbe maintaining its competitive position by con-straining itself in other categories because ofmarket conditions. Hence, Standard & Poor’s isnot constructing a grid that dictates the busi-ness profile of highly rated companies byrequiring them to fit a range of specific charac-teristics. Instead, Standard & Poor’s expectscompanies with a strong competitive position tohave some characteristics that give them a sus-tainable competitive advantage and maintain astrong financial profile.

Management and Corporate Strategy

Although management has little control overindustry risk, altering the company’s competi-tive position to its advantage and managingits resources and finances in a prudent andultimately profitable way are internal factorsover which management can exert significantinfluence. Therefore, no company analysiswould be complete without an assessment of acompany’s formulation and implementation ofthe strategy dictated by its management.

Standard & Poor’s Ratings Services consid-ers management and corporate strategy a keyelement of the criteria that form the foundationof the financial strength rating process. Anorganization’s strategy, operational effective-ness, and financial risk tolerance will shape itscompetitiveness in the marketplace and thestrength of its financial profile.

It can be argued that the analysis of man-agement and corporate strategy is the mostsubjective area of any rating methodology.Therefore, Standard & Poor’s has developed aprocess that is applicable to all rated insuranceand reinsurance companies. Although the ele-ment of subjectivity cannot be avoided entirelybecause of the qualitative nature of this vari-able, it is precisely the analysts’ opinion of thehuman element that gives further valuableinsights not provided by quantitative measuresalone. This insight also distinguishes theprocess from a mere quantitative assessmentthat does not include meeting with the compa-ny’s senior team members to ask them ques-tions that can be extremely revealing and canadd substantial depth to Standard & Poor’sanalysis and conclusions.

This area of inquiry consists of a review of:� Strategic positioning.� Operational effectiveness.� Financial risk tolerance.� Organization structure and management

breadth and experience and how they fit thecompany’s strategy.When assessing the company’s strategic

positioning, it is important to establish what


management’s goals are and how its strategywas developed. The analyst must discernwhether the goals and objectives are marketshare-oriented, financial, or traditional andwhether they are internally consistent. The ana-lyst then projects what their implications arefor the company’s future.

To develop a formal and well-articulatedstrategy, a planning process needs to be inplace. Therefore, questions such as how strate-gic milestones are developed and updated, andhow compensation systems are designed to sup-port them are relevant. Standard & Poor’s taskis to evaluate whether the strategy managementhas chosen is consistent with the organization’scapabilities and whether it makes sense in itsmarketplace. Standard & Poor’s also wants to

know management’s record of converting plansinto action and if effective systems are in placeto communicate plans to lower managementand assess performance versus plans.

Operational effectiveness essentially involvesassessing a company’s ability to execute thechosen strategy. Standard & Poor’s evaluatesmanagement’s expertise in operating each lineof business as well as assessing the adequacy ofaudit and control systems. How has it they per-formed compared with expectations? What typeof internal audit controls does it use? Is the corporation centralized or decentralized, anddoes this structure improve efficiencies? Doesthe company’s organization fit with the strategy chosen?



Insurance Company Scoring Guidelines: Management & Corporate Strategy


I. StrategicHas a formal process forstrategic analysis.

Entire management teamthinks strategically and hasa record of convertingplans into action.

Strategy chosen is consis-tent with the organization’scapabilities and makessense in its marketplace.

Has an effective system inplace to communicate itsplans to lower levels ofmanagement.

Board is independent, highlyqualified, and willing to exer-cise proactive judgment.

Strategic planning processis informal or lacks depth.

Only some managers arecapable of thinking strate-gically. Company is oftenunable to convert strategicdecisions into positiveaction.

Strategy includes somecontradictions with theorganization’s capabilities.Achievement of someobjectives appears unlikely.

Communication of strategicdecisions to lower levels ofmanagement is incomplete.

Board is independent.

No strategic planningprocess exists, or plans are superficial.

Most managers are notcapable of thinking strate-gically. Company is oftenunable to convert strategicdecisions into positiveaction.

Strategic thinking includesmany contradictions withthe organization’s capabili-ties, and many goalsappear unattainable.

Little, if any, communicationof strategic planning tolower levels of manage-ment exists.

Board is heavily populatedwith insiders.

Evaluating financial risk tolerance allowsStandard & Poor’s to understand management’sviews on financial goals, capital structure,financial and accounting conservatism, boardoversight, and risk acceptance. What are man-agement’s specific financial goals? What are theamount and types of capital in the capital struc-ture and the level of leverage employed? Whatare the quality and allocation of invested assetsand measures of capital adequacy, such as risk-based capital? What are the reserving practicesand use of reinsurance? How strong is the risk-management function? Does the company havepredetermined limits for acceptable levels of

risk? Are these guidelines detailed or general?Do they apply to many areas of the operationor just a few? Does the company generallyoperate aggressively or conservatively? Is theboard of directors involved in the managementof the company, or is it just a rubber stamp? Isthe company run for management, the owners,the policyholders, or the agents? Responses tothese questions reveal management’s conserva-tive or aggressive posture in managing the balance sheet and form the basis of Standard &Poor’s opinion.

Organizational structure and managementbreadth and experience must support the strat-




II. Operational Management has consider-able expertise in operatinglines of business companyis engaged in and hasdemonstrated an ability toexercise strong control overits operations.

Audit and control systemsare extensive.

Company has performedwell against plan.

Management has gooddepth and breadth.

Management has demon-strated a stable history offinancial performance with-out interference of unusualitems (i.e., few surprises).

Organizational structure fits strategy.

Management lacks expertise in operating somelines of business, but maintains good control overits business.

Audit and control systemsare average.

Company usually performswell against plan.

Some holes exist in man-agement depth or breadth.

Unusual items disrupt thebalance sheet or incomestatement occasionally.

Organizational structuredoes not fully foster strategy.

Management lacks ability to understand and controlits business.

Audit and control systemsare weak and/or areignored.

Company often misses plan.

Many holes exist in man-agement depth or breadth.

Unusual items commonlydisrupt the balance sheet or income statement.

Organizational structureimpedes implementation of strategy.

egy to produce the desired results. Who arethe senior managers? What are their functionalbackgrounds? How long has the team beentogether? Standard & Poor’s typically asks aninsurer to provide it with a managerial organi-zation chart. Who reports to whom? Is thecompany organized:

� Functionally (marketing, underwriting,claims, actuarial, etc.)?

� By product (personal lines, commercial mul-tiple peril, workers’ compensation, commer-cial auto, etc.)?

� By market (individual, small business,national accounts, etc.)?

� Geographically (the South, California, etc.)?� By distribution channel (agents, brokers,

direct marketing, etc.)?This process allows Standard & Poor’s to

develop an organized review of each company’smanagement and corporate strategy, which, inturn, provides the needed perspective asStandard & Poor’s evaluates a company’s busi-ness review and the more objective areas ofoperating performance and capitalization.

Analytic Guidelines for Evaluating Management and Corporate StrategyIn evaluating an insurer’s management and cor-porate strategy, Standard & Poor’s has a list ofguidelines for the analyst (see table beginningon page 26).

Accounting and Financial Reporting

The purpose of this section of Standard &Poor’s Ratings Services analysis of insurers is tocapture in one place the major accountingissues that affect an issuer’s financials and theirrelated analytical significance. This section isnot intended to be a summary of every account-ing policy. Accounting policies that affect in amaterial way the view of another rating factorwill likely be cross-referenced in the appropriatesection (evaluation of loss reserve adequacy,contingent capital instruments affecting capitaladequacy, instruments or activities affecting theevaluation of financial leverage, etc.).

The Accounting and Financial ReportingSection will not be scored. However, it isexpected that judgments will be made about





III. Financial Has set of financial standards in place.

Has set of above-averagestandards for operationalperformance.

Maintains very conservativeoperating performance.

Has conservative reservingpractices and uses reinsur-ance judiciously.

Has set of financial standards in place.

Standards for operationalperformance are similar to industry levels of performance.

Has no commitment tomaintaining conservativeoperating and/or financialleverage.

Reserving practices areacceptable, and use of rein-surance is not aggressive.

Has no defined set of financial standards.

Lacks standards for operational performance or has low standards.

Disregards any reasonablestandards for operatingand/or financial leverage.

Is aggressive in settingreserves and in its use ofreinsurance.

how conservative or aggressive specific practicesare and how these accounting issues positivelyor negatively affect the various categories ofanalysis that Standard & Poor’s uses to evaluateinsurance companies. It is expected that thissection will appear on a selective and discre-tionary basis in Standard & Poor’s credit analy-sis report where accounting or financial report-ing matters are deemed significant to the rating.

In general, this section will be limited to fourareas that address:

� Analytical adjustments and areas of potentialconcern.

� Significant transaction and notable eventsthat have accounting implications.

� Significant accounting and financial-report-ing policies and the underlying assumptions.

� The level of financial and footnote disclosurerelative to other industry participants andwhat bearing it had on any analytical judg-ments made in the analysis.

Operational Analysis

Standard & Poor’s Ratings Services assessmentof a company’s earnings performance is an inte-gral part of the overall rating analysis. Themeasurement of earnings focuses on a compa-ny’s ability to efficiently translate its strategiesand competitive strengths into growth opportu-nities and sustainable margins on its revenues.Although a property/casualty insurer’s level ofcapital adequacy provides an equity cushion rel-ative to the risks it takes, a company’s prospec-tive earnings performance will determine itsability to grow and attract capital.

Standard & Poor’s has developed an earn-ings adequacy ratio (EAR) to better assess prop-erty/casualty insurers’ operating performance byevaluating their results in the context of therisks associated with each line of business theyare writing. The EAR also accounts for the roleof investment income in different lines of busi-ness, depending on the length of the liabilities’tail. This ratio assists in the evaluation of oper-ating performance relative to the industry andenhances Standard & Poor’s assessment of thefinancial effect of changing mixes in business.Standard & Poor’s analysis of operating per-

formance focuses on both historical andprospective earnings trend analyses. Standard &Poor’s believes companies that produce stableearnings streams, based on the competitiveadvantages they have in the marketplace, arewell-positioned to succeed in the industry.

Although the analysis of earnings easilylends itself to quantitative analysis, Standard& Poor’s views the qualitative aspects of earn-ings as being equally important. The singlemost important determinant of the quality ofearnings is the assessment of a company’sreserve position. As such, an analysis of acompany’s reserve adequacy is a precursor tothe earnings analysis. Other factors—such asvolatility, diversity, and sustainability of earn-ings—are also considered in the evaluation ofoperating performance.

Overall PerformanceStandard & Poor’s bases its analysis of operat-ing performance on ROR, ROA, and ROE.Although many organizations use ROE as aperformance benchmark, Standard & Poor’stends not to emphasize this ratio because it canbe easily influenced by the company’s capitalstructure. For a property/casualty insurancecompany, Standard & Poor’s believes that thekey driver of profitability is the profit marginthe company is able to produce on its operatingrevenues. This margin is best measured usingpretax ROR, which, unlike ROE, is somewhatinsulated from the effects of leverage. RORincludes both underwriting and investmentcomponents and thus captures both sources ofan insurance company’s earnings. It also blendseasily with the traditional combined ratio analy-sis. Standard & Poor’s evaluates earnings beforetax and capital gains to understand the prof-itability of the recurring sources of incomewithout the effects of these two variables.Standard & Poor’s believes that for many com-panies, capital gains are largely opportunisticand are a function of economic and interest rateconditions. However, to the extent that a com-pany can demonstrate a consistent strategy ofreaping capital gains as a part of a total invest-ment and operating strategy, Standard & Poor’swill adjust its analysis accordingly. Standard &


Poor’s also looks at ROA, which takes intoaccount both capital gains and the effects oftaxes for property/casualty insurers. By lookingat these measures concurrently, Standard &Poor’s covers all facets of profitability.

Although ROR is useful as a broad meas-ure of earnings adequacy, it has its draw-backs. ROR does not differentiate betweenvarious product lines that often have differentrisks, some of which require higher levels ofROR for a certain standard of performance.Standard & Poor’s earnings adequacy ratio isdesigned to measure performance across abroad array of business lines while differenti-ating earnings targets by business line, giventhe risks and pricing assumptions associatedwith each product class.

UnderwritingUnderwriting performance is an important com-ponent of the overall operating performanceand is the key driver of earnings strength. Theassessment of underwriting performance isbased on:

� Loss ratios for the overall company and formajor lines of business.

� Expense ratio.� Policyholder dividend ratios

(where applicable).

� Combined ratios.� Premium growth.

These measures are used to determine theunderlying sources of earnings strength and areimportant indications of a company’s strategy.The competitive advantages established by acompany translate into strong earnings by wayof increased underwriting margins or increasedmarket share. Premium growth indicates gainsin market share or at least the maintenance ofthe same, while loss and expense ratios reveal acompany’s ability to achieve favorable pricingor operational efficiencies. All these ratios areanalyzed in the context of the competitive land-scape; company results are always viewed bothin absolute terms and relative to peer compa-nies as well as to the overall industry.

The ratios outlined are useful measures buthave some limitations. Because of the many dif-ferent types of products offered within theproperty/casualty industry and the different lev-els of risk associated with each product, com-parisons of combined ratios between differentlines of business and different companies can bemisleading. Investment earnings play a greaterrole in long-tail lines of business than in short-tail lines. Likewise, high-risk lines of businessrequire high levels of return. As such, a com-bined ratio of 110% has a different implicationdepending on the line of business a companywrites. Standard & Poor’s earnings adequacymodel sets underwriting targets for each line ofbusiness, thus taking into account the role ofinvestment income in each line.

Standard & Poor’s Earnings Adequacy ModelStandard & Poor’s property/casualty earningsadequacy model establishes a standardizedbenchmark for all property/casualty companies.At its core, it is a risk-adjusted analysis of acompany’s earnings stream, reflecting the insur-er’s underwriting risks and investment income.Standard & Poor’s earnings adequacy modeladdresses the weakness of the traditional ratioanalysis by considering the role of investmentincome in pricing and establishes benchmarksthat reflect the levels of risks inherent in differ-ent lines of business.



Earnings Adequacy Scale

Rating Earnings Adequacy Ratio (%)

AAA 250 and higher

AA 190 to 249

A 130 to 189

BBB 70 to 129

BB 10 to 69

B 9 or lower

Standard & Poor’s Earnings Adequacy Ratio (EAR)

Actual RORRisk-adjusted ROR

Earnings adequacy ratio =

The earnings target used in the model is alevel considered good (‘BBB’) for each businessline. By applying these line targets to each com-pany, Standard & Poor’s can establish uniquebenchmarks measured as a risk-adjusted RORbased on each company’s business mix. Thisbenchmark ratio has associated standards ofperformance across all levels, from weak (‘B’)to good (‘BBB’) to extremely strong (‘AAA’).Thus, instead of relying solely on the traditionalmeasures such as the ones listed above,Standard & Poor’s evaluates each company onthe basis of how well it performs given its busi-ness mix. Using this tool, Standard & Poor’scan compare the performance of two or morecompanies in completely different lines of busi-ness and overcome some shortcomings of theanalyses of the traditional ratios.

The earnings adequacy model differentiatesbetween earnings derived from underwritingand investment income earned from reservesand surplus. In this way, Standard & Poor’s iso-lates the primary drivers of a company’s earn-ings and is, therefore, better able to predict acompany’s earnings potential.

Standard & Poor’s earnings adequacy ratiouses the pretax ROR as its primary measureand precludes any consideration of capitalgains. Standard & Poor’s prefers to use the con-solidated statutory accounts of the company orgroup of companies being analyzed. The meas-ure is time-weighted over three years to mitigatethe effects of yearly fluctuations and industrycyclicality as well as to smooth the effects ofone-time events. Current-year earnings are moreheavily weighted than are previous years’ earn-ings based on the belief that more recent yearsare better predictors of future earnings.

Standard & Poor’s adds 50% of the mostcurrent year’s earnings adequacy ratio, 30% ofthe previous year’s ratio, and 20% of the thirdyear’s ratio to arrive at a time-weighted averageof the company’s earnings adequacy.

The model produces two ratios: raw EAR andcapital-adjusted EAR. The raw EAR measures thecompany’s overall profitability by comparing thecompany’s actual ROR with its target, risk-adjusted ROR, which is derived as follows: The

company’s operating revenue by business line ismultiplied by the ‘BBB’ risk-adjusted return devel-oped by Standard & Poor’s for each respectiveline of business. (A company’s net investmentincome is allocated to lines of business in propor-tion to its outstanding loss, loss adjustmentexpense, and unearned premium reserves by line.)These products are then added to produce a levelof return used to calculate the company’s bench-mark, risk-adjusted ROR. This figure comparedwith actual earnings produces the raw EAR.

Capital-adjusted EAR is similar to the rawEAR, except that it neutralizes the effect ofvarying capital levels on investment income.Each company’s surplus is adjusted so its capi-tal adequacy level, as measured by Standard &Poor’s capital adequacy model, reflects the cur-rent overall industry capitalization level.Investment income is then also adjusted toreflect the new level of capital. For example, forovercapitalized companies, an adjustment ismade to extract the investment returns associat-ed with the excess capital from both incomeand revenues. The amount to be extracted iscalculated by multiplying each company’sreturn on invested assets by the amount ofexcess capital. A new ROR is calculated usingthese capital-adjusted results, which is thencompared with the company’s risk-adjustedROR as before. This measure differentiates thequality of earnings among companies that gen-erate equivalent earnings on a preadjusted basis.Both ratios are measured against the same scale.

Adjustments to the EARIn the interactive ratings process, analysts canadjust the raw data used in the model toaccount for unique situations. For example,analysts can normalize the earnings used in themodel if any year’s earnings are consideredabnormal because of nonrecurring events.Likewise, the earnings targets applied to eachline of business are considered adequate for theindustry overall. To the extent that a company’sproducts are considered more or less risky, theanalyst can adjust the target up or down.

Given that Standard & Poor’s rating processtakes a prospective view of a company’s finan-cial performance, Standard & Poor’s analysts


often construct earnings adequacy ratios thatinclude their projections of an insurer’s earn-ings. Although a company’s past performance isoften a good indicator of its future, industryconditions or management’s strategies often sig-nificantly alter a company’s earnings profile.

Although the following are the most com-mon adjustments made to the EAR, otheritems that will be adjusted for are unique tocertain companies.

Reserves. This is the single factor to whichthe model is the most sensitive. Standard &

Poor’s performs its own analysis of loss reservesusing various statistically accepted methods.The analysts then use their judgment on theresult of these methods to assign any redundan-cies or deficiencies of reserves to the periodunder consideration for the earnings model.

Investments in tax-exempt bonds. Companiesthat have high amounts of tax-exempt bonds intheir investment portfolios are penalized becauseStandard & Poor’s model is developed on a pre-tax basis. (Tax-exempt bonds have much lowerpretax yields than do taxable bonds.) Standard& Poor’s replaces actual investment income onthese bonds with the company’s estimates ofearnings on a taxable-equivalent basis. However,this adjustment is made only for companies withsignificant holdings of tax-exempt securities.

Capital gains. For companies with a demon-strated, consistent strategy of harvesting capitalgains, the model will be adjusted to include aproportion of the realized gains.

Earnings quality. The analysis of operatingperformance would be incomplete withoutassessing the quality of earnings. Besides reserveadequacy, volatility and diversity of earningsplay an important part in earnings quality.Companies with concentrated profit streams areviewed by Standard & Poor’s as more vulnera-ble to adverse economic and business conditionsthan are those with more diversified earningssources. Likewise, stable earnings are viewedmore favorably than are volatile earnings. Thesefactors, in conjunction with the quantitativemeasures cited above, depict a comprehensiverepresentation of a company’s operating per-formance and establish Standard & Poor’s over-all assessment of operating performance.

SummaryStandard & Poor’s rating process attempts toform a prospective view of a company’s finan-cial strength. Although operating performanceis a critical part of this process, other factorsare carefully considered in the evaluation of aproperty/casualty company’s financialstrength. Such factors include the businessprofile, management and strategy, capitaliza-tion, liquidity, investment risk, and franchiserisk. These factors are evaluated in other



Target ROR by Line of Business

EAR = Actual ROR/expected ROR, time-weighted as follows:

� 50% current year

� 30% previous year

� 20% third year

ExpectedLine of business ROR (%)*

Homeowners/farm owners 6.06

Private passenger auto liability/medical 3.60

Combined two-year lines 4.31

International 8.37

Commercial auto/truck liability/medical 6.18

Medical malpractice-occurrence 11.75

Medical malpractice-claims made 7.67

Special liability 5.63

Other liability-occurrence 12.75

Other liability-claims made 7.22

Products liability-occurrence 16.25

Products liability-claims made 11.22

Commercial multiple peril 5.94

Workers’ compensation 6.85

Reinsurance A 11.97

Reinsurance B 8.99

Reinsurance C 14.05

*These benchmarks represent a ‘BBB’ level of performance.

areas of the analysis and could offset the relative strength or weakness in the operatingperformance.

Investments

Asset quality and investment performance areintegral to a property/casualty insurer’s opera-tions and to remaining competitive in today’senvironment. Premiums and deposits investedtoday must provide a yield sufficient to covertomorrow’s claims. Historically, property/casu-alty companies have managed more conserva-tive investment portfolios because of the less-predictable timing and nature of their claims.Annuity and life companies generally havetaken greater advantage of the predictablenature of their claims to take more risk inreturn for higher yields. Accordingly, Standard& Poor’s Ratings Services evaluation of theinvestment portfolio considers policyholders’competing and often conflicting demands forhigher yields versus safety and liquidity.

By far, the key element of the analysis isunderstanding the process by which the com-pany allocates cash flows to various assetclasses. Different classes of assets have custom-ary risk profiles and accompanying returns;thus, by choosing which asset to emphasize, acompany preordains a large part of the returnon the portfolio.

Standard & Poor’s review begins with theinsurer’s allocation of assets among investmentssuch as bonds, mortgages, preferred stock, realestate, common stock, CMOs, and derivativeinstruments. The assets are evaluated for creditquality and diversification. Of concern are assetconcentrations by type and maturity, low creditquality, industry, geographic location, and with-in single issuers. An insurer’s asset allocation isalso examined to determine how appropriate itis to support policyholder liabilities.

Standard & Poor’s also reviews the implicitderivative options within fixed-income portfolios.Asset-backed portfolios are reviewed for theirsensitivity to interest rate risk, including prepay-ment and extension risk. The degree of interestrate risk in the investment portfolio is then com-pared with the company’s product structure.

Portfolio DiversificationOnce the asset allocation strategy is understood,Standard & Poor’s reviews any unusual concen-trations, such as by asset type, industry sector,or individual companies. The essence of build-ing a portfolio is diversification, and any accu-mulations can subvert diversification. Examinedclosely are issues that might not look correlatedbut in fact are, such as common and preferredstock issued by the same entity and perhapsconvertible debt also issued by the same entityor a closely related family member. In this case,for instance, the nominal issuer might not bethe same company, but if they are all part of thesame family and control, a clear concentrationcan be developed. Another example would beto look at the overall real estate concentration,which would include MBS, commercial and res-idential mortgages, and equity real estate. In alow-interest-rate environment, all these assetscould suffer.

Invested Asset Credit QualityCredit risk is measured normally by Standard& Poor’s default studies and credit risk changesin Standard & Poor’s capital model.Nevertheless, it is important to understand howand why the company has invested in issuesthat might contain credit risk so Standard &Poor’s can form an opinion of the future dispo-sition of cash flow. Does management have atendency to invest in issues with credit risk, orare current assets with credit risk so-called fall-en angels? Does management invest in nonratedpaper, perhaps to hide its credit risk appetite?

Interest Rate RiskStandard & Poor’s is concerned about insur-ers’ interest rate risk. Given thatproperty/casualty insurers do not typicallyextend an explicit interest rate guarantee oreven an implicit promise, this is not as crucialan element as it is for life insurance analysis.However, Standard & Poor’s would not becomfortable with a significantly long assetprofile relative to liabilities. For instance, thenormal property/casualty company’s liabilityduration is three to four years, and Standard& Poor’s would not be comfortable with the


majority of a company’s investments in 30-year paper. Alternatively, Standard & Poor’swould not expect precise duration matchingby these insurers in light of their normallystrong cash flows.

Holdings of mortgage-backed bonds andother asset-backed bonds can add an elementof option risk. Option risk in MBS is definedas the prepayment or extension risk implicitin this asset class. It can be a two-edgedsword: When interest rates go up, these assetscan extend mortgagees’ minimum payments,and there are fewer refinancings. Investors,therefore, have less money to invest at thethen-higher rates. Conversely, when interestrates go down, these assets tend to prepay(refinancings increase), and investors havemore cash to invest at lower rates. This rein-vestment risk can create issues from bothcash-management and asset/liability manage-ment perspectives. Property/casualty compa-nies with significant allocations to securitieswith option risk are modeled for these risks.In particular, Standard & Poor’s analyzes theoption risk inherent in such assets as callablebonds, asset-backed bonds, and MBS (includ-ing pass-throughs, CMOs, and whole loans).A mitigating element is the adequacy of thecapital base, which can act as a cushionagainst temporary fluctuations in asset values.

LiquidityRelatively speaking, almost all property/casualtyinsurer portfolios are somewhat liquid, butStandard & Poor’s reviews the portfolio withregard to overall liquidity because insurersmight need to liquidate assets quickly to payclaims, especially if significant catastropheexposures are present. Key considerationsregarding liquidity include:

� The percentage of public versus privateassets.

� How much of the portfolio is short-term versus long-term.

� How long the portfolio is and if it is subjectto additional market risk.

� The percentage, duration, and type of MBS.� The percentage, type, and quality of equity.

Market RiskThe final element of risk that insurers can nor-mally be expected to accept is market risk,which is the risk that the value of assets, com-monly equity securities, can fluctuate with themarket. Because many property/casualty insur-ance companies invest relatively heavily in com-mon equities, they can often incur significantmarket risk. Standard & Poor’s capital modelhas asset charges for the volatility. However,Standard & Poor’s is also interested in under-standing the investment policies with regard toequity securities or other securities whose valuesare marked to market daily and in projectingfuture investments of cash flow.

Return (Current Yield and Total Return)By analyzing each of these broad areas and theeffective tax rates, Standard & Poor’s can identi-fy and explain how a given level of ROA orROR is generated. Standard & Poor’s then looksat the trend in ROA or ROR over time and rela-tive to the industry. The objective of this phase ofthe analysis is to gain a clear understanding ofthe company’s ongoing profitability.

Capitalization

Standard & Poor’s Ratings Services capital ade-quacy model is a significant part of the analysisof a property/casualty insurer’s or reinsurer’scapital strength. The model compares totaladjusted capital minus realistic expectations ofpotential investment losses and credit lossesagainst a base level of surplus appropriate tosupport ongoing business activities at a securerating level (‘BBB’). This calculation produces acapital adequacy ratio. An insurer’s capitalstrength is considered good if its capital ade-quacy ratio is at least 100%. Various levels ofthe ratio above 100% correspond to Standard& Poor’s standards for strong, very strong, andextremely strong capital strength.

There can be no single measure that fullycaptures the breadth of information needed toevaluate an insurer’s level of capital adequacy.In fact, focusing on a single measure risksoveremphasizing its importance in Standard &Poor’s overall analysis of the financial strength



of an organization. All too often, both companymanagement and analysts can focus on themanagement of capital to a specific ratio andignore the larger risks inherent in the organiza-tion. The foundation of an insurer’s capital basecan differ significantly based on its quality ofcapital. To better capture an insurer’s quality ofcapital, Standard & Poor’s has incorporatedinto its analysis both its traditional measure ofa risk-based CAR and a more stringent measureof capital adequacy that excludes softer formsof capital. This measure, referred to as thehardCAR, compares a capital base thatexcludes the value of insurance in force,deferred acquisition costs, hybrid equity instru-ments, and other associated haircuts with thesame risk-based capital needs used in Standard& Poor’s traditional model.

Standard & Poor’s has not established anyspecific benchmarks of appropriate hardCARsfor various rating categories. Rather, this meas-ure will be used in a relative context when com-paring an insurer with its peers. When evaluat-ing an insurer using Standard & Poor’s tradi-tional risk-based capital model, total capitalmight be found to be consistent with the rating.However, looking at an insurer versus its peersunder a more stringent measure of capital ade-quacy could indicate that its quality of capital iseither significantly better or worse than the peergroup. Because Standard & Poor’s ratings aredetermined in both absolute and relative con-texts (an insurer’s measure of financial strengthshould be consistent with various standards setfor each rating category as well as consistentwith other similarly rated companies), Standard& Poor’s considers that multiple views of capi-tal adequacy better capture this element offinancial strength.

Although considerable attention is focusedon capital adequacy, Standard & Poor’sassessment of capital adequacy is only one ofmany factors used in arriving at the financialstrength rating on a company. Standard &Poor’s ratings process will continue to bebased on the belief that capital adequacyratios are not a substitute for a broad-basedanalysis of insurer credit quality. Strengths or

weaknesses in other key areas—such as acompany’s management and corporate strate-gy, business profile, operating performance,liquidity, and financial flexibility—can morethan offset relative strengths or weaknesses incapital adequacy.

How the Model WorksThe numerator of the capital adequacy ratio istotal adjusted capital minus realistic expecta-tions of potential investment losses and creditlosses. The total ‘C-1’ asset-risk charge isadjusted by multiplying by a portfolio sizefactor and adjusting for any single issuer con-centration risk. The ‘C-2’ credit risk reflectsthe collectibility risk associated with certainassets or receivables on the balance sheet.

The denominator of the ratio reflects thecosts associated with doing business. The ‘C-3’ risk charge or underwriting risk reflects therisks associated with the lines of business acompany is writing today and in the future.The ‘C-4’ risk charge or reserve risk reflectsthe risk today for business written in the pastbased on loss reserves. The last ingredient inthe denominator, the ‘C-5’ risk charge, is for other business risks the company is subjectto. (See below for further discussion of these charges.)

Determination of Total Adjusted CapitalTotal adjusted capital is reported statutory sur-plus adjusted for certain items that affect thequality of that surplus. By far, the largest liabilityon the balance sheet is loss and loss adjustmentexpense reserves. Standard & Poor’s conducts itsown analysis of loss reserves using various actu-arially accepted methods. The analysts draw aconclusion about the adequacy of a company’sreserves based on the result of the methods. Asany deficiency or redundancy affects the qualityof capital, the amount of the deficiency/redun-dancy, net of tax, will be subtracted/added tocapital. After reserves have been adjusted to ade-quate levels, an adjustment is included for theeffects of the time value of money. This realignswriters of long-tail business with writers ofshort-tail business to the timing of payments oflosses and associated capital needs.


Statutory goodwill is viewed as a very softform of capital. Given the spate of write-downsStandard & Poor’s has seen, it has been unreli-able as a cushion to absorb long-term risks and,accordingly, is deducted from the calculation oftotal adjusted capital.

Lastly, surplus is adjusted for anything thathas not already been considered that willimprove or impair the level of available capital,i.e., surplus notes, extraordinary necessity forenvironmental reserves, etc.

Evaluation of Asset RisksStandard & Poor’s looks at the quality of aproperty/casualty insurer’s investment portfolioto establish a reasonable estimate of expectedlosses over a period of several years. The pres-ent value of these anticipated losses is chargedagainst surplus.

Bonds. The charges used for credit riskvary with the credit rating on the bond.Expected default losses are assumed to occurover a period of 10 years and are present-val-ued using a default discount rate of 6%. Thegross charges are adjusted for the assumedrecovery rate (see table on page 40). Thedefault and recovery expectations are based onStandard & Poor’s analysis of default trendsand findings by other studies. Analytical judg-ment is used in determining appropriatecharges for bonds of a parent or affiliate. Inthe absence of the information necessary tomake this judgment, these bonds are assessed arisk charge of 100% of their carrying value.Standard & Poor’s model also incorporatescharges for interest rate risk associated withbonds, particularly MBS.

Typically, mortgage investments for proper-ty/casualty companies are minimal. As a result,Standard & Poor’s applies a flat charge of 5%for the risk associated with foreclosure, delin-quencies, or restructurings. If a company has asignificant holding of mortgages, it will berequired to complete the mortgage section ofthe Standard & Poor’s property/casualty survey.Based on the information provided, a moredetailed analysis will be performed to assess theportfolio’s quality, and an appropriate chargewill be applied.

For non-U.S. insurance companies that pre-pare GAAP financial statements, bonds arecharged for volatility risk wherever credit isgiven for unrealized gains or losses. The chargesare made against the bond’s full market value,with the charge varying according to the periodremaining to maturity. The charges are general-ly consistent with an immediate 100 basis pointincrease in interest rates. (Bonds with periods tomaturity of up to one year are charged at 1%,one to five years at 4%, five to 10 years at 6%,and more than 10 years at 8%.)

Unaffiliated common stock. Standard &Poor’s analysis of stock market movements indi-cates that a 15% risk factor is appropriate forunaffiliated stock holdings. This is one standarddeviation in the S&P 500 Stock Index year-to-year change, as calculated since 1945.

Unaffiliated preferred stock. Preferredstocks in the property/casualty company’sannual statement are not reported by theNAIC class. Therefore, it is not possible toassess a charge based on the issue rating. Thecharge of 7.11% for all preferred stockreflects the average credit quality of the pre-ferred stock portfolios held by insurance com-panies. However, as opposed to the defaultcharge used for bonds, no recovery is includedbecause of the nature of preferred stockinstruments.

Affiliated common and preferred stock. Toanalyze the risk associated with the compo-nents of a group, an analyst must first assessthe various operating components and sepa-rate them into insurance or noninsurance enti-ties and, within those two categories, decide ifthey are core, strategic, or nonstrategic to theultimate group. Only insurance entities thatare deemed to be core or strategic will havetheir assets and liabilities fullyconsolidated/combined as part of the group,in which case the various charges relating tothem will be determined using this model.Minority interests, where they exist for coreor strategic insurance entities, will receive fullcredit as capital. All other entities within thegroup—i.e., nonstrategic categorized insur-



ance and all noninsurance members—willhave their assets and liabilities deconsolidatedfrom the group. A charge against the group’scapital will then be applied for these entitiesin an amount sufficient to support their assetsand liabilities at their rated level if a stand-alone rating exists or at the ‘BBB’ level whenthere is no stand-alone rating. In this regard,analysts consult with other departments with-in Standard & Poor’s to determine the appro-priate capitalization levels. If capital require-ments cannot be determined, the defaultcharge will be equal to the entity’s historicalbook value on the group’s accounts. The pre-sumption in the latter case is that whatevercapital is invested in the entity is what man-agement deems to be required and, as such, isunavailable under normal circumstances tosupport the group’s needs.

Common stock of a parent is assessed a100% charge. For insurance affiliates,Standard & Poor’s consolidates the affiliates’assets, underwriting, and reserve exposuresinto the model. For noninsurance affiliates, ifthe company is not a core or strategicallyimportant operation, the asset charge wouldbe an amount equivalent to ‘BBB’ capital,unless the affiliate has a higher rating. In thatcase, the charge would be for capital at theappropriate higher rating level.

If the subsidiary is core or strategicallyimportant, the charge is dependent on the rat-ing on the subsidiary. If the subsidiary has astand-alone rating, the charge will be equiva-lent to the capital needed to maintain the rat-ing. If the subsidiary has a supported rating,the charge is dependent on the group ratingand the capital necessary to maintain that rat-ing. If the subsidiary does not have a rating

because it most likely benefits from the ratingon the parent, the charge is based on the capi-tal necessary to maintain a ‘BBB’ rating plusany additional capital necessary to maintainthe rating on the parent.

Real estate. Standard & Poor’s believes thisasset class poses a greater risk on averagethan common stock and should be assessedusing a risk factor slightly greater than thatfor problem mortgages. Therefore, Standard& Poor’s applies an 18% risk factor to thisasset class.

Schedule BA invested assets, includingbonds, mortgages, real estate, and commonstock. Given the range of assets in this schedule,including high-risk assets, analysts, at their dis-cretion, may apply the charges that reflect theasset type and charges assessed against similarassets in the model. However, given the higherrisk of these classified assets, Standard & Poor’smay chose to apply a 20%-50% charge toreflect the higher risk inherent in these assets.

Other invested assets. For all other classes ofinvested assets—including collateral loans,write-ins, and off-balance-sheet items—Standard & Poor’s assesses a charge of 5.0%.

For companies that employ a hedge fund-of-fund investment strategy, Standard & Poor’sacknowledges that the default capital charge(20%-50%) might not reflect the reducedvolatility of a fund-of-fund investment strate-gy. As an alternative to the general capitalcharge, Standard & Poor’s has developed a tai-lored analytical approach for forecasting thelikely volatility for any hedge fund-of-fundinvestment strategy. For the fund-of-fundinvestment strategies that are analyzed underthis enhanced analytic approach, Standard &Poor’s will use a volatility charge that reflectsthe risk-mitigating techniques employed by the


Capital adequacy ratio =

Total adjusted capital - asset-related risk charges (‘C-1’) -credit-related risk charges (‘C-2’)

Underwriting risk (‘C-3’) + reserve risk (‘C-4’) + other business risk (‘C-5’)

fund manager, at a ‘BBB’ level of confidence,using a one-year time horizon.

Concentration risk. This adjustment is forsingle-issuer concentrations of more than 15%of total adjusted capital for investment-gradebonds and 10% for other types of assets. Assetsassociated with a single issuer that exceed theapplicable concentration are assessed a gradedcharge based on the size of the concentration.All assets of a single-issuer-bearing credit riskare aggregated for this assessment.

Size factor. A size factor is incorporated inthe ‘C-1’ charge. This incorporates the riskassociated with the size of a company’s portfo-lio, i.e., the larger the portfolio, the more likelyit is diversified and will withstand various risks.The factor is based on total invested assets andis multiplied by the total asset default riskcharge for the insurer, subject to a minimum of1x. This means the largest insurers would stillbe subject to the full asset charges determinedin the model but would not be subject to a sur-charge for the size of their portfolios. Smallerinsurers would also be subject to the full assetcharges determined in the model but would alsobe subject to a surcharge because of the lack ofdiversification in their portfolios.

Evaluation of Credit RisksCredit risk reflects the collectibility risk associ-ated with certain assets or receivables on thebalance sheet. The risk inherent in reinsurancerecoverables is by far the largest one for prop-erty/casualty companies. The analysis of thisrisk is an area from which Standard & Poor’scan draw on its experience worldwide toderive the factor. By using Standard & Poor’sratings on domestic and international reinsur-ance companies, the credit risk can be assessedbetter. With this information, Standard &Poor’s analyzed the default rate of reinsurancecompanies by rating category to derive the

appropriate charge by rating. This charge isthen applied to the recoverables from reinsur-ers that fall into the specific rating category toderive a total charge. Reinsurers under someform of regulatory control are deemed to be similar to a ‘CCC’ reinsurer; reinsurers that are not rated are deemed to be similar to‘B’ reinsurers.

A charge is assessed for other noninvestedassets and includes agents balances in thecourse of collection, accrued premiums, taxrecoverables, and all other receivables. Acharge is also assessed for any other credit risknot already captured above and will includeother nonstandard items, such as write-ins.

Evaluation of Underwriting and Reserve RisksThe fundamental risk associated with under-writing and reserving is that in setting both pre-mium and reserve levels, the actual cost ofclaims will vary from the expected cost by lineof business. The risk exists not only on all pres-ent and future business but also on past busi-ness not already settled. Although internal fre-quency and severity estimation accounts for alarge part of the variability, changes in econom-ic, legal, and social conditions can add furthervariability to claim costs.

Standard & Poor’s uses the methodologyemployed by the American Academy ofActuaries (AAA) Property/Casualty Risk-BasedCapital Task Force to derive underwriting andreserve charges. This study employs an expectedpolicyholder deficit approach. This approach isa way to assess insolvency risk, whereby foreach risk, the net risk capital charges should beset high enough so the expected cost of insol-vency because of that risk is reduced to anacceptably low level.

There are other benefits to the AAA’sapproach. Instead of reflecting the worst-casescenario, the AAA methodology reflects the



Total Adjusted Capital

Total adjusted capital = Statutory surplus +/- loss reserve deficiency + time value of money +/- other

extent to which the industry’s actual claim costson a present-value basis will typically vary fromexpected claim costs over time. In adjustingclaim costs to a present-value basis, the AAAapproach varies the interest rate based on pre-vailing interest rates during the historical peri-od. This reflects the important part investmentincome levels play in considering where to setprice levels.

Underwriting risk. Underwriting risk is therisk that the company’s present and future busi-ness will be unprofitable and that underwritinglosses will need to be covered by capital. This ismeasured by the variability in the industry lossand loss adjustment expense ratio by line ofbusiness for the previous 10 years. The under-writing risk charge is applied to the most recentyear’s written premium by line of business as aproxy for both present and future writings.

Reserve risk. The reserve risk is the riskthat past business will be less profitable thanexpected as a result of additional variability inestimating frequency and severity trends aswell as changes in economic, legal, and socialconditions that can add further variability toclaim costs. The reserve risk charge does notattempt to measure the adequacy of reserves;this is accounted for elsewhere in the formula.The reserve risk charge measures only thevariability a company would expect toencounter in its reserve levels given its lines ofbusiness and ensures that capital is sufficientto cover this expected variability. This ismeasured by comparing the present value ofthe actual claim runoff that has emerged with

the reserves originally established for thoseclaims by industry. This charge is applied toreserves by line of business, adjusted to anadequate level.

Other Business Risks: Guaranty Fund AssessmentsThe model incorporates a charge based on thecompany’s exposure to guaranty fund assess-ments. Standard & Poor’s measurement of thisexposure is based on premiums by state and theassessment rate by state.

Adjustments to the ModelThe capital adequacy model is designed to be areasonably conservative approach to measur-ing capital adequacy for insurers. Still, theresults are only a benchmark for the analysisof capital adequacy. However, other factors—both qualitative and quantitative—are alsoimportant in assessing capital adequacy. Thesefactors include:

� A company’s ability to generate capital and self-fund growth internally throughearnings.

� Companies with consistent records of goodearnings, which have a better capacity forsurplus growth than companies withvolatile results. Growth plans and manage-ment’s commitment are also considered.

� The capital needs of a parent, affiliate, orsubsidiary.

� The ability of a parent, subsidiary, or affil-iate to provide capital support, whichcould positively influence Standard &Poor’s views of an insurer’s capital adequa-cy. Conversely, potential calls on capital byan affiliate, subsidiary, or a parent via div-idends could adversely affect Standard &Poor’s view of capital adequacy.

Environmental and asbestos (E&A)Historically, E&A liability was a major factorinfluencing financial strength ratings in theproperty/ casualty industry. Exposure to E&Aclaims impaired the companies’ capital ade-quacy, earnings power, and competitive posi-tion. Although many affected companiesincreased reserves significantly, and Standard& Poor’s viewed this action favorably,


Assessment of Capital Adequacy

Capital adequacy Assessment of capital ratio (%) adequacy

Less than 100 Marginal

100-124 Good

125-149 Strong

150-174 Very strong

175 and higher Extremely strong

Standard & Poor’s does not believe this willultimately be enough. The next round of E&Aclaims strengthening will most likely consistof continued yearly reserve development fund-ed through earnings power, financial flexibili-ty, strong capital positions, or a combinationof these. The assessment of how this affectsthe rating on a company is based on detaileddiscussions and surveys.

Large subsidiary/affiliate capital charge.When large subsidiaries/affiliates constitutemore than 10% of total adjusted capital andare viewed as nonstrategic under Standard &Poor’s group ratings methodology, Standard &Poor’s applies its equity volatility charge (asapplicable in that market) plus a 15% concen-tration charge on the total subsidiary invest-ment in a capital model. In the U.S., this means



Asset Default/Loss-Risk Factors

Recovery Rate With Incident of Asset class Rating 6% Discount Rate Default Assumption Net Factor

Bonds Exempt obligations 0% 0.0000A or higher (Class 1) 50% 0.115% evenly 0.0051

over 10 yearsBBB (Class 2) 45% 0.911% evenly 0.0391

over 10 yearsBB (Class 3) 40% 2.4% years 1-5; 0.0936

1.6% years 6-10B (Class 4) 40% 5% years 1-5; 0.1740

2% years 6-10CCC (Class 5) 35% 8% years 1-5; 0.2756

2% years 6-10Class 6 30% net charge 0.3000

Mortgages 0.0500Unaffiliated common stock 15% 0.1500Unaffiliated preferred stock 6% 0.0600Affiliated common Insurance Treated as a 1.0000and preferred stock line of business

Noninsurance Charges vary with subsidiary

Real estate 18% 0.1800Schedule BA characterized 30% Same factor as as bonds, preferred and corresponding common stocks, mortgage non-BA assetloans, and real estateOther Schedule BA assets 20% 0.2000Cash and short-term 0.30% 0.0030investmentsAll other assets, 0.0500including write-ins,collateral loans,and off-balance-sheet items

Concentration risks from single issuer: Charges are graded based on the percentage of total adjusted capital above 15% forinvestment-grade bonds, 10% of adjusted capital for other investments (combine all investments in a single issuer).

Asset size factors: Multiply asset charges by asset size factor (minimum asset size factor = 1). Size factor = Total weighted dollaramount divided by total invested assets. Size factor = ((First $100 million invested assets x 2.5) + (next $100 million x 1.5) + (over$200 million x 0.8))/Total invested assets.

the charge will be a 15% equity volatilitycharge plus a 15% concentration charge, total-ing a 30% charge on the entire investment inthe subsidiary/affiliate. This total charge is aminimum charge, and the analyst can increasethe charge if he or she believes the subsidiaryholding has greater-than-normal volatility, if the

holding is overvalued, or if it is expected to besignificantly devalued.

Capital Credit for Subsidiaries With PubliclyTraded Minority InterestsAs a result of several insurers recently decidingto partially spin off subsidiaries, Standard &Poor’s has adopted an approach for measuringcapital credit for subsidiaries and strategic affili-ations with publicly traded minority interests.This approach applies to subsidiaries and affili-ates that are considered core or strategicallyimportant under Standard & Poor’s group rat-ings criteria.

Subsidiaries and affiliates considered non-strategic under Standard & Poor’s group rat-ings criteria are excluded. Companies consid-ered nonstrategic and that have publicly trad-ed minority interests will be included at fullmarket value, just as any other equity invest-ment would be. These investments are subjectto Standard & Poor’s capital charge for mar-ket volatility (typically 15% globally) and toStandard & Poor’s concentration risk chargesif the investment constitutes more than 15%of group capital.

Standard & Poor’s accepts capital creditgiven within any group capital model using thefollowing guidelines:

� Capital credit for the market value of a sub-sidiary or strategic affiliate can be given onlywhen there is a public valuation of shares ofthe subsidiary. Sufficient shares must be out-standing to constitute a liquid market for thestock with a credible share price (that is,there are a sufficient number of bids oroffers to develop a market price).

� Capital credit for the excess of market valueover book value of the subsidiary or strate-gic affiliate will not exceed credit given bythe regulators in the jurisdiction of the par-ent insurer’s domicile (this applies only whenregulatory capital guidelines exist).

� Capital credit for the excess of marketvalue over book value of the subsidiary orstrategic affiliate will not exceed 25% ofthe difference between market value andbook value.


Credit Risk Factors, Reinsurance Recoverables (C-2)

Rating Factor

AAA 0.005

AA 0.012

A 0.019

BBB 0.047

BB 0.096

B 0.238

CCC 0.497

U 0.250

S 0.500

NR 0.250

R 0.500

Premiums and agents’ balances in course of collection 0.020

Premiums and agents’ balances and installments booked not yet due 0.020

Accrued retrospective premiums 0.020

Federal income tax recoverable 0.050

Interest, dividends, and real estate income due and accrued 0.010

Receivables from parent, subsidiaries, and affiliates 0.050

Amounts receivable relating to uninsured accident and health plans 0.050

Aggregate write-ins for other than invested assets 0.050

Accident and health plans, andthose not rated 0.050

A charge is assessed for other noninvested assetsand includes agents’ balances in the course of col-lection, accrued premiums, tax recoverables, and allother receivables. A charge is also assessed for anyother credit risk not already captured above and willinclude other nonstandard items such as write-ins.

� Capital credit for the excess of market valueover book value of the subsidiary or strate-gic affiliate will not exceed 10% of totaladjusted capital (including this capital credit)in the group capital model.

Reserves

Without a doubt, the thorniest issue any analystmust deal with when assessing the securityoffered by a property/casualty insurance compa-ny is loss reserve adequacy. Property/casualtycompanies issue policies that (generally) prom-ise to reimburse a policyholder for a coveredloss. Few policyholders expect losses, but histo-ry has shown that a certain portion willinevitably suffer a loss. Furthermore, althoughinsurance companies can estimate the percent-age of policies that will suffer a loss (in essence,

the frequency of loss), little reliable data existsto estimate the size of the loss incurred (e.g., theseverity). The final element that must be dealtwith is the timing. Even if accurate estimates offrequency and severity are made, estimates ofwhen payments will be made are necessarilyinconclusive because of numerous outside fac-tors, such as the length of time needed for juriesto finish deliberations.

The final element—timing—also adds tothe ultimate cost (the severity) of claimsbecause if loss settlement is projected overseveral years, inflation, both social and eco-nomic, can inflate the ultimate cost of lossesincurred in previous years.

Accordingly, Standard & Poor’s has devel-oped various methods to analyze the adequacyof loss and loss-adjustment expense reserves



Underwriting and Reserve Risk Factors

Line of Business Underwriting Factor (C-3) Underwriting Factor (C-4)

Homeowners/farm owners 0.27 0.21

Private passenger auto liability/medical 0.07 0.11

Combined two-year lines* 0.18 0.28

International 0.28 0.15

Commercial auto/truck liability/medical 0.17 0.11

Medical malpractice-occurrence 0.40 0.07

Medical malpractice-claims made 0.25 0.06

Special liability¶ 0.17 0.16

Other liability-occurrence 0.33 0.13

Other liability-claims made 0.20 0.10

Product liability-occurrence 0.37 0.15

Product liability-claims made 0.22 0.11

Commercial multiple peril 0.14 0.14

Workers’ compensation 0.15 0.09

Reinsurance A 0.45 0.28

Reinsurance B 0.29 0.10

Reinsurance C 0.45 0.28

* Includes special property, auto, physical damage, fidelity, surety, credit, accident and health, financial/mortgage guarantee, ocean marine, aircraft boiler, and machinery.

¶ Includes ocean marine, aircraft boiler, and machinery.

carried on the balance sheet of a property/casu-alty insurance company or group of companies.Using these methods enables Standard & Poor’sto estimate the appropriateness of a company’sreserving methodologies for its largest lines ofbusiness and what effects they might have on itsability to meet its obligations. The data used inthe analysis is from the company’s statutoryannual statement on Schedule P. The followingsections explain the various analytical methodsStandard & Poor’s uses in determining theappropriateness of company methods to analyzeloss reserves.

Analytical MethodsThe reserve model estimates ultimate lossesfor the liability lines of business as theyappear in the Schedule P of a company’sfinancial statement. Where appropriate, othernonliability lines are also analyzed as part of

the overall loss reserve adequacy process. Theprimary source of data is Schedule P, which istherefore limited to 10 accident years.However, a great deal of uncertainty relatedto loss reserves is associated with accidentyears beyond 10 years, as it takes many yearsto settle long-tail liability claims. Standard &Poor’s uses industrywide benchmark tail fac-tors as a proxy to estimate potential futureloss emergence beyond 10 years. Standard &Poor’s will also consider a company’s own tailfactor experience for its loss-developmentanalysis. Standard & Poor’s uses standardactuarial methodologies (loss developmentmethod, Bornheutter-Ferguson method, etc.),which are broadly used in actuarial practicesin general. For a company or a group of com-panies, the model estimates reserve adequacyfor each Schedule P liability line of business.The indicated reserve is the analyst’s best esti-


Other Business Risk (C-5)

Premiums Subject to Guaranty State Fund Assessment (%)

Alabama 1Alaska 2Arizona 1Arkansas 2California 2Colorado 2Connecticut 2Delaware 2District of Columbia 2Florida 2Georgia 2Hawaii 2Idaho 1Illinois 2Indiana 1Iowa 2Kansas 2Kentucky 2Louisiana 2Maine 2Maryland 2Massachusetts 2Michigan 1Minnesota 2Mississippi 1Missouri 1

Premiums Subject to Guaranty State Fund Assessment (%)

Montana 2Nebraska 1Nevada 2New Hampshire 2New Jersey 2New Mexico 2New York 2North Carolina 2North Dakota 2Ohio 2Oklahoma 2Oregon 2Pennsylvania 2Rhode Island 2South Carolina 1South Dakota 2Tennessee 2Texas 2Utah 2Vermont 2Virginia 2Washington 2West Virginia 2Wisconsin 2Wyoming 1

mate of the required reserve as of a givenaccounting date. Because Standard & Poor’sreserve model is primarily based on ScheduleP data, the results produced by the model arepreliminary. However, the preliminary esti-mate of reserves is reviewed further, subject toavailability of additional company data.Therefore, the results of the different method-ologies serve as a basis for further discussionwith company management before any con-clusions can be drawn.

A First LookBefore evaluating the company’s estimate of lossreserve redundancy/deficiency, it is helpful to getan understanding of overall incurred loss andreserve levels as well as a feel for companytrends. The first way to do this is to look at theratio of the company’s estimate of total incurredlosses to earned premiums (the incurred lossratio) for each accident year at the end of eachcalendar year. An accident year is defined as theyear when the accident occurs, regardless of thedate it gets reported to the company. For exam-ple, the accident year ending Dec. 31, XX,includes data on all accidents occurring betweenJan. 1, XX, and Dec. 31, XX.

The trend in the incurred loss ratios fromcalendar year to calendar year helps determinewhether the estimates of reserves originallymade by management were accurate, low, orhigh. This is done by comparing the incurredloss ratio for the earliest calendar year withthe same loss ratio at the end of later calendaryears. If the ratio has increased or fluctuated,original estimates were too low or too high.The accuracy of previous estimates provides afoundation for confidence in current estimates.In addition, Standard & Poor’s compares thecompany’s latest accident-year loss ratios withthe same ratios for the industry. Again, thisaids in determining how the company is per-forming compared with the rest of the industryand adds to/detracts from confidence levels forcurrent estimates.

The second ratio Standard & Poor’s looks atis the ratio of total reserves at the end of eachcalendar year to premiums earned. Because pre-miums earned is a proxy for the level of expo-

sure to loss carried by the company, the ratio ofreserves to earned premiums factors out reduc-tions or increases in reserve levels due solely toexposure changes.

This data helps the analyst assess the effectsof reserve changes on the incurred loss ratiospreviously discussed. The ratio of total reservesto premiums earned is also useful as a means ofcomparison among companies and in the analy-sis of non-U.S. companies because this ratio isoften the only readily available data on lossreserves for these companies. The analyst cancompare the foreign company with a similarlypositioned U.S. company to assess relativereserve strength.

The third set of ratios calculates the ratioof paid losses and case-incurred losses to total incurred losses by accident year at theend of each calendar year, respectively. Thismethod quantifies how long a company’s losses take to pay out, referred to as the tail.Standard & Poor’s uses this data to comparethe tail of the company’s business with indus-trywide measures of the tail. In addition, it isimportant to look at the ratios for stabilityand for favorable or adverse trends. Theratios are also useful in comparing companies,as one could have a significantly longer payout than another.

Reserve ModelStandard & Poor’s reserve model calculates theadequacy of a company’s (or a group of compa-nies’) loss and loss adjustment expense reservesbased on Schedule P data. Because of the limita-tions of schedule P data being restricted to 10accident years only, the model does not provideany potential reserve adequacy related to acci-dent years prior to the 10 most recent ones.Indicated loss and loss adjustment expensereserves for each line of business are calculatedbased on three methodologies: paid loss devel-opment, case incurred loss development, andBornheutter-Ferguson. The determination ofwhich method is appropriate is based on theparticular line of business being considered. Forexample, paid loss development methodology isgenerally appropriate to calculate reserve ade-quacy for personal auto liability. This is because



of the short-tail nature of the personal auto lia-bility business, where the ultimate losses areexpected to settle in a relatively shorter periodof time. Alternatively, the majority of long-tailedline reserves are analyzed using a case-incurredloss-development methodology, primarilybecause it could be several years between thetime a claim is incurred and when it is paid andtherefore little paid data is available. Each ofthese methodologies is described in detail below.

Based on the analyst’s selection of eitherpaid or case incurred methodology, the nextstep is to make a selection of loss-developmentfactors and an associated tail factor for eachline of business. There are three available selec-tions of loss development factors (LDF) tochoose from: five-year simple average, five-yearweighted average, and five-year excluding Hi-Lo average. Standard & Poor’s has recentlyenhanced the model to incorporate the lattertwo selections instead of being limited to thesimple average of the first. These new options,with these additional selections, have addedmore flexibility and robustness in estimatingreserves. For example, selection the five-yearexcluding Hi-Lo loss development factor iscommonly used for low-frequency/high-severitylines like product liability-occurrence type busi-ness. The reason for such a selection is to elimi-nate or reduce the impact of distortions in thedata because of occasional large reported losses.

Paid Loss DevelopmentThough useful, none of the above techniquesdirectly assesses adequacy of loss reserves butrather deals primarily with relationships. Thefirst method Standard & Poor’s uses to estimateadequacy levels of loss reserves is the paid lossdevelopment methodology. The data used is con-tained in Schedule P, Part 3, of the annual state-ment and includes paid losses—includingdefense and cost-containment expenses—foreach accident year by evaluation date. Variousage-to-age development factors for the accidentyears presented are calculated. Age-to-age fac-tors track the changes in total paid losses—including defense and cost-containment expens-es—on a given set of claims over several calen-dar years. The factors are then used to predict

how paid losses for more recent accident yearswill change in future calendar years. Under thefive-year simple average, the five age-to-age fac-tors for the five most recent accident years areaveraged. Under the five-year weighted average,the sum of cumulative paid losses includingdefense and cost-containment expenses for cal-endar period t+12 is compared with that forperiod t (t=12 months, 24, 36, etc., up to 108).The ratio of paid losses including defense andcost-containment expenses for period t+12 tothat of period t is the five-year weighted aver-age. Finally, under the five-year excluding Hi-Loselection, the highest and the lowest age-to-agefactors for the most recent five accident yearsare excluded, and the average of the remainderof the three factors are then averaged.

Standard & Poor’s selected the five-yearweighted average as the most appropriate lossdevelopment factor because it maintains a bal-ance between stability and responsiveness indeveloping age-to-age factors. These individualage-to-age factors are used in conjunction withthe industrywide benchmark tail factors toobtain age-to-ultimate factors. The estimate ofultimate losses for each accident year is thenobtained by multiplying the cumulative paidlosses by the appropriate age-to-ultimate factor.Standard & Poor’s also uses industrywide lossdevelopment factors to make an additionalindependent estimate of projected losses.

In addition to the factors derived from com-pany-paid losses and the industrywide factors,the analysis might include adjustments to thesefactors based on company-specific situations.This would result from discussions with compa-ny management.

Incurred Loss DevelopmentThe incurred loss development method is simi-lar to the paid loss development method exceptthat case-incurred losses are used instead ofpaid losses. Case-incurred losses are defined asthe sum of accident-year paid losses plus acci-dent-year case reserves. For lines of businesssuch as medical malpractice, in which it willlikely be several years between the time a claimis incurred and when it is paid, there will be nopaid losses in the earlier development periods of


an accident year on which to base age-to-agefactors. For this reason, it is more appropriateto use case-incurred losses for certain lines ofbusiness when calculating age-to-age factors.The data used is derived from Schedule P, Parts2 and 4. Schedule P, Part 2, includes data fortotal incurred losses, including bulk andincurred but not reported (IBNR) estimates.Because the bulk and IBNR estimates are thesubjects of the adequacy testing, they should beexcluded from the analysis. Schedule P, Part 4,includes data for bulk and IBNR estimates only.By subtracting data in Part 4 from that in Part2, a data set of case-incurred losses can bederived. This data is the basis for the incurredloss development method.

As with the paid loss development methodol-ogy, various development factors are calculatedfor the accident years under study. The five-yearweighted average is again selected as the mostappropriate selection because it maintains a bal-ance between stability and responsiveness in thefactors. The average factors are then used toproject losses from more recent accident yearsinto the future. Again, this is accomplished bymultiplying the case-incurred losses for eachaccident year as of a given accounting date bythe appropriate factor. As with the paid lossdevelopment method, Standard & Poor’s usesindustrywide tail factors to project lossesbeyond 10 years. Standard & Poor’s also usesindustrywide factors to make an additionalindependent estimate of projected losses.

In addition to the factors derived from thecase-incurred losses and the industrywide fac-tors, the analysis might include adjustments tothese factors based on company-specific situa-tions. This would result from discussions withcompany management.

Bornheutter-Ferguson MethodThe Bornheutter-Ferguson method is used main-ly for reinsurance and when limited data isavailable and estimates of IBNR claims are dif-ficult, if not impossible, to make from actualcompany data. IBNR claims are defined asclaims as of a given date that have occurred andare the company’s responsibility but have notbeen reported to the company or have not been

recorded on the company’s books. An exampleof when one might use the Bornheutter-Ferguson method would be a company enteringa new line of business or one having insufficientdata points on a long-tail line of business.

There are several ways to apply thismethod. In general, an estimate of ultimateincurred losses is made independent of presentloss-reserve levels. IBNR reserves are then esti-mated by applying independent estimates ofreporting patterns to the ultimate incurred-lossestimate and are added to actual reported loss-es to derive total incurred losses for the line ofbusiness. An independent estimate of ultimateincurred losses is made by multiplying the com-pany-earned premiums by expected ultimateloss ratios. The industrywide estimate of thisratio is used. This ratio is calculated by line ofbusiness and by accident year. The selected per-centages of ultimate loss reported and unre-ported are again based on industrywide esti-mates. IBNR reserves are derived by multiply-ing the expected ultimate incurred loss fromabove by the percentage unreported. Actualreported incurred losses are then added to theIBNR estimate to derive projected ultimateincurred losses.

As with the other methods, adjustment to theloss ratios and/or reporting percentages might bemade based on company-specific situations.

Determination of IndicatedRedundancy/DeficiencyHaving estimated projected ultimate lossesusing up to five different methods, it is nowpossible to quantify the redundancy/deficiencyimplied by the estimates. The required reserveby accident year is calculated by subtractingactual paid losses from the projected losses esti-mated by each of the five methods. Thus,Standard & Poor’s calculates five different esti-mates of the required reserve: two based oncompany data, two based on industrywide data, and one based on the Bornheutter-Ferguson method.

The redundancy/deficiency by accident yearis calculated as the difference between therequired reserve estimated by the various meth-ods and the actual carried reserves. Standard &



Poor’s does not pinpoint the smallest or thelargest difference between the estimated andactual reserve in the analysis. Rather, the ana-lyst uses the data to make his or her own esti-mates of loss reserve adequacy.

SummaryA summary of the results of the various meth-ods enables Standard & Poor’s to compare themethods in a consistent fashion and to selectthe most appropriate method. Based on actu-arial judgment, a preferred method has beenselected for each line of business—usually thepaid loss development method for short-taillines and the incurred loss developmentmethod for long-tail lines. The resultingredundancy/ deficiency serves as an initialpoint estimate for further discussions with the company.

In addition, Standard & Poor’s can calculatea range into which the level of adequacy willlikely fall and quantify the possible effect onsurplus. The point estimate and the endpointsfor the range of estimates are compared withsurplus to estimate the effect any potentialreserve deficiency might have on the company’sability to meet its obligations.

Potential DistortionsA virtually unlimited number of company-spe-cific situations can distort the results obtainedfrom the above methodologies. Through discus-sions with company management and thereserve questionnaire responses, Standard &Poor’s can identify the most important adjust-ments needed. Listed below are the more common distortions Standard & Poor’s hasencountered:

� Changes in claims personnel. If staff hasbeen added, payments will likely be made ata quicker rate, distorting the paid loss devel-opment age-to-age factors. These factorsneed to be adjusted to reflect the differinglevels between present payments and histori-cal payments. If staff has been reduced, asimilar but opposite adjustment might bewarranted. In both cases, incurred loss devel-opment will be more stable and presentmore reliable results.

� Changes in claims department philosophy. Ifclaims are being assigned an average caseamount, and this amount is changed (whichhappens often), using the data before thechange to project losses after the change willgive distorted results. As another example,management might push to get claims off thebooks as quickly as possible. This wouldcause distortions similar to those whenclaims staff is added. The treatment of inde-pendent adjusters or legal services, or aswitch from or to the use of independentadjusters or legal services, can also have aneffect on the loss development, especially forlong-tail, third-party lines of business.

� External occurrences. This is very commonfor workers’ compensation in which auto-matic benefit- and income-level changes andlegal changes are frequent. In these cases, itis important to ascertain when the changetook place as well as how it is being applied(i.e., to all claims or only those as of a cer-tain date).

� The need to exclude many types of risk-shar-ing mechanisms, such as paid and incurredloss retros from the Schedule P data. Thesepolicies pose little or no insurance risk to thecompany because the losses are passedthrough. However, when the company paysthe loss, it is recorded as a paid loss and isincluded in Schedule P. When loss develop-ment factors are applied, these paid-loss ret-ros are not differentiated from other paidlosses, and reserves are implied for theselosses even though they are not needed.Thus, the data will indicate a deficiency onthese policies because they are not carryingreserves for them.

� When a company exits a line of business.Because no new policies are being written,accident-year results occurring after the dateof discontinuance will be different from thosebefore the discontinuance, and using the olddata will cause distortions. The loss develop-ment factors developed from historical acci-dent years are not appropriate for these lateraccident years and need to be adjusted.


� Reinsurance. A company’s historical lossexperience could be affected by various rein-surance plans, including finite reinsurance.Standard & Poor’s evaluates the impact ofthese reinsurance programs (aggregateexcess, loss portfolio transfers, etc.) in determining the company’s overall lossreserve adequacy.The distortions presented above are a very

small subset of the problems that could beencountered when using loss developmentdata, and are only illustrative. Responses tothe reserve questionnaire should encompassenough areas so Standard & Poor’s can identi-fy any major distortions. These can be dealtwith individually.

Liquidity

All insurance organizations need to be highlyliquid. Standard & Poor’s Ratings Servicesassessment of this important area identifies thesources of cash and enables Standard & Poor’sto identify companies with strengths or weak-ness in this generally strong category.

The primary source of liquidity is derivedfrom operating cash flows. Although cash flowfrom underwriting is considered in the analysisof investment income, it is essential to measurethis element in assessing liquidity. It is impor-tant to measure both the absolute level of cashflow from underwriting as well as the ratio ofcash inflows (premiums collected and other) tocash outflows (paid losses, paid loss expenses,and underwriting expenses). This measurehighlights whether insurance underwritingactivities are healthy. In addition, it is neces-sary to analyze total cash flow, again in termsof absolute levels as well as a ratio. Thisaddresses the total corporate financial healthand liquidity.

A second source of liquidity for a proper-ty/casualty insurer is its investment portfolio.It is relevant to measure this again both inabsolute dollar terms and as a ratio to thetotal invested assets.

Standard & Poor’s also reviews the liquidi-ty of the insurer’s investment portfolio in rela-tion to any significant catastrophe exposures

that might be present. In such events, insurerscould need to liquidate assets quickly to pay claims.

Finally, it is relevant to take into considera-tion other outside sources of liquidity, such asbank lines of credit and established commer-cial paper programs.

Financial Flexibility

This last element in analyzing an insurer is pre-dominantly qualitative. It is broken down intocapital requirements and capital sources.Capital requirements refer to factors that mightgive rise to an exceptionally large need for long-term capital or short-term liquidity. Almost bydefinition, these exceptional requirements tendto relate to the company’s strategic objectivesand, thus, often involve acquisition or recapital-ization plans.

Capital sources involve an assessment of acompany’s ability to access an unusually largeamount of short-term and long-term capital.Typically, these sources consist of demonstrat-ed access to multiple types of capital markets,such as the long-term public debt market, thecommercial paper market, and theEuromarkets. In addition, a company mighthold assets with significant unrealized capitalgains that could be sold without affecting thebasic enterprise. The ability or demonstratedwillingness to raise common equity capital isanother important source of financial flexibili-ty, as is the ability to obtain reinsurance inadequate amounts from a variety of high-quality markets.

One common source of financing for insur-ance companies is reinsurance. Although pru-dent use of reinsurance is often advisable, itcan be misused in many fashions. A character-istic to be analyzed is the degree of reinsur-ance leverage as measured by the ratio of netwritten premium to gross written premium aswell as net reserves to gross reserves.Reinsurers’ creditworthiness is always a con-cern, but it becomes more relevant as thisratio falls. Pure coinsurance of risks can be avaluable source of capital and financial flexi-



bility, while surplus relief transactions withlittle risk transfer have little value.

A review of Schedule F for property/casual-ty insurance companies is necessary to identifythe reinsurers being used. Among the itemsStandard & Poor’s Ratings Services reviewsare the creditworthiness of the names, the useof brokers with no real name behind them,large cessions to poor-quality names, and soon. Reinsurance protection is also reviewed indiscussions with management. It is normallyimportant for the company to have routineprocedures for review and acceptance of allreinsurers. Companies that abdicate theresponsibility are asking for trouble.

By far, the best source of long-term flexibil-ity is created through generating good returns.Therefore, the returns on equity, assets, andpermanent capital are evidence of the compa-ny’s long-term access to sources of financing.

The most important element is the relation-ship between an organization’s needs for long-term capital and the sources available to it.Companies with modest needs could be quitesuccessful with few sources other thanretained earnings, while those with a vora-cious appetite for acquisitions might not beable to satisfy these needs, even with all theabove-identified sources available to it.


Reinsurance

The reinsurance industry provides primaryinsurers with the capacity to assume additionalrisk and capital while offering intellectualresources and value-added services to improverisk management and stabilize earnings. Toassess a reinsurer’s financial strength, Standard& Poor’s uses both quantitative and qualitativefactors similar to the ones employed for pri-mary insurers: industry risk, management andcorporate strategy, business review, operatingperformance, capital, liquidity, and financialflexibility. This chapter identifies the main areaswhere the analyst modifies the process toaddress the fundamental differences inherent inthe reinsurance industry.

Standard & Poor’s believes that the risks forcompanies operating in the nonlife reinsurancesector are high for a number of reasons. Forexample, there are limited barriers to entry, par-ticularly in short-tail lines. This has beendemonstrated by the ease and speed with whichnew re/insurers have been created, raised capi-tal, and started writing business, particularlyfollowing the losses related to the terroristattacks on Sept. 11, 2001. This makes it diffi-cult for established players to leverage theirpositions fully during periods of attractive rates.

Compounding the issue of limited barriers toentry is that as a product, reinsurance is rela-tively homogeneous. Aside from differentiatingthemselves based on financial strength and geo-graphic/product coverage, reinsurers have hadlimited success in developing a truly distinctbrand or offering for which cedents are pre-pared to pay significantly more. For associatedreasons, reinsurance also suffers from competi-tion from substitute products, particularly riskretention by cedents but also from a small butgrowing capacity provided directly by the capi-tal markets.

Because of the risks inherent in the reinsur-ance sector, to be assigned a rating equivalent tothose assigned to companies in other sectors of

the insurance industry, reinsurers have to have astronger profile.

By the nature of many of the risks assumedby the industry, nonlife reinsurers’ profitabilityis volatile for two reasons. First, the reinsurancepremium pricing cycle has demonstrated some-what greater amplitude than other sectors ofthe industry. It is critical for the industry tointroduce more discipline across the cycle toreduce these pricing peaks and troughs. Second,there has been a trend since the mid 1980stoward larger losses (increasing severity), withclaims inflation exceeding the rise in propertyvalues. This presents reinsurers with boththreats and opportunities, but regardless, itincreases the pressure to continue to improvethe analysis of these risks.

Another fundamental problem for reinsurersis that they are removed from the original risk.This makes reinsurers reliant on the cedent toprovide accurate, timely information. To anextent, improved cedent auditing and transac-tion structuring can mitigate this dependency,but the cedent will very often be in a betterposition to analyze the risk, thereby increasingthe danger of anti-selection.

Management and Corporate Strategy

Management and corporate strategy underpinall the main areas of analysis. As such, they areseen as key drivers in the ranking of reinsurers.As with primary companies, this area of analy-sis is divided into strategy, operational controls,and risk tolerance.

A strategy should have a formal plan of exe-cution that is consistent with the company’sgoals. The analyst will look at management’stechnical and administrative experience in exe-cuting previous plans as well as its benchmark-ing process to control what has been accom-plished and what resources need to be acquiredto fulfill the reinsurer’s goals.


Reinsurance

Internal communications are often critical inthe successful execution of a company’s strate-gy, and details about how the reinsurer is man-aging the flow of information are important.Understanding an organization’s structure, func-tional responsibilities, and internal-controlstructure will assist the analyst in determininghow the strategy is likely to influence futureprofitability.

Given that the reinsurers’ traditional role isto assume underwriting risk, reinsurers requirea strong set of risk-management skills that canaccurately price risks and screen out the risksthat are unattractive at any price. A conse-quence of this skill set is the ability and where-withal to withdraw from lines of business onceterms and conditions fall below the cost of capi-tal. Reinsurers are expected to redeploy capitalcontinually to the markets in which they haveexpertise and that provide returns that exceedtheir cost of capital. Similarly, they should leavecapital unutilized until terms and conditionsimprove or, in extreme cases, return excess capi-tal to shareholders.

Therefore, the reinsurance analyst will seekto determine how the reinsurer is pricing andcontrolling underwriting risks and the compa-ny’s tolerance for other areas of risk, such asinvestment risk. In addition, the analyst has tounderstand how the reinsurer monitors riskaggregations and their potential impact on capi-tal, such as through diversification. This willalso include a review of the outwards reinsur-ance (retrocession) program and other risk-transfer mechanisms (e.g., insurance-linkedsecurities). Risk tolerance in other areas—suchas investments—and the appetite for financialleverage are expected to be somewhat lowerthan in other insurance sectors.

Standard & Poor’s experience is that mostreinsurance group management teams recognizethe importance of strong controls. When a rein-surance company gets into difficulties, they areoften caused by the failure of operating con-trols, the inability of management to put itsgood intentions into practice by adequately con-trolling and monitoring the activity of under-writers, and high and inappropriate risk toler-

ances. For reinsurance groups in particular, therisks associated with management lapses areenormous because of the relatively high level ofexposure delegated to individual underwriting.

Competitive Position

A company’s competitive position is an impor-tant rating factor in Standard & Poor’s analysisof reinsurers and consequently carries a relative-ly high weighting in the derivation of the over-all rating. Because of the long-term nature ofratings, the rating on a particular company willrarely be significantly higher than the rating onits business position.

In general, competitive position is an evalua-tion of a reinsurer’s ability to increase its busi-ness while maintaining a sound risk profile andstrong profitability. In particular, for reinsurers,it is the amalgamation of a number of factors,including:

� Distribution. Stronger reinsurers will havedeveloped attractive flows of business, eitherthrough a strong relationship between theunderwriter and the cedent or through astrong relationship among the underwriter,the intermediary, and the cedent. Weakerreinsurers will be anti-selected, being left offof attractive risks and writing a greater pro-portion of higher-risk accounts.

� Nature of cedent relationship. Relationshipsremain very important in the reinsuranceindustry, but strong, long-standing relation-ships are not sufficient. The very large directreinsurers—with their preponderance oflong-term, relationship-driven, proportionalbusiness—have underperformed those with abroker-oriented, nonproportional businessorientation. The relationships that are basedclearly on the understanding that the reinsur-er needs to make a normal profit each yearhave proved to be the most enduring.

� Capacity. Does the reinsurer have the finan-cial muscle and appetite to offer the level ofcapacity that a cedent requires? Is the rein-surer a leading or following market? What isits dependence on retrocessionaires?

� Products and service. Does the reinsurer pro-vide the range of products required? What


are the reinsurer’s capabilities to provide tai-lored solutions, in particular alternative risktransfer/financing (including financial rein-surance)? Does the cedent have ready accessto underwriting decisionmakers? What is thereinsurer’s reputation for efficiency of policyissuance and claims-handling, including thewillingness and speed of paying claims?

� Expense base. Reinsurers, particularly thoseoperating in the life reinsurance market,derive considerable advantage through lowercosts, which can be passed on to the client.Clearly, this is only a differentiating factorwhen the reinsurer has sound, comprehen-sive underwriting and risk managementalready in place.

� Diversity of revenue streams across geogra-phy, cedents, distribution channels, andproduct type. Diversity is also an importantfactor in the analysis of capital and earnings,but the emphasis in that instance is on diver-sity of exposure. Diversity for its own sakehas a low value. For it to add value, eachdiversified business line must be valuable inits own right.

� Brand and coverage. This is less importantfor reinsurers but remains a factor. Does thereinsurer provide cover in a particular mar-ket, and what is the reputation of the com-pany in that market?

Operating Performance

Operating performance is a reflection of howwell a reinsurer’s competitive position isexploited and is also key to sustaining share-holder value and raising capital. It is one of themost important criteria for Standard & Poor’srating of reinsurers because of the influence ithas on overall financial strength. Althoughinvestment income often plays a key role in pro-ducing a positive bottom-line result, of mostinterest is the underlying underwriting operat-ing performance, particularly in the currentinvestment environment.

In the long term, a strong business positionshould translate into consistently strong operat-ing performance. If it does not, then this tendsto be the result of poor management.

Because of the fluctuations inherent in non-life reinsurance in particular, Standard &Poor’s prefers to consider operating perform-ance for a period of years, preferably at leastfive, and Standard & Poor’s also looks aboutthree years ahead.

As with the primary nonlife market, a vari-ety of measures are used when analyzing a rein-surer’s operating performance, including thecombined ratio (and its separate expense andloss ratio elements), ROR, and ROE. However,when using these and other measures, the rein-surance analyst has to consider the reinsurer’sbusiness mix critically. This is because each lineof business will have different characteristics,particularly in terms of duration (longer-tailedbusiness has the benefit of holding—and earn-ing investment income on—a cedent’s premiumfor a longer period), loss volatility, and pricingcyclicality. Consequently, it is inappropriate tocompare directly at a point in time the com-bined ratio of a short-tail writer of volatile (e.g.,property catastrophe) business with that of alonger-tailed writer. All other things beingequal, more volatile, shorter-tailed lines requirelower comparable combined ratios.

Stronger reinsurers are expected to providean attractive risk-adjusted rate of returnthrough the underwriting cycle that wellexceeds their cost of capital. Better-performingcompanies will have more stable earnings byredeploying capital to better-performing lines ofbusiness. In soft markets, Standard & Poor’swould expect that better-performing reinsurerswill have substantially lower gross and net pre-miums, reflecting poorer overall underwritingconditions. Standard & Poor’s looks to differen-tiate reinsurers that are underwriting high risksat unattractive margins from those that are ableto identify where lines are attractively priced.Stronger reinsurers will continuously redeploycapacity away from lines that are poorly pricedrelative to the risks presented.

Diversification of earnings is a reflection ofthe business position and strategy of a reinsurer,and this issue is also addressed in this section ofthe analysis. Standard & Poor’s believes reinsur-ers that are very well diversified by geography,

R E I N S U R A N C E


type of business, or both are generally strongerthan reinsurers operating more narrowly.

Consistently poor underwriting performancewill affect the financial strength of the reinsurer,even though investment income might oftenplay a key role in producing a positive bottom-line result. Investment income is restricted bythe need for reinsurers to remain liquid and bythe general investment environment, which hasworsened significantly in recent years. Standard& Poor’s is reluctant to give much credit to anoperating performance that depends heavily onunsustainable realized gains.

Investments and Liquidity

Asset allocation, asset/liability managementtechniques, liquidity, and yield are the main fac-tors considered when assessing a company’sasset management. In addition, investment per-formance has increasingly become key to theoverall performance.

The key part of Standard & Poor’s analysisof investments is based on the allocation tovarious asset classes, as this determines thelevel of risk and liquidity of the investmentportfolio. Generally, reinsurers have adoptedstrategies that make their portfolios highly liq-uid in response to their often-volatile under-writing risks. Other key issues are the portfo-lio diversification within each asset class, anyconcentration of assets, underperformingassets, the invested asset credit quality, interestand currency exposures, and market risks.Asset/liability management is becomingincreasingly important, more so for life rein-surance and alternative risk transfer than non-life, where high quality and liquidity remainthe main objectives. Investment performanceis, of course, often an important contributor tothe overall operating performance.

Standard & Poor’s analysis of a reinsurer’sinvestments and investment strategy looks atwhether the investments provide sufficient,readily realizable assets to meet the liquidityrequirements under the most stressed loss fre-quency and severity scenarios. The analysis ofinvestments and investment strategy is impor-tant because notwithstanding the level of capi-

talization, the assets underlining capital haveto be realizable. The market and credit risksthat affect realization value are important forthe analysis. Therefore, the focus is on threemain areas:

� The extent to which there is sufficient liquid-ity in the form of realizable assets that coverstressed loss scenarios. Stressed loss scenar-ios cover both large catastrophe-type eventsas well as liquidity strains resulting fromincreasing attritional losses. Cash, near-cashitems, or a combination of the two mustcover probable maximum losses. Standard &Poor’s would also look at to what extentrealizability is adversely affected by collater-alization requirements, including funds with-held. Similarly, liquidity risks can be mitigat-ed by the availability of committed standbycredit facilities.

� The volatility of asset values, particularlythrough exposure to equities and othervolatile asset classes. Standard & Poor’swould also consider concentration risks andthe efficacy of hedging strategies to reducemarket risk.

� The extent of credit risk carried. Standard &Poor’s assesses the credit quality of the bondportfolio (in particular, the proportion ofnoninvestment-grade bonds) and other coun-terparties. Once again, Standard & Poor’swould also look for existing and potentialconcentrations.Liquidity is also enhanced by strong opera-

tional cash flows. However, cash flows are sen-sitive to changes in the insurance cycle and arenot a substitute for an appropriate long-termasset-allocation strategy.


Financial flexibility is an important part ofStandard & Poor’s analysis and is defined asthe ability to source capital and liquidity rela-tive to requirements. An analysis of financialflexibility takes into consideration the group’sneeds for, and availability of, capital and liq-uidity in the future.

The analysis of financial flexibility for rein-surers will also include their requirements for


capital and liquidity to finance growth and tomeet large-loss events. Sources of financial flex-ibility include the appetite in the capital mar-kets for further equity and debt of the issuer(including risk securitizations), existing com-mitted bank lines, and the availability of out-wards reinsurance.

Capitalization

Capitalization is important in the analysis offinancial strength because it measures the abilityof the reinsurer to absorb large losses and gen-erally to withstand difficult underwriting, eco-nomic, credit, and investment conditions.Capitalization can be seen as dependent on theinteraction of all the other analytical categories.Standard & Poor’s does not use a single meas-ure when analyzing capitalization. However, animportant tool used by the analyst is Standard& Poor’s risk-based capital model, from whicha capital adequacy ratio is derived. A staticmodel is used, measuring the capital availableagainst the needs for capital. Capital needs areprimarily expressed in terms of premium andreserve-based changes, indicating the degree towhich current or prior-year business can cause adepletion of capital.

The limitations of a one-size-fits-all, static,approach are well recognized, however.Consequently, considerable analytical judg-ment is used in interpreting the model’s results.In addition to this model, the analysis of capi-tal is also a function of the quality of capital,the impact of reserves, and the utilization of reinsurance.

An additional hard capital adequacy ratio,which removes the soft capital components—such as deferred acquisition costs, the value ofinsurance in force, the loss reserve discount,and hybrid equity—from the existing capitaladequacy ratio was introduced in 2003.Standard & Poor’s uses this ratio as an addi-tional part of its analysis of the quality of capi-tal, and this ratio is used to compare the qualityof reinsurers’ capital on a relative basis.

Reinsurance (strictly speaking, retrocession)is an important component of the analysis.Standard & Poor’s measures it to determine the

post-reinsurance impact of catastrophic eventsand the degree of dependencies on reinsuranceor particular reinsurers. Standard & Poor’s fac-tors in the counterparty credit exposure arisingfrom reinsurance recoverables. On a qualitativebasis, Standard & Poor’s also factors in situa-tions where reinsurance recoverables are a sig-nificant component of capital.

Reserves are a key component of Standard& Poor’s analysis and are treated as a subset ofcapitalization, though reserve adequacy levelsfrom one year to the next influence the view ofeconomic earnings. Adjustments are made inthe analysis of capital (in the capital model) toreflect over/under reserving. Normally, credit of100% is given for equity-type reserves such asequalization reserves, catastrophe reserves, andlump-sum incurred but not reported reservesbut rarely more than 50% for estimated reserveredundancies. Earnings are adjusted for all per-ceived reserve deficiencies or redundancies. Anexplicit discount is deducted from capital andreplaced with Standard & Poor’s own estimatesfor the time value of money. Relatively smalladjustments to loss reserve discount rates canheavily influence the outcome of the Standard& Poor’s capital model, especially where rein-surers write significant volumes of casualtybusiness. Any estimated reserve deficiencies aredebited 100%. Reserve deficiencies are general-ly considered to be a negative influence onStandard & Poor’s view of management. Anexception is made when the reserve deficiency isthe result of an industry development, such as achange in the legal environment. Companieswith persistent recognition of reserve deficien-cies over time will be viewed as weaker thantheir peers.

Evaluation of Loss Reserves Enhanced

Loss reserving for property/casualty reinsuranceand insurance groups has had a checkeredrecent history, particularly where it has involvedU.S. casualty business. Over the past threeyears, many groups have had to make addition-al provisions for past underestimations of loss



reserves (so-called “reserve strengthening”),which has simultaneously reduced the U.S.insurance industry’s pretax earnings and capitalby more than $35 billion in the past threeyears. The analysis of loss reserves is often themost challenging component in evaluating aninsurer’s current balance-sheet strength.Analyzing the current balance sheet is, in turn,an important component in determining theoverall rating.

Standard & Poor’s has recently enhanced itscriteria for evaluating the loss reserves of globalreinsurance groups and certain non-U.S. insur-ance groups writing casualty business.

BackgroundLoss reserves for casualty business are morevolatile than for property, as the ultimate settle-ments for casualty claims are not usuallyknown for many years, due to the long-tailnature of such claims. This reflects the fact thatcasualty loss events are less well defined, lesseasily identified, and can be valued less accu-rately and on a less timely basis than propertyloss events. Within casualty business, lossreserves relating to U.S. risk are most volatilefor several reasons. The willingness to litigateon the part of aggrieved individuals and corpo-rates is higher in the U.S. than anywhere else inthe world. Furthermore, litigation advice isreadily accessible to, and affordable by, all (forexample, via no-win, no-fee arrangements). Thejury system can result in huge compensationawards, which may be supplemented by puni-tive damages.

This is both good and bad news for insurers.On one hand, it creates a need for casualtyinsurance for those parties on the wrong end ofthis litigation, be they directors, officers, advis-ers, or owners of homes, cars, businesses, ships,or aircraft. On the other, as soon as an insurerbecomes a potential party to litigation, its“deep pockets” are a magnet for litigators.Hence, a vicious circle has been created, and theinsurance industry has had huge problems inreflecting future “social inflation” in its premi-um rates, and in estimating the cost of futureclaim payments on the policies it has in force.

Although some of these trends are apparent

in Europe, it is to a much lesser extent.Nevertheless, social inflation is gathering pace,and new forms of litigation are emerging all thetime. Historically, there are other reasons whygroups have reserved for casualty claims conser-vatively. Opaque accounting throughoutEurope, tax incentives in Germany andSwitzerland, regulatory approaches in France,and the lack of a shareholder value culture haveall served to keep reserves high. Reforms ofaccounting, tax, and regulation, and increasingshareholder influence are, however, starting tochange the landscape. The impact of globaltrends points to a need to focus more than everbefore on loss reserve adequacy in credit analy-sis, both for European and U.S. business.

New CriteriaStandard & Poor’s will analyze the adequacy ofproperty/casualty reinsurance and insuranceloss reserves using conventional actuarial tech-niques. The new criteria will be applied to:

� All reinsurance groups (including those filingAnnual Statements in the U.S., as Standard& Poor’s considers the Schedule P disclo-sures in those statements to be inadequatefor reinsurers);

� All subsidiary companies of groups writing amaterial proportion of third-party reinsur-ance business;

� All non-U.S. primary insurance companieswriting a material proportion of casualtybusiness; and

� All reinsurers and insurers where credit isgiven for surplus reserve adequacy inStandard & Poor’s capital adequacy model. The new criteria will not be applied to U.S.

primary insurance companies filing AnnualStatements with Schedule P disclosures. The cri-teria already in use will continue to apply forthese companies.

Each of these groups and companies will beasked to complete a loss-reserving spreadsheetmodel for individual casualty classes of busi-ness, representing at least 85% of total casualtyloss reserves (excluding asbestos and environ-mental claims, which will be subject to separateanalysis). In view of the lower risk associatedwith property classes the criteria will only be


applied at the analyst’s discretion.Claims data will be collected, in convention-

al triangulation format, gross of ceded reinsur-ance by lines of business/reserving classes usedby the reinsurer or insurer.

For stand-alone companies, this would nor-mally mean individual spreadsheets for:

� Different lines of business/reserving classes;and

� Different original currencies.For groups, this would normally mean indi-

vidual spreadsheets for: � Different subsidiaries; � Different lines of business/reserving classes;

and � Different original currencies.

The total of these classes will be reconciledto the group’s or company’s balance sheet.

The triangulation data may be presented onan accident- or underwriting-year basis. Whilethe insurers’ reserving classes should be used,Standard & Poor’s would expect U.S. and non-U.S. risk to be separated, as would beaccepted proportional and nonproportionalreinsurance business.

Why Gross of Ceded Reinsurance?Standard & Poor’s will focus its analysis on lossreserves gross of reinsurance for the followingreasons:

� Given the computer processing power at thedisposal of insurers today, most project theirloss reserves on a gross basis, and then applythe impact of their various reinsurance pro-grams to the gross reserve estimates.

� For prudence purposes, although insurersrecognize the potential reinsurance recoveriesarising from ceded nonproportional reinsur-ance due to gross “case” reserves in theirbalance sheet (that is, for events that havebeen reported to the insurer), many do notseparately estimate and recognize recoveriesdue to gross incurred but not reported(IBNR) reserves (events that have occurredbut have not been reported to the insurer).

� The alternative—estimating reserves on anet-of-ceded reinsurance basis—would sufferfrom many shortcomings, most notably theeffect of the complexity of reinsurance pro-

grams and changes therein over time (partic-ularly as the market hardens and softens).Historically, many insurers who were heavyusers of ceded reinsurance got their reserveestimates badly wrong where they reservedon a net basis.When it comes to calculating the loss reserve

redundancy or deficiency net-of-ceded reinsur-ance under the criteria, Standard & Poor’s willapply the relevant reported net–to-gross reservepercentage to the gross surplus or deficiency todetermine the net surplus or deficiency. Wherethe insurer has significant individual reinsur-ance transactions, such as whole-account stoploss and other forms of financial reinsurancecontract, Standard & Poor’s will separately ana-lyze the impact of these transactions on theinsurer’s net loss reserves.

Interaction with InsurersThe new criteria will only apply to interactivelyrated insurers. This is mainly because the datarequired is rarely available from public informa-tion. Interaction between insurers and analystswill be necessary since significant judgmentswill be required to make estimates based on thedata supplied. Analysts will need to make judg-ments about a number of issues, including:

� Which projection techniques are required foreach line of business (for example, on a paidor incurred basis);

� How many years of data to incorporate inthe analysis;

� Whether there are anomalies in the datawhich should not be projected forward; and

� Which “tail factors” to add to the historicdata supplied.

The ResultsThe individual line of business spreadsheets(including the calculated redundancy or defi-ciency net of reinsurance ceded) will be summa-rized in reporting currency, reconciled to thefinancial statements, and the total reserveredundancy or deficiency calculated.

The results derived under the new lossreserve criteria will not be viewed in isolation,and will be compared with any third-partyactuarial analysis. Analysts will also continue to



obtain details of the historic run-off profits andlosses by class of business and triangulations ofultimate/terminal loss ratios (that is, includingthe insurer’s estimate of IBNR reserves).

In the insurers’ capital adequacy model, atleast 65% (100% less 35% for deferred taxbenefit) of any deficiency would be deductedfrom the total adjusted capital (TAC), and up to50% of any surplus would be added to TAC.Adjustments would also be made to capitalrequirements to allow for reserve risk to reflectStandard & Poor’s assessment of the true eco-nomic level of loss reserves.

In its analysis of operating performance,Standard & Poor’s will adjust reported operat-ing performance for the full amount of deficien-cy or surplus determined in arriving at its viewof underlying economic earnings.

Property Catastrophe Reinsurance

For reinsurers with large excess-of-loss propertycatastrophic writings, Standard & Poor’s RatingsServices does not believe that reinsurance premi-ums provide a representative indication of expo-sure. Instead, Standard & Poor’s assesses capitalrequirements for property catastrophe risk basedon the reinsurer’s aggregate limits in force. Thesummation of the reinsurer’s limit exposures onevery active property catastrophe policy serves asin integral input into the model.

Standard & Poor’s capital model processstarts by examining a reinsurer’s gross aggre-gate exposure limits (per zone and by desig-nated peril) based on their respective third-party or proprietary model’s probabilistic out-put (i.e. exceedence probability curve; EPcurve) using a risk-analysis model. Standard& Poor’s will then evaluate the reinsurer’s riskmanagement (retrocessional program) of lia-bility assumed by looking at the shape of itsnet EP curve. For both the gross and net EPcurves, the scenarios (on an occurrence basis)used range from 1-in-10 years through 1-in-500 years, with total aggregate limits alsoprovided.

Following the evaluation of the company’snet EP curve data points for each zone andperil, Standard & Poor’s runs this datathrough a random generator, and the resultsare then carried to a distribution output chartby return interval. Credit is given that isequivalent to 80% of net written premiumsrelated solely to excess of loss catastrophicrisk. The required capital needed at a ‘BBB’level of confidence is the model’s 1-in-250-year scenario level for a monoline propertycatastrophe reinsurer and a 1-in-100-year sce-nario for well-diversified reinsurers with astrong track record of property catastrophicrisk management.


Captive Analysis

Captive insurers continue to be a viable, grow-ing alternative to purchasing insurance protec-tion through commercial market participants.According to Standard & Poor’s RatingsServices’s insurance rating criteria, the assign-ment of counterparty credit and financialstrength ratings to captives is guided by the fol-lowing factors and considerations:

Rating Approach

To assign a rating to a captive, it is not essen-tial for Standard & Poor’s to have a publicrating on the parent. The parent will have tobe rated, as this rating is the basis for the rat-ing on the captive, but the rating on the par-ent need not be made public. Regardless, itwill always be necessary to establish a firmview of the parent’s financial strength—madepossible with the involvement of the appropri-ate noninsurance Standard & Poor’s analyst—before the rating decision on the captive canbe made.

The main issue to be addressed in rating acaptive is whether it is considered core to itsparent. Once a captive is considered core, itwould be assigned the same rating as its parent.It should be noted that the issues related to thecore status of a captive differ from those thatdetermine if an insurance subsidiary is core,which are outlined in Standard & Poor’sFinancial Services Group Methodology. Theseare the main issues in determining whether acaptive is core:

� The captive must be a pure captive, whichmeans that it insures and/or reinsures therisks of its parent almost exclusively. Anythird-party business must be insignificantcompared with the parent risk; it shouldnot exceed 10% of the net written premi-um or constitute net exposures significantlyin excess of—or materially different from—parent risks. When the parent operates ajoint venture, it is acceptable for the cap-

tive to underwrite risks beyond the jointventure equity stakes of the parent, andpremium from such risks should not countfor the purpose of the 10% third-partypremium ceiling. However, insurance of theparent’s customers is considered third-partyrisk. When a captive exceeds the limita-tions of a pure captive, Standard & Poor’scan consider rating this as a traditionalinsurer or reinsurer according to standardcriteria. In some cases, a captive maychoose to underwrite third-party risks ofup to 30% of total premium for the pur-pose of satisfying fiscal requirements, typi-cally to obtain tax deductibility for the pre-miums paid to the captive by its parent. Insuch cases, Standard & Poor’s will considerwhether appropriate underwriting guide-lines, expertise, reinsurance, and other fac-tors are prudent enough that the companycan still be considered a captive.

� The captive’s strategy should be clearlydefined and closely aligned with the par-ent’s risk-financing strategy.

� Investments in the parent must be ofacceptable quality and liquidity. Theinvestment activity must be supportive of—and not equal to or more important than—the insurance operation.

� The score on Standard & Poor’s capitaladequacy model must be at least in linewith rating on the parent. In addition, thecaptive should be able to withstand theimpact of the largest net loss imaginablewithout capital falling below a good level of capital adequacy according to the Standard & Poor’s risk-based capital model.

� The captive’s reinsurance program mustprovide complete protection for all risksaccepted by the captive, with the exceptionof the risks that the captive has planned to


Rating Captive Insurers

retain for its own account. No gaps mustexist between the limits and conditionsprovided to the parent and the captive’sreinsurance protection, except as plannedby the captive and covered by its assets.

� If a captive does not purchase reinsurance,the captive’s exposures must be covered byits assets. It must be able to withstand theimpact of the largest net loss imaginablewithout capital falling below a good levelof capital adequacy according to Standard& Poor’s risk-based capital model.

A Captive Rating is Limited by theRating on Its ParentIt should be noted that in the vast majority ofcases, the rating on the parent will be higherthan what would be assigned to the captive ifit was considered as a stand-alone insurancecompany with no parental support. The mainreason is that the captive’s business position issignificantly impaired by the dependency onone client. At the same time, it is important tooutline why, in nearly all cases, it is not possi-ble for a captive to be rated higher than itsparent. The main reasons are:

� The industry risk of the parent provides aceiling for the captive’s industry risk.

� The captive’s business position is limited tothe parent and fellow subsidiaries.

� The captive’s management and corporatestrategy are determined by the parent.

� Operating performance is generally a reflec-tion of the parent’s risk-financing strategyand the role played by the captive.

� Investments can ultimately be determined bythe parent, though some captives determinetheir own strategy.

� Capital is provided by the parent, which isnormally also in a position to determine thelevel of dividend.

� The captive is completely dependent on theparent for financial flexibility.

Rating a Captive on a Public-Information BasisStandard & Poor’s has decided against ratingcaptives on a purely public information (pi)

basis because of the lack of public informationavailable about captives’ relationships with theirparents, which is a crucial part of the rating.

Consideration of a Captive According toStandard & Poor’s Rating CriteriaThe risks insured by the captive will be closelyassociated with the industry risks of the par-ent. Therefore, it is appropriate to useStandard & Poor’s opinion of the relevantindustry as a guide for the captive’s industryrisk. This will typically take into considerationany outlook established on the industry inquestion. In addition, the rating on the parentis likely to provide a ceiling on the view of thecaptive’s industry risk.

Business Position

For a pure captive, the business position is theinsurance and/or reinsurance of the risks ofthe parent. As such, the captive does not havea business position without the parent. Theparent’s strategy is to use the captive as amechanism to finance risks, either as a directinsurer or as a reinsurer of a third-partyinsurer, a so-called fronting insurer. Thisdependency on the parent generally leads tothe captive’s business position being consid-ered good (‘BBB’ range) but not any betterthan good because of the complete single-cus-tomer dependency. A limitation is when theparent’s industry risk is below ‘BBB’, in whichcase a view in line with the opinion of theparent’s industry risk would be appropriate.

Management and Corporate strategy

In the analysis, it will be important to deter-mine that the management of the captive—whether through the captive’s own employeesor outsourcing—has the necessary expertise toimplement the strategy effectively and carryout the required operational functions. It isalso important that the parent’s requirementsfor sufficient control and management infor-mation are met.


Operating Performance

Operating performance is considered accord-ing to Standard & Poor’s normal criteria, tak-ing into account that the operating perform-ance is likely to be determined by the risk-financing strategy of the parent. A strategythat aims to break even or accepts very con-siderable volatility can therefore be accept-able. However, the availability of capital,including an appropriate reinsurance pro-gram, will be an important consideration indetermining the validity of the strategy.

Investments and Liquidity

The investment strategy and allocation ofassets will be judged according to Standard &Poor’s normal criteria and must, in particular,be appropriate to the business underwritten bythe captive. Investments in the parent or fellowsubsidiaries could fail to meet the quality crite-ria, result in a concentration charge inStandard & Poor’s capital model, and preventthe captive from being assigned the same ratingas the parent. Any quality assessment of invest-ments in the rest of the group is likely to beinfluenced by Standard & Poor’s view of thefinancial strength of the entity in which theinvestment is made. In extreme cases, Standard& Poor’s could decide that the investmentactivities of the captive—in the parent or else-where—significantly exceed the importance ofthe insurance activities, in which case theassignment of an insurer financial strength rat-ing might not be appropriate.

Capital Adequacy

Several evaluations will be made, including theneed to achieve a score on Standard & Poor’scapital adequacy model that is at least in linewith the rating on the parent. In addition, thecaptive should be able to withstand the impactof the largest net loss imaginable without capi-tal falling below a good level of capital adequa-cy according to the model. The premium andreserve charges are often meaningless for a cap-tive and may, at the analyst’s discretion, be sub-stituted by a charge equivalent to the largestimaginable loss.

The existence of an appropriate reinsur-ance program is often the most importantstand-alone factor in rating a captive. It isimportant to note that the failure of a cap-tive’s reinsurance program could lead to thegroup being unable to recover from externalreinsurers, which could affect the financialstrength on the parent if the amounts are sub-stantial. Accordingly, in most situations, theterms and conditions of a captive’s reinsur-ance protections are expected to mirror pre-cisely those of its captive insurance policies.

Reserves are considered as per Standard &Poor’s insurance criteria.


A captive’s financial flexibility is normallycompletely derived from the parent and con-sidered at the parent’s level because it isexpected that the parent will fully support its subsidiary.

C A P T I V E A N A LY S I S


Group Methodology

Over the past few years, corporate manage-ments in the financial services sector have beentaking a much harder look at the strategic via-bility of the businesses they are in. Executivesin this sector appear more apt to cut the cordwith less-strategic or underperforming opera-tions than they had been in the past. This situ-ation indicates to Standard & Poor’s RatingsServices that the strategic significance of sub-sidiaries in these groups must be reviewed dili-gently and that subsidiaries that might beviewed as strategic today could be candidatesfor sale tomorrow.

In recent years, there have been several casesof a management selling or spinning-off sub-sidiaries that it once had considered strategicand to which it had indicated its commitment.On an ongoing basis, Standard & Poor’s will bereviewing the strategic nature of rated legalentities within financial services enterprises andthe strength of their operational performancewithin the context of the organizations ofwhich they are a part. To the extent that thestrategic importance of these subsidiaries iscalled into question or operational performanceissues are present, the degree of support embed-ded in the ratings will be reduced.

Applying the Group Methodology Criteria

The accelerated pace of consolidation hasheightened the complexity of analyzing finan-cial services groups. This trend is expected tocontinue on a global basis. To capture the risksand strengths of this changing terrain, Standard& Poor’s has developed and refined its analyticmethodology for rating the individual compa-nies within financial services groups.

In many cases, Standard & Poor’s expectsthat the group will support subsidiaries, butincreasingly it has become necessary to questionthe ongoing nature of this support in the con-text of how the subsidiary fits into the long-term strategy of the overall financial services

enterprise. Indeed, over the past few years, anumber of financial services groups have divest-ed major subsidiary operations or have refo-cused and redefined subsidiaries that had previ-ously been considered central to their commer-cial strategy. On the other hand, the refocusingof operations has also occasionally led tochanges in which some previously peripheralsubsidiaries have become much more integral.

A more dynamic management style requiresa more dynamic analytic process. During thisanalytic process, two principal issues need to be addressed:

� What is the overall financial security of thegroup?

� How does each entity in the group, whethera holding company or an operating compa-ny, fit into the overall group structure, andwhat would be the likelihood of group man-agement proving willing and able to supporteach such entity if significant capital supportwere required? Conversely, what is the likeli-hood of group management wanting to sell,putting into run-off, or, ultimately, beingcapable of walking away from a given groupmember?When addressing these issues, Standard &

Poor’s believes that for many financial servicesgroups, it is appropriate to evaluate operatingbanks, insurers, holding companies, and othersubsidiaries—both on an individual basis and inthe context of the aggregate financial security ofthe group. Standard & Poor’s also believes thateven if a group isolates its riskier lines of busi-ness into a so-called bad subsidiary, such segre-gated risks should not be ignored when analyz-ing the group. The methodology for analyzingfinancial services groups attempts to provide aconsistent framework for assessing the credit-worthiness of the entire organization as well asthe individual (rated) entities within it.

Standard & Poor’s approach essentially com-prises three stages:

� Undertake a consolidated and unconsolidat-ed group analysis to allow notional group


Group Methodology

ratings to be confidentially assigned acrossthe entire group as though it were a singlecorporate entity.

� Establish confidential stand-alone and statusquo ratings for each individually rated entitywithin the group.

� Complete the analysis by designating eachrated entity within the group as either core,strategically important, or nonstrategic tothe ultimate parent group and adjust thefinal public rating accordingly to reflect theappropriate level of group support.

Group Financial AnalysisThe first objective of the group analyticalexercise is to establish a set of notional (non-public) aggregate ratings for the financialservices group under review. By looking at allthe operating and holding-company units thatare material to the group in terms of size orrisk, aggregated ratings are determined thatare applicable to the consolidated group riskprofile as if it were a single corporate entity.Such aggregated core group ratings becomethe reference point for any public ratings thatmay subsequently be assigned to the individ-ual legal entities that actually constitute thegroup. This group analysis is based on a com-bination of consolidated and individual com-pany financial data, and the ratings so derivedare usually indicative of the counterpartycredit, senior debt and, for insurers, financialstrength ratings that are deemed applicable tothe main operating companies of the consoli-dated group. These notional core group rat-ings are internally assessed with respect to themain operating and holding company entitiesacross the group. However, the notional rat-ings applicable to pure holding companieswithin groups are derived indirectly, usuallyby notching down by one to three ratingsnotches from the notional core group counter-party credit rating assigned to the main oper-ating companies of the group. Any notchingor gapping between the notional operatingand holding company ratings reflects percep-tions of greater default risk for a group’s(unregulated) holding company liabilities than for that same group’s (regulated)operating companies.

Stand-Alone and Status-quo Analyses of Individual Entities.In the second phase of the group analysis,Standard & Poor’s subjects each rated sub-sidiary to a full credit assessment, includingboth financial and nonfinancial factors. Thisprocess initially produces both stand-aloneand status quo rating assessments of the indi-vidually rated legal entities within the group.

The stand-alone rating is a rating commit-tee’s confidential assessment of what a singlelegal entity within a group would be rated ifanalyzed exclusively on the basis of its intrin-sic merits as a totally independent, free-stand-ing operation. This stand-alone rating isentirely devoid of any influence—whetherpositive or negative—by external factors atthe wider group level. In some circumstances,the committee could conclude that the entityunder review would not be viable outside itsgroup, in which case the entity would beassessed on a status quo basis as opposed to astand-alone basis.

The status quo rating is a rating commit-tee’s confidential assessment of what a singlelegal entity within a group would be ratedincorporating the benefits or problems ofbeing part of the same group, including suchthings as access to group distribution, involve-ment of group management, access to groupresources (excluding capital contributions),and the benefit or detriment of the group’sfinancial flexibility. A status quo rating wouldnot include any potential capital contributionfrom the group.

If any strong implicit or explicit group sup-port exists for the group member underreview, this will be factored into the existingstand-alone and status-quo analyses to pro-duce a final rating. In generating the final rat-ing, the notching upward, if any, is normallyfrom the status quo rating because in mostcases, a divestment of the subsidiary isdeemed unlikely. However, if divestment fromthe parent group were an active analytic con-cern, the notching upward, if any, would befrom the stand-alone rating assessment andnot from the status quo rating.


Group Status: Core, StrategicallyImportant, or Nonstrategic?

In the third stage of the analysis, Standard &Poor’s classifies group members into one of threecategories: core, strategically important, or non-strategic. Certain characteristics of each of thesecategories can be found in many subsidiaries ofvaried group status, and not all characteristicsneed be present for a subsidiary to be consideredcore or strategically important. However, the fol-lowing factors are indicative of what a ratingcommittee will closely consider when seeking toestablish an entity’s group status:

Core Group CompaniesCore group companies are those whose exis-tence and operations are considered whollyintegral to the group’s current identity andfuture strategy and which Standard & Poor’sbelieves would be supported by the rest of thegroup under any foreseeable circumstance.Based on analysis of their importance to theentire organization, companies considered coreto the group would be assigned the core groupratings that would be applicable either to oper-ating or to holding companies, as appropriate.

Core group companies are defined as thosesubsidiaries:

� Operating in lines of business integral toStandard & Poor’s understanding of theoverall group strategy. The activities under-taken or the products sold are very closelyaligned to the mainstream business of thecompany and are often sold to customers inthe same target market. Nevertheless, thenature of the subsidiary’s business shouldnot be substantially more risky than thegroup’s business as a whole.

� Sharing the same name or brand with themain group unless there is a strong business-development incentive to use a differentname.

� Separately incorporated—mainly for legal,regulatory, or tax purposes—but de factooperating more as a division or profit centerwithin the overall enterprise, usually exhibit-ing similar business, customers, and regionalfocus to other principal operations of the

group. Core subsidiaries will often sharethings like a distribution network andadministration with other major operatingunits.

� To which senior group management hasdemonstrated a strong commitment—a trackrecord of support in good times as well asbad. Another indication could be to totallyintegrate the operations of a subsidiary oraffiliate so that it is fully integrated into theentire enterprise. In some cases, an insurancesubsidiary might be 90%–100% reinsuredinternally by the group.

� That constitute a significant proportion ofthe parent group’s consolidated position,particularly at least a 5%–10% share of con-solidated group capital (or capable of reach-ing this level within three to five years). It islikely also to contribute on a sustainablebasis a significant proportion of consolidatedgroup turnover and earnings.

� That are appropriately capitalized commen-surate with the rating on the group. Higher-rated entities are expected to be better capi-talized, in line with the rating on the group.

� That are reasonably successful at what theydo or have realistic medium-term prospectsof becoming successful relative to bothgroup management’s specific expectations ofthe subject company and the earnings normsachieved elsewhere within the group. Thesubsidiaries demonstrating ongoing perform-ance problems or that are expected to under-perform group management’s expectationsand group earnings norms over the mediumto long-term would not be viewed as core.

� Where it is inconceivable that the unit couldbe sold, such as when administrative, opera-tional, and infrastructure dependence on therest of the group make it impossible to severthe entity from the rest of the parent group.

� That are at least 51% voting-controlled bythe group.

Strategically Important Group CompaniesThese are group companies with ratings thatare considered supported by external group fac-tors and which in their own right appear almostto satisfy the core characteristics but where the

G R O U P M E T H O D O L O G Y


rating committee concludes that there is somedoubt concerning unequivocal eligibility forcore group status. All group entities designatedstrategically important will initially be assessedon both stand-alone and status-quo bases,essentially on their intrinsic merits. The keycharacteristics analyzed are the operating per-formance, market position, and capital adequa-cy of each strategically important subsidiary.However, based on Standard & Poor’s analysisof their importance to the overall organization,the final public rating on strategically importantsubsidiaries will incorporate some additionalcredit for the likelihood of ongoing group sup-port. In most instances, Standard & Poor’s willassign three notches (one full rating grade) ofsupport to the status quo rating on a strategi-cally important subsidiary.

Standard & Poor’s does not believe that anorganization’s commitment to a strategicallyimportant subsidiary is as strong as the commit-ment to a core subsidiary. Therefore, in general,it will not bring the strategically important sub-sidiary rating up to that on the core groupmembers. In other words, the ratings on astrategically important subsidiary, when includ-ing implied support, will be at least one notchbelow the ratings assigned to core group mem-bers. However, in some limited circumstances,strategically important subsidiaries to which thegroup is strongly committed could have thesame ratings as those on the core group mem-bers. For strategically important entities to havethe same ratings as those on the core members,Standard & Poor’s must be confident that thereis a particularly strong commitment by thegroup to these entities. To the extent that theseentities demonstrate ongoing performance prob-lems, Standard & Poor’s believes managementis re-evaluating its commitment to these opera-tions or they are part of a corporate restructur-ing, Standard & Poor’s will establish a ratingsgap between the subsidiary rating and that onthe group.

Strategically important subsidiaries aredefined as those subsidiaries:

� That share most of the core characteristicsidentified above but do not exhibit the nec-

essary size and/or capital adequacy requiredfor core status.

� That are important to the group’s long-termstrategy but are operated more on a stand-alone, autonomous basis.

� That do not have the same name, nor is itreadily apparent that the different name hasunique value. (In such instances, the concernmust be that the different name is being usedas a way to distance the parent companyfrom the subsidiary.)

� That even if not of sufficient size and capi-talization to meet core requirements, arenonetheless prudently capitalized for theirbusiness risk and within their market envi-ronment, with the level of capitalization atleast being assessed by a rating committee as clearly compatible with an investment-grade rating.

� To which group management is committed,and where the subsidiary is not likely to besold. The rating committee may nonethelessconclude that group commitment might onlybe valid over a finite period.

� That share the same customer/distributionbase and many other characteristics with thecore group but where the nature of the busi-ness transacted is of a distinctly higher riskprofile than is normal elsewhere within thegroup and could constitute a potentially sig-nificant threat to the earnings and/or finan-cial strength of the consolidated group.

� That are reasonably successful at what theydo or have realistic medium-term prospectsof becoming successful relative both togroup management’s specific expectations ofthe subject company and to the earningsnorms achieved elsewhere within the group.The subsidiaries expected to underperformgroup management’s expectations and group earnings norms over the medium to long term would not be viewed as strategically important.

� For which the nature of the incurred risks inpractice precludes the subsidiary from everbeing sold even though the product lineand/or market is not core to the group, suchas a major subsidiary with a significant but


difficult-to-quantify book of latent or contin-gent liabilities.It should be noted that significant acquisi-

tions are normally expected to be viewed as nomore than strategically important rather thancore, at least in the first year or two of owner-ship within the group. The sooner a majoracquisition is assimilated, the faster it couldmove from being classified as strategicallyimportant to being recognized as a core sub-sidiary. On the other hand, significant and sus-tained operating deterioration or earningsunderperformance at a previously core unitcould result in its reclassification to strategicallyimportant or even to nonstrategic.

Unless the group has established internation-al status, subsidiaries located in countries orregions different from the de facto country orregion of domicile of the parent might be con-sidered strategic but are usually not accepted ascore. This is especially true for subsidiaries inemerging markets. In addition, because of thehigher risk of investments in emerging markets,even acceptance of strategic importance mightstill not prove sufficient cause for a rating com-mittee to assign more than one or two notchesas an uplift to the basic status quo rating(rather than the standard three notches that arecommonly accorded for strategically importantgroup status elsewhere).

In some infrequent instances, subsidiariesmay be considered strategically important to theenterprise despite clearly operating outside ofthe mainstream business of the company. Thesecompanies’ products might typically be sold todifferent customer groups and through differentdistribution channels than those of the group’sprincipal companies. The management of theseoperations might not be closely integrated intothe group. Nevertheless, Standard & Poor’smay judge these operations to be an importantpart of the group’s ongoing strategy if groupmanagement has demonstrated a strong com-mitment to the subsidiary, and the likelihood ofthe subsidiary being sold is accepted as beingvery remote. In these rare situations, Standard& Poor’s will impute two notches of group sup-port into the final public ratings. It also could

be appropriate to impute two notches of sup-port in cases when an acquisition has beenrecently completed but the committee judges itprudent only to recognize the benefits of inte-gration if they happen over time.

On occasion, a rating committee may assignmore than three notches of credit to the statusquo assessment of a strategically importantgroup company if particular circumstances war-rant it. This would occur in cases where thesubsidiary is too new to be assessed highly oneither a stand-alone or a status quo basis butwhere the committee judges that there isnonetheless a very substantial commitment bythe parent to support this particular operation.In particular, this would include subsidiarieswith stand-alone or status quo ratings that suf-fer because of a lack of economy of scalebecause of their start-up nature. These sub-sidiaries would be expected to grow into ahigher stand-alone or status quo rating, thusjustifying their parental commitment. For exam-ple, recently launched subsidiaries with a viablebut unproven business plan (such as selling viathe Internet or by telephone rather than by tra-ditional methods) could fall into this category.Standard & Poor’s would not view matureoperations as meeting these circumstances.

It is worth noting that strategically impor-tant status is often considered within Standard& Poor’s as being a dynamic state where thesubsidiary in question is evolving either towardfull core status over time or where its prospec-tive strategic significance to the parent group isperceived as being increasingly questionable.Failure of the group to support any subsidiarythat is experiencing financial or operating dete-rioration would be considered cause for subject-ing the supported rating on the subsidiary tosevere scrutiny. In addition, putting up for saleor divesting a subsidiary that has support con-siderations factored into the rating mustinevitably trigger a reassessment of the rating.In some cases, it might be appropriate toremove the support from the rating immediate-ly, such as when the subsidiary will be spun offand a committee is able to assess its credit qual-ity on a pro forma basis. In other cases, espe-



cially when the regulatory and market frame-work would likely prevent a severe decline increditworthiness from being allowed to occur, itcould be appropriate to wait before taking anyrating action other than placing the rating onCreditWatch.

Nonstrategic group companiesStandard & Poor’s classifies nonstrategic sub-sidiaries as akin to passive investments of thegroup. They are not considered strategic, long-term holdings of the group, and the ratingsreflect the concern that they could be soldopportunistically in the near or intermediateterm. In most instances, these subsidiarieswould be rated on a purely stand-alone basis,and such ratings would almost invariably belower than the core group rating. If the ratingcommittee were to conclude that for whateverreason, a sale in the near to medium term wasunlikely, then this belief would be factored intothe analysis, and an appropriate status quo rat-ing ascertained. If the subsidiary possesses sev-eral strategically important characteristics, if itis not obviously a candidate for sale over theshort term, and if Standard & Poor’s believesthe subsidiary would receive parental supportwere it to experience financial difficulties, thenone additional notch of support could be addedto the status quo rating.

Nonstrategic subsidiaries are defined asthose subsidiaries:

� That do not meet sufficient criteria to bedesignated core or strategically important.

� That are not prudently capitalized.(Capitalization is not considered consistentwith an investment-grade rating.)

� That are start-up companies operating forfive years or less.

� That Standard & Poor’s believes might besold in the relatively near or intermediateterm or be placed in runoff.

� That are highly unprofitable or marginallyprofitable and for which there is little likeli-hood of a turnaround or of additional sup-port from the group.

� That are in ancillary, nonstrategic businesses.

Rating Core or StrategicallyImportant Subsidiaries Higher thanthe Core Group Rating

There could be rare situations in which a sub-sidiary is recognized by Standard & Poor’s tohave operational characteristics in its own right—other than just superior capital adequacy—thatcause it to request and clearly merit considerationfor a rating above the core group level. Such sub-sidiaries can be rated at most up to two notchesabove the applicable core group rating. However,it must be emphasized that to be so rated, thesubsidiary must exhibit superior business andoperating characteristics relative to the rest of itsgroup and be demonstrably severable and inde-pendently sustainable if the parent group forsome reason would get into serious difficulties.Moreover, faced with the hypothetical scenario ofsuch severance occurring, the rating committeewould need to feel confident that the higher-ratedentity would be able to maintain its capitalizationunimpaired (i.e., its assets would not be liable toseizure by creditors elsewhere in the group) whileremaining able to operate effectively outside theformer parent group. The superior and sustain-able financial profile of the entity relative to itsmain parent group would be seen as being furtherprotected if there is outside minority ownershipof 10%–20% with effective board representationand if its distribution channels are autonomous ofthe rest of the group. In addition, a clear econom-ic incentive for a sustained higher rating mightalso prove compelling.

In such situations, Standard & Poor’s analyticstance would be to deconsolidate the capital usedto fund this higher-rated subsidiary from theanalysis of the residual capital available to therest of the parent group. By considering theresources held at the higher-rated entity to beunavailable to the rest of its group, the standardcore group ratings could themselves be lowered.This analytic adjustment may in turn furtherrestrict the initially determined higher rating onthe subsidiary because of application of the rulethat the maximum allowable differential betweena higher-rated subsidiary and its parent groupremains two notches.




Maintenance-of-Net-Worth AgreementsExplicit support may be used to raise the rat-ing on both strategically important and non-strategic entities within a group. Acceptedforms of explicit support are guarantees and,in some cases, net-worth-maintenance agree-ments. A full guarantee that allows timelycash payments can be used to raise the rele-vant ratings to the level of the guarantor. Inaddition, strongly worded net-worth-mainte-nance agreements can be used as a means ofexplicit support for both strategically impor-tant and nonstrategic subsidiaries, but usual-ly only in cases where a guarantee is legallynot available.

Under Standard & Poor’s group ratingsmethodology, the rating on a subsidiary thatis considered strategically important to thegroup and that has received an acceptablenet-worth-maintenance agreement as explicitsupport may be raised to one notch belowthe rating on the entity providing the sup-port. In the case of a nonstrategic subsidiary,an acceptably worded net-worth-mainte-nance agreement will normally allow the rat-ing on the subsidiary to be raised by one rat-ing category but no higher than one notchbelow the core group rating. A net-worth-maintenance agreement will be acceptedonly when Standard & Poor’s believes that policyholders or other third-party beneficiaries, such as regulators, can enforcethe agreement.

In some circumstances, Standard & Poor’scould choose to assign highly rated, strategi-cally important subsidiaries the same ratingsas those on other core group members if theyhave received a very strongly worded mainte-nance-of-net-worth agreement from a coregroup member. For this to happen, Standard& Poor’s must be confident that there is aparticularly strong commitment by the groupto these entities. To the extent that these enti-ties demonstrate performance problems,Standard & Poor’s believes management isre-evaluating its commitment to these opera-

tions, or they are part of a corporate restruc-turing, Standard & Poor’s will maintain agap of one notch between the subsidiary rat-ing and that on the group.

Maintenance of tangible net worth. Thesubsidiary should be prudently capitalizedusing a multiple of a regulatory solvencymargin or regulatory risk-based capital ratio.(In a letter, management should also indicateits intention to maintain the appropriate levelof capitalization in line with Standard &Poor’s measures of capital adequacy.) Theparental support under this agreement shouldnot be capped.

Liquidity. The parent will cause the sub-sidiary to have sufficient cash for the timelypayment of contractual obligations issuedby the subsidiary.

Ownership. The parent will own thissubsidiary and must be at least a majorityowner, though not necessarily 100%.

Successor agreement. The agreement is binding on successors.

Duration. The agreement shall continue indefinitely.

Rights of policyholders. If the parentfails to perform under this agreement, poli-cyholders or other third-party interests,such as the regulators, have a direct rightto enforce this agreement.

Modification and termination. Modifi-cation or termination can be effected only ifsuch changes do not adversely affect the poli-cyholders’ or beneficiaries’ interests.Acceptable clauses would include an agree-ment to support all existing policyholders atthe time of termination or an agreement tosell only to an entity with the same rating asthe parent. The agreement may be terminat-ed when the subsidiary receives a stand-alonecredit rating equal to the supported rating.

The effect on the provider credit rating ofthe support given under a guarantee or a net-worth-maintenance agreement must be evalu-ated by Standard & Poor’s prior to its assign-ing the supported rating.


Guarantee CriteriaThe term “guarantee” can apply to any formof guarantee, including a parent guarantee, adebt-purchase agreement, a surety bond, aletter of credit, or—in certain circum-stances—an insurance contract. In transac-tions using guarantees as a form of creditenhancement, the evaluation of the credit-worthiness of the primary obligor is shiftedto an evaluation of the creditworthiness ofthe guarantor and the compliance of theguarantee with certain criteria. The guaran-tee criteria are intended to ensure that thereare no circumstances that would enable theguarantor to be excused from making a pay-ment necessary for paying the holders of therated securities.

Guarantees that are being relied on byStandard & Poor’s should contain the fol-lowing statements:1. The guarantee is one of payment and not

of collection.2. The guarantor agrees to pay the guaran-

teed obligations on the date due andwaives demand, notice, marshaling ofassets, etc.

3. The guarantor’s obligations under theguarantee rank pari passu with its seniorunsecured debt obligations.

4. The guarantor’s right to terminate theguarantee is restricted.

5. The guaranteed obligations are uncondi-tional—irrespective of value, genuineness,validity, waiver, release, alteration,amendment, and enforceability of theguaranteed obligations—and the guaran-tor waives the right of set-off, counter-claim, etc. In connection with lease trans-actions, the guarantee also should pro-vide that in the event of a rejection of alease in a bankruptcy proceeding, theguarantor will pay the lease payment,notwithstanding the rejection and asthough the rejection had not occurred.

6. The guarantee is reinstated if any guaran-teed payment made by the primary oblig-or is recaptured as a result of the primaryobligor’s bankruptcy or insolvency.

7. The guarantor waives its right to subroga-tion until the guaranteed obligations arepaid in full.

8. The guarantee is binding on successors ofthe guarantor, and the trustee is a benefi-ciary of the guarantee.

9. The holders of the rated securities areexplicit third-party beneficiaries of theguarantee.

10. The guarantee cannot be amended orterminated without the consent of 100%of the holders of the rated liabilitiesand/or securities.

11. The guarantor has subjected itself tojurisdiction and service of process in thejurisdiction in which the guarantee is tobe performed.These 11 concepts are used in reviewing

guarantees in U.S. transactions. If the trans-actions involve entities that are domiciledoutside the U.S., tax provisions and currency-exchange provisions should also be considered.

All guarantees are unique to the specificcircumstances of the guarantor and guaran-teed entities and/or obligations.Consequently, Standard & Poor’s reviewseach guarantee against these criteria on acase-by-case basis. The analyst will reviewmanagement’s intent, making sure that it isaligned to the legal guarantee. In providinga rating uplift after reviewing a guarantee,Standard & Poor’s would expect the guar-antee to be long term. If Standard & Poor’sviews the guarantee as shorter than theobligations it supports, the rating uplift willnot be given.

Standard & Poor’s expects beneficiariesof the guarantee to be able to enforce it.Legal opinions are required to demon-strate that the guarantee is enforceableand that existing policyholders remainprotected even after termination.

When guarantees are used to enhance thefinancial strength ratings on insurance com-panies through the guarantee of only policyobligations, that entity will not have a coun-terparty credit rating, as the credit strength relies on the guarantee. Standard & Poor’sregularly reviews guarantees that enhancefinancial strength in line with current guarantee criteria.

Segmented Ratings: Rating Subsidiaries OneCategory Above the Rating on the GroupA subsidiary may be rated up to one category(three notches) above the group rating assumingits stand-alone business, operating, and capitalcharacteristics can support it and also assumingthat the subsidiary can be properly evaluated ona segmented basis. These segmented ratingsrequire a greater degree of protection of thesubsidiary’s financial strength in the event offinancial stress at the group than would exist inthe situation outlined in the previous section.As mentioned above, in such situations, thecapital necessary to support this higher-ratedsubsidiary would be deconsolidated from theanalysis of the total consolidated capital posi-tion, and this could reduce the group rating,which, in turn, could restrict the initially deter-mined higher rating on the subsidiary.

To evaluate group subsidiaries on a segment-ed basis, the following would be necessary:

� The subsidiary should be severable from thegroup and able to stand on its own or sub-contract certain functions previously provid-ed by the parent.

� Standard & Poor’s would have received anopinion by outside counsel that the subsidiarywould not be expected to be taken intoadministration (or equivalent) in the event ofinsolvency at the parent-company level.

� Standard & Poor’s would have received aletter from the parent covering the dividendpolicy from the subsidiary and the independ-ent integrity of the subsidiary.

� There would exist either an independenttrustee with the ability to enforce the pro-tection of the rights of third parties or out-side ownership of at least 20% with someindependent membership on the board ofdirectors.In all cases, there should be an economic

basis for the parent’s commitment to maintainthe capital to support the higher rating on thesubsidiary.

Evaluating Start-Ups Under Group MethodologyTraditionally, start-ups (operations with a busi-ness track record of five years or less) have not

been viewed as strategically integral to finan-cial services groups because of their lack of aproven operating history and Standard &Poor’s perception that there could be morevolatility in their earnings than in existingoperations. In view of these issues, Standard &Poor’s will not view start-up operations as coreto financial services groups. One exception tothis policy is the emergence of a growing num-ber of newly established, tax-efficient sub-sidiaries set up in centers such as Dublin,Bermuda, the Cayman Islands, and theChannel Islands. To the extent that these sub-sidiaries are set up specifically to serve animportant number of existing customers withsimilar products and services with which thegroup has had longstanding relationships,Standard & Poor’s can consider such sub-sidiaries core to the group despite their recentcreation. If the subsidiary only serves a smallcross section of customers or primarily will getbusiness from a new set of customers, at mostStandard & Poor’s will consider the entitystrategically important to the group.

Standard & Poor’s often sees groups settingup new subsidiaries to sell the same products ina different geographic locale or to sell newproducts to its existing customer base. Start-upentities that sell essentially the same productsalready being sold by the group but in a differ-ent geographic locale may be considered strate-gically important to the group if they meet mostof the criteria for strategically important enti-ties. Likewise, start-up entities that sell newproducts to an existing core customer base maybe considered strategically important to thegroup if they too meet most of the criteria forstrategically important entities. A letter coveringthe group’s strategic intent for the subsidiaryreceived from management might be helpful inthis regard.

If Standard & Poor’s has been asked to ratea subsidiary and not the entire organization,Standard & Poor’s reserves the right to under-take sufficient analysis of the group to deter-mine that subsidiary’s potential vulnerability toa weak member of the group, including the par-ent company. The other group members might



not be rated, but their financial and businesscharacteristics will be captured in the analysisthat ultimately leads to the single public ratingon the given subsidiary.

Rating Interaffiliated Pools

In rating members of interaffiliated poolingreinsurance agreements, pool members thatStandard & Poor’s considers core or strategical-ly important to the group receive the same rat-ing as other strategic members that are part ofthe reinsurance agreement. However, pooledcompanies that Standard & Poor’s determinesto be nonstrategic members of the group areevaluated on the same basis as nonstrategicmembers of other groups that do not have pool-ing agreements in place. As is the case withnonstrategic insurers that receive an acceptablyworded maintenance-of-net-worth agreementfrom a parent, these nonstrategic pool membersfirst are rated on a stand-alone basis and thenreceive only one category of benefit (limited bythe rating on the group).

The primary reason for this is that in somecases, companies that were included in poolingagreements have been removed from their poolsand sold. The reinsurance protection that sup-ported policyholders and the financial strengthratings on these insurers ended with the termi-nation of the members from the interaffiliatedpooling agreements and the subsequent sale bytheir parent groups. This can cause a dramaticchange in the financial strength ratings on theseformer pool members as companies shift theirstrategic focus to other lines of business.

Defining an Interaffiliated PoolAn interaffiliated pool is a network of reinsur-ance and retrocession agreements covering theinsurance liabilities of a group of property/casu-alty companies that normally operates undercommon ownership. Typically, all units of thepool cede all of the primary insurance theywrite to the flagship carrier in the group. Theflagship retains some of the business for its ownaccount and retrocedes the rest—together withthe cession of a portion of its primary busi-ness—to other members so that all are severally

responsible for homogenous shares of all busi-ness written by the pooled insurers. If combinedwith a pro rata sharing of loss-adjustment, gen-eral, and administrative expenses, this arrange-ment ensures uniform underwriting results.

Insurance groups often set up separate legaloperating insurance companies. Doing so servesvarious business needs, including:

� Minimizing tax liabilities by isolating companies in states with more onerous premium taxes.

� Shielding the group from the unfavorableregulatory environment of a particular stateby isolating in one entity the group’s directwriting for that state.

� Isolating distinct lines of business in a specif-ic company that might have a different man-agement structure than the rest of the groupas well as different customers, different dis-tribution, and different risk characteristics tothe business being underwritten.

� Management might wish to account by legal entity line-of-business results or resultsby state.That said, many of these groups would pre-

fer to pool results for a variety of reasons. Somepools are set up for financial reasons as an effi-cient way to blend group resources and resultsacross all pool members. Other groups set uppools for strategic reasons to present a financialpicture of a single, blended enterprise. Poolsmight be set up to mask specific results so thatcompetitors cannot determine individual line-of-business performance in a specific state or bycompany. A group also might want to present aconsolidated posture of financial strength of allpool members to their agents, policyholders,and other interested parties.

The Workings of an Interaffiliated PoolAs long as a member company is part of a pool,it is difficult to envision different default charac-teristics for any individual pool member versusany other member of the pool. Through thereinsurance pooling agreement, member compa-nies share the same net underwriting experiencethroughout the pool. Pool members’ reserves aremixed, being recorded on an assumed basis andon a direct basis, less ceded business. The


income-statement impact of these reinsuranceagreements is that pool members record premi-ums on a net basis and all member companiesshare pooled underwriting results plus their owninvestment income as the main components ofeach company’s pretax gain from operations.

Pool members have different capital posi-tions and their own portfolios of investedassets, which could lead to small differences infinancial strength. However, it is Standard &Poor’s position that an active pool memberwould not be allowed to fail by the group.Standard & Poor’s would expect the pooledgroup members to provide capital support to anactive member under stress for various businessand regulatory reasons:

� The consequences to the group for allowingan active pool member to fail would beenormous.

� Such an action would cause immeasurabledamage to the group in the marketplace.

� Usually, pooled companies operate under acommon management team, which wouldpresent all sorts of difficulties in the courtswith policyholders of the failed member tak-ing action against the solvent companies.

� Separating out reinsurance recoverables andthe capital impact of failed members is anextremely difficult and contentious exercise.

� The regulatory pressure that the groupwould face against allowing a member to failwhile other pooled companies are solventwould be enormous.Standard & Poor’s believes other pool mem-

bers will end up paying the policyholder obli-gations of an active pool member that hasfailed. So what incentive is there to let it go inthe first place?

Rating Nonstrategic Pool MembersAlthough Standard & Poor’s believes insuranceorganizations will support active pool membersthat operate in the same business segments as thegroup as a whole, Standard & Poor’s is not assanguine about pool members whose direct busi-ness differs from the rest of the groups. In such acase, Standard & Poor’s believes many groupshave become comfortable terminating nonstrate-gic companies’ participation in interaffiliated

pooling reinsurance agreements as a prelude totheir disposal. Having reviewed the terminationprovisions of a large number of interaffiliatedpooling reinsurance agreements, Standard &Poor’s believes that most such agreements pro-vide little protection to policyholders of non-strategic companies. In a large majority of cases,the termination provisions of these reinsuranceagreements require no more than 90 days noticeto sever a member or to dissolve the pool.Usually, there is no residual obligation on thepart of the pool to support a terminated member,or explicit run-off protection can end with thecommutation of residual obligations between thepool and the terminated member. There is no tailcoverage to terminated members from the pool,with these companies now being solely responsi-ble for all claims presented after termination.

Given the weakness of termination provi-sions, Standard & Poor’s believes that non-strategic members in the pool could easily beterminated and that, overnight, these companiescould be reconstituted with a dramatically dif-ferent risk profile. These nonstrategic poolmembers would be companies in different linesof business from most of the pool members oroperate in specific states with distinct risk char-acteristics, such as catastrophic risk exposure ora poor pricing environment. There is plenty ofcase history where pools have terminated non-strategic members and have done so with verylittle notice.

Of course, the pool members most likely tobe terminated would be those in weaker,poorly performing lines. One day there wouldbe strong underwriting results on a net pooledbasis for these companies, and the next day,the terminated company would have poorunderwriting performance, as its results reflectonly the performance of its direct business.Because the company is no longer part of thepool, Standard & Poor’s would not expectany further capital support; in fact, these arecompanies that the group would likely sell orterminate. The potential for precipitouschanges in the financial strength of theseinsurers is the impetus to amending the crite-ria for analyzing pools.



In implementing Standard & Poor’s interaf-filiated pooling reinsurance criteria, Standard& Poor’s identifies the pooled companies thatit considers to be nonstrategic members of thegroup. These companies first will be rated ona stand-alone basis and then will receive onlyone category of benefit (as long as the ratingdoes not go higher than the rating on thegroup) based on their ongoing participation inthe pooling agreement. Standard & Poor’seffectively views the amount of support pro-vided to nonstrategic entities under a poolingagreement to be the same as if they were thebeneficiaries of an acceptably worded net-worth-maintenance agreement.

As a first step, nonstrategic entities will beidentified based on their gross, nonaffiliatedwritings versus the business of the predomi-nance of pooled members. These companieswould be writing, on a direct basis, differentlines of business from the predominance ofpool members or operating in specific stateswith distinct risk characteristics, such as cata-strophic risk exposure or a poor pricing envi-ronment. As a second step, the analyst wouldthen discuss with the group the strategic fit ofthese companies. Companies that Standard &Poor’s determines to be strategically importantto the group would still receive the same rat-ing as other pool members.

If, at the end of this strategic review,Standard & Poor’s determines that a poolmember is nonstrategic to the group, theinsurer might still be assigned the group rat-ing if it receives stronger explicit support froma core unit. This support could take the formof a guaranty or a stronger pooling agreementthat must be reviewed by Standard & Poor’s.Pooling agreements with stronger policyholderprotection language that provides for longertermination protection to member companies,strong tail coverage to terminated members,and coverage of the incurred but not reportedclaims might provide sufficient explicit sup-port such that even nonstrategic memberscould receive the group rating.

Determining a Pool Member’s Stand-alone Financial StrengthIn evaluating a pool member’s stand-alonefinancial strength, Standard & Poor’s reviewsthe company’s business position, stand-aloneunderwriting performance, and stand-alonereserve position, making judgments about theadequacy of reserves for specific lines of busi-ness. In doing this, Standard & Poor’s is look-ing to develop sufficient information to assess apool member’s capital adequacy.

From existing financial information, as wellas from discussions with management, Standard& Poor’s reviews a pool member’s underwritingexperience on a direct premium basis (that is,the losses associated with a company’s directbusiness). Standard & Poor’s also analyzes aschedule of reserves related to the pool mem-ber’s direct business. Based on discussions withmanagement, Standard & Poor’s makes judg-ments about the capital adequacy of the pooledmember by allocating capital to specific lines ofbusiness.

SummaryStandard & Poor’s expects that the overwhelm-ing majority of insurers that are part of existinginteraffiliated pooling agreements will be con-sidered strategically important or core to thegroup and, thus, will be assigned the same rat-ing as other pool members. In a small minorityof cases, a member of a pool could be identifiedas a nonstrategic member of the group with thepotential for a different rating. In these cases,either the pool member will receive strongerexplicit support from the group in order toreceive the same rating as other pool membersor the rating on that member will be lower thanthe ratings on the other pool members. With agrowing number of management teams becom-ing more comfortable selling businesses that donot fit in well with their strategies, Standard &Poor’s believes these nonstrategic entities aremore appropriately evaluated on a stand-alonebasis, receiving a more limited amount of sup-port from the group.


Holding CompanyAnalysis

Although much has been written aboutStandard & Poor’s Ratings Services approach toanalyzing operating insurance companies, thisarticle presents a comprehensive discussion ofinsurance holding-company analysis. Much ofthe criteria used to evaluate insurance holdingcompanies are similar to those used to evaluateother financial institutions and other corporateentities. However, given the unique regulatoryand operating environment that insurers oper-ate within, key differences are also identified.

In all sectors, Standard & Poor’s evaluatesthe parent companies of insurance organiza-tions relative to the operating insurance compa-ny subsidiaries that they own. In the simplestcases, the holding-company evaluation is direct-ly related to the creditworthiness of the sub-sidiary. This approach is used if the holdingcompany is a true holding company, i.e., if theholding company has no operating characteris-tics in its own right. It also is used if the struc-ture is direct (no intermediate holding compa-nies) and if there is essentially one subsidiary.The standard gap for holding companies is onecategory (three notches) lower than the finan-cial strength rating on the operating company.A gap of this size recognizes the dependence ona dividend stream from subsidiaries for debt,preferred-stock servicing, or both. It also recog-nizes that regulatory intervention can restrictthe flow of funds.

That being said, there are several aspects ofholding-company analysis that Standard &Poor’s uses in making its overall evaluation ofthese organizations. The rating on an insur-ance holding company is influenced not onlyby the financial security of its operating sub-sidiaries but also by the capital structureemployed by the organization. The level offinancial leverage and coverage of interest andpreferred dividends at a holding company ulti-mately might not only affect the debt and pre-ferred stock ratings on the holding company

but also could affect the ratings on the operat-ing companies’ financial security.

In the case of a holding company with sever-al subsidiaries in diverse sectors—such as amajor life insurance subsidiary and a majorproperty/casualty subsidiary—the senior debtrating on the parent could be based on the port-folio of business owned and the quality of thosebusinesses. If the portfolio is well-balanced andcomplementary and the levels of financial lever-age and interest coverage are strong, the seniordebt rating is the same as the issuer credit rat-ing (also called counterparty credit rating) onthe parent. It also could be equal to the finan-cial strength rating on the subsidiaries or could even be higher than that of one of the subsidiaries.

Therefore, it is possible that the gap betweenthe holding company and its wholly owned sub-sidiary or subsidiaries could be narrowed fromthe standard one category. This is likely tooccur if any one of the three following circum-stances is applicable:

� Earnings and assets are well diversified atthe holding-company level.

� Significant nonregulated operating sub-sidiaries are deemed able to upstream divi-dends with limited restrictions.

� Measures of the holding company’s financialstrength—such as financial leverage andfixed-charge ratios—are significantlystronger than the standard rating gap wouldindicate under a variety of scenarios.When a debt issue is judged to be junior to

other debt issues of the company and, therefore,has relatively worse recovery prospects, thatissue is assigned a lower rating than the issuercredit rating. As a matter of rating policy, thedifferential is limited to one rating designationin the investment-grade categories. For exam-ple, when the issuer credit rating is ‘A’, juniordebt may be rated ‘A-’. In the speculative-gradecategories, where the possibility of default is


Holding Company Analysis

greater, the differential is up to two ratingnotches. Notching relationships between debtissues (or other financial obligations) are basedon broad guidelines that combine considerationof asset protection and ranking. The guidelinesare designed to identify material disadvantagefor a given issue by virtue of the existence ofbetter-positioned obligations. The analyst doesnot seek to predict specific recovery levels,which would involve knowing the exact assetmix and values at a point well into the future.

Notching relationships are subject to reviewand change when actual developments varyfrom expectations. Changes in notching do notnecessarily have to be accompanied by changesin default risk.

Evaluating Management’s Financial Policy

U.S. insurers continue to access the capital debtmarkets via a variety of issuances, including tra-ditional securities—such as common equity anddebt, hybrid equities like trust preferreds,mandatory convertible securities, and surplusnotes—and, more recently, pass-through trustsecurities. The principal drivers behind this have been:

� The need to finance growth in light of theimproved property/casualty pricing marketconditions.

� Recapitalization in light of significant loss-reserve recognition and World TradeCenter–related losses.

� Restoring capitalization because of increasedinvested asset volatility, mergers, and acqui-sitions (most notably in the life and healthsectors).

� Making the most of the low interest environment.Standard & Poor’s attaches great importance

to management’s philosophies and policiestoward financial risk and its appetite for finan-cial risk tolerances, especially in light of prioractions. More sophisticated business managershave thoughtful policies that recognize cashflow parameters and the interplay between busi-ness and financial risk.

Many firms that have set goals do not havethe wherewithal, discipline, or managementcommitment to achieve these objectives. Acompany’s leverage goals, for example, need tobe viewed in the context of its past record andthe financial dynamics affecting the business. Ifmanagement states, as many do, that its goal isto operate at 35% debt-to-capital, Standard &Poor’s factors that into its analysis only to theextent it appears plausible. For example, if acompany has aggressive spending plans, that35% goal would carry little weight unless man-agement has committed to a specific programof asset sales, equity sales, or other actions thatin a given time period would produce thedesired results.

Standard & Poor’s does not encourage com-panies to manage themselves with an eyetoward a specific rating. The more appropriateapproach is to operate for the good of the busi-ness as management sees it and let the ratingsfollow. Certainly, prudence and credit qualityshould be among the most important considera-tions, but financial policy should be consistentwith the needs of the business rather than anarbitrary constraint.

If opportunities are foregone merely to avoidfinancial risk, the firm is making poor strategicdecisions. In fact, it could be sacrificing long-term credit quality for the facade of low risk inthe near term. One financial article described acompany that curtailed spending expressly “tobecome an ‘A’ rated company.” As a result,“...the company’s business responded poorly toan increase in market demand. Needless to say,the sought-after ‘A’ rating continued to eludethe company.”

In any event, pursuit of the highest ratingattainable is not necessarily in the company’sbest interests. A ‘AAA’ rating is the highest rat-ing, but that does not suggest that it is the mostappropriate rating for a particular company.Typically, a company with virtually no financialrisk is not optimal with respect to meeting theneeds of its various constituencies. An under-leveraged firm is not minimizing its cost of capi-tal, thereby depriving its owners of potentiallygreater value for their investment. In this light,


a corporate objective of having debt rated‘AAA’ or ‘AA’ is, at times, suspect. Whatever acompany’s financial track record, an analystmust be skeptical if corporate goals are implicit-ly irrational. A firm’s conservative financial phi-losophy must be consistent with the firm’s over-all goals and needs.

Ratios Used to Evaluate Holding Companies

Standard & Poor’s primarily uses eight ratios toanalyze the risks associated with insuranceholding companies’ financial leverage. Theseratios are calculated excluding the effects ofFAS 115 (unrealized gains/losses on fixed-income assets) for U.S. insurers but will valuefixed-income instruments at market value incountries where regulatory accounting usesmarket-to-market valuation for these assets.Unrealized gains/losses on equity assets areincluded. In addition, these ratios are adjustedto exclude debt that is part of the working capi-tal of financial services subsidiaries as opposedto debt used to capitalize operations or debtused to fund more speculative activities.

In conducting an analysis of an insurer’s capi-tal structure, including hybrid equity, Standard& Poor’s first attempts to understand manage-ment’s goals regarding the various forms of capi-tal present in a group’s structure. For example,is the capital permanent, or will it eventually bereplaced? The more that funds are perceived aspermanent and not putting an unnecessarystrain on the group regarding servicing require-ments, the more favorably they are viewed. Forexample, stock insurance groups can issue debtat senior holding-company levels and down-stream it to insurance operating subsidiaries asequity, a process using double leverage (a figurelong used in assessing the capital structure offinancial institutions such as banks), where itreceives full credit as capital available to support

insurance operations under both Standard &Poor’s and regulatory risk-based capital models.

Analytically, an issue arises if servicingand/or repayment of part or all of the holding-company debt is dependent on a continuingflow of funds from the insurance operating sub-sidiaries. In that circumstance, the holding-com-pany debt becomes, in effect, a call on the capi-tal of the operating insurance subsidiaries andbrings into question the permanency of suchequity in the latter’s capital structure. InStandard & Poor’s opinion, this downstreameddebt, when combined with its legally subordi-nated and technically bankruptcy-remote natureto policyholder claims, takes on more character-istics of a form of hybrid equity similar to asurplus note. Double leverage helps determinethe quality of capital when analysis is conduct-ed at the operating-company level.

The published formula for double leverageapplies to U.S. GAAP. Double leverage appliesto unconsolidated parent balance sheets onlyand is calculated as investments in subsidiariesplus net affiliated balances related to capitalenhancement divided by common equity plushybrid equity. (The double leverage ratio onlyapplies to holding companies, and therefore,only hybrid equity raised at the holding compa-ny is included in the denominator.) An impor-tant consideration when using double leverageis the valuation of investments in subsidiaries.Under U.S. GAAP, these investments are carriedat accounting net asset value of the subsidiaries.Only when the equity investment in subsidiariesis valued at the net assets of the subsidiaries dothe double leverage benchmarks apply.

In Europe and Bermuda, Standard & Poor’suses the consolidated financial leverage ratio asthe key indicator of quality of capital and thecapital adequacy ratio as the main indicator ofquantity of risk-adjusted capital to capitalrequired. Double leverage is usually disregardedwhen Standard & Poor’s uses consolidated bal-

H O L D I N G C O M PA N Y A N A LY S I S


Double leverageratio =

Nonconsolidated investment in subsidiaries

Nonconsolidated common equity plus hybrid equity

ance sheets as the analytical base. In the U.S.,double leverage is much more extensively usedbecause the analytical focus is on the operatingcompany and consolidated operating companiesconcerned; the analysis is supported by the hugeamount of data available on operating compa-nies provided in the U.S. statutory filings.

Double leverage can be a relevant measurein Europe when determining the amount ofholding-company senior debt that can be givencapital credit in a consolidated capital model.When it is not possible to apply the doubleleverage benchmarks, Standard & Poor’s canadd holding-company senior debt to totaladjusted capital in a consolidated capitalmodel, subject to a cap at 15% of consolidat-ed total adjusted capital. The analyst shouldbe convinced that the holding company debt isdownstreamed as equity before including it intotal adjusted capital.

A group’s double leverage ratio will be cal-culated as shown in the chart on page 82, based on information contained in the GAAP,unconsolidated holding company statementsfor the group.

Double leverage is measured for all ratedinsurance groups in which a holding-companystructure, either stock or mutual, exists.Double leverage tolerance ratios by rating cat-egory are based on the financial strength rat-ing on the senior operating company, unlesssignificant alternative noninsurance-relatedsources of cash flow are available (see right).

If a group’s double leverage ratio is inexcess of these maximums, the difference nec-essary to reduce it to the threshold level willbe treated as debt and, as such, subtractedfrom the operating insurance group’s totaladjusted capital used for Standard & Poor’srisk-based capital measurement purposes.

Debt includes both long- and short-termdebt, and total capital includes all debt, pre-ferred stock, hybrid capital, and common stock.These ratios are calculated on a consolidatedcompany basis, and capitalized leases should beincluded in debt. When consolidated companyleverage is analyzed, hybrid equity raised at theoperating company will be treated as debt, and

the servicing of this capital will be included inthe debt-coverage ratios. The logic for this isthat the servicing of operating-company hybridequity is usually at least pari passu with holdingcompany debtholders and is often senior tothese debt obligations.

There are several income-statement and cashflow-based ratios that are used to evaluate aninsurer’s debt-servicing capabilities. The pri-mary measure would be GAAP-based.

The interest expense is adjusted to includethe amortization of interest in any sale/lease-back of property or equipment or any othertype of lease. The interest expense shouldalways be the gross interest expense before sub-tracting capitalized interest. Where a companyissues zero coupon or discounted interestbonds, some or all of the interest is capitalizedrather than being paid out as periodic cashinterest. This capitalized interest expense needsto be considered in the calculation of interestcoverage, as one of the goals of the ratio is tomeasure how well economic earnings cover eco-nomic interest expense. There is a benefit to thefirm’s flexibility in being able to defer interest


Double Leverage Tolerance Ratios

Rating Ratio (%)

AAA 115

AA 125

A 135

BBB and lower 145

Primary Leverage Ratios

The two primary leverage ratios tht are used to evaluate insurance companies are:

Debt leverage =

Debt + preferred leverage =

Debt

Total capital

Debt + preferred, including hybrids

Total capital

payments, as in the cases of zero-coupon debt,income bonds, or intercompany debt.

When evaluating a preferred stock rating,Standard & Poor’s would uses GAAP fixed-charge coverage instead of interest coverage.

The interest expense is adjusted to includethe amortization of interest in any sale/lease-back of property or equipment or any othertype of lease. Both of these coverage ratioswould be calculated on a consolidated companybasis. Fixed-charge coverage should also includeany regular contractual costs that are payableregardless of operating performance. Fixed-charge cover indicates the margin of comfortfor lenders and bondholders that their debts canbe serviced by the borrower. Fixed-charge coveris a key factor in determining a company’sfinancial flexibility—its ability to service exist-ing fixed-cost funding and borrow more if nec-essary. Of all the ratios considering debt, this isthe most important. A high fixed-charge cover-age ratio implies that the company has extradebt-finance capacity.

Statutory interest coverage measures the var-ious sources of cash available for upstreamingto the holding company as well as the net cashbeing generated at the holding company, andcompares these sources with the interestexpense. Statutory interest coverage is viewed asan important differentiation of investment-grade companies versus noninvestment-gradecompanies, though it is not as useful in differen-tiating among the higher rating categories. Thisis because Standard & Poor’s evaluates insurersas ongoing enterprises, which are better coveredunder GAAP accounting, while statutoryaccounting is liquidation-based. Higher-ratedfirms are expected to have greater flexibility tomeet interest payments as they become due.Still, insurance holding companies need to paytheir bills while operating within statutoryrestrictions on their insurance subsidiaries, andcompanies that are expected to maintain low

statutory interest coverage on an ongoing basiswill be viewed as speculative.

In addition, Standard & Poor’s analyzes theinsurance company equivalent of funds fromoperations to total debt. This ratio evaluates thecash flow available in relation to debt outstand-ing, the theory being that the inverse of thisratio calculates the number of years needed fora company’s cash flow to equal its debt out-standing. Given the multi-tiered structures ofinsurance holding companies owning operatingcompanies and that available cash flow to theholding company is more relevant than cashflows at the holding company, Standard &Poor’s will analyze funds available from opera-tions to total debt.

Total debt is on a consolidated companybasis. Noncash expenses would include suchitems as depreciation, capitalized interest, anddeferred taxes. Standard & Poor’s recognizesthat healthy, growing insurance companiesmight need to be evaluated somewhat different-ly on this measure, given the issue of statutorystrain on earnings.

With primary emphasis on GAAP coveragein this analysis, Standard & Poor’s focuses onthe statutory coverage centers on funds avail-able for dividending up to the parent ratherthan numbers purely derived from statutoryincome. This means that companies operatingin states with dividend restrictions in the formof “the lesser of 10% of the prior year’s statu-tory capital or the prior year’s net operatingincome” will be at a disadvantage versus thosecompanies located in a “greater of” state.

Goodwill is not recognized in Standard &Poor’s view of consolidated statutory capitaliza-tion. However, many managed care organiza-tions have GAAP goodwill at the holding com-pany as a result of prior acquisitions. FAS 141requires that this goodwill be booked as part ofpurchase accounting. Since Jan. 1, 2002, FAS142 has required that the goodwill remain on



GAAP interest coverage =(GAAP pretax operating income + interest expense)

Interest expense

the balance sheet unless or until it is impaired.Standard & Poor’s analysis of goodwill con-

tinues to be a qualitative assessment. Standard& Poor’s will continually review an organiza-tion’s business-segment cash flows and the sus-tainability of cash flows used for its FAS 142impairment testing. Furthermore, Standard &Poor’s will aggressively discount or removegoodwill from the balance sheet and all holdingcompany ratios when Standard & Poor’sbelieves the goodwill could be impaired. It is forthis reason that Standard & Poor’s might alsolook at ratios such as debt to tangible capitaland debt to EBITDA in addition to traditionalleverage ratios.

Financial Leverage Ratio GuidelinesThe ratios used to analyze the financial leveragerisks are:

� Double leverage.� Debt leverage.� Debt plus preferred leverage.� GAAP interest coverage.� GAAP fixed-charge coverage.� Statutory interest coverage.� Statutory fixed-charge coverage.� Funds available from operations/total debt.

These ratios are meant to be used as guide-lines only. For a given rating category, financialratios can be expected to vary with the businessor operating profile of a company. A companywith a stronger competitive position, more favor-able business prospects, and more predictableearnings can afford to undertake added financialrisk while maintaining the same credit rating.

A great deal of discretion is required inapplying these guidelines. Although they pro-vide insight into ratings in general, it is a mis-take to oversimplify the entire thought processbehind a specific rating by relying solely on thenumbers. Guidelines focus on only a few ratios.Many additional measures are used to roundout the analysis or to focus on specific issues.Obviously, strengths reflected in one financialmeasure can offset or balance relative weaknessin another.

Ratings are an assessment of a company’sability to meet its obligations in the future, andratio standards relate to a company’s expectedfinancial condition. Ratings are designed toreflect performance over the anticipated courseof business cycles and not in what is viewed asa peak or trough period. Ratio standards donot always conform to an as-reported basis.Rather, a firm’s financial figures may be adjust-ed to reflect ongoing performance.

Analysis of more volatile speculative-gradecredits does not revolve around traditional finan-cial measures and defies the relatively patternedmethodology associated with investment-gradecredits. Numbers shown in the ‘BB’ column serveprimarily to delineate the ‘BBB’ range.

Operating Leverage VersusFinancial Leverage

As insurers participate in match-funded trans-actions that involve the raising of externalfunding, Standard & Poor’s is often askedwhether these companies’ debt or debt-like


(GAAP pretax operating income + interest expense)

(Interest expense + tax-adjusted preferred stock dividends

Statutory interest coverage =

(Dividend capacity + continuing holding company income - continuing holding company operating expenses excluding interest expense)

Interest expense

Interest expense is based on consolidated company statements.

GAAP fixed-charge coverage =

obligations are viewed as financial leverage oroperating leverage. Financial leverage is gener-ally meant to measure the amount of debt ordebt-like funding that is used by an insurer tomeet its general capital needs. Alternatively,insurers might use debt or debt-like instru-ments to fund a discrete pool of financialassets—such as bonds or other high-quality,fixed-interest instruments. In these cases,Standard & Poor’s may treat this debt as oper-ational leverage when there is strong asset/lia-bility matching or active risk managementemployed and when there is little to no riskthat the assets will not be able to repay thefunding. A distinct version of operationalleverage, financial intermediation, is when theassets do not exist on the balance sheet whenthe transaction is initiated or when a thirdparty’s assets are match-funded. The purposeof this section is to codify and documentStandard & Poor’s treatment of operationalleverage and financial intermediation activitiesin its analysis of insurance companies.

The difference in the credit impact betweenfunding viewed as financial leverage and fund-ing viewed as operational leverage can be great.For example, debt raised to meet an insurer’sgeneral capital needs would be viewed as finan-cial leverage, and typically, highly rated compa-nies could have 10%-35% of their capital inthese debt or debt-like instruments.Alternatively, insurers may issue funding agree-ments, GICs, or even debt backed by high-qual-ity, fixed-interest assets with matching dura-tions, tightly corresponding cash flows, andpositive convexity. Standard & Poor’s would

view such an issuance as a financial-intermedia-tion activity, these funds would be consideredoperational leverage as long as the residual riskis insignificant, and the sums would be exclud-ed from financial-leverage ratios.

By contrast to funding viewed as financialleverage, these lines of business can commonlyhave funding levels that are 10x-30x theamount of total equity for highly rated insur-ers. Standard & Poor’s will continue to beconservative in its interpretation of the natureof the issuance of these funding instruments.Standard & Poor’s will view both types asfinancial leverage in the absence of a thoroughanalysis of the assets and controls supportingthese funding mechanisms, including segrega-tion of pools of assets.

Historically, Standard & Poor’s has foundthat individual instances of financial interme-diation and operational leverage in its analysesof insurance companies tended to fall into ahandful of classes. One of the most commonclasses is the institutional spread-based busi-ness of some U.S. life insurance companies.However, the number and variety of types ofactivities that are arguably instances of finan-cial intermediation and potentially worthy ofoperational leverage treatment in Standard &Poor’s analysis have multiplied in recent years.No longer are they always obviously identifi-able as belonging to an existing class of opera-tional-leverage transactions, nor do they lendthemselves to the ready application of rules-based criteria.

Rather than establish a formal rules-basedapproach, Standard & Poor’s has elected to set



Dividend capacity + continuing holding companyincome - continuing holding company operating

Funds available from operations/total debt =expenses + noncash expenses

Total debt

Pre-tax operating income (excluding realized capital gains (losses)) + holding

Statutory fixed charge coverage=company income - holding company operating expenses (excluding interest expense)

Interest expense + tax-adjusted preferred stock dividend

clear definitions of terms, to enunciate theprinciples underlying its views on financialintermediation and operational leverage, andto establish a process that will insure a consis-tent application of these principles.

When considering the appropriateness ofoperational leverage treatment in any applica-tion, whether traditional or new, Standard &Poor’s will apply the following definitions andprocedures.

Definitions. Financial intermediation isdefined as any activity that a) raises cash by theissuance of debt or debt-like instruments thatcreates funding for b) a discrete asset or pool ofassets and any related hedge instruments andcapital, at least notionally segregated from therest of the issuer’s assets whose cash flows willbe sufficient to pay all returns on and of theprincipal of that debt with c) insignificant riskof any of the issuer’s other assets being calledon to make such payments. Specific examplesinclude GICs, funding agreements, medium-term notes, synthetic securitizations, securitieslending, and retail-note programs.

Operational leverage (operational debt) isdebt incurred in the process of funding assetsfor financial-intermediation purposes.Measuring the relative magnitude of this busi-ness will be based on the calculation of threeratios: 1) the total amount of operational lever-age divided by total equity, 2) the amount ofearnings from financial-intermediation businessdivided by total earnings, and 3) the expectedrisk-based capital to total capital. AlthoughStandard & Poor’s acknowledges that it mighteventually need to set limits or sub-limits on themaximum levels that any of these numberscould reach for particular rating levels,Standard & Poor’s has not set any specificguidelines on the amount of operational lever-age on an insurer’s balance sheet. However,when the overall amount of operational lever-age rises to the point of constraining an insur-er’s financial flexibility, this stress will bereflected in the ratings on that insurer.

Principles. The risks and associated meas-ures that must be reduced to an insignificantlevel are provided below. (In this context,

“insignificant” means that the cumulativemodeled loss on the business from these risksis reduced to a ‘AAA’ or higher probability of default.)

� Liquidity risk: the probability of insufficientliquidity.

� Financial market risk: dollar exposure usinga financial products company-type model(e.g., interest rate risk).

� Insurance risk: probability of a stressed-caseevent (e.g., mortality).

� Financial flexibility risk: measurement of thepotential impact on access to capital mar-kets, such as spread widening.

� Business risk: return on risk-adjusted capitalrelative to core businesses and continuedprofitability (reputational, market disrup-tion, etc.).

� Diversification/concentration risk: includingthe proportion of capital or earnings com-mitted to any one class of financial interme-diation or volatility of payment.

� Credit risk: concentration limits by individ-


Debt Leverage

Rating category Debt leverage (%)

AAA Less than 15

AA 15-25

A 25-35

BBB 35-45

BB 45-65

GAAP Interest Coverage Ratio

GAAP interest coverage

Rating Low interest High interest category rate environment rate environment

AAA 10x or more 8x or more

AA 8x-10x 6x-8x

A 5x-8x 4x-6x

BBB 3x-5x 3x-4x

BB 2x-3x 2x-3x

ual credit, industry, or sovereign, taken tounderlying levels.

� Regulatory risk.� Any other risk that might be identified in

connection with a specific transaction.Structural considerations. In addition, it is

expected that certain structural elements of abusiness could mitigate or exacerbate the risksof any given transaction or class of transac-tions. These include:

� Whether the debt is full recourse, limitedrecourse, or non-recourse.

� Whether any embedded options exist forpolicyholders or whether options exist forthe holders of the debt.

� Whether or not there are any cross-defaultprovisions in the debt or other debt.

� The extent to which the assets are segregated(ring fenced) or used to collateralize otherobligations.

� The tangible or intangible nature of the assets.

� The volatility of the asset valuations overtime.

� The potential of proposed operational lever-age to distort the overall risk profile of theinsurer.Application. The analytical application of

operational leverage treatment will be made toindividual entities within groups unless thoseentities are assigned ratings in consideration ofimplicit or explicit support from the group. Inthe event of such support, the applications willbe made on a consolidated basis to the group.

All debt judged to be operational leveragewould receive the analytical treatment describedas follows:

� The debt will be excluded from Standard &Poor’s calculation of financial leverage.

� The interest will be excluded from the calcu-lation of interest and fixed-charge coverage.

� The income from the associated assets willbe excluded from the calculation of interestand fixed-charge coverage.

� Any capital (e.g., unrealized gains) in thestructure will be excluded from the calcula-tion of total adjusted capital.

This will be true whether the obligation forfunds raised is literally in the form of debt ordebt-like instruments (such as GICs) that havemany characteristics similar to debt.

Any debt not judged to benefit from opera-tional leverage treatment would be treated asfinancial leverage. If the cumulative residualrisks cease to be insignificant or assets arereused for unrelated purposed (e.g., repo’s) dur-ing the term of the debt, Standard & Poor’smay cease to award operational leverage treat-ment to that debt. There will be no intermediatelevels of treatment.

Off-Balance-Sheet Financing

Off-balance-sheet items factored into the lever-age analysis include the following:

� Operating leases.� Debt of joint ventures and unconsolidated

subsidiaries.� Guarantees.� Receivables that have been factored, trans-

ferred, or securitized.� Contingent liability, such as potential legal

judgments or lawsuit settlements.Various methodologies are used to determine

the proper adjustment value for each off-balance-sheet item. In some cases, the adjustment isstraightforward. For example, the amount ofguaranteed debt can simply be added to theguarantor’s liabilities. Other adjustments aremore complex or less precise.

Nonrecourse debt of a joint venture may beattributed to the parent companies, especially ifthey have a strategic tie to the operation. Theanalysis may burden one parent with a dispro-portionate amount of the debt if that parent hasthe greater strategic interest or operating controlor if its ability to service the joint-venture debt isgreater. Other considerations that affect a com-pany’s willingness to walk away from suchdebt—and other nonrecourse debt—includeshared banking relationships and common coun-try location. In some instances, the debt may beso large in relation to the owner’s investmentthat the incentives to support the debt are mini-mized. In virtually all cases, though, the parentwould likely invest additional amounts before



deciding to abandon the venture. Accordingly,adjustments would be made to reflect theowner’s current and projected investment, even ifthe venture’s debt were not added to the parent’sbalance sheet.

The debt-equivalent value of operating leasesis determined by calculating the present value ofminimum operating lease obligations as reportedin the annual report’s footnotes. The leaseamount beyond five years is assumed to matureat a rate approximating the minimum paymentdue in five years.

The variety of lease types could require theanalyst to obtain additional information or useestimates to evaluate lease obligations.

Equity Credit for Preferred Stockand Hybrid Equity

Preferred stock and hybrid equity can qualifyfor treatment as equity for the purpose of calcu-lating capital structure ratios. Some preferredsand hybrids are viewed as debt—or somethingbetween debt and equity—depending on theirfeatures and the circumstances.

What is equity? What constitutes equity inthe first place? Traditional common stock—theparadigm equity—sets the standard. But equityis not a monolithic concept; rather, it has sever-al dimensions. Standard & Poor’s looks for thefollowing positive characteristics in equity:

� It requires no ongoing payments that couldlead to default.

� It has no maturity or repayment require-ment.

� It provides a cushion for creditors in the caseof a bankruptcy.

� It is expected to remain as a permanent fea-ture of the enterprise’s capital structure.If equity has these distinct defining attrib-

utes, it should be apparent that a specificsecurity can have a mixed impact. For exam-ple, hybrid securities, by their very nature,will be equity-like in some respects and debt-like in others. Standard & Poor’s analyzes thespecific features of any financing to determinethe extent of financial risks and benefits thatapply to an issuer. In any event, the security’s

perceived economic impact is relevant; itsnomenclature is not. A transaction that islabeled debt for accounting, tax, or regulatorypurposes could still be viewed as equity forrating purposes, and vice versa.

For Standard & Poor’s to view any capitalissuance as more equity-like in nature, it musthave a maturity that is consistent with theadvantages offered by long-term capital.Standard & Poor’s views instruments withmaturities of 20 years or longer as being partof an insurer’s long-term capital and, there-fore, treats them as equity. Obligations withmaturities of between 10 and 20 years may beviewed as long-term capital but will be evalu-ated in the context of how aggressive aninsurer’s overall capital structure is relative tothe outstanding ratings. In addition, to beconsidered equity-like, these instruments mustbe subordinated in the payment of interestand principal to debt and policy obligations.Finally, the insurer should not be forced intobankruptcy or receivership if interest, divi-dends, or principal repayment on the obliga-tion is not paid.

The rationale for determining whether aparticular instrument is more debt-like orequity-like is as follows:

Equity Requires No Ongoing Payments ThatCould Lead to DefaultEquity pays dividends but has no fixedrequirements that could lead to default andbankruptcy if these dividends are not paid.Moreover, there are no fixed charges thatmight, over time, drain the company of fundsthat might be needed to bolster operations. Acompany is under pressure to pay both pre-ferred and common dividends but ultimatelyretains the discretion to eliminate or deferpayment when it faces a shortage of funds. Ofcourse, a firm’s reluctance to pass on a pre-ferred dividend is not identical to its reticenceto altering its common payout. Accordingly,there is a difference in equity credit affordedto common equity relative to preferred equity.

The longer a company can defer dividends,the better. An open-ended ability to defer divi-dends until financial health is restored is best.


As a practical matter, the ability to defer dividend payments for five or six years ismost critical in helping prevent default. If the company cannot restore financial healthin five years, it probably never will. The

ability to defer payments for shorter periods is also valuable, but equity content diminishesas constraints on the company’s discretionincrease.

Equity Provides a Cushion for Creditors in theEvent of DefaultWhat happens in bankruptcy also pertains tothe risk of default, albeit indirectly. Companiescan continue to raise debt capital only as longas the providers feel secure about the ultimaterecovery of their loans in the event of a default.Debtholders’ claims have priority in bankrupt-cy, while equity holders are relegated to a resid-ual claim on the assets. The protective cushioncreated by such equity subordination allows thecompany access to capital, enabling it to staveoff a default in the first place.

Equity is Expected to Remain a Very Long-Term Feature of the Enterprise’s Capital StructureAt any time, a company can choose to repur-chase equity or issue additional shares.However, some securities are more prone tobeing temporary than others. Standard &Poor’s analysis tries to be pragmatic, lookingfor insights as to what might ultimately occur.Preferred stock, in particular, is likely to haveprovisions for redemption or exchange, if notan outright stated maturity. A preferred stockthat the analyst believes will be refinanced even-tually with debt is viewed as a debt-equivalent,not equity all along. Auction preferreds, forexample, are perpetual on the surface. However,they are often merely a temporary debt alterna-tive for companies that are not current taxpay-ers until they once again can benefit from thetax deductibility of interest expense. Moreover,the holders of these preferreds would pressurefor a redemption in the event of a failed auctionor even a rating downgrade. Standard & Poor’sdiscussions with management regarding thefirm’s financial policies provide insights into the

company’s plans for the securities: whether acompany will call or repurchase an issue andwhat is likely to replace it.

Given the quality-of-capital considerations,at some point, the issuance of additional pre-ferred stock or hybrid equity puts sufficientpressure on a company that Standard & Poor’swill view the incremental capital as more debt-like than equity-like. Currently, Standard &Poor’s views insurance holding companies withtotal preferred stock and hybrid equity in excessof 15% of total capital as having sufficientquality-of-capital concerns that the increment ofpreferreds and hybrids above 15% of capital isviewed as more debt-like than equity-like. If acompany has issued hybrid instruments abovethis tolerance, the excess amount is treated aspure debt for the leverage calculations. For thepurposes of leverage calculations, the distinc-tion between hybrid treated as equity or debt isonly relevant for the numerator. The denomina-tor is total consolidated capital, which includesstockholders’ equity, all debt, and all hybridsecurities. Certain preferred and hybrid securi-ties that are mandatorily convertible to com-mon stock would be considered outside thislimited equity basket of securities. Total adjust-ed capital includes eligible hybrid up to a maxi-mum of 25% of the total. Within total adjustedcapital exists a sub-limit of 15% for the follow-ing forms of hybrid capital: preference sharesand dated and undated subordinated hybridcapital issues with capacity to defer interest.The additional 10% that brings the limit for eli-gible hybrid equity in total adjusted capital to25% can only be composed of eligible manda-torily convertible securities. To date, the onlyforms of hybrid equity included in total adjust-ed capital above the 15% sub-limit are shorter-dated (three years or less) mandatory convert-ible securities. Standard & Poor’s generally clas-sifies mandatory convertible securities into twogroups: shorter-dated issues that convert withinthree years and longer-dated issues that convertover a longer time frame. Many shorter-datedmandatory convertible securities have strongequity-like characteristics. Standard & Poor’stypically includes them up to its highest toler-



ance limits for hybrid equity instruments if thefollowing guidelines are met:

� Within three years of issue, the securitiesconvert on a mandatory basis into new com-mon equity of the issuer. There must be nooption for the securities to be retired withcash at any time or under any circumstancesduring the life of the securities, unless thatcash is itself the direct product of a newequity issue by the issuer.

� The issuer is highly rated (in general, atleast an ‘A-’ counterparty credit rating) orthe securities must have an acceptable,credit-related trigger that accelerates con-version before the mandatory conversiondate. Note that the existence of a mecha-nism that triggers deferral of coupon understress or a nominal coupon renders amandatory convertible security even moreequity-like.

� The securities have a robust mechanism thatensures the conversion will not excessivelydilute the issuer’s share price. This mecha-nism should reduce to a minimum the poten-tial buy-back of newly issued shares resultingfrom conversion.Mandatorily convertible securities (MCS)

with a longer period to conversion—more thanthree years—often have many equity-like char-acteristics. Standard & Poor’s will include themwithin the total adjusted capital sub-limit of15% along with noncumulative perpetual pre-ferred shares and other hybrids, if they meet thefollowing guidelines:

� At maturity, the securities convert on amandatory basis into new common equity ofthe issuer. There must be no option for thesecurities to be retired with cash at any timeor under any circumstances during the life ofthe securities, unless that cash is itself thedirect product of the new equity issue by the issuer.

� The securities have an acceptable, credit-related trigger that accelerates conversionbefore the mandatory conversion date, or thesecurities contain a clause that enables theissuer to defer cash interest payments toabsorb losses on an ongoing basis.

� The securities are subordinated to all otherdebt of the issuer.

� The securities have a robust mechanism thatensures that conversion will not excessivelydilute the issuer’s share price. This mecha-nism should reduce to a minimum the poten-tial buy-back of the newly issued sharesresulting from conversion.The closer an MCS is to mandatory conver-

sion, the more equity-like it becomes. During thelast three years before mandatory conversion,Standard & Poor’s considers an eligible MCS asshorter-dated and includes it up to the highesttolerance limits for hybrid equity instruments.

Some hybrid capital instruments with step-upclauses or the potential to dilute excessivelyexisting common shareholders—a characteristicof some MCS—create incentives for managementto retire the instrument or repurchase the com-mon shares after conversion. These characteris-tics cast doubt on the permanency of the capitalraised. This, in turn, leads Standard & Poor’s toestablish reasonable limits in analytical ratios or,in some cases, exclude altogether an instrumentfrom analytical measures. Furthermore, hybridsecurities with a step-up clause of more than 100basis points, which are issued in conjunctionwith a call option, will be viewed as having aneffective maturity coinciding with the call date.

Even when the elimination or deferral of acoupon payment does not constitute a defaultunder the terms of the issue, Standard & Poor’sconsiders theses events a failure to pay andwould revise a specific issue rating to ‘D’ in suchcases. The potential for a payment failure(including allowed eliminations or deferrals) isreflected in the rating on the instrument. Notethat the payment of the coupon in kind (such asa stock settlement) is not a payment failure pro-vided that this option is clearly defined in theoriginal prospectus of the security. The rating ona hybrid capital instrument also reflects subordi-nation of the instrument in liquidation.

Certain shorter-dated MCS that have featuresthat render them virtually indistinguishable fromcommon equity—notably, accelerated conversionunder stress and a coupon that participates in thefinancial performance of the issuer—could enter


Standard & Poor’s more narrowly defined meas-ures of common equity, within appropriatelyprudent limits. To qualify for inclusion inStandard & Poor’s tangible common equitymeasures, these instruments must be seen asequivalent to common equity in the eyes ofinvestors, regulators, accountants, and theissuers themselves.

Redeemable preferred stock issues may alsobe refinanced with debt once an issuer becomesa taxpayer. Preferreds that can be exchanged fordebt at the company’s option also may beviewed as debt in anticipation of the exchange.However, the analysis would also take intoaccount any offsetting positive factors associat-ed with the change in tax status. In cases wherethe investor is given a put option to forceredemption (which can be exercised within 10years of remaining life on the issue), Standard& Poor’s will generally view such securities asdebt-like. Often, the trigger prompting anexchange or redemption would be improvedprofitability. Then, the added debt in the capitalstructure would not necessarily imply lowercredit quality. The implications are different formany issuers that do not pay taxes for variousother reasons, including availability of tax-losscarryforwards or foreign tax credits. For them,a change in taxpaying status is not associatedwith better profitability, though the incentive toturn the preferred into debt is identical.

In the same vein, sinking fund preferreds areless equity-like. The sinking-fund requirementsthemselves are of a fixed, debt-like issuance,which results in the sinking fund preferred beingjust the precursor of debt. It would be misleadingto view sinking fund preferreds, particularly thatportion coming due in the near to intermediateterm, as equity, only to have each payment con-vert to debt on the sinking fund payment date.Accordingly, Standard & Poor’s views at least theportion of the issuer’s sinking fund preferredsdue within the next five years as debt.

Any security with a maturity of less than 10years at original issue will usually be treated asa debt-like instrument. For issues (includingsinking fund preferreds) with longer originalmaturities, within 10 years of repayment date,

Standard & Poor’s will gradually treat theinstrument as more debt-like, using a five-yearamortization schedule whereby for each yearunder 10 years, an incremental 20% of theinstrument is treated as debt until, at five yearsof remaining life, the issue is viewed as com-pletely debt-like.

Standard & Poor’s continues to review a vari-ety of pre-funded contingent capital arrangementsand, assuming acceptable security features, hasaccepted these as eligible hybrid equity up to 5%of the capital structure for investment-gradeissuers. This 5% is a subset of the traditionalhybrid 15% capital bucket. For example, perpet-ual or long-dated pass-through securities areissued by a trust, with the proceeds ultimatelyused to purchase eligible assets that reside in aRegulation 114 Trust. For these securities, theinsurer has a put option giving it the right to putto a special-purpose entity, the insurer’s prefer-ence shares having a liquidation value equivalentto the assets owned by the trust. Standard &Poor’s would expect a trigger to be included inthe securities, requiring mandatory exercise of theput if the insurer’s credit strength falls belowinvestment grade in order for these securities tobe viewed as current equity.

Standard & Poor’s would accept the instru-ment, when drawn, as equity just as any otheracceptable hybrid security, up to 15% of capital.As with other hybrid instruments viewed as equi-ty, they must have an appropriate long-termmaturity, cannot be funded with an auction pre-ferred mechanism, and cannot have any featurethat would cause management intend to makethem a short-term security.



Hybrid Equity Tolerance for Operating Companies

Rating Hybrid Equity Tolerance (%)

AAA 15AA 20A 25BBB and lower 30

Hybrid Equity Tolerance in Operating Insurers’Capital StructuresFrom the policyholders’ perspective, commonequity and surplus remain the preferred forms ofcapital, but for mutuals that cannot issue stock,selling hybrid equity is the only way to raiseadditional capital externally and improve financial strength.

As previously noted, when looking atinsurance holding companies, the overall tol-erance for hybrid equity within an insurer’scapital structure is 15% across all rating cate-gories, whereas debt levels vary, higher levelsof leverage being permissible as one movesdown the ratings spectrum. In contrast withpast practice, which applied the same toler-ance to operating companies, hybrid equitytolerance for operating companies by ratingcategory varies according to the counterpartycredit rating on the operating company (seetable below).

Hybrid equity exposure at an operating company is calculated on a statutory accounting basis.

The result ties in with what Standard & Poor’sunderstands to be regulators’ maximum tolerancefor these types of instruments. However, to theextent that a regulator disallowed a hybrid equityissuance within a particular insurer’s capital struc-ture, that issuance would be treated as debt forrisk-based capitalization model and hybrid equitytolerance purposes.

All issuances of hybrid equity by operatingcompanies that are part of stockholding compa-nies are viewed as debt in evaluating consolidat-ed stock holding-company debt leverage.Standard & Poor’s believes holders of theseoperating-company instruments have an equal,if not senior, call on operating-companyresources versus holding-company debtholders.

These standards allow insurers to manage

capital structures more optimally according totheir own needs. The combination of operatingcompany hybrid equity tolerance with doubleleverage analysis for insurance holding compa-nies also helps level the playing field betweenstock companies and mutuals because toler-ances then combine both debt and hybrid equi-ty exposure. In the end, however, these stan-dards are just that, and as such, they are onlyone part of Standard & Poor’s analysis of aninsurer’s financial strength. In and of them-selves, they will not be the sole determinants ofa rating on a company or group.

Preferred Stock Rating Criteria

Preferred stock ratings address the issuer’scapacity and willingness to pay dividends—andprincipal, in the case of limited life preferreds—on a timely basis. They address the likelihoodof timely payment of dividends, notwithstand-ing the legal ability to pass on or defer a divi-dend payment. Accordingly, the long-term rat-ing definitions pertain to preferred stock aswell. However, in the case of preferred stockthat is not currently paying, the rating would be‘C’. If payments are being made, but an arrear-age remains, the preferred stock would be rated‘CC’. If the issuer defaulted on debt or filed forbankruptcy protection, the rating would berevised to ‘D’.

Standard & Poor’s rates the credit risk ofpreferred stock and similar instruments along asingle continuum that includes all other fixed-income obligations issued by the company.Broadly, the criteria are to rate preferred stocktwo notches below the counterparty credit rat-ing on an investment-grade issuer and threenotches below that on a speculative-gradeissuer. The ability to defer payment and deepsubordination will constitute the decisive ana-lytical factors and could broaden the notching.


Where TAC = total adjusted capital used for capital model purposes. As such, it does not include debt.

Hybrid equity exposure = Hybrid equity

Common plus hybrid equity (TAC)

The same basic methodology and rationorms are used to rate both debt and preferredstock. The financial analysis performed in con-junction with preferred stock ratings is virtuallythe same as that used to rate debt. Fixed-chargecoverage and capitalization ratios are calculatedtreating preferred stock obligations as thoughthey were debt. Although issuers have the rightto defer payments on their preferred stock with-out triggering default, a large amount of pre-ferred stock outstanding will drag down a cred-it rating as well. Even though a company underduress can stop paying the preferred dividendsto avoid default, the burden increases the riskthat the company will face such a financial cri-sis. The company will pay dividends as long aspossible; this can sap its financial strength orsiphon off funds that otherwise could be usedto protect the firm’s competitive position.

Preferred stock ratings also consider thedividend’s vulnerability to the firm’s discre-tionary passing on a payment. It is, therefore,appropriate to rate preferred stock lower thanindicated by pure financial analysis—and wellbelow the debt rating—in the case of specula-tive-grade credits. Such issuers may be expect-ed to eliminate preferred dividends to helpavoid financial constraints.

Covenants in debt instruments can endan-ger payment of preferred dividends, even iffinancial measures indicate a capacity to pay.State charters also restrict payments whenthere is a deficit in the equity account. Thiscan occur following a write-off, even whilethe firm is healthy and possesses ample cashto continue paying.

Conversion Preferred Stock

Securities such as preferred equity redemptioncumulative stock (PERCS) provide for manda-tory conversion into common stock. In theinterim, the security is preferred stock, andthe dividend yield approximates prevailingpreferred stock yields. To the extent that theshare price exceeds that specified price, theinvestor receives only a fraction of a share.The investor thus gives up part of the poten-tial appreciation in return for a dividend that

is larger and more predictable than the com-mon dividend.

As with other preferred stock, Standard &Poor’s rates conversion preferred stock toindicate the likelihood that the issuer will paydividends in a timely fashion. In the case ofPERCS, the period during which dividends arepaid is limited because the issue converts tocommon stock after three years. The ratingdoes not address the amount or value of the common equity the investor will ultimately receive.

Trust Preferred Stock

When using a trust preferred, a company estab-lishes a trust that is the legal issuing entity ofthe preferred stock. The sale proceeds of thepreferred are loaned to the parent company,and the payments on this intercompany loanare the source for servicing the preferred obliga-tion. In some cases, this financing structure canprovide favorable equity treatment for the com-pany, even while the payments are taxdeductible.

Standard & Poor’s rating of trust preferredsis based on the parent company’s creditworthi-ness and the terms of the intercompany loan.Any equity credit that might be associated withthese issues also is a function of the terms of theintercompany loan, especially with respect topayment flexibility.

This variety of preferred was introduced in1995 as TOPrS (Trust Originated PreferredSecurities). TOPrS were a structural alternativefor deferrable-payment hybrids that had beensold since late 1993 under the appellation MIPS(Monthly Income Preferred Securities).

Canadian companies have issued a securitymore recently called COPrS. This preferred stockis similar in terms of economic substance but isissued directly, without the trust structure.Canadian tax and accounting treatment facilitatestax deductibility for this type of equity instrumentwithout the complexity of indirect issuance.

The use of a trust neither enhances nordetracts from the structure compared with thealternative issuing entities. The legal form of theissuing entity can be a business trust, limited



partnership, offshore subsidiary in a tax haven,or onshore limited liability corporation. Thesestructures have in common an intercompanyloan with deferral features (typically five years),no cross-default provision, a long maturity, anddeep subordination. The preferred dividend issimilarly deferrable as long as common divi-dends are not being paid. After the deferralperiod, the trust preferred holders have legallyenforceable creditors’ rights—in contrast toconventional preferreds, which provide onlyvery limited rights.

The extent of any equity credit for the par-ent company depends on the specific features ofthe intercompany loan. It can be equal to thatof conventional perpetual preferred stock.

Surplus Notes in Insurers’ Capital Structures

Surplus notes provide long-term funding at alow cost of carry because the interest paid onthe notes is only slightly higher than the insur-er’s investment rate of return. If structuredproperly, the notes are treated as surplus byinsurance regulators. Depending on the struc-ture and maturity of these instruments,Standard & Poor’s also views surplus notes asequity-like in nature, with positive implicationsfor the ratings on an insurer’s policy obligation.

Surplus notes are capital instruments thatregulators generally treat as part of the capitaland surplus of an operating insurance company.The notes, which usually pay interest semiannu-ally or annually, have a stated maturity (usually10-30 years), though the issuer has the optionto call some notes. Surplus notes have restric-tive repayment features that give regulators theability to prevent principal and interest pay-ments if an insurer’s financial condition deterio-rates. The notes also contain equity features,i.e., they are subordinated in the payment ofinterest and principal to debt and policy obliga-tions. Yet the insurer is not forced into bank-ruptcy or receivership if interest or principal isnot paid.

Traditionally, surplus notes were sold onlyby troubled companies or insurers whose hold-

ing companies had undergone a leveraged buy-out. In a leveraged buyout, the insurance sub-sidiary would issue a surplus note in favor of itsparent holding company. The cash flow fromthe surplus note would match the parent com-pany’s debt obligations so the holding companycould ensure its ability to service its debt. Thesurplus note offered the insurer some taxadvantages as well.

Analyzing Surplus NotesIn Standard & Poor’s view, the structure andmaturity of an insurer’s surplus notes dictatehow much support the notes provide for policy-holder obligations as well as what rating shouldbe assigned to the notes relative to the financialstrength rating on the company. To receive equi-ty-type treatment by Standard & Poor’s, thenotes must be subordinate in the payment ofinterest and principal to all other types of obli-gations, such as debt and policy obligations. Inthe event of nonpayment of interest or principal,the noteholders must not be able to force theissuer into bankruptcy, receivership, liquidation,or any other form of regulatory supervision.

To date, regulators agree that notes requiringthe commissioner’s approval for each paymentof interest and principal should be treated assurplus. At longer maturities—at least 10years—Standard & Poor’s also views these notesas equity-like and treats them as equity capitalin support of a financial strength rating.Opinion is much more divided within the NAICabout how notes that contain a formula forpreapproving such payments will be treated.Many regulators believe if they include a preap-proval clause, the notes should be viewed as aliability, not as a surplus. At longer maturities,Standard & Poor’s still views these types ofnotes as more equity-like in nature comparedwith a debt obligation and views them as sup-porting claims obligations. Still, Standard &Poor’s makes qualitative adjustments in the com-pany’s evaluation, recognizing that these notesare not as strong in equity characteristics asnotes that require approval for each payment.

For Standard & Poor’s to view surplusnotes as equity-like in nature, they must havea maturity that is consistent with the advan-


tages offered by long-term capital. Standard &Poor’s views notes in the longer end of thematurity range, 20 years and beyond, as partof an insurer’s long-term capital and, there-fore, treats them as equity. A 10-year note attime of issuance is the shortest maturityStandard & Poor’s will consider as equity. Atthis maturity, the quality of the surplus note asequity capital is not as strong as that of longermaturities; therefore, Standard & Poor’smakes distinctions between these maturities inits analysis. Surplus notes with maturities ofless than 10 years are increasingly viewed asmore debt-like as their maturities shorten.Standard & Poor’s views surplus notes asdebt-like within five years of maturity.

Standard & Poor’s will tier the rating on asurplus note off the financial strength rating onthe company. To date, the ratings on surplusnotes have been two notches below the finan-cial strength rating as long as the financialstrength rating is secure (‘BBB-’ or higher). Togive a perspective of how Standard & Poor’srates surplus notes versus debt, the senior debtand financial strength ratings on an operatinginsurance company are generally the same, andthe subordinated debt rating will typically beone notch lower as long as the senior debt andfinancial strength ratings are in the securerange. The subordinated debt will be rated twonotches below the financial strength rating ifthe financial strength rating is not secure (‘BB+’or lower).

To understand the regulator’s perspectives onsurplus notes, Standard & Poor’s, in coopera-tion with the issuing company, asks the insur-ance regulatory agency in the insurer’s state ofdomicile the following questions:

� Does the regulatory agency explicitly takeinto account the capital market’s expecta-tions with respect to the timely payment ofprincipal and interest on the surplus notes?How sensitive is it to the implications for thecapital markets, the insurer, and its policy-holders, if payments are not allowed?

� Does the regulatory agency view the insurer’sissuance of surplus notes as a positive action,with the expectation that the approval of

repayment on the notes will not be withheldunreasonably?

� Does the regulatory agency recognize thatthere could be some financial deteriorationat the insurer and still allow payment on the notes?The gap between the financial strength rat-

ing and the rating on the surplus note widens asan insurer’s financial condition deteriorates.Although the above criteria apply to insurerswith secure ratings, the ratings gap will increasesignificantly if the insurer is rated vulnerable.Standard & Poor’s believes the likelihood ofregulatory intervention on the payment of asurplus note’s interest or principal is high forinsurers rated ‘BB+’ or lower. Consequently, atthat rating level, the gap between the financialstrength rating and a surplus note rating will betwo rating categories.

Lastly, Standard & Poor’s believes surplusnotes should be a prudent amount of aninsurer’s total capitalization to comply withthe above gap criteria. If surplus notes pur-chased by unaffiliated third parties constitutemore than 15% of total capital, the ratingsgap is likely to be wider, and Standard &Poor’s gives less equity credit for the note.The more equity-like in nature surplus notesare, the more positive the implications for theinsurer financial strength rating because thenotes’ maturity and structure support the pay-ment of policy obligations. Conversely, noteswith the most equity-like characteristics tendto be rated lower than are their counterpartsbecause their relative likelihood of repaymentis lower.

Although many companies have not identi-fied specific business opportunities that this newcapital will support, they have issued surplusnotes in the belief that such an opportunity forlow-cost capital might not arise again. For anindustry that always seems to be starved forcapital but never short of new opportunities onwhich to spend it, such longer-term thinkingseems to be prudent.

If surplus notes are issued to unaffiliatedthird parties by an operating company that isultimately owned by a holding company, any



amount exceeding 15% of capital will be treat-ed as debt.

If the surplus notes are issued to an affiliatedgroup member, Standard & Poor’s will considerincremental amounts of surplus notes exceedingthe 15% threshold as equity capital. Oftenthese notes are issued to the parent as a tax-effi-ciency strategy.

In situations where the parent and subsidiarydo not file a consolidated tax return, the taxdeduction that the parent receives for debt serv-icing cannot offset the subsidiary’s earnings. Byissuing a surplus note at the subsidiary level,the debt-servicing expense can offset the sub-sidiary’s earnings. The parent commits that thenote is a permanent part of the subsidiary’s cap-ital base and commits to restructure the note toavoid a default.

In certain situations, Standard & Poor’s willaccept up to 30% of a subsidiary’s capital inthe form of parent-held surplus notes if the sub-sidiary is viewed as strategically important orcore to the parent and the parent has commit-ted that the surplus notes will be a permanentpart of the capital structure.

Commercial Paper and Confidence-Sensitive Debt

Commercial paper consists of unsecured prom-issory notes issued to raise short-term funds.Typically, only companies of strong creditstanding can sell their paper in the money mar-ket, though there was some issuance of lesser-quality, unrated paper prior to the junk bondmarket collapse late in 1989.

The commercial paper and confidence-sensi-tive debt markets’ acute sensitivity to creditquality and the speed with which confidencecan be lost are of great concern to Standard &Poor’s. When a crisis of confidence strikes,issuers that do not have alternative sources ofliquidity could default on their commercialpaper or any other obligations coming due. Allprudent issuers of confidence-sensitive debtshould have alternative sources of liquidity. Thepurpose of backup liquidity is to protect theissuer in the event that investors are reluctant to

roll over short-term debt because of develop-ments—e.g., bad business conditions, a lawsuit,management changes, a rating change—affect-ing a single issuer or group of issuers, eventhough Standard & Poor’s believes the issuerremains creditworthy.

In addition to examining liquidity backupfor rated commercial paper programs, Standard& Poor’s reviews liquidity backup for all confi-dence-sensitive, short-term debt for all ratedinsurers. Confidence-sensitive, short-term debtis defined as rated or unrated commercial paperissued in all markets (based on authorizedamount unless Standard & Poor’s is told inwriting that the company will maintain a loweramount outstanding); borrowings under moneymarket lines; short-term borrowings frommutual funds and other organizations that arenot banks; master notes; loans due on demand;and current maturities of publicly held long-term debt, including medium-term notes.Borrowings not considered confidence-sensitivewould be traditional bank loans and debt owedto an affiliate.

Evaluation of an issuer’s commercial paperand other short-term debt issues reflectsStandard & Poor’s opinion of the issuer’s fun-damental credit quality. The analyticalapproach is virtually identical to the one fol-lowed in assigning a long-term rating, and astrong link exists between the short-term andlong-term rating systems.

In effect, the minimum credit quality associat-ed with the ‘A-1+’ commercial paper rating is theequivalent of an ‘A+’ long-term rating. Similarly,for commercial paper to be rated ‘A-1’, the long-term rating would need to be at least ‘A-’. (In fact, the ‘A-/A-1’ combination is rare.Typically, ‘A-1’ commercial paper ratings areassociated with ‘A+’ and ‘A’ long-term ratings.)Conversely, the long-term rating will not fullydetermine a commercial paper rating because ofthe overlap in rating categories. However, therange of possibilities is always narrow. To theextent that one of two commercial paper ratingsmight be assigned at a given level of long-termcredit quality, criteria to make that determinationare as follows:


Overall strength of the credit within the rat-ing category is the first consideration. Forexample, a marginal ‘A’ credit would likelyhave its commercial paper rated ‘A-2’; a solid‘A’ would almost automatically be rated ‘A-1’.

In addition, the commercial paper rating per-spective sometimes focuses more intensely onthe near term. The time horizon for a commer-cial paper rating extends well beyond the typical30-day life of a commercial paper note, the 270-day maximum maturity for the most commontype of commercial paper, or even the one-yeartenor used to distinguish between short-termand long-term ratings in most markets. Thus,commercial paper ratings are likely to endure,rather than change frequently. Nonetheless, thenear-term outlook is occasionally distinct fromlong-term prospects. An example is companieswith substantial liquidity, which provides protec-tion in the near or intermediate term, but thatalso have less-than-stellar profitability, a long-term factor. Similarly, companies with relativelylarge cash holdings that might be used to fundacquisitions fit in this category.

Liquidity Backup Policies

Having a substantial level of liquidity—in theform of bank facilities or readily available liq-uid resources—is prudent for virtually all

issuers and will continue to be necessary to sup-port an investment-grade rating on both com-mercial paper and long-term debt. From time totime, developments affecting a single companyor group of companies could make commercialpaper investors nervous and unwilling to rollover the issuer’s paper, even though the issuerremains creditworthy. Prearranged bank facili-ties are often essential in protecting against therisk of default under these circumstances.

Another purpose of having a backup bankline is to ensure that an issuer can meet its obli-gations in the event of a disruption to thefinancial markets that might inhibit the normalrollover of commercial paper, even while theissuer’s own financial condition remainedstrong. However, given the growth of the com-mercial paper market, the protection affordedby back-up facilities could not be relied onwith a high degree of confidence in the event ofwidespread disruption of the commercial papermarkets. A general disruption would be a high-ly volatile scenario under which most banklines would represent unreliable claims onwhatever cash would be made availablethrough the banking system to support themarket. Standard & Poor’s neither anticipatesthat such a scenario is likely to develop norassumes it never will.

Lower-rated issuers typically provide 100%backup—excess liquid assets or bank facilities—for commercial paper outstanding. However,companies with the highest credit quality can pro-vide a lower percentage of coverage. Issuers rated‘A-1+’ need not prearrange 100% coveragebecause they should be able to raise funds quicklyeven if adversities develop. The exact amount isdetermined by the issuer’s overall credit strengthand its access to capital markets.

Traditionally, implementation of backuppolicies has revolved around determining howmuch committed bank credit line backup is nec-essary in relation to the size of the rated pro-gram. Standard & Poor’s expects appropriatebackup decisions to combine not just commer-cial paper but all confidence-sensitive debt indetermining the issuer’s overall liquidity posi-tion and policies.



‘AAA’

‘AA+’

‘AA’

‘AA-’

‘A+’

‘A’

‘A-’

‘BBB+’

‘BBB’

‘BBB-’

‘BB+’

‘A-1+’

‘A-1’

‘A-2’

‘A-3’

‘B’

Correlation of Commercial Paper Ratings withLong-Term Ratings Counterparty Credit Ratings

The institution’s on-balance-sheet liquidity inrelation to overall confidence-sensitive liabilitieswould then be the primary area of analysis.

Backup liquidity must be sufficient to pro-vide the appropriate level of coverage for allmaturing short-term debt, not just commercialpaper. Backup for 100% of rated commercialpaper is meaningless if other debt maturities—for which there is no backup—coincide withthose of commercial paper. Thus, the scope ofbackup liquidity must extend to unrated com-mercial paper, master notes, syndicated banknotes, and other similar confidence-sensitiveobligations.

The issuer is expected to meet the followingguidelines at all times. If liquidity needs fluctu-ate during the year, liquidity backup must bemaintained to cover the seasonal peak.

At the very least, Standard & Poor’s expectsall back-up lines to be in place and confirmedin writing; preapproved lines or verbally com-mitted lines are insufficient. Standard & Poor’sis also particularly skeptical about reliance onmoney-market lines or similar arrangementsthat are little more than an invitation to dobusiness at some future date. Payment for thelines—whether by fee or balances—generallycreates some degree of moral commitment onthe part of the bank. Whether a facility isspecifically designated for commercial paperbackup is of little significance.

No distinction is made between a 364-dayand a 365-day facility. However, it is obviouslycritical that the facility at all times extendsbeyond the longest maturity of the paper it isbacking. A prudent company will arrange forthe continuation of its banking facilities well inadvance of their lapsing.

The weaker the credit, the greater the needfor more reliable forms of liquidity. Issuers rated‘A-1+’ have superior access to capital because oftheir strong credit profiles; one assumes thatbanks would not hesitate in honoring lines ofcredit to such borrowers. By contrast, Standard& Poor’s considers it prudent for ‘A-1’, ‘A-2’,and certainly ‘A-3’ rated commercial paperissuers to have a substantial portion of theirbanking facilities contractually committed in theform of a revolving credit. These revolversshould provide same-day availability of funds.

As a general guideline, an ‘A-1’ issuer shouldhave sufficient revolving credit capacity to pro-vide for the next 10 days’ maturities of out-standing paper. In the case of ‘A-2’ and ‘A-3’issuers, revolvers should cover at least 15 daysof maturing paper. Usually, for ‘A-2’ and ‘A-3’issuers, this means backup of 50% of total out-standings with revolving credits. The rest of thebackup should be with other committed facili-ties, such as compensated lines. Stronger back-up may be required in some cases to provideadditional protection against potential roll-overproblems caused by declining market confi-dence in the issuer.

Standard & Poor’s recognizes that evenrevolving credit agreements, which are usually


Minimum Liquidity Backup Coverages

A-1+ Cash and liquid assets* + 50% of confidence-Committed bank lines¶ = sensitive short-term

debt (CS STD)

A-1 Cash and liquid assets* + 75% of CS STDCommitted bank lines¶ =

A-2 & Cash and liquid assets* + 100% of CS STDlower Committed bank lines¶ =

* Cash and liquid assets. The best source of liquidityis cash and immediately marketable securities.Marketability is the key analytical focus here, andonly assets that can be easily sold in a short periodshould be considered “liquid.” The best securitiesare government obligations, bank instruments, andcorporate instruments that are readily disposable,particularly high-grade, public, short-term obliga-tions such as high-grade commercial paper.Investment equity holdings, loan sales, and othernonmarketable assets would be looked at only as alast resort.

¶ Committed bank lines. Banks offer various types ofcredit facilities that differ widely regarding thedegree of the bank’s commitment to advance cashunder all circumstances. Ever-weaker forms of commitment, which are less costly to issuers, havebecome common in recent years, providing bankswith great flexibility to redirect credit at their own discretion.

the strongest commitment a bank can make,often include material-adverse-change clausesthat allow the bank to withdraw under certaincircumstances. Although inclusion of an escapeclause weakens the commitment, Standard &Poor’s does not consider it critical—or realis-tic—for most borrowers to negotiate removal ofmaterial-adverse-change clauses.

It is important to note that even the strongestform of backup—a revolver with no material-adverse-change clause—does not enhance theunderlying credit and does not lead to a higherrating than indicated by the company’s owncreditworthiness. Credit enhancement can beaccomplished only through letters of credit oranother instrument that unconditionally trans-fers the debt obligation to a higher-rated entity.

Banks providing issuers with facilities forbackup liquidity should be sound institutionswith the capacity to lend funds as committed.The credit rating on the bank can serve as aguide to its soundness: an investment-grade rat-ing should indicate sufficient financial strengthfor providing a commercial paper issuer with areliable source of funding.

Standard & Poor’s does not require that thebank credit rating equal the issuer rating. Nordoes Standard & Poor’s require that the bankcredit rating be ‘AA’, ‘A’, ‘A-1’, or even ‘A-2’ tobe included in the lineup of banks supporting anissuer’s liquidity. There is no reason to presumethat any potential difficulties for the bank wouldcoincide with the period during which the issuerwould look to it for support. Moreover, highercredit quality of the bank does not lead to aninclination to add assets at a given time or to lendto a given borrower. Nonetheless, Standard &Poor’s looks askance at situations where most ofa company’s banks are only marginally invest-ment-grade. That indicates an imprudent relianceon banks that might deteriorate to weaker, nonin-vestment-grade status.

Dependence on just one or very few banks isalso viewed as an unwarranted risk. Apart fromthe potential that the bank will not have adequatecapacity to lend, there is the chance that it willnot be willing to lend to this issuer. Having sever-al banking relationships diversifies the risk that

any bank will lose confidence in this borrowerand hesitate to provide funds.

Concentration of banking facilities also tendsto increase the dollar amount of an individualbank’s participation. As the dollar amount of theexposure becomes larger, the bank could be morereluctant to honor its commitment. In addition,the potential requirement of higher-level authori-zations at the bank could create logistical prob-lems with respect to expeditious access to funds for the issuer.

Diversification is desirable up to a point. Acompany must not spread its banking businessso thin that it lacks a substantial relationshipwith any of its banks. In the end, a solid busi-ness relationship with a bank is the key towhether the bank will stand by its client.Standardized criteria cannot capture or assessthe strength of such relationships. Standard &Poor’s is interested, though, in any evidence—subjective as it might be—that could demon-strate the strength of an issuer’s banking rela-tionships. For example, the nature of creditand noncredit services provided by the bankand the length of the business relationship canoften provide some insight.

Extendible commercial notes provide built-in backup by allowing the issuer to extend forseveral months if there is difficulty in rollingover the notes. Accordingly, there is no needto provide backup for them. However, there isno way to prevent the issuer from tappingbackup facilities intended for other debt anduse the funds to repay maturing extendiblecommercial notes instead of extending. Thisrisk is known as leakage. Accordingly, forissuers that provide 100% backup, unbackedextendible commercial notes must not exceed20% of extant backup for outstanding con-ventional commercial paper. Companies pro-viding backup based on upcoming maturitylevels could not issue extendible commercialnotes without backup because that woulddegrade their coverage below what is deemeda minimum level.


1 0 0 www.pccriteria.standardandpoors.com

Guaranteed Commercial Paper and Other Parent and SubsidiaryArrangements

When a corporate commercial paper program isguaranteed, the guarantor’s liquidity is the subject

for analysis. Bank lines and liquid assets shouldbe in the guarantor’s name, not the issuer’s. If theissuer becomes insolvent or bankrupt, it will loseaccess to its bank lines and will not be able topay off commercial paper with its liquid assets ina timely fashion. Thus, backup lines and liquidassets should be in the hands of the guarantor.

Standard & Poor’s � Insurance Ratings Criteria Property/Casualty Edition 1 0 1

Over what time frame does Standard & Poor’scalculate ratios?Standard & Poor’s may calculate many varia-tions of the ratios to identify the key drivers of performance. Typically, Standard & Poor’slooks for trends in ratios based on five-year historical data and projections up to three years.

Why does Standard & Poor’s sometimes makeadjustments when calculating ratios?It is appropriate to measure underlying per-formance, so one-off profits or losses can beexcluded, and profits and losses from acquisi-tions and disposals can be annualized.However, materiality should always be considered.

How important are financial ratios in determiningthe final rating?Standard & Poor’s analysis is not confined to models, numbers, and ratios. Subjectiveanalytical judgment often outweighs the hardnumbers. Financial ratios are used to helpform opinions on a company’s performance inthe analytical areas of Standard & Poor’s rating process.

How are ratios interpreted by Standard & Poor’s?Guideline benchmarks are given for debt lever-age, the interest-coverage ratio, and the capitaladequacy ratio. Holding-company doubleleverage indicates how holding-company debtcan be treated in Standard & Poor’s risk-basedcapital models, and the hybrid equity ratioindicates how hybrid instruments can be treat-

ed in Standard & Poor’s capital models andthe leverage calculation. Other ratios are usedto help measure operating performance,investment quality, and liquidity.

How should ratio benchmarks be used?Benchmarks must be used with caution. Agreat deal of discretion is required in applyingthese guidelines. Although they provide insightinto ratings in general, it is a mistake to over-simplify the entire thought process behind aspecific rating by relying solely on the num-bers. Guidelines focus on only a few ratios.Many additional measures are used to roundout the analysis or to focus on specific issues.Obviously, strengths reflected in one financialmeasure can offset, or balance, a relativeweakness in another.

Are the guideline benchmarks applicable tostatutory or GAAP reported financials?The guideline benchmarks should be appliedto ratios that show earnings and net worth ina realistic economic light. GAAP presents amore economic view of financial performancethan statutory data. In Europe, analysts usethe best available financial information whencalculating ratios to reflect economic worthand earnings, some of which might be confi-dential. In reality, the availability of publicfinancial information can change from year toyear. However, Standard & Poor’s underlyinganalysis looks through the changes in account-ing treatment and availability of financialinformation to assign a consistent final rating.

Frequently Asked Questions

If a subsidiary issues commercial paper with-out a guarantee, the commercial paper backupshould be based on the subsidiary’s liquid assetsand bank lines, not the parent’s, unless the ratingon the subsidiary is based on substantial andtimely support from a stronger parent. If a main-tenance-of-net-worth agreement or other docu-ment allocates a specified amount of the parent’s

liquidity to the subsidiary, this might be countedas part of the subsidiary’s backup. The sub-sidiary’s commercial paper should then be includ-ed in the parent’s confidence-sensitive debt whenbackup for the parent’s commercial paper is cal-culated and, more broadly, when the parent’s liq-uidity is evaluated.

C H A P T E R T I T L E


Counterparty Credit Ratings and theCredit Framework

Issue Credit Ratings

A Standard & Poor’s Ratings Services issuecredit rating is a current opinion of an obligor’screditworthiness with respect to a specific finan-cial obligation, a specific class of financial obli-gations, or a specific financial program. It takesinto consideration the creditworthiness of guar-antors, insurers, or other forms of creditenhancement on the obligation as well as thecurrency in which the obligation is denominat-ed. An insurer financial strength rating is anexample of an issue credit rating because itfocuses on insurance policy obligations.

On a global basis, Standard & Poor’s issuecredit rating criteria have long identified theadded country risk factors that give externaldebt a higher default probability than domes-tic obligations. In 1992, Standard & Poor’srevised its criteria to define external versusdomestic obligations by currency instead of bymarket of issuance. This led to the adoption ofthe local currency/foreign currency nomencla-tures for issue credit ratings. As rating cover-age expands to include a growing range ofemerging-market countries, the analysis ofpolitical, economic, and monetary risk factorsbecomes even more important.

Counterparty Credit Ratings

In response to a need for issuer rating evalua-tions when no public debt is outstanding,Standard & Poor’s provides a counterparty(also called issuer) credit rating—an opinion ofthe obligor’s overall capacity and willingnessto meet its financial commitments as theycome due. The opinion is not specific to anyfinancial obligation, as it does not take intoaccount the specific nature or provisions ofany obligation. Issuer credit ratings do nottake into account statutory or regulatory pref-erences, nor do they take into account thecreditworthiness of guarantors, insurers, or

other forms of credit enhancement to an obli-gation. Counterparty credit ratings, corporatecredit ratings, and sovereign credit ratings areall forms of issuer credit ratings.

Evolution of a distinct set of issuer creditrating definitions recognized the long-standingmarket practice of using senior debt ratings asshorthand for an issuer’s general credit stand-ing. Rapid growth of the interbank and deriva-tives markets has strongly accelerated such useof counterparty credit ratings. Because a coun-terparty credit rating provides an overallassessment of a company’s creditworthiness, itis used for a variety of financial and commer-cial purposes, such as negotiating long-termleases or minimizing the need for a letter ofcredit for vendors.

Sovereign Risk

Sovereign credit risk is a key consideration inthe assessment of the credit standing of finan-cial institutions and corporates. Sovereign riskcomes into play because the unique, wide-rang-ing powers and resources of a national govern-ment affect the financial and operating environ-ments of entities under its jurisdiction.Experience has shown time and again thatdefaults by otherwise creditworthy borrowerscan stem directly from a sovereign default orindirectly from the deterioration in the localoperating environment or regulatory frameworkthat typically accompanies a sovereign default.

In the case of foreign currency debt, the sov-ereign has first claim on available foreignexchange, and it controls the ability of any resi-dent to obtain funds to repay creditors. To serv-ice debt denominated in local currency, the sov-ereign can exercise its powers to tax, controlthe domestic financial system, and even issuelocal currency in potentially unlimited amounts.Given these considerations, the credit ratings onnonsovereign borrowers most often are no high-er than the ratings on the relevant sovereign.


Counterparty Credit Ratings andthe Credit Framework

Although “sovereign ceiling” is an inappro-priate term, when determining the creditworthi-ness of an issuer, Standard & Poor’s doesalways assess the impact of sovereign risk andhow it could affect that issuer’s ability to fulfillits obligations according to the terms of a par-ticular debt instrument. This is done in a moreflexible manner than the term “ceiling” suggestsby looking at the issuer’s own position and abil-ity to meet its obligations in general as well asthe particular features of a specific obligationthat might affect its timely payment. For exam-ple, borrowers could add features to specificdebt issues, such as external guarantees, or theycould structure them in particular ways—suchas asset-backed transactions—that enhance thelikelihood of payment. Nevertheless, for debtissuers in all but the highest-rated countries, thesovereign risk factor remains an extremelyimportant consideration in the assignment ofoverall creditworthiness.

There are two key elements that form thebasis for Standard & Poor’s evaluation of sov-ereign risk on the creditworthiness of a particu-lar issuer or debt issue:

� The economic, business, and social environ-ments that influence both the rating on thesovereign itself and the ratings on the issuersdomiciled there.

� The ways in which a sovereign can directlyor indirectly intervene to affect an entity’sability to meet its offshore debt obligations,even if that entity has sufficient funds onhand to meet that obligation.

Actions by the sovereignSovereign governments in many countries actto constrain an issuer’s ability to meet off-shore debt obligations in a timely manner.Although higher-rated sovereigns are notexpected to interfere with the issuer’s abilityto use available funds to meet such offshoreobligations, the chances of some form ofintervention increase significantly for entitiesdomiciled in lower-rated nations.

At a time of local economic stress, whenforeign exchange is viewed as an increasinglyscarce and valuable commodity, the likelihoodof direct constraint on, intervention in, or

interference with access to foreign exchangecan be high. For this reason alone, it is unlike-ly that most issuers’ ability to meet offshoredebt obligations in a timely manner can beviewed as more probable than their sover-eigns’ own likelihood of meeting their off-shore debt obligations.

Even when the issuer has sufficient fundsto meet its offshore debt obligations, the sov-ereign may absolutely prohibit or otherwiseconstrain the issuer from meeting those obli-gations in a timely manner. For example, theVenezuelan government in 1994 and 1995and the Argentine government in 2001 and2002 rationed the availability of foreignexchange to private-sector entities to the pointthat many of these entities defaulted on for-eign currency debt obligations—despite someof them having sufficient funds to meet theseobligations in a timely manner if access toforeign exchange had been possible.

A sovereign government under severe eco-nomic or financial pressure that is seeking toretain valued foreign-currency reserves in thecountry and that might not be able to meet—or already has not met—its timely obligationson offshore debt could impose many con-straints on other governmental or private-sec-tor borrowers, including:

� Setting limits on the absolute availability toforeign exchange.

� Maintaining dual or multiple exchange ratesfor different types of transactions.

� Making it illegal to maintain offshore or for-eign-currency bank accounts.

� Requiring the repatriation of all funds heldabroad or the immediate repatriation of pro-ceeds from exports and conversion to localcurrency.

� Seizing physical or financial assets if foreign-exchange regulations are breached.

� Requiring that all exports (of the goods inquestion) be conducted through a centralizedmarketing authority or the posting of a sig-nificant bond prior to the export of goods toassure immediate repatriation of proceeds.

� Implementing restrictions on inward andoutward capital movements.


� Refusing to clear a transfer of funds fromone entity to another.

� Revoking permission to use funds to repaydebt obligations.

� Mandating a moratorium on interest andprincipal payments or required reschedulingor restructuring of debt.

� Nationalizing the debt of an issuer and mak-ing it subject to the same repayment terms ordebt restructuring as that of the sovereign.

Local Currency/Foreign Currency Distinctions.Country risk considerations are a standard partof Standard & Poor’s analysis for credit ratingson any issuer or issue. Currency of repayment isa key factor in this analysis. An obligor’s capac-ity to repay foreign currency obligations couldbe lower than its capacity to repay obligationsin its local currency because of the sovereigngovernment’s own relatively lower capacity torepay external versus domestic debt. These sov-ereign risk considerations are incorporated inthe debt ratings assigned to specific issues.Foreign currency issuer ratings are also distin-guished from local currency issuer ratings toidentify instances when sovereign risks makethem different for the same issuer.

Local currency/foreign currency distinctionsare effectively made every time a credit rating isassigned to a debt issue. At the issuer credit rat-ing level, the distinction is conveyed in theassignment of separate local currency issuer cred-it ratings and foreign currency issuer credit rat-ings. Once again, these issuer credit ratingsreflect the obligor’s general capacity to repayfinancial obligations and do not address the spe-cific terms or risks of any financial transactions.

For most of the issuers covered by Standard &Poor’s, the local currency and foreign currencyissuer credit ratings are identical.

Local currency/foreign currency distinctionsexist for several highly rated sovereign issuers.In many countries farther down the ratingsspectrum, a large number of issuers have for-eign currency credit ratings that are lower thantheir local currency credit ratings because ofsovereign risk considerations. Local currencyissuer credit ratings in these countries can bevery valuable information because they fully

identify the stand-alone credit characteristicsof each issuer and are often different than for-eign currency issuer credit ratings, which couldbe constrained by external payment risks relat-ed to the sovereign.

The analytical challenges posed by the rapid-ly globalizing financial markets are substantial.Ratings on many emerging-market credits arebound to be dynamic, and analytical techniqueswill have to develop in concert. At this juncture,the frameworks that distinguish issuer versusissue credit ratings and local currency versusforeign currency credit ratings add powerfulanalytical insights.

Factoring Sovereign Risk into Insurer Financial Strength RatingsStandard & Poor’s definition of insurer financialstrength ratings explicitly incorporates the poten-tial for direct sovereign risk. The potential fordirect government intervention, demonstrated pri-marily through mandated changes in contractualterms of insurance obligations in response to eco-nomic crisis, can result in lower ratings on insur-ers, including foreign branches and guaranteedsubsidiaries, especially for those domiciled inhigher-risk environments in which systemic risksor severe economic stress—the predecessors to government intervention—are perceived to be greatest.

Although the incidence of direct governmentintervention in the insurance sector is infrequent,the role of this important sector in facilitatinglocal economic and commercial markets can leadand has lead to government or regulatory inter-ventions. These actions, which could entail gov-ernment- or regulator-mandated changes in con-tract terms (such as in Argentina or Brazil), usual-ly reduce systemic risks. However, through theirunilateral nature, they can affect all insurers oper-ating in the domicile regardless of their intrinsicfinancial strength, foreign affiliation, or support.The potential for such risk to impair policyholderor creditor protection is difficult to assess. Injudging the potential for the government interven-tion, Standard & Poor’s will consider the systemicrisk in the insurance sector, the role and contribu-tion of the sector in underpinning local commer-cial and financial markets, overall economic envi-

C O U N T E R PA RT Y C R E D I T R AT I N G S A N D C R E D I T F R A M E W O R K


ronment, and government and regulatory policiestoward intervention.

Incorporating country risk as a critical inputinto all ratings within a given domicile has longbeen Standard & Poor’s practice. These sover-eign risk considerations are included in thefinancial strength ratings assigned to insurersand debt ratings assigned to specific issues. Thevast majority of insurance companies are ratedno higher than the sovereign state exercisingjurisdiction over them, reflecting each govern-ment’s broad legal and regulatory powers,including its control over the domestic financialsystem and its ability to tax and impose foreignexchange controls. Financial strength ratingsalso reflect the influence of general country riskfactors on the insurer’s business franchise andfinancial standing. Local currency/foreign cur-rency distinctions are effectively made everytime a credit rating is assigned. At the issuercredit rating level, the distinction is conveyedin the assignment of separate local currencyissuer credit ratings and foreign currency issuercredit ratings.

Financial strength ratings (both full, interac-tive ratings and pi ratings, which are based onpublic information) are local currency ratings.Financial strength ratings address an insurer’scapacity to repay local-currency obligations,which could be stronger than its capacity torepay obligations in foreign currency because ofthe sovereign government’s potential to imposeconvertibility or exchange controls. In additionto incorporating the risk of direct sovereignintervention, other direct and indirect sovereignrisks—such as the impact of macroeconomicvolatility, currency devaluation, asset impair-ment, or investment portfolio deterioration—and other possible controls are factored into thefinancial strength rating.

Sovereign stress has an overwhelming impacton insurer creditworthiness—through bothdirect and indirect effects. The direct impact ofa sovereign local currency default should weighheavily on companies with direct exposure tosovereign local currency debt, as is often thecase for insurers that have a significant liquidityposition maintained in government bonds. For

this reason, the rating on insurance subsidiariesthat are considered core operations of globalinsurance groups will not be higher than thesovereign local currency rating without explicitsupport. Similarly, Standard & Poor’s will notassign domestic insurers a rating higher thanthe local currency rating on the sovereign inwhich they are domiciled, other than in demon-strated cases of extraordinary financial strengthand other characteristics that mitigate domesticrisk factors. Only in exceptional circumstanceswould the rating on a company be higher thanthe local currency rating on its home countrywithout explicit support. Such would be thecase if the local insurer can be shown to havethe wherewithal to survive a comprehensive setof stress case assumptions consistent with a sov-ereign default scenario (e.g., government bondstrading at a fraction of their face value, highlydepressed equity valuations, or loan and bondassets having migrated to highly speculative lev-els if not defaulted).

Rating Insurers Higher than the SovereignReasonable conclusions from historical prece-dent—combined with Standard & Poor’s currentexpectations about future sovereign default sce-narios—are that there can be insurers that,through a guarantee from a parent, demonstratethat they are partially sheltered from sovereignand country risk. Even when the sovereign hasdefaulted on its obligations, there have beenmany instances when insurers have been able tomeet their policy obligations. If the parent isfinancially strong and is domiciled in a countrywith a strong sovereign rating, Standard & Poor’swould not necessarily expect the subsidiary to failto meet its policy obligations during a sovereignlocal (and foreign) currency default scenario.Likewise, if the insurer has a branch operation ina sovereign undergoing a local currency defaultscenario, Standard & Poor’s would not necessari-ly expect the branch to fail to meet its policy obli-gations. As a general matter of corporate law, abranch has no separate existence from the insur-ance company. However, it is not always clearwhether certain obligations of branches (or obli-gations of guaranteed subsidiaries) would be serv-iced in a full and timely manner if the host sover-


What is the difference between issuer creditratings and issue credit ratings?An issuer credit rating is an opinion of anobligor’s overall financial creditworthiness topay its financial obligations. It does notapply to any specific financial obligation. Inaddition, it does not take into account thecreditworthiness of the guarantors, insurers,or other forms of enhancement on the obli-gation (although if a guarantor guaranteesall obligations, the guaranteed entity mayreceive the same issuer credit rating as the guarantor).

An issue credit rating is an opinion ofan obligor’s creditworthiness with respectto a specific financial obligation or a specif-ic financial program. Because a financialstrength rating is a rating on a specific classof obligations, namely policy obligations,and does not apply to all obligations of the company, it is considered an issue credit rating.

What is the difference between an issuercredit rating and a counterparty credit rating?The terms “counterparty credit rating” and “issuer credit rating” are interchange-able—they are different product names forthe same rating. “Corporate credit ratings”and “sovereign credit ratings” are also formsof issuer credit ratings. Standard & Poor’sinsurance ratings group adopted the productname “counterparty credit rating” in 1995.

Can an obligor be assigned both long-termand short-term counterparty credit ratings?An obligor may be assigned a counterpartycredit rating on the long-term rating scale,the short-term rating scale, or both.

Do counterparty credit ratings have both localcurrency and foreign currency ratings?Country risk considerations are a standardpart of Standard & Poor’s analysis for credit

ratings on any issuer or issue. Currency ofrepayment is a key factor in this analysis. Anobligor’s capacity to repay foreign currencyobligations might be lower than its capacityto repay obligations in its local currencybecause of the sovereign government’s ownrelatively lower capacity to repay externalversus domestic debt. These sovereign riskconsiderations are incorporated in the debtratings assigned to specific issues. Foreigncurrency issuer ratings are also distinguishedfrom local currency issuer ratings to identifyinstances when sovereign risks make themdifferent for the same issuer. Both local cur-rency and foreign currency counterpartycredit ratings are assigned to all insuranceholding companies and all insurance operat-ing companies with a public Standard &Poor’s financial strength rating.

Are counterparty credit ratings interchange-able with financial strength ratings?The counterparty credit rating refers to anissuer’s overall financial capacity to pay itsobligations and does not address any specificclass of obligations. The financial strengthrating is an issue credit rating because itrefers only to a specific class of obligations,namely policyholder obligations.Counterparty credit ratings measure an enti-ty’s overall default risk, while an issue creditrating refers to the default risk only of a spe-cific instrument or class of obligations.

When would an insurer be assigned a coun-terparty credit rating that is different from theinsurer financial strength rating?Because a counterparty credit rating is an opinion of an obligor’s overall capacity to pay its financial obligations, including itssenior obligations, it would be unusual for a company to be assigned a different financial

Frequently Asked Questions




strength rating from its counterparty creditrating, given that policyholder obligations are typically an insurer’s most senior obliga-tions. One example of when this can happenis when policy obligations are judged to beexpressly subordinate to other obligations.In that case, the financial strength ratingwould be lower than the counterparty creditrating. Another example is when the finan-cial strength rating is derived from a guaran-tee that supports only policy obligations.

How is a counterparty credit rating deter-mined for an operating insurance company?Assuming that Standard & Poor’s is work-ing with an existing financial strength rat-ing as the starting point and the financialstrength rating has not been derived from aguarantee that supports only policy obliga-tions, the procedure for determining acounterparty credit rating is as follows: Ifin the country of jurisdiction, policyholderclaims are the senior-most claims or arepari passu with the senior-most obligationsof the company, the counterparty creditrating assigned will be the same as thefinancial strength rating. This is becausethe counterparty credit rating should be atthe level of the company’s senior-most obli-gations. If in the country of jurisdiction,policyholder claims are subordinate toother obligations, the financial strengthrating will most likely be one notch lowerthan the counterparty credit rating.

What is an insurer counterparty credit rating if the financial strength rating is derived from a guarantee that supports only policy obligations?In this case, Standard & Poor’s would not assign a counterparty credit rating or thecounterparty credit rating would be

derived from the stand-alone rating on the insurer.

When does Standard & Poor’s assign counter-party credit ratings? Every obligor that receives a rating from Standard & Poor’s also receives a counter-party credit rating. The exceptions areoperating insurance companies that do nothave financial strength ratings, structuredfinance entities, and entities whose onlyrated obligations are guaranteed.

Does every financial strength rating get a counterparty credit rating?Financial strength ratings refer only to policyobligations, while counterparty credit ratingsmeasure an entity’s overall default risk; theyare not interchangeable. That being said,every insurer that receives a financialstrength rating will also be assigned a coun-terparty credit rating unless the financialstrength rating on the insurer is derived froma guarantee that covers only policy obliga-tions. In those instances, Standard & Poor’sassigns a counterparty credit rating that isequivalent to the stand-alone rating on theinsurer or will not assign a counterpartycredit rating if no stand-alone rating hasbeen assigned. As mentioned above, operat-ing insurance companies that do not havefinancial strength ratings will not receivecounterparty credit ratings.

Does every counterparty credit rating have anoutlook associated with it? By extension,does every financial strength rating have an outlook?Outlooks are assigned to both counterpar-ty credit and financial strength ratings, andevery interactive counterparty credit andfinancial strength rating has an outlook.


eign government were to restructure the paymentof public and private sector local currency obliga-tions or unilaterally alter payment terms and/orconditions that effectively prevented the localbranch from paying on that obligation in a timely manner.

With explicit support—such as a guarantee oras a branch—the financial strength rating on aninsurer would generally be six notches higherthan the sovereign local currency rating in domi-ciles where the sovereign local currency rating isinvestment grade and four notches higher indomiciles where the sovereign local currency rat-ing is noninvestment grade, limited by the ratingon the guarantor. The same degree of supportwould be applied to the financial strength ratingon a branch operation. Ideally, these would becompanies or branches to which senior groupmanagement has demonstrated a strong commit-ment—a track record of support in good times aswell as bad.

Without a guarantee, there are limited,exceptional circumstances that could occur thatwould result in a company or branch ratingabove the local currency rating on the sover-eign. These include, but are not limited to,insurers domiciled in certain specified financialcenters—such as the Cayman Islands orBermuda—that are viewed as independent ofthat financial center’s sovereign risk or whenmost assets are located outside of the jurisdic-tion and a sovereign collapses with no impair-ment to the financial strength of the insurer.

Governing Law

The law governing a specific debt issue, as wellas other legal factors, could be relevant in eval-uating whether a sovereign could affect timelypayment of a debt obligation. However,Standard & Poor’s exercises caution in placingweight on the legal factor. When sovereignpowers are involved, issues such as conflicts oflaw, waivers, and permission to hold and usefunds held outside the country of domicile areconfused at best and would likely be tested andresolved by the courts only after, rather thanprior to, a default.

Special Cases

In some instances, an issuer is technically domi-ciled in a country for tax or other reasons thanbusiness undertaken within that country. Forexample, insurers domiciled in certain specifiedfinancial centers, such as Bermuda or theCayman Islands, are viewed as independent ofthat financial center’s sovereign risk. No sub-stantial business is undertaken within that juris-diction, no substantive assets are maintained inthat jurisdiction, and the issuer could change itslocation quickly and without risk to thedebtholder if the sovereign imposes any form ofcontrols or onerous taxes.

Multilateral lending institutions, such as theInternational Bank for Reconstruction andDevelopment (the World Bank), theInternational Finance Corp., and theInterAmerican Development Bank enjoy pre-ferred creditor status. By virtue of the borrow-ing country’s membership in the lending organi-zation and as a condition of eligibility to receiveloans, the country ensures that it will notimpose any currency restriction or other impair-ment to the repayment of such loans. In somecases, the treaty establishing the organizationalso specifies such special treatment of loans bymember nations. Often, these loans, thoughmade to other nonsovereign entities, are alsoguaranteed by the borrowing country, and thelending institution has a policy that no furtherloans will be granted to borrowers in that coun-try if any loans are in default.

These factors give the borrowing countrystrong incentives to maintain timely loan repay-ment. The result has been an excellent repay-ment record for such obligations, even whileother borrowings from banks or other lendershave fallen into default. One analytical elementis assessing the creditworthiness of these loansin the proportion of a country’s total externalindebtedness made up of this type of obligation.The larger the proportion, the more difficult itmight be for the country to meet these in atimely manner and preserve its special status.


Criteria for Rating Start-ups

Standard & Poor’s Ratings Services typicallydoes not rate companies unless they have atleast a five-year operating track record orexplicit support as a substitute. For a start-upcompany to be assigned a rating in the absence of both of these, Standard & Poor’swould request:

� A detailed, credible, five-year business planthat addresses the lines of business to bewritten and indicates revenue targets, incometargets, and capitalization plans for eachyear. Standard & Poor’s is looking for man-agement to have a track record in successful-ly managing and underwriting its chosenbusinesses. In the business plan, Standard &Poor’s would like to see a road map forwhat management would expect to be doingfor the next five years, including how muchbusiness it would expect to be doing at thebeginning and in what lines, how quickly itwould like to grow in each of these lines,and how that growth in business relates tothe capital that it would expect to have inthis entity over the planning horizon. Thebusiness plan should indicate what competi-tive advantages the company has in each ofits chosen lines of business to generate prof-itable growth.

� A detailed discussion with managementregarding its capital-management strategy,including dividend philosophy, share-repur-chase strategy, and future capital marketissuances.

� Evidence of prudent underwriting thatdemonstrates the capability to write prof-itable business and provides Standard &Poor’s with confidence that the company canmonitor and determine capital adequacy.

� The make-up of the board of directors,

including their experience and ongoing inter-action with management.

� Biographies of all senior managers describingtheir current functions and discussing indetail their prior work experience as itrelates to their ability to execute their newresponsibilities successfully.

� A discussion of the expectations and long-term objectives of key investors about thisstart-up.Standard & Poor’s expects the company’s

projected capital adequacy to be at or abovethat of the assigned rating over the intermediateterm (three years) and for capital to remainconsistent with the assigned rating throughoutthe term of the business plan (five years).However, to satisfy Standard & Poor’s viewthat a start-up should have the financial flexi-bility to maintain capital consistent with theassigned rating over a longer-term horizon,Standard & Poor’s expects the company todemonstrate the ability to tap several sources ofadditional capital if needed. These sourcesinclude reinsurance, borrowing, additional equi-ty offerings, and asset sales. If the start-up hasaggressively tapped several of these sourcesalready, Standard & Poor’s would seriouslyquestion the company’s ability to maintain capi-tal adequacy consistent with a high rating. Inaddition, it is important that Standard & Poor’sdevelops a strong level of confidence in man-agement and its ability to implement the busi-ness plan. A proven track record is very helpfulin evaluating management’s capability.

These will be reviewed as minimum stan-dards. Small companies without explicit sup-port and companies (managements) that fail theminimum standards will not be rated.


Criteria for Rating Start-ups

Alternative CapitalMarket or StructuredSolutions to Insurance RiskThis section will discuss the rating process and established criteria for a variety of insurance secu-

ritizations and structure to enhance capital optimization. Although the underlying risk being secu-

ritized could be considered germane to one sector, Standard & Poor's is making it widely avail-

able because we are convinced that each sector will continue to seek capital-market solutions to

improve company financial characteristics through alternative channels. With the introduction of

new asset or insurance risks securitizations, Standard & Poor's will continue to develop tools and

criteria to meet industry needs.

The following sections describe a nonlife company's securitization of property catastrophe risk, a

life insurance company's decision to create a regulatory closed block of participating policies to

reduce the insurer's economic risk, and a life insurance company's securitization of its noneco-

nomic loss reserves (excess XXX life reserves).

Insurers continue to turn to the capital marketsfor structured finance and derivative solutionsto the volatility of both insurance capacity and pricing.

Standard & Poor’s Ratings Services criteriafor these transactions address their legal andstructural components, the models evaluatingtheir underlying perils, and the potential for rat-ing-agency capital relief for the ceding insurer.Standard & Poor’s has expanded coverage ofrated securitizations to indexed and parametrictransactions. Standard & Poor’s has also con-sidered the possibility of rating some transac-tions investment grade.

Evolution in the Capital Markets

The historical increase in the loss severity of cat-astrophic events has affected reinsurers’ riskappetites and, at times, called into question theircapital adequacy. In the early 1990s, reinsurersraised premiums sharply and tightened the avail-ability of certain covers, which forced primaryinsurers to try to control catastrophe exposuresthrough the use of increased deductibles andcoverage limitations to their policyholders,including caps on replacement costs.

Insurers have also established maximumaggregate insured limits per county or zip code.In some high-risk areas, government-sponsoredfunds stepped in to provide reinsurance. Entitiessuch as the Florida Windstorm UnderwritingAssoc., the Florida Hurricane Catastrophe Fund,the Texas Windstorm Insurance Association,and the California Earthquake Authority aresupported by industry assessments.

Clearly, it would benefit insurers to seekadditional underwriting capacity from the larg-er capital markets. However, it is difficult fortraditional noninsurance company investors toparticipate in the rewards of insurance under-writing, which include diversification into non-traditional risks. Only licensed insurers haveregulatory authority to underwrite insurance

risks, either by writing policies or by enteringinto reinsurance agreements.

Insurance securitization provides an effectiveway for investors to target their investmentsand for insurers to access the markets’ risk capi-tal. The key to the transfer lies in the use of aspecial-purpose reinsurer: a special-purpose,bankruptcy-remote vehicle incorporated toenter into the reinsurance agreement with thecedent. Most securitizations have used aBermuda or Cayman Islands special-purposevehicle, although some issuers have employed aEuropean or U.S.-based special-purpose vehicle.

Catastrophe Bonds: Benefits and Risks to Investors

Investors are subject to loss of principal in theevent of a catastrophic insured peril. From aninvestor’s perspective, the appeal of propertycatastrophe and other natural hazard insur-ance lines is their low correlation with moretypical capital market risks. Because of thelow correlation between, for instance, earth-quake risk and interest rate risk, an invest-ment in natural hazard bonds raises a portfo-lio’s Sharpe ratio.

Equity investments in property/casualty rein-surance companies do not provide the capitalmarkets investor much risk diversification awayfrom the market portfolio, according to a 1996study published in the Journal of Derivatives.That study showed that such direct investmentswere highly correlated with the equity markets,with a beta exceeding 0.80, while the correla-tions of insurance securitizations with the muchlarger markets were near zero.

Each insurance note is collateralized by ahighly rated investment portfolio. The portfolioprincipal may be protected by a highly ratedcounterparty, which also swaps returns on theportfolio into a floating-rate coupon (usuallyLIBOR-based), mitigating price volatility.


Alternative Capital Market or Structured Solutions to Insurance Risk

Coupons exceed those of corporate bondswith similar default expectations, but Standard& Poor’s recognizes that a portion of whatappears to be excess spread in the note couponstems from the nature of the default risk inthese securities. Catastrophe notes are struc-tured and rated with regard to the probabilityof triggering the underlying insurance cover.Although the probability of default is low, thenotes are likely to default without a gradualdecline in credit quality and with little warningto investors. (This phenomenon is sometimesreferred to as the credit cliff.) For this reasonand because uncertainty inherent in the model-ing of complex, high-severity, low-frequencyperils implies a certain level of false precision,Standard & Poor’s has chosen not to rate catas-trophe bonds above ‘BBB+’ except for catastro-phe bonds with a triple-event payout trigger.Because triple-event catastrophe bonds require asuccession of qualifying events, there is agreater degree of early warning that mitigatesthe concern of a credit cliff. Consequently, themaximum rating assigned to a catastrophe bondwith a triple event payout trigger is ‘A+’. Inaddition, it is prudent to expect defaulted catas-trophe bonds to offer no significant post-defaultrecovery, while corporate issues usually do.

Investors should also consider the possibilityof moral hazard. To the extent that a cedinginsurer has retained significant exposure to theperil underlying the notes, investors are unlikelyto see atypical risk in the notes. This retentionmay protect noteholders from aberrations in thecedent’s claims-settlement process.

Catastrophe Bonds: Benefits to Ceding Insurers

Insurers and reinsurers that met difficulties in theearly 1990s have been interested in developing amarket with deeper capital and greater structuralsophistication. Although the reinsurance markethas not experienced significant strain in severalyears, and soft pricing prevails, many reinsurersand primary companies are eager to protectthemselves from the capacity and premium gyra-tions that prevailed in the recent past.

The primary issuer benefit is the introduc-tion of the greater capital and risk capacity ofthe capital markets. For instance, in a widelyhypothesized super catastrophe, hurricane dam-age to Miami might reach $100 billion, morethan five times the $18 billion in damagecaused by Hurricane Andrew. This $100 billionwould be less than 0.5% of the market capital-ization of the S&P 500, a loss frequently andeasily absorbed in the U.S. stock markets on agiven day.

Issuers may also find greater flexibility in theterms of coverage as well as a first-perfectedsecurity interest in the principal of the collateralaccount supporting the notes. The use of collat-eral removes counterparty credit concerns fromthe reinsurance treaty or retrocessional agree-ment providing relief to the issuer.

Standard & Poor’s believes the capital mar-kets might one day support the hedging needsof potential issuers more cheaply than tradition-al reinsurance. By assuming natural-hazard riskinto their portfolios, traditional capital-marketsinvestors receive greater benefits of diversifica-tion than property/casualty reinsurers, whoseaggregate businesses are already concentratedthere. Thus, capital markets investors mightrequire a lower risk premium than that askedby reinsurers. Investor demand following alarge catastrophe would probably weaken, forc-ing coupons upward, but this surge in premiumwould likely be less than in the reinsurancemarket, which is smaller.

The use of structured finance and derivativetechnologies may allow issuers to create a widevariety of structures linked to insurance risks.Three broad securitization categories haveemerged so far.

Types of Bond Cover

Indemnified NotesWhen insurance securitizations were first con-sidered, insurers were reluctant to disclose toomuch of their underwriting data. Cedentsreceive the most precise coverage from indemni-fied transactions, which respond directly to aspecified group of policies, but many werereluctant to reveal their underwriting proce-


dures or actual policy composition (beyondstatutory filings).

An indemnified transaction reflects theunderwriting and claims-settlement process ofthe ceding company. To this extent, Standard &Poor’s experience in analyzing the cedent’s busi-ness provides investors with analytical support.

Following the risk of a covered peril event,the primary difficulty facing investors in indem-nified notes is the existence of lengthy develop-ment periods, which are bond extensions thatallow for the discovery of damage and the set-tlement of claims, a feature typical of insurancecover. Although the risk period ends on thescheduled maturity, at the option of the cedent,investors might have to wait two years or moreto determine the disposition of their investment.

Indexed NotesSome insurance bonds are linked not to the ced-ing insurer’s business but to the behavior of anindustry-wide or geographic index, such as thedata compiled by Property Claims Services(PCS) in the U.S. Ceding insurers that issueindexed notes can be exposed to significantbasis risk to the extent that the index does notmimic cedent losses. Because it is generally easi-er to calculate an index than the final claims ofthe ceding insurer, indexed notes tend to havedevelopment periods under two years.

Parametric NotesFinally, notes can be structured parametrically,without reference to the cedent’s business.Parametric notes make their payments based ona mathematical formulation related primarily tothe quantities associated with pertinent events,such as magnitude, intensity, and epicenter of anearthquake, or wind speed, forward velocity, andcounty of landfall of a hurricane. In fact, thisformulation could be complicated and could beviewed as an attempt mathematically to create avirtual replica of the cedent’s subject business.This synthetic indemnification could reduce basisrisk to the cedent while nearly eliminating thedevelopment period for investors.

Each indexed or parametric transaction mustspecify mathematically the relationship betweenthe parametric formula or index and resultant

claims against note principal by the cedinginsurer. This can be a simple mathematicalfunction (linear or step), or it can be a complex,multivariable relationship that attempts toreduce basis risk to the cedent.

Impact on the Ceding Companies

Indemnified Transactions Receive Reinsurance CreditOne of the primary concerns of the ceding com-pany is whether it can expect capital relief uponthe issuance of an insurance securitization. Forfinancial strength rating purposes, Standard &Poor’s gives full reinsurance credit to cedentsusing indemnified securitizations because theyare exposed to no basis risk and little credit risk.

Nonindemnified Transactions Reduce Moral HazardStandard & Poor’s takes a positive view of theuse of parametric and indexed insurance bondsfor investors because they reduce the uncertain-ty surrounding the cedent’s claims-settlementprocess. In particular, these bonds may reducemoral hazard from the cedent. Here the settle-ment of claims cannot prejudice investors.

The Impact of Derivatives on Traditional AnalysisStandard & Poor’s applies its standard creditcharges to investments in securitized risks andincludes losses from these transactions in itsview of operating performance. Standard &Poor’s evaluates the risk transfer in nonindem-nified securitizations and may allow capitalrelief for exposures that are substantially ceded.

If a ceding company relies on an indexed orparametric note for protection, the cedent’sability to manage risk depends on its ability tomodel its exposures.

In addition, statutory accounting treatmentof these products affects their use as hedgingtools. Property/casualty insurers are measuredand benchmarked by various performanceratios, most notably the loss ratio and the com-bined ratio. These ratios are calculated frompremiums, losses, and expenses, as defined bystatutory accounting principles. Investmentincome is not directly considered in any under-

ALTERNATIVE CAPITAL MARKET OR STRUCTURED SOLUTIONS TO INSURANCE RISK


writing calculations or ratios. The purchase ofreinsurance directly affects these values, and theimpact of the reinsurance transaction is reflect-ed in the net underwriting results.

Hedge Accounting for NonindemnifiedTransactions and DerivativesThe purchase of an insurance-linked derivativeis currently treated as an investment transac-tion. For example, under current statutoryaccounting, a purchased option is treated as anasset during its life. If the option expires with-out exercise, it is treated as an investmentexpense. If the option is exercised, the gain isplaced on the income statement underMiscellaneous Investment Income. Underwritingprofits and ratios are not affected by the pur-chase of the option.

After a loss, an insurer that purchased anindex-based derivative would post higher netunderwriting losses and a higher combinedratio than an identical company covered byreinsurance with identical payouts. If no lossoccurs, the impact on underwriting results isthe opposite. If there were no difference in tax-ation, each company would end up with identi-cal surplus, but when evaluated by statutoryratios, the insurer that transferred risk through the derivative might be viewed asa poorer underwriter.

Following FAS 133, only an effective hedgeis allowed hedge accounting treatment. TheNAIC formed a Securitization Working Groupto consider changes to statutory accountingtreatment that would achieve underwritingrather than investment accounting for thosenonindemnified derivatives shown to be effec-tive in hedging the insured exposure. The profitor loss of such a derivative would offset under-writing income and affect underwriting ratios inGAAP. This group, assisted by the CasualtyActuary Society and the American Academy ofActuaries, is working on an objective test toevaluate the hedge effectiveness of nonindemni-fied insurance derivatives, including options,futures, and indexed and parametric insurancecatastrophe bonds.

In Standard & Poor’s opinion, for financialstrength rating purposes, a properly structured

catastrophe bond serves the same function as aprogram of reinsurance. This is evident withan indemnified transaction. For other transac-tions, following the determination of theNAIC working group, this will follow from anexamination of the effectiveness of the hedge.To the extent that a capital charge is assessedfor property catastrophe exposure, Standard& Poor’s will assess a capital credit for effec-tively hedged instruments that mitigate shocksto a company’s capital base. Standard &Poor’s expects clarification of this topic to leadto a greater use of securitization, even in thoseinsurance lines where there are currently fewcapacity constraints.

Rating Methodology

Peril ModelingOne of the primary factors in the analysis of acatastrophe securitization is the quantificationof both frequency and severity of the risksunderlying it. The risk analysis has normallybeen carried out by one of three peril-modelingfirms whose models Standard & Poor’s hasevaluated for rating purposes.

For each peril model, Standard & Poor’sexamines its source of data. For nearly two cen-turies, industry and various national govern-ments have funded research in atmospheric sci-ence and seismogeology, particularly in the U.S.,Japan, and throughout Europe. Some perils insome parts of the world might not be well doc-umented, but these lie outside the realm ofrated transactions.

Primary global sources of peril data include:� United Nation’s International Atomic Energy

Agency� Japanese Meteorological Agency� Nation Center for Atmospheric Research� Japanese National Research Institute for

Earth Science and Disaster Prevention� U.S. Geological Survey� European-Mediterranean Seismological

Centre� Laboratoire de Détection et de Géophysique, a

network of seismic stations of an agency ofthe French government responsible for moni-toring nuclear test explosions and earthquakes


� University NAVSTAR Consortium, an inter-national organization of more than 80 uni-versities and research institutions

� The agencies of the National Oceanic andAtmospheric Administration, including theNational Weather Service and the NationalHurricane CenterStandard & Poor’s reviews the pertinent aca-

demic literature, engineering research, and otherinformation delivered by the ceding company toevaluate whether the modeling assumptions andtechniques are consistent with the literature.

Standard & Poor’s may review the variables,including temperature, wind speed, rotationalstorm velocity, presence of rain, composition ofsoils covering bedrock, fault activity (includingslippage and subduction), and fire followingquake. Standard & Poor’s may then evaluatewhether the model results correlate with local his-torical activity and refer to academic research toevaluate whether the model properly incorporatesspecific local features.

Standard & Poor’s may also consider whetherthe peril model is supported by the weight ofmarket as well as scholarly and scientific opinion:whether the model in question is relied on byusers who face substantial financial, personal, andpolitical consequences in the event of failure.Such users could include builders or operators ofhydroelectric dams, missile silos, alpine tunnels,elevated highways, and underground structures.For example, the three peril-modeling firmswhose various models Standard & Poor’s hasreviewed for use in insurance securitization areconsulted by primary property/casualty insurancecompanies and reinsurance companies represent-ing 75% of global catastrophe insurance capacity.Other significant users include:

� Developers, large industrial corporations,schools, hospitals, low- to high-rise offices,R&D facilities, hotels, convention centers,museums, and parking and undergroundstructures.

� Energy producers looking for oil and gas orthose siting and building offshore drilling plat-forms, conventional power plant structures,energy storage tanks, and nuclear facilities.

� Nuclear-device-assembly facilities in the U.S.and Europe.

The purpose of these reviews was not todetermine each model’s accuracy at predictingcatastrophe but, rather, the model’s reasonable-ness in the face of known engineering, scientific,and mathematical studies. At present, onlyApplied Insurance Research, EQEInternational’s EQECAT, and Risk ManagementSolutions have had their models subjected toreview. Each of the three has been reviewed forboth earthquake and windstorm modeling.

Legal IssuesStandard & Poor’s reviews the structure of thevarious corporate and partnership entitiesinvolved in an insurance securitization to deter-mine that they meet Standard & Poor’s struc-tured finance criteria for bankruptcy-remote-ness, grant of security interests to the cedentand the note holders, whether the issuing spe-cial-purpose vehicle is bankruptcy-remote, andwhether the collateral that supports both thereinsurance and the notes is sufficient to pay therated notes in accordance with their terms.

Depending on the particular transactionstructure, Standard & Poor’s may request legalopinions addressing the following issues:

� If applicable, a nonconsolidation opinion tothe effect that the issuing trust and the reinsur-ing entity would not be consolidated with anycontrolling entity.

� If applicable, an opinion that the issuing trustand the reinsuring entity have been properlyconstituted as a Delaware business trust.

� Opinions addressing, among other things, thedue organization of the transaction parties, theenforceability of the transaction documents,and the compliance with all applicable lawsand regulations, including those related toinsurance matters.

� For offshore transactions, an opinion to theeffect that the entity would not, for tax pur-poses, be deemed to be engaged in a trade orbusiness in the U.S.

� An opinion to the effect that the rated obliga-tions will not be subject to regulation of con-tracts of insurance or reinsurance under appli-cable state law and that the holders of suchnotes would not be subject to regulation asproviders of insurance or reinsurance.



� If applicable, an opinion that the issuing trustand the reinsuring entity may not be terminat-ed prior to the termination of the trust inden-ture without the consent of the indenturetrustee, and that the trust may not be termi-nated by creditors and transferees of themunicipality except as provided in the docu-mentation.

� An opinion that the issuing trust and the rein-suring entity are not required to register underthe 1940 Act.

� A debt-security-interest opinion to the effectthat the issuing trust and the reinsuring entity,if applicable, have granted to the indenturetrustee/custodian a first-priority perfectedsecurity interest in the transaction collateraland any proceeds thereof.

The Assignment of a RatingIn assigning a rating to a catastrophe bond,Standard & Poor’s bases its analysis on its cor-porate default study, which reflects 19 years ofU.S. corporate note defaults. The resultantmatrix is statistically stationary and is consis-tent with Standard & Poor’s practices in ratingcollateralized debt obligations. Each notederives its rating by comparison with two rowsof the matrix: the first corresponds to the matu-rity of the note (or, in the case of a re-settingnote, the re-set term); the second stands as asurrogate for the instantaneous probability ofattachment. Standard & Poor’s compares thenote’s lifetime and annual probabilities ofattachment with the appropriate maturities andlocates in each row the first rating category

whose likelihood of default exceeds the corre-sponding probability of attachment. The lesserof these ratings will be the maximum possiblerating on the note, subject also to a maximumrating of ‘BBB+’ (‘A+’ in the case of a third-event trigger).

Whether a given note achieves the ratingbased on its attachment probability dependson Standard & Poor’s analysis of the manyparties to the transaction, particularly theswap counterparty and the ceding insurer. Thisanalysis covers the strength of the agreementsbinding each party, the nature of any indemni-fication offered by these parties, and the safetyof the assets in the collateral account. Thisanalysis also covers the quality of the perilmodeling and Standard & Poor’s opinion ofthe cedent’s financial strength and underwrit-ing abilities.

Standard & Poor’s does not refer to expectedlosses directly in this calculation, but factorsexpected loss into the statistical analysis of theoutput of the peril modeling, where it is a meas-ure of how well the loss distribution convergesand how well the tail of the distribution behaves.

A portion of the matrix follows:� Standard & Poor’s Cumulative Default

Probabilities (%) - Statistically stationarytable for catastrophe securitizations

� Under Standard & Poor’s criteria, catastro-phe bonds are generally subject to a ‘BBB+’cap. However, some third-event catastrophebonds may be rated higher, subject to a‘A+’ cap.


Standard & Poor’s Cumulative Default Probabilities (%)

Statistically stationary table for catastrophe securitizations

Maturity (yrs) A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B

1 0.140 0.140 0.150 0.230 0.230 0.540 1.670 2.770 2.790 3.670 8.590 2 0.311 0.324 0.368 0.541 0.648 1.353 3.322 5.262 5.664 7.541 14.508 3 0.512 0.553 0.647 0.924 1.198 2.314 4.924 7.496 8.377 11.086 18.586 4 0.743 0.823 0.978 1.368 1.834 3.343 6.448 9.488 10.822 14.131 21.437 5 1.002 1.130 1.353 1.861 2.523 4.389 7.876 11.255 12.970 16.665 23.479



Optimizing Capital Througha Regulatory Closed Block

In the life insurance industry, an effective risk-mitigation structure is created through achange in the contractual relationship betweenan insurance company and the policyholderthrough the process of demutualization. In ademutualization, the creation of a regulatoryclosed block (RCB) of participating policieshas the potential to fundamentally reduce eco-nomic risk to the insurer. Older policies can beisolated and grouped together because of com-mon characteristics, such as low face amounts,low interest rate guarantees, conservative mor-tality assumptions, high-quality assets, and ageneral maturity of liabilities. As a result,these policies have stable, predictable mortalityand lapse experience. The characteristics ofsuch blocks are documented in an insurer’splan of demutualization. In many cases, thecreation of an RCB can substantially reducethe insurer’s capital needs.

By agreeing to an insurer’s plan of demutual-ization, the policyholders and regulators haveaccepted that the assets assigned to the closedblock will be the assets used to meet policyobligations. Importantly, the insurer’s assetsoutside the closed block will not be used tomeet policy obligations, except to the extentthey are needed to meet minimum guaranteedobligations. In many instances, the formation ofa closed block of policy obligations substantial-ly reduces an insurer’s risks and, as a result, itscapital needs. Often, the actuarially determinedamount of assets necessary to support the mini-mum guaranteed obligations of the closed blockpolicy liabilities is a small fraction of the actualassets assigned to the closed block. The excessassets assigned to the block are expected to beused to meet reasonable policyholder expecta-tions through future dividends. These dividendscan, and will, be reduced to the extent theinsurer incurs adverse experience in its invest-ments, expenses, or underwriting results.

Standard & Poor’s Rating Services reevalua-tion of an organization’s capital needs startswith understanding what additional protections

are possible to reduce or better manage risks. Itis not enough for a company merely to demon-strate effective risk management as the basis foradjusting capital charges. A formal structure forrisk isolation, management, and mitigationmust be created. The proven existence of such astructure is the basis upon which Standard &Poor’s reconsiders capital adequacy charges.

There are five key areas in the evaluation ofrisk isolation, management, and migration:

� The existence of a significant dividend cush-ion is actively considered as evidence thatcontractual minimums can be paid, evenwith quite adverse experience.

� Reasonable adverse experience in mortality,persistency, or investment performanceshould not produce a combined statutoryloss, even if dividends are unchanged.

� Effective segmentation of assets insulates theblock from poor performance elsewhere inthe insurance company and in turn acts as abuffer for the insurance company fromfinancial responsibility for poor performancewithin the closed block.

� Conservative mortality assumptions areimportant to consider, given the long dura-tion of these contracts.

� Evidence of effective oversight on the part ofthe insurance department of the state ofdomicile provides further assurance thatinsurance company management will managethe block as necessary to maintain funding. Information that is reviewed includes:

� A review of any regulatory reports filed withthe insurer’s state of domicile regarding theproposed demutualization.

� A copy of the insurer’s actuarial analysis,third-party actuarial analysis, or both as theypertain to the closed block.

� Statistical and other data supplied by theinsurer in support of its analysis of theamount of asset, insurance, and credit risksembedded in the regulatory closed block.

Closed Block Description

It has become customary in life insurer demutual-izations to set up a closed block of liabilities andassets. The closed block consists of participating

life insurance policies that represented ownershipin the mutual insurance company. The purpose ofthe closed block is to wall off the participatingpolicies and their assets from the rest of thedemutualized company as a way of preserving thereasonable dividend expectations of policyholdersand to keep decisions about dividend policy outof reach of the management, directors, and share-holders of the demutualized company.

In setting up RCBs, it is common to findthat the assets amount to less than the liabili-ties. In an open block of participating life busi-ness, most of the profits on each policy arereturned to the policyholder as dividends, but asmall portion is retained to support the capitalgrowth of the company. In the case of a closedblock, the future profits of the block are walledoff from the remainder of the company. Becauseno contribution to surplus is expected, the divi-dend scale can be supported with a somewhatsmaller amount of assets. In other words, theembedded profits in the business will supportthe contractual obligations and policyholderdividends, even with an amount of assets some-what less than the full amount of the statutoryliability. This is in part because of the extraordi-nary conservatism contained in the statutoryreserve basis, particularly for older policies.

Commonly, an insurer will set aside addi-tional assets outside the closed block to coverthe discrepancy between assets and liabilities inthe RCB. This is especially true if the primaryinsurer is using reinsurance to transfer some orall of the risk-based capital needs to reinsurers.These notional assets are the property of thegeneral account and are not part of the closedblock. However, they can be used to protect thereinsurers in the event that the assets within theclosed block are not sufficient to cover contrac-tual obligations.

The amount of assets that must be set asidewithin an RCB is determined through a detailedseries of actuarial projections. The main projec-tion incorporates the assumptions underlyingthe current dividend scale. This is based on thetheory that if current assumptions hold, thenthe dividend should be unchanged and all con-tractual obligations should be met. In addition,other tests are performed to assure that even inmoderately adverse situations, the dividend will

be reduced but all contractually guaranteedobligations will be met. Based on this analysis,Standard & Poor’s determines the amount ofassets needed to meet the contractually guaran-teed obligations of the closed block. Theremaining assets are the amount needed tocover the present value of future dividends.

The goal of the closed block is to ensure thatthe closed block assets will meet all policy obli-gations and dividend expectations and when thelast policy terminates, all assets will be exhaust-ed. This requires diligence on the part of theinsurer to assure that dividend scales are adjust-ed, as better or worse experience emerges.Standard & Poor’s will want to establish that theinsurer has an obligation to its policyholders andto the regulator to ensure that the assets run offalong this path. If the assets are not sufficient,the insurer is responsible for meeting the contrac-tual obligations. If assets remain after the lastpolicy matures, then they must be distributed tothe policyholders in some equitable manner.

A life company can demonstrate it is follow-ing this glide path by presenting an annualopinion to the insurance department certifyingthat the closed block is sufficiently funded andby periodically seeking an independent actuarialreview to assure that funding remains appropri-ate. A life insurer’s reorganization plan, filed aspart of its demutualization, should ensure thatthe dividend scale will be reset periodically toassure that the segmented closed-block assetsremain sufficient to cover the liabilities. Thateffectively transfers all investment risk (C-1)and mortality/pricing risk (C-2) from the insur-er to the policyholder. To receive significantcapital relief, it must be extremely unlikely thatthese risks would exceed the ability to adjustthe dividend scale and therefore affect surplus.Interest rate/disintermediation risk (C-3) is alsoexpected to be transferred to policyholders.

Elements of Risk Within a Closed Block

Standard & Poor’s evaluates the following ele-ments of risk when determining the capitalneeds of a regulatory closed block:


� How mature and stable are the liabilities with-in the block? Well-seasoned ordinary lifeinsurance and endowments tend to be amongthe most stable blocks of business and thuswould usually have a low risk profile.Similarly, some well-seasoned participatingpension liabilities could also be viewed as hav-ing low risk. Standard & Poor’s evaluates thestability and predictability of mortality andlapse experience.

� Is there sufficient spread of risk? Standard &Poor’s examines the average face amount ofthe closed block life policies. A large numberof policies and a low average face amountgreatly diminish the likelihood of random fluc-tuations in mortality or lapse experience.

� What is the nature of the guarantees onclosed-block policies? Are the policy guaran-tees based on mortality rates that are signifi-cantly higher than the rates currently beingexperienced? Are the interest rate guaranteeslow compared with current rates?

� What is the portfolio’s asset quality?� Is there effective segmentation of assets? Are

the assets of the closed block segmented fromthe rest of the insurer? Standard & Poor’sascertains whether the insurer is insulatedfrom the performance of the closed block out-

side any funding needed to meet minimumguaranteed obligations. Any transfer of assetsbetween closed and open blocks must be con-ducted at market value, further reducing thepossibility that the block would becomeunderfunded based on management actions.

Determining Risk-Based CapitalCharges of a Closed Block

The risk charges for a regulatory closed block ofparticipating policies are determined by evaluat-ing the performance risk, timing risk, and operat-ing risk within the block. The closed block per-formance analysis covers all risks related to theRCB assets’ probability of default, policy lapses,mortality, and expenses, which cannot be mitigat-ed from the changes in the policyholder liability.In addition, Standard & Poor’s stresses the port-folio for interest rate risk to determine the level ofinterest rates needed to support the minimumguarantees. The performance risk is evaluated inconjunction with the dividend cushion and fund-ing cushion of the closed block. It must be deter-mined that contractual minimums can be paideven under significant adverse experience. Inaddition, a determination is made that even if div-idends remain unchanged, some level of adverse



RCB Risk Charges

Risk Capital Charge

Closed block performance 0.42% x Ratio 1 x Ratio 2

Timing risk 0.05%

Operating risk 0.10%-0.30%

Ratio 1a = (total RCB assets minus present value of assets needed to meet RCB contractual obligations)/total RCB assets

Ratio 1 = Ratio 1a/expected industry average of Ratio 1a

Ratio 2a = (asset risk capital charges or C-1 of the RCB/RCB invested assets)

Ratio 2 = Ratio 2a/estimated industry average of Ratio 2a, which is equal to 4.5% based on Standard & Poor’s analysis

Total capital charge = capital charge for the closed block performance x RCB statutory assets + 0.15% (timing risk + operating risk) x RCB statutory reserves

experience would be possible without causing astatutory loss. Standard & Poor’s assumes that aclosed block set up to mitigate risk will have aperformance risk equal to the risk associated witha long-term, strong, investment-grade bondadjusted upward or downward based on the sizeof the dividend cushion and the level of riskinherent in the closed block assets versus industryaverage benchmarks. The closed block assetswould then be multiplied by this charge to deter-mine the overall performance risk capital charges.

Although most interest rate risk fluctuationsare covered by the ability to adjust the policy-holders’ dividend, dividends are revised retro-spectively, based on experience of the prior peri-od. As a result, there is the potential for poorperformance producing statutory losses duringa calendar period that will be recovered duringa subsequent period. Therefore, a small chargeis applied against the closed block reserves tocover the risk that dividends are not adjusted ina timely fashion.

Lastly, a capital charge is applied for operat-ing risk. This includes management risk and reg-ulatory risk. Management risk covers the riskthat for marketing, public relations, or other fac-tors, the insurer could maintain a dividend scalethat is not supported by the experience of thebusiness. There is also a very remote risk that theregulator would not require the insurer to reducedividends sufficiently to maintain sufficiency ofthe closed block assets. This would most likelyoccur in an extreme scenario in which the insur-ance department places public policy or percep-tion ahead of policyholder equity.

Closed Block’s Risk TransferCriteria as Adopted by Standard & Poor’s

Because of the flexibility of adjusting policy-holder dividends, adverse deviations from mor-tality, investments, and lapse risk can be some-what mitigated.

The risk charges for a closed block of partic-ipating policies would be applied as follows:

� RCB Risk Charges - Risk � The above capital charges are all in lieu of

the full C-1, C-2, and C-3 charges thatwould be applied in a non-RCB or in anRCB that Standard & Poor’s has not had theopportunity to analyze fully.

Risk Charges Outside the RCB(Notional Assets)

The full C-1 capital charge is applied to theassets outside the RCB. These assets are man-aged by the investment policy of the cedingcompany and are set up to cover the deficiencybetween assets and liabilities in the RCB.However, the performance of these assets is notreflected in the determination of the dividendscale of this block.

Other ChargesNo risk reduction or capital credit is given tothe ceding company for the reinsurance transac-tion where there is no meaningful transfer ofeconomic risk.

The above charges are based on:� The closed block performance category cov-

ers all the risks related to the RCB assets’probability of defaults, lapses, mortality, andexpenses, which cannot be mitigated fromthe changes in the policyholder liability.

� In addition, most of the interest rate riskfluctuations are covered by the ability toadjust the policyholders’ dividend.

� No obvious operational risks are apparent.The above sets of RCB capital needs are the

baseline charges to the demutualizing companyand assume no substantive risk transfer to areinsurer. If the ceding company chooses toreinsure all or part of its obligation, then someof these charges may be transferred to the rein-surer. Depending on the level of experiencerefunds or make-whole provisions in the treaty,it is possible that performance risk will remainall or in part with the ceding company.However, depending on the transaction, timingrisk may be considered transferred and there-fore charged against reinsurer capital.

Total Adjusted CapitalTotal adjusted capital for the open block will bemodified to exclude any benefits from the regu-


latory closed block. Therefore, total adjustedcapital for the open block will be calculated asthe sum of capital and surplus plus asset valua-tion reserve.

Limits Imposed for the RCB Risk ReductionThe maximum credit that would be given forthe RCB analysis is the difference between theRCB assets and RCB liabilities at the time thecompany demutualizes.

Use of Reinsurance

To reduce regulatory risk-based capital require-ments, life companies may choose to reinsureparts or all of their RCBs. Depending on thenature of these reinsurance treaties, the risktransfer to the reinsurer may range from only anegligible amount to full risk transfer. In mostcases, Standard & Poor’s expects only a minimalamount of risk transfer between the primarycompany and its reinsurer. As mentioned above,as insurers transfer these risks through reinsur-ance, the risk-based capital requirements of theseblocks are charged against reinsurer capital.

Commonly, reinsurers use companies locatedin domiciles with more flexible reservingrequirements to assume this business. It is notunusual that little, if any, reserves are actuallyput up by the reinsurer despite its acceptance ofthe transfer of billions of dollars of primaryinsurer reserve liability. For this reason,Standard & Poor’s looks to the primary lifeinsurer’s annual statements to determine theamount of risk transfer to reinsurance compa-nies. If the amount of reserves ceded to the rein-surer is significant, Standard & Poor’s will dis-cuss with the reinsurer the nature of the trans-action and assign risk-based capital charges. Inmost cases, the total charge for these transac-tions ranges from a minimum of 15 basis points(bps) to 35 bps. This capital charge is appliedto the closed block statutory reserve transferredto the reinsurer. The above range is based onthe assumption that there is minimum risktransfer between the ceding company and thereinsurance company.

Typically, a reinsurer assumes RCB riskthrough a modified coinsurance treaty. The pri-

mary company holds assets and liabilities onthe reinsurer’s behalf. If there are multiple rein-surers on the treaty, each reinsurer remainsresponsible for its share of the benefits, divi-dends, and reserves and is credited with itsshare of the premiums. The risk the reinsurer isassuming is that the closed block is underfund-ed. This means that there are not sufficientassets in the closed block to support the guaran-teed liabilities.

Elements of Protection for the ReinsurerIn assuming a regulatory closed block liability,there are a number of ways a reinsurer can mit-igate its risk:

� Establishing notional assets outside theclosed block. These are an earmarked selec-tion of assets outside the closed block cover-ing reinsurance reserves. Therefore, from thereinsurers’ perspective, the block is fullyfunded. These assets are the property of thegeneral account and are not part of theclosed block. However, they can be used toprotect the reinsurers if the assets within theclosed block are not sufficient to cover con-tractual obligations.

� Experience refunds. The reinsurance treatycan establish a vested interest for the pri-mary company to manage the business prof-itably to receive refunds of statutory profits.Under such a treaty, the primary companyreceives a full refund of the statutory profitfor some period of time. If there are anystatutory losses, these are accumulated atinterest and charged against future refunds.Because of the experience refund, the pri-mary company is effectively responsible forall of the policy cash flows, up to the pointof a statutory loss.

� Regulatory supervision of the closed block.In a strong regulatory environment, theinsurance department should oversee the lifecompany so that it manages the dividends ina manner that will assure all of the policy-holders are paid. This includes lowering thedividends when necessary to assure that theassets suffice.

� Repayment of losses on recapture. Often,these reinsurance treaties allow the life com-



pany the right to recapture the reinsurancewithout penalty at any point after severalyears. The contract can be structured so thatif the reinsurer has an accumulated statutoryloss at the time of recapture, the insurermust reimburse the loss with interest.

� Asset valuation reserve. By including assetvaluation reserve contributions in the refundmechanism, the reinsurer can be assured thatthe life insurer has a vested interest in main-taining asset quality. Furthermore, credit andequity losses are charged against the asset val-uation reserve, thereby dampening the effecton income. This makes it less likely that therewill be a statutory loss in a given year.

� The dividend. The dividend can be an enor-mous cushion against statutory losses. If theprimary company manages the dividendappropriately, future statutory earnings oftenwould have to decrease by an extraordinaryamount before the dividends are exhausted.Because of the features of reinsurance

treaties that contain the above protections—most notably the strong incentive to recapturein a short period, the likely reimbursement oflosses by cedent to reinsurer, and the unlikeli-hood of statutory loss to the reinsurer—Standard & Poor’s does not consider this sortof treaty to contain meaningful risk transfer. Assuch, Standard & Poor’s will neither providecredit to the ceding life insurer in its capitalmodel for the proportionate share of risk underthe treaty nor fully charge the reinsurer.

Remaining Risks to the ReinsurerReinsurers that have assumed closed block lifereserves and have mitigated their risks throughthe use of the above mentioned contractual pro-tections would still face some minimal risk.These risks include:

� Timing risk. Dividends are revised retrospec-tively based on experience of the prior peri-od. As a result, there exists the possibility ofpoor performance producing statutory lossesduring a calendar period that would berecovered during a subsequent period.

� Management risk. For marketing, publicrelations, or other reasons, the primary lifeinsurer could maintain a dividend scale that

is not supported by the experience of thebusiness.

� Regulatory risk. The regulators might notrequire the primary life insurer to reducedividends sufficiently to maintain sufficiencyof the closed block assets. This would mostlikely occur in an extreme scenario in whichthe regulator places public policy or percep-tion ahead of policyholder equity.The total risk-based capital charge to rein-

surers that have assumed closed block lifereserves using these minimal risk transactionswould range from a minimum of 15 bps to 35bps of assumed reserves.

All reinsurers in the treaty would be assessedthe same capital charge, based on their propor-tional assumptions, assuming that the risk andthe covenants in the treaty are exactly the same.If there are some differences in the contractsamong the reinsurers and the ceding company,Standard & Poor’s retains the right to increasethe charges to individual participants if risks arehigher or uncertain.

Dynamic Financial Analysis and Rating Agency Models: Room for Both

In recent years, industry watchers have becomeincreasingly focused on the models used byStandard & Poor’s to analyze (re)insurers’ capitaladequacy, partly because such models are freelyavailable and very transparent. In particular, cer-tain commentators have questioned whyStandard & Poor’s has not adopted the latestmodeling techniques—particularly DynamicFinancial Analysis (DFA)—that are available inthe market. This misunderstands both the ratingprocess and the use of models within the process.

Capital Analysis and the Rating Process

Ultimately, the key objective in applying anyanalytical tool is to come up with a rating thatshould be a robust and comprehensive evalua-tion of a (re)insurer’s financial strength. Capitalanalysis, whether using a dynamic modeling


approach or a static risk-based analysis, ismerely one tool among many to be used whenassessing capital adequacy. It is not a substitutefor a comprehensive analysis of all the relevantfactors that contribute to financial strength.

There can be no single measure that fullycaptures the breadth of information needed toevaluate a (re)insurer’s level of capital adequacy.All too often, both company management andoutside analysts focus on the management ofcapital to a specific ratio and ignore the largerrisks inherent in the organization. For example,the foundation of a (re)insurer’s capital basecan differ significantly based on its quality ofcapital. Since Standard & Poor’s ratings aredetermined in both absolute and relative con-texts—a (re)insurer’s measure of financialstrength should be consistent with various stan-dards set for each rating category as well asconsistent with other companies with similarratings—Standard & Poor’s considers that mul-tiple views of capital adequacy better capturethis element of financial strength.

Although considerable attention is paid tocapital adequacy, Standard & Poor’s alsoassesses many other factors before determiningthe insurer financial strength rating on a com-pany. Standard & Poor’s rating process willcontinue to be based on the belief that capitaladequacy ratios are not a substitute for abroad-based analysis of (re)insurer credit quali-ty. Strengths or weaknesses in other key areas—such as a company’s management and corporatestrategy, business position, operating perform-ance, liquidity, and financial flexibility (definedas the ability to source capital relative torequirements)—can more than offset relativestrengths or weaknesses in capital adequacy.

The Role of Models

Both static risk-based analysis and dynamicmodeling offer important insights into thestrength of (re)insurers and, conversely, bothare saddled with significant drawbacks, whichare recognized by Standard & Poor’s.

A static risk-based capital analysis offers aconsistent analysis of (re)insurers that is trans-parent, easily understood, and can be compared

across time for the same (re)insurer. Such mod-els are retrospective, however, and ignorant oftrends that might impair future financialstrength, including changes to premium pricingand exposure. These models fail to identifynuances within risk categories and do not rec-ognize the interplay of various risks.

No one type of model offers the best answer.As (re)insurers attempt to balance financialstrength with capital management, they contin-ually seek new risk management techniques tobetter manage capital. Often, this means per-suading regulators and rating agencies that therisks that they have assumed differ materiallyfrom industry averages. As is the case with moststatic capital models, Standard & Poor’s capitaladequacy ratio assesses risks while maintaininga standard of comparison among companies.This means that classes of risk are evaluatedsimilarly from company to company as part ofStandard & Poor’s normal surveillance of thecapital needs of the (re)insurers it rates.

DFA – a Universal Panacea?

DFA can be loosely defined as a financial mod-eling framework that is designed to projectresults under a variety of scenarios, showinghow outcomes may be affected by changing riskconditions. It uses one or, more often, a numberof models, both deterministic and stochastic,which are designed to simulate the economicimpact of changes in underlying variables (suchas changes in interest rates and business mix).The economic impact is usually analyzed byway of cash flows generated by the models.DFA has its origins as far back as World War II,and more latterly has been used by large indus-trial corporations as a tool to test the strategicoptions available to management. It gained realpublicity in its alleged role in the failure ofLong-Term Capital Management, and has beenused by various sections of the (re)insuranceindustry for at least a decade.

The attractions of DFA are clear. Dynamicfinancial models are valuable in effectively ana-lyzing the complex interrelations of variablesrelevant to a (re)insurer’s results. DFA allowsmanagement to quantify what effects their deci-



sions could have on their company’s revenuesand costs. In particular, it assists managementin understanding the complex interrelationshipbetween assets and liabilities, an area that hashistorically been somewhat compartmentalized,particularly in the non-life market. DFA is notdesigned to predict what will happen in thefuture, but rather to allow quantification of thevarious outcomes and therefore comparison ofthe options available to management.

The drawbacks of dynamic modeling, partic-ularly in their application as a one-stop arbiterof financial strength, are equally challenging,however. Some of the issues are as follows:

� There is a lack of market standards for DFAmodels, and therefore a lack of consistencyin the underlying assumptions, as the modelsare tailored to the specific portfolios of a(re)insurer. The transparent ‘one-size-fits-all’approach that is required by the rating agen-cies to allow comparison across all compa-nies cannot be easily facilitated by the use ofsuch models.

� Insurance concerns rarely fail solely as a resultof catastrophe events. The most commoncause of failure is endemic underpricing overa period of several years and/or poor under-writing controls. Many DFA models work ona limited time horizon and do not fully cap-ture these ‘slow-burn’ operational issues.

� The experience of catastrophe modelingagencies is pertinent. The main agencies haveconsiderable resources and expertise at theirdisposal; they are significant users of DFAand deal with but one facet of the risks fac-ing (re)insurers. Nevertheless, there can besignificant variations in the results generatedby each of the modeling agencies for rela-tively similar scenarios.

� While DFA models are able to quantify theeconomic benefits of diversity due to the sto-chastic techniques embedded in the models,they do not take into account a variety ofqualitative factors that ultimately determinethe success of a diversification strategy. Forinstance, what will the effect on performancebe of the additional management timerequired for the new business and can the

company write the new line of business aswell as historical statistics suggest?

� A big challenge facing the users of DFA is toensure that the data used to generate theresults is accurate and up to date. Due to thecomplexity of these models, significantamounts of data are required. Errors in thedata can be compounded, resulting in‘garbage in, garbage out’.

� Notwithstanding the widespread acceptanceof the techniques used in DFA, the concept isstill relatively new. Even within some of thelarger (re)insurance groups, a fully integratedmodeling approach has only been used for acouple of years. Consequently, the validity ofthese models in a number of cases has yet tobe fully tested under real world circum-stances. It is interesting to note that many ofthese models are calibrated to a risk of ruinequivalent or higher than an observable‘AAA’ default rate. At the same time, the lev-els of solvency capital required under themodels are often lower than those that havebeen historically held by the industry. Whilethis does not suggest that the models arewrong, there is clearly a need to test themover a longer period of time.

� Building a robust model and populating itwith quality data is only part of the chal-lenge; the effectiveness of the model alsodepends on how a company’s managementuses the information generated in its riskmanagement process and how clearly a com-pany can communicate what the resultsmean, both internally and externally.Management’s understanding of how themodel itself works is also critical; slavishreliance on the output from a ‘black box’has obvious dangers. To understand DFA isto understand its limitations.

Incorporating DFA into the Rating ProcessStandard & Poor’s considers the usage of suchdynamic financial models to be an importantpart of management’s decision-makingprocesses and, for the more complex (re)insur-


ance groups, would expect DFA to be usedwidely on an integrated basis. Even for lesscomplex groups in the (re)insurance industry,Standard & Poor’s would expect a company’smanagement to use the techniques availableeither via a bespoke or off-the-peg model soldby the modeling agencies to model its expo-sure to catastrophe risks. As part of its ratingprocess, Standard & Poor’s discusses withmanagement its use of such models and howthey are incorporated into the decision-mak-ing process. These discussions give Standard& Poor’s valuable insight into the risk toler-ance of the management concerned and thestrength of the (re)insurer’s risk managementprocesses. Futhermore, if companies candemonstrate—and Standard & Poor’s can val-idate—that they have materially reduced theirrisks either through superior risk managementtechniques or through contractual protections,then Standard & Poor’s will adjust its capitaladequacy model to reflect the (re)insurer’sreduced capital needs.

Standard & Poor’s remains open to the fur-ther incorporation of DFA methodologies intoits insurance rating process. It has and willcontinue to look at the potential of the vari-ous models produced by companies and con-sultants involved in the industry. Indeed,Standard & Poor’s has already developed itsown sophisticated modeling tools and process-es to analyze the financial markets and creditand insurance risks existing at (re)insurancecompanies, and has successfully applied themto the closed blocks and spread lending busi-nesses of a growing number of U.S. (re)insur-

ance companies. This dynamic modelingapproach enables Standard & Poor’s to arriveat a rating that reflects a company’s actuallevel of risk tolerance (risk profile) and therisk management practices employed by thecompany, such as hedging techniques, under-writing, and contractual protection. However,Standard & Poor’s limits the application ofthese advanced techniques to companies thatanalyze, report, and manage their risks in asophisticated manner—consistent withStandard & Poor’s modeling—and that there-fore typically produce a risk profile that ismore conservative than industry norms.

DFA is unlikely to fully replace the blend ofqualitative and quantitative analysis thatStandard & Poor’s requires to determine a rat-ing, in the same way that such models willnever fully replace the skills of the managementand underwriters of those (re)insurers that therating agencies rate.

Evaluating the Effect of RegulationXXX on Insurers’ Capital

In the U.S., life insurance companies work ina highly regulated environment. As a result,these companies have to adapt to new regula-tory changes regularly. Regulation Triple X(also referred to as Regulation XXX) is creat-ing some pressures for life insurance compa-nies because of the substantial amount ofredundant reserves that now are required forterm and universal life insurance writers.

This article summarizes the problemsencountered in the capital analysis of lifeinsurance companies that hold a substantialamount of business related to term life anduniversal life insurance. It contains a briefdescription of Regulation XXX, its impact onStandard & Poor’s Ratings Services’s view ofcapital, and a summary table describing thevarious alternatives available in the market-place to eliminate the excess reserves. In addi-tion, this article serves as a guide to howStandard & Poor’s will adjust its analysis ofcapital and earnings for each of those alterna-tive market solutions.



Example of a Correlation Between Mortality Assumptions and Society of Actuaries75/80 Tables

Percentage of the SocietyRisk Class of Actuaries 75/80 Tables

Best Preferred 25-35

Preferred 30-65

Standard 45-100

Regulation XXX and the Problem It Created in the LifeInsurance Marketplace

Regulation XXX was adopted by many U.S.states as of Jan. 1, 2000. A handful of otherstates adopted the regulation on Jan. 1, 2001.Regulation XXX applies to new life insurancebusiness issued on or after the date the particu-lar state adopted it. All the life insurance poli-cies in force before the regulation was adoptedwere grandfathered and were not affected bythis change.

Regulation XXX resulted in a significantincrease in gross statutory reserves require-ments—both basic reserves and deficiencyreserves—for all major term life insurance anduniversal life (with secondary guarantees) insur-ance writers. To understand the problem withRegulation XXX, it is important to understandthe main cause. These increases in reserves areprimarily a result of the significant differencebetween the statutory valuation mortality (the1980 CSO table) and recent mortality experi-ence (a 0.5%-1% improvement in mortality peryear since that table was created). The construc-tion of the 1980 table is based on insured expe-rience from 1970-1975 on policies issued in1970 or prior.

This difference in mortality assumptions cre-ates a major disparity between economicreserves (the calculated reserves based on whatmost companies are experiencing in their actualmortality) and the statutory reserves. In otherwords, the statutory reserves became more con-servative (or redundant) after Regulation XXX.

To aggravate the problem with this discrep-ancy, life insurance companies are creatingmany distinct underwriting classes, such assuper preferred nonsmoker (using about 40%of the 1980 CSO mortality table as the assump-tion), preferred nonsmoker (using about 40%-60%), select nonsmoker (60%-80%), standard(85%-100%), and many substandard categories(using more than 100%). Many of the percent-ages vary substantially from company to com-pany. However, the statutory assumptions arenot segmented in the same form, which is main-

ly standard or substandard, male or female, andsmoker or nonsmoker. Therefore, the impact ofRegulation XXX is magnified for preferred andsuper preferred classes.

In the meantime, differences between eco-nomic and statutory reserves continue to grow,creating a substantial reserve redundancy, pres-sures in the prices of these insurance products,and lower statutory profits. There are no signsof regulatory changes in this area anytime in thenear future. As a result, regulators are not bail-ing companies out of this Regulation XXXproblem. It should be noted that the NAICrecently passed a regulation to adopt a new val-uation mortality standard, the 2001 CSO mor-tality table, which incorporates some of themortality improvements of the 1980s and1990s, but it is not enough.

Table 1 shows an example of how a com-pany’s mortality assumptions could have cer-tain percentages of the Society of Actuaries75/80 tables:

Some of the key analytical factors that couldaffect the mortality profile of the company are:

� Any significant changes to the company’sbusiness plan, distribution system, or under-writing guidelines, practices, and proceduressince January 2002 that would affect mortal-ity assumptions.

� Actual/expected mortality trends.� The reinsurance market.� Competitive pressures affecting pricing.� Regulatory changes affecting the contractual

features.

Alternative Solutions and Standard & Poor’s CriteriaRecommendations

The life insurance companies facing RegulationXXX have been using various solutions toaddress the difference between the statutoryreserve requirements and the economicreserves. Standard & Poor’s credit analystshave been revising the capital models in vari-ous ways and will continue to make adjust-ments to the analysis of earnings and capital.Table 2 summarizes Standard & Poor’s view of


various ways to address Regulation XXXissues, such as reinsurance programs and struc-tured finance transactions.

Conclusion

In general, Standard & Poor’s believes thatRegulation XXX creates a reserve redundancyfor some term insurance and universal life prod-ucts. However, the quantity of the redundancyvaries from company to company, and analyti-cal adjustments to Standard & Poor’s view of

capital and earnings will be performed by theanalyst on a case-by-case basis. Many solutionshave been created in the marketplace to providean alternative for Regulation XXX, and theway Standard & Poor’s quantifies the impactvaries depending on the solution. The capitalmarkets and the reinsurance marketplace willcontinue to create more innovative solutions totake advantage of the difference between statu-tory requirements and economic reality that isbeing created by Regulation XXX.



Analysis of Various Methods To Address Regulation XXX Issues

Standard & Poor’sAlternative Capital Adequacy Ratio AnalyticalSolution Description Recommended Treatment Issues

Third-party reinsurer (yearly renewable term or co-insurance)

Unaffiliated offshore rein-surer through a combina-tion of modified coinsur-ance and full coinsurance(Co/mod-co).

Transfer all the mortalityrisks to the third-partyreinsurer at a cost.

Unaffiliated offshore rein-surer will set up a trust ora letter of credit to coverthe difference betweenthe GAAP reserves andthe STAT reservesrequired by the U.S. regu-lators to get credit for theregulatory risk-based cap-ital model.

Risk is relieved from thedirect writer and charged tothe reinsurer.

Total adjusted capital willbe calculated based on thenew GAAP reserves for thereinsured block as long asthe letter of credit is froman unaffiliated third partyand regulators approve therisk-based capital credit.Therefore, total adjustedcapital will increase. C2 andC3 risk charges remainunchanged at the directwriter company becausethere is no risk transferred.However, a factor will beapplied to the GAAPreserves instead of thestatutory reserves. Oneissue that needs to beaddressed is the ability toraise funds if the directwriters can't obtain moreletters of credit or regularreinsurance.

Over-reliance on reinsur-ance. Third-party reinsur-ance cost is increasing.Reinsurer still faces theRegulation XXX problem.

Letter-of-credit capacitymight dry up. Some statis-tics indicate that the let-ter-of-credit capacity in2008 will be $25 billion andthe Regulation XXXexcess reserve could bemore than $100 billion.Letters of credit are one-year terms, while the lifeinsurance policies are 10-40 years long. Direct writ-ers will have to put backthe excess reserves intheir books if the letter ofcredit can't be renewed,and this will come at theworst time for them.Alternatively, the compa-nies will continue to faceearnings pressures fromthe increase of the lettersof credit.


Analysis of Various Methods To Address Regulation XXX Issues

Standard & Poor’sAlternative Capital Adequacy Ratio AnalyticalSolution Description Recommended Treatment Issues

Affiliated offshore reinsur-er through a combinationof modified coinsuranceand full coinsurance(Co/mod-co).

Structured finance transaction

Affiliated offshore reinsur-er will set up a trust or aletter of credit to coverthe difference betweenthe GAAP reserves andthe STAT reservesrequired by the U.S. regu-lators to get risk-basedcapital surplus relief.

Structured transactionsserve as a substitute forthe offshore reinsurerswith longer terms of cov-erage instead of the one-year letters of credit.

Total adjusted capital will becalculated based on the newGAAP reserves for the rein-sured block as long as theletter of credit establishesthat the reserves are trulyredundant. Therefore, totaladjusted capital willincrease. The affiliated rein-surer would have to hold aninvestment-grade level ofStandard & Poor's risk-based capital. C2 and C3 riskcharges remain unchangedat the direct writer companybecause there is no risktransferred. However, a fac-tor will be applied to theGAAP reserves instead ofthe statutory reserves. Oneissue that needs to beaddressed is the ability toraise funds if the direct writers can't obtain more letters of credit or regularreinsurance.

Using GAAP reservesinstead of STAT reservesenhances total adjusted cap-ital as long as an unaffiliatedthird party covers the differ-ence. Risk charges remainunchanged at the directwriter company but will beapplied to economicreserves instead of statutoryreserves. Standard & Poor'scurrently treats this as oper-ational leverage, but therethe analyst might set up alimit on a case-by-casebasis. One issue that needsto be addressed is the abilityto raise funds if the directwriters lose part of theirfinancial flexibility.

Letter-of-credit capacitymight dry out. Some sta-tistics say that the letter-of-credit capacity in 2008will be $25 billion and theRegulation XXX excessreserve could be morethan $100 billion. Letters ofcredits are one-year termswhile the life insurancepolicies are 10-40 yearslong. Direct writers willhave to put back theexcess reserves in theirbooks if the letter of creditcan't be renewed, and thiswill come at the worsttime for them.Alternatively, the compa-nies will continue to faceearnings pressures fromthe increase of the letterof credit.

There is a risk to financialflexibility to fund theexcess reserves. Theoperational leveragecould be limited. Thestructure is tied to thecompany's financialstrength because of thelimited recourse or theability of the insurer tocontrol the policyholder'sbehavior. Usually involvesa bond insurer to providemore financial flexibility.

Appendix

A Standard & Poor’s Insurer Financial StrengthRating is a current opinion of the financial secu-rity characteristics of an insurance organizationwith respect to its ability to pay under its insur-ance policies and contracts in accordance withtheir terms. Insurer Financial Strength Ratingsare also assigned to health maintenance organi-zations and similar health plans with respect totheir ability to pay under their policies and con-tracts in accordance with their terms.

This opinion is not specific to any particularpolicy or contract, nor does it address the suit-ability of a particular policy or contract for aspecific purpose or purchaser. Furthermore, theopinion does not take into account deductibles,surrender or cancellation penalties, timeliness ofpayment, nor the likelihood of the use of adefense such as fraud to deny claims. Fororganizations with cross-border or multination-al operations, including those conducted by sub-sidiaries or branch offices, the ratings do nottake into account potential that may exist forforeign exchange restrictions to prevent financialobligations from being met.

Insurer Financial Strength Ratings are basedon information furnished by rated organizationsor obtained by Standard & Poor’s from othersources it considers reliable. Standard & Poor’sdoes not perform an audit in connection withany rating and may on occasion rely on unauditedfinancial information. Ratings may be changed,suspended, or withdrawn as a result of changesin, or unavailability of such information orbased on other circumstances.

Insurer Financial Strength Ratings do notrefer to an organization’s ability to meet nonpolicy(i.e., debt) obligations. Assignment of ratings todebt issued by insurers or to debt issues that arefully or partially supported by insurance policies,contracts, or guarantees is a separate processfrom the determination of Insurer FinancialStrength Ratings, and follows procedures con-sistent with issue credit rating definitions and

practices. Insurer Financial Strength Ratings arenot a recommendation to purchase or discontinueany policy or contract issued by an insurer or to buy, hold, or sell any security issued by aninsurer. A rating is not a guaranty of an insurer’sfinancial strength or security.

Long-Term Insurer Financial Strength RatingsAn insurer rated ‘BBB’ or higher is regarded ashaving financial security characteristics that out-weigh any vulnerabilities, and is highly likely tohave the ability to meet financial commitments.

AAAAn insurer rated ‘AAA’ has EXTREMELYSTRONG financial security characteristics.‘AAA’ is the highest Insurer Financial StrengthRating assigned by Standard & Poor’s.

AAAn insurer rated ‘AA’ has VERY STRONGfinancial security characteristics, differing onlyslightly from those rated higher.

AAn insurer rated ‘A’ has STRONG financialsecurity characteristics, but is somewhat morelikely to be affected by adverse business condi-tions than are insurers with higher ratings.

BBBAn insurer rated ‘BBB’ has GOOD financialsecurity characteristics, but is more likely to beaffected by adverse business conditions than arehigher rated insurers.

An insurer rated ‘BB’ or lower is regarded ashaving vulnerable characteristics that may out-weigh its strengths. ‘BB’ indicates the leastdegree of vulnerability within the range; ‘CC’the highest.

BBAn insurer rated ‘BB’ has MARGINAL financialsecurity characteristics. Positive attributes exist,but adverse business conditions could lead toinsufficient ability to meet financial commitments.


Rating Definitions

BAn insurer rated ‘B’ has WEAK financial securitycharacteristics. Adverse business conditions will likely impair its ability to meet financialcommitments.

CCCAn insurer rated ‘CCC’ has VERY WEAKfinancial security characteristics, and is depend-ent on favorable business conditions to meetfinancial commitments.

CCAn insurer rated ‘CC’ has EXTREMELY WEAKfinancial security characteristics and is likelynot to meet some of its financial commitments.

RAn insurer rated ‘R’ has experienced a REGULATORY ACTION regarding solvency.The rating does not apply to insurers subjectonly to nonfinancial actions such as marketconduct violations.

N.R.An insurer designated ‘N.R.’ is NOT RATED,which implies no opinion about the insurer’sfinancial security.

Plus (+) or minus (–)These signs following ratings from ‘AA’ to‘CCC’ show relative standing within the majorrating categories.

CreditWatchThis highlights the potential direction of a rat-ing, focusing on identifiable events and short-term trends that cause ratings to be placedunder special surveillance by Standard &Poor’s. The events may include mergers,recapitalizations, voter referenda, regulatoryactions, or anticipated operating develop-ments. Ratings appear on CreditWatch whensuch an event or a deviation from an expectedtrend occurs and additional information isneeded to evaluate the rating. A listing, how-ever, does not mean a rating change isinevitable, and whenever possible, a range ofalternative ratings will be shown. CreditWatchis not intended to include all ratings underreview, and rating changes may occur without

the ratings having first appeared onCreditWatch. The “positive” designationmeans that a rating may be raised; “negative”means that a rating may be lowered; “devel-oping” means that a rating may be raised,lowered or affirmed.

‘pi’ RatingsThese ratings, denoted with a ‘pi’ subscript, areInsurer Financial Strength Ratings based on ananalysis of an insurer’s published financialinformation and additional information in thepublic domain. They do not reflect in-depthmeetings with an insurer’s management and aretherefore based on less comprehensive informa-tion than ratings without a ‘pi’ subscript. ‘pi’ratings are reviewed annually based on a newyear’s financial statements, but may be reviewedon an interim basis if a major event that mayaffect an insurer’s financial security occurs.Ratings with a ‘pi’ subscript are not subject topotential CreditWatch listings. Ratings with a‘pi’ subscript generally are not modified with ‘+’or ‘–’ designations. However, such designationsmay be assigned when the insurer’s financialstrength rating is constrained by sovereign riskor the credit quality of a parent company oraffiliated group.

National scale ratingsThese ratings, denoted with a prefix such as ‘mx’(Mexico) or ‘ra’ (Argentina), assess an insurer’sfinancial security relative to other insurers in itshome market. For more information, refer tothe separate definitions for national scale ratings.

Short-Term Insurer Financial Strength RatingsShort-Term Insurer Financial Strength Ratingsreflect the insurer’s creditworthiness over ashort-term time horizon.

A-1An insurer rated ‘A-1’ has a STRONG ability to meet its financial commitments on short-termpolicy obligations. It is rated in the highest cate-gory by Standard & Poor’s. Within this catego-ry, certain insurers are designated with a plussign (+). This indicates that the insurer’s abilityto meet its financial commitments on short-termpolicy obligations is EXTREMELY STRONG.


A-2An insurer rated ‘A-2’ has a GOOD ability tomeet its financial commitments on short-termpolicy obligations. However, it is somewhat moresusceptible to the adverse effects of changes incircumstances and economic conditions thaninsurers in the highest rating category.

A-3An insurer rated ‘A-3’ has an ADEQUATE abilityto meet its financial commitments on short-termpolicy obligations. However, adverse economicconditions or changing circumstances are morelikely to lead to a weakened ability of the insurerto meet its financial obligations.

BAn insurer rated ‘B’ is regarded as VULNERABLEand has significant speculative characteristics.The insurer currently has the ability to meet itsfinancial commitments on short-term policyobligations; however, it faces major ongoinguncertainties which could lead to the insurer’sinadequate ability to meet its financial obligations.

CAn insurer rated ‘C’ is regarded as CUR-RENTLY VULNERABLE to nonpayment andis dependent upon favorable business, finan-cial, and economic conditions for it to meet itsfinancial commitments on short-term policyobligations.

RSee definition of “R” under Long-term Ratings.Standard & Poor’s ratings and other assess-ments of creditworthiness and financial strengthare not a recommendation to purchase or discontinue any policy or contract issues by aninsurer or to buy, hold, or sell any security issuedby an insurer. In addition, neither a rating noran assessment is a guaranty of an insurer’sfinancial strength.

Rating Outlook Definitions A Standard & Poor’s Rating Outlook assessesthe potential direction of a long-term credit orfinancial strength rating over the intermediateto longer term. In determining a RatingOutlook, consideration is given to any changesin the economic and/or fundamental business

conditions. An Outlook is not necessarily aprecursor of a rating change or futureCreditWatch action.

� Positive means that a rating may be raised. � Negative means that a rating may

be lowered. � Stable means that a rating is not likely to

change. � Developing means a rating may be raised or

lowered. � N.M. means not meaningful.

Insurer Financial Enhancement Rating DefinitionsA Standard & Poor’s Insurer FinancialEnhancement Rating is a current opinion of thecreditworthiness of an insurer with respect toinsurance policies or other financial obligationsthat are predominantly used as credit enhance-ment and/or financial guarantees. When assign-ing an Insurer Financial Enhancement Rating,Standard & Poor’s analysis focuses on capital,liquidity, and company commitment necessaryto support a credit enhancement or financialguaranty business. The Insurer FinancialEnhancement Rating is not a recommendationto purchase, sell, or hold a financial obligation,in that it does not comment as to market priceor suitability for a particular investor.

Insurer Financial Enhancement Ratings arebased on information furnished by the insurersor obtained by Standard & Poor’s from othersources it considers reliable. Standard & Poor’sdoes not perform an audit in connection withany credit rating and may, on occasion, rely onunaudited financial information. InsurerFinancial Enhancement Ratings may be changed,suspended, or withdrawn as a result of changesin, or unavailability of, such information orbased on other circumstances. Insurer FinancialEnhancement Ratings are based, in varyingdegrees, on all of the following considerations:

Likelihood of payment-capacity and willing-ness of the insurer to meet its financial commit-ment on an obligation in accordance with theterms of the obligation, especially for structuredtransactions were timely payment-no matterwhat-is critical to the integrity of the transaction;

R AT I N G D E F I N I T I O N S


Nature of and provisions of the obligations;and Protection afforded by, and relative position of,the obligation in the event of bankruptcy, reor-ganization, or other arrangement under thelaws of bankruptcy and other laws affectingcreditors’ rights.

Insurer Financial Enhancement Ratings

AAAAn insurer rated ‘AAA’ has EXTREMELYSTRONG capacity to meet its financial commitments. ‘AAA’ is the highest InsurerFinancial Enhancement Rating assigned byStandard & Poor’s.

AAAn insurer rated ‘AA’ has VERY STRONGcapacity to meet its financial commitments. Itdiffers from the highest-rated insurers only insmall degree.

AAn insurer rated ‘A’ has STRONG capacity tomeet its financial commitments but is somewhatmore susceptible to the adverse effects ofchanges in circumstances and economic condi-tions than higher-rated insurers.

BBBAn insurer rated ‘BBB’ has ADEQUATE capaci-ty to meet its financial commitments. However,adverse economic conditions or changing cir-cumstances are more likely to lead to a weak-ened capacity of the insurer to meet its financialcommitments.

Insurers rated ‘BB’, ‘B’, ‘CCC’, and ‘CC’ areregarded as having significant speculative char-acteristics. ‘BB’ indicates the least degree ofspeculation and ‘CC’ the highest. Although suchinsurers will likely have some quality and pro-tective characteristics, these may be outweighedby large uncertainties or major exposures toadverse conditions.

BBAn insurer rated ‘BB’ is LESS VULNERABLE inthe near term than other lower-rated insurers.However, it faces major ongoing uncertaintiesand exposure to adverse business, financial, or

economic conditions that could lead to theinsurer's inadequate capacity to meet its finan-cial commitments.

BAn insurer rated ‘B’ is MORE VULNERABLEthan the insurers rated ‘BB’, but the insurer cur-rently has the capacity to meet its financialcommitments. Adverse business, financial, oreconomic conditions will likely impair theinsurer’s capacity or willingness to meet itsfinancial commitments.

CCCAn insurer rated ‘CCC’ is CURRENTLY VUL-NERABLE, and is dependent upon favorablebusiness, financial, and economic conditions tomeet its financial commitments.

CCAn insurer rated ‘CC’ is CURRENTLY HIGH-LY VULNERABLE.

Plus (+) or minus (-):Ratings from ‘AA’ to ‘CCC’ may be modified bythe addition of a plus or minus sign to show rel-ative standing within the major rating categories.

RAn insurer rated ‘R’ is under regulatory supervi-sion owing to its financial condition. During thependency of the regulatory supervision, the reg-ulators may have the power to favor one classof obligations over others or pay some obliga-tions and not others. Please see Standard &Poor’s issue credit ratings for a more detaileddescription of the effects of regulatory supervi-sion on specific issues or classes of obligations.

N.R.An issuer designated N.R. is not rated.

Issue Credit Rating DefinitionsA Standard & Poor’s issue credit rating is a current opinion of the creditworthiness of anobligor with respect to a specific financial obli-gation, a specific class of financial obligations,or a specific financial program (including rat-ings on medium term note programs and com-mercial paper programs.) It takes into consider-ation the creditworthiness of guarantors,


insurers, or other forms of credit enhancementon the obligation and takes into account thecurrency in which the obligation is denominat-ed. The issue credit rating is not a recommenda-tion to purchase, sell, or hold a financial obligation, inasmuch as it does not comment as to market price or suitability for a particular investor.

Issue credit ratings are based on currentinformation furnished by the obligors orobtained by Standard & Poor’s from othersources it considers reliable. Standard & Poor’sdoes not perform an audit in connection withany credit rating and may, on occasion, rely onunaudited financial information. Credit ratingsmay be changed, suspended, or withdrawn as aresult of changes in, or unavailability of, suchinformation, or based on other circumstances.

Issue credit ratings can be either long-termor short-term. Short-term ratings are generallyassigned to those obligations considered short-term in the relevant market. In the U.S., forexample, that means obligations with an originalmaturity of no more than 365 days—includingcommercial paper. Short-term ratings are alsoused to indicate the creditworthiness of anobligor with respect to put features on long-termobligations. The result is a dual rating, in whichthe short-term rating addresses the put feature, inaddition to the usual long-term rating. Medium-term notes are assigned long-term ratings.

Long-Term Issue Credit RatingsIssue credit ratings are based, in varyingdegrees, on the following considerations:1. Likelihood of payment—capacity and will-

ingness of the obligor to meet its financialcommitment on an obligation in accordancewith the terms of the obligation;

2. Nature of and provisions of the obligation;3. Protection afforded by, and relative position

of, the obligation in the event of bankruptcy,reorganization, or other arrangement underthe laws of bankruptcy and other lawsaffecting creditors’ rights.The issue rating definitions are expressed in

terms of default risk. As such, they pertain tosenior obligations of an entity. Junior obligationsare typically rated lower than senior obligations,

to reflect the lower priority in bankruptcy, asnoted above. (Such differentiation applies whenan entity has both senior and subordinated obli-gations, secured and unsecured obligations, oroperating company and holding company obli-gations.) Accordingly, in the case of junior debt,the rating may not conform exactly with thecategory definition.

AAAAn obligation rated ‘AAA’ has the highest ratingassigned by Standard & Poor’s. The obligor’scapacity to meet its financial commitment onthe obligation is EXTREMELY STRONG.

AAAn obligation rated ‘AA’ differs from the highestrated obligations only in small degree. Theobligor’s capacity to meet its financial commit-ment on the obligation is VERY STRONG.

AAn obligation rated ‘A’ is somewhat more susceptible to the adverse effects of changes incircumstances and economic conditions thanobligations in higher rated categories.However, the obligor’s capacity to meet itsfinancial commitment on the obligation is still STRONG.

BBBAn obligation rated ‘BBB’ exhibits ADEQUATEprotection parameters. However, adverse eco-nomic conditions or changing circumstances aremore likely to lead to a weakened capacity ofthe obligor to meet its financial commitment onthe obligation.

Obligations rated ‘BB’, ‘B’, ‘CCC’, ‘CC’,and ‘C’ are regarded as having significant spec-ulative characteristics. ‘BB’ indicates the leastdegree of speculation and ‘C’ the highest. Whilesuch obligations will likely have some qualityand protective characteristics, these may be outweighed by large uncertainties or majorexposures to adverse conditions.

BBAn obligation rated ‘BB’ is LESS VULNERABLEto nonpayment than other speculative issues.However, it faces major ongoing uncertaintiesor exposure to adverse business, financial, or



economic conditions which could lead to theobligor’s inadequate capacity to meet its finan-cial commitment on the obligation.

BAn obligation rated ‘B’ is MORE VULNERABLEto nonpayment than obligations rated ‘BB’, butthe obligor currently has the capacity to meetits financial commitment on the obligation.Adverse business, financial, or economic condi-tions will likely impair the obligor’s capacity orwillingness to meet its financial commitment onthe obligation.

CCCAn obligation rated ‘CCC’ is CURRENTLYVULNERABLE to nonpayment, and is depend-ent upon favorable business, financial, and eco-nomic conditions for the obligor to meet itsfinancial commitment on the obligation. In theevent of adverse business, financial, or economicconditions, the obligor is not likely to have thecapacity to meet its financial commitment onthe obligation.

CCAn obligation rated ‘CC’ is currently HIGHLYVULNERABLE to nonpayment.

CThe ‘C’ rating may be used to cover a situationwhere a BANKRUPTCY PETITION HAS BEENFILED or similar action has been taken, butpayments on this obligation are being continued.

DAn obligation rated ‘D’ is IN PAYMENTDEFAULT. The ‘D’ rating category is used whenpayments on an obligation are not made on thedate due even if the applicable grace period hasnot expired, unless Standard & Poor’s believesthat such payments will be made during suchgrace period. The ‘D’ rating also will be usedupon the filing of a bankruptcy petition or thetaking of a similar action if payments on an obli-gation are jeopardized.

Plus (+) or minus (–)The ratings from ‘AA’ to ‘CCC’ may be modi-fied by the addition of a plus or minus sign toshow relative standing within the major ratingcategories.

rThis symbol is attached to the ratings ofinstruments with significant noncredit risks. Ithighlights risks to principal or volatility ofexpected returns which are not addressed inthe credit rating. Examples include: obligationslinked or indexed to equities, currencies, orcommodities; obligations exposed to severeprepayment risk—such as interest-only orprincipal-only mortgage securities; and obliga-tions with unusually risky interest terms, suchas inverse floaters.

Short-Term Issue Credit RatingsA-1A short-term obligation rated ‘A-1’ is rated inthe highest category by Standard & Poor’s. Theobligor’s capacity to meet its financial commit-ment on the obligation is STRONG. Within thiscategory, certain obligations are designated witha plus sign (+). This indicates that the obligor’scapacity to meet its financial commitment onthese obligations is extremely strong.

A-2A short-term obligation rated ‘A-2’ is some-what more susceptible to the adverse effects ofchanges in circumstances and economic condi-tions than obligations in higher rating cate-gories. However, the obligor’s capacity to meetits financial commitment on the obligation isSATISFACTORY.

A-3A short-term obligation rated ‘A-3’ exhibitsADEQUATE protection parameters. However,adverse economic conditions or changingcircumstances are more likely to lead to aweakened capacity of the obligor to meet itsfinancial commitment on the obligation.

BA short-term obligation rated ‘B’ is regardedas having SIGNIFICANT SPECULATIVECHARACTERISTICS. The obligor currentlyhas the capacity to meet its financial commit-ment on the obligation; however, it facesmajor ongoing uncertainties which could leadto the obligor’s inadequate capacity to meet itsfinancial commitment on the obligation.


CA short-term obligation rated ‘C’ is CURRENTLYVULNERABLE to nonpayment and is dependentupon favorable business, financial, and economicconditions for the obligor to meet its financialcommitment on the obligation.

DA short-term obligation rated ‘D’ is IN PAYMENTDEFAULT. The ‘D’ rating category is used whenpayments on an obligation are not made on thedate due even if the applicable grace period hasnot expired, unless Standard & Poor’s believesthat such payments will be made during suchgrace period. The ‘D’ rating also will be usedupon the filing of a bankruptcy petition or thetaking of a similar action if payments on anobligation are jeopardized.

Local Currency and Foreign Currency RisksCountry risk considerations are a standard partof Standard & Poor’s analysis for credit ratingson any issuer or issue. Currency of repayment isa key factor in this analysis. An obligor’s capac-ity to repay foreign currency obligations may belower than its capacity to repay obligations in itslocal currency due to the sovereign government’sown relatively lower capacity to repay externalversus domestic debt. These sovereign risk con-siderations are incorporated in the debt ratingsassigned to specific issues. Foreign currencyissuer ratings are also distinguished from localcurrency issuer ratings to identify those instanceswhere sovereign risks make them different forthe same issuer.

Issuer Credit Rating DefinitionsA Standard & Poor’s Issuer Credit Rating is acurrent opinion of an obligor’s overall financialcapacity (its creditworthiness) to pay its financialobligations. This opinion focuses on the obligor’scapacity and willingness to meet its financialcommitments as they come due. It does not applyto any specific financial obligation, as it does nottake into account the nature of and provisions ofthe obligation, its standing in bankruptcy or liqui-dation, statutory preferences, or the legality andenforceability of the obligation. In addition, itdoes not take into account the creditworthiness ofthe guarantors, insurers, or other forms of credit

enhancement on the obligation. The Issuer CreditRating is not a recommendation to purchase, sell,or hold a financial obligation issued by an oblig-or, as it does not comment on market price orsuitability for a particular investor.

Counterparty Credit Ratings, ratingsassigned under the Corporate Credit RatingService (formerly called the Credit AssessmentService) and Sovereign Credit Ratings are allforms of Issuer Credit Ratings.

Issuer Credit Ratings are based on currentinformation furnished by obligors or obtainedby Standard & Poor’s from other sources itconsiders reliable. Standard & Poor’s does notperform an audit in connection with any IssuerCredit Rating and may, on occasion, rely onunaudited financial information. Issuer CreditRatings may be changed, suspended, or with-drawn as a result of changes in, or unavailabilityof, such information, or based on other circum-stances. Issuer Credit Ratings can be either long-term or short-term. Short-Term Issuer CreditRatings reflect the obligor’s creditworthinessover a short-term time horizon.

Long-Term Issuer Credit RatingsAAAAn obligor rated ‘AAA’ has EXTREMELYSTRONG capacity to meet its financial commit-ments. ‘AAA’ is the highest Issuer Credit Ratingassigned by Standard & Poor’s.

AAAn obligor rated ‘AA’ has VERY STRONGcapacity to meet its financial commitments. Itdiffers from the highest rated obligors only insmall degree.

AAn obligor rated ‘A’ has STRONG capacity tomeet its financial commitments but is somewhatmore susceptible to the adverse effects of changesin circumstances and economic conditions thanobligors in higher-rated categories.

BBBAn obligor rated ‘BBB’ has ADEQUATE capacityto meet its financial commitments. However,adverse economic conditions or changing circumstances are more likely to lead to a



weakened capacity of the obligor to meet itsfinancial commitments.

Obligors rated ‘BB’, ‘B’, ‘CCC’, and ‘CC’are regarded as having significant speculativecharacteristics. ‘BB’ indicates the least degree ofspeculation and ‘CC’ the highest. While suchobligors will likely have some quality and pro-tective characteristics, these may be outweighedby large uncertainties or major exposures toadverse conditions.

BBAn obligor rated ‘BB’ is LESS VULNERABLEin the near term than other lower-rated oblig-ors. However, it faces major ongoing uncertain-ties and exposure to adverse business, financial,or economic conditions which could lead to theobligor’s inadequate capacity to meet its finan-cial commitments.

BAn obligor rated ‘B’ is MORE VULNERABLEthan the obligors rated ‘BB’, but the obligorcurrently has the capacity to meet its financialcommitments. Adverse business, financial, oreconomic conditions will likely impair theobligor’s capacity or willingness to meet itsfinancial commitments.

CCCAn obligor rated ‘CCC’ is CURRENTLY VULNERABLE, and is dependent upon favorablebusiness, financial, and economic conditions tomeet its financial commitments.

CCAn obligor rated ‘CC’ is CURRENTLY HIGHLYVULNERABLE.

Plus (+) or minus (–)Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.

Public Information RatingsRatings with a ‘pi’ subscript are based on ananalysis of an issuer’s published financial infor-mation, as well as additional information inthe public domain. They do not, however,reflect in-depth meetings with an issuer’s man-

agement and are therefore based on less com-prehensive information than ratings without a‘pi’ subscript. Ratings with a ‘pi’ subscript arereviewed annually based on a new year’s finan-cial statements, but may be reviewed on aninterim basis if a major event occurs that mayaffect the issuer’s credit quality. Outlooks arenot provided for ratings with a ‘pi’ subscript,nor are they subject to potential CreditWatchlistings. Ratings with a ‘pi’ subscript generallyare not modified with ‘+’ or ‘-’ designations.However, such designations may be assignedwhen the issuer’s credit rating is constrained bysovereign risk or the credit quality of a parentcompany or affiliated group.

Short-Term Issuer Credit RatingsA-1An obligor rated ‘A-1’ has STRONG capacityto meet its financial commitments. It is rated inthe highest category by Standard & Poor’s.Within this category, certain obligors are desig-nated with a plus sign (+). This indicates thatthe obligor’s capacity to meet its financial commitments is EXTREMELY STRONG.

A-2An obligor rated ‘A-2’ has SATISFACTORYcapacity to meet its financial commitments.However, it is somewhat more susceptible tothe adverse effects of changes in circumstancesand economic conditions than obligors in thehighest rating category.

A-3An obligor rated ‘A-3’ has ADEQUATE capacityto meet its financial obligations. However,adverse economic conditions or changing cir-cumstances are more likely to lead to a weak-ened capacity of the obligor to meet its financialcommitments.

BAn obligor rated ‘B’ is regarded as VULNER-ABLE and has significant speculative charac-teristics. The obligor currently has the capaci-ty to meet its financial commitments; howev-er, it faces major ongoing uncertainties whichcould lead to the obligor’s inadequate capacityto meet its financial commitments.


CAn obligor rated ‘C’ is CURRENTLY VUL-NERABLE to nonpayment and is dependentupon favorable business, financial, and economicconditions for it to meet its financial commitments

R An obligor rated ‘R’ is under regulatory supervi-sion owing to its financial condition. During thependency of the regulatory supervision the regula-tors may have the power to favor one class of obli-gations over others or pay some obligations andnot others. Please see Standard & Poor’s issuecredit ratings for a more detailed description of theeffects of regulatory supervision on specific issuesor classes of obligations.

SD and D An obligor rated ‘SD’ (Selective Default) or ‘D’ hasfailed to pay one or more of its financial obliga-tions (rated or unrated) when it came due. A ‘D’rating is assigned when Standard & Poor’s believesthat the default will be a general default and thatthe obligor will fail to pay all or substantially all ofits obligations as they come due. An ‘SD' rating isassigned when Standard & Poor’s believes that theobligor has selectively defaulted on a specific issueor class of obligations but it will continue to meetits payment obligations on other issues or classes ofobligations in a timely manner. Please see Standard& Poor’s issue credit ratings for a more detaileddescription of the effects of a default on specificissues or classes of obligations.

N.R. An issuer designated N.R. is not rated.

Local Currency and Foreign Currency RisksCountry risk considerations are a standard partof Standard & Poor’s analysis for credit ratingson any issuer or issue. Currency of repayment is a key factor in this analysis. An obligor’scapacity to repay foreign currency obligationsmay be lower than its capacity to repay obliga-tions in its local currency due to the sovereigngovernment’s own relatively lower capacity torepay external versus domestic debt. These sov-ereign risk considerations are incorporated inthe debt ratings assigned to specific issues.Foreign currency issuer ratings are also distin-

guished from local currency issuer ratings toidentify those instances where sovereign risksmake them different for the same issuer.

Rating Outlook DefinitionsA Standard & Poor’s rating outlook assesses thepotential direction of a long-term credit ratingover the intermediate to longer term. In deter-mining a rating outlook, consideration is givento any changes in the economic and/or funda-mental business conditions. An outlook is notnecessarily a precursor of a rating change orfuture CreditWatch action.

• Positive means that a rating may be raised.• Negative means that a rating may be lowered.• Stable means that a rating is not likely

to change.• Developing means a rating may be raised

or lowered.• N.M. means not meaningful.

CreditWatchCreditWatch highlights the potential directionof a short- or long-term rating. It focuses onidentifiable events and short-term trends thatcause ratings to be placed under special surveil-lance by Standard & Poor’s analytical staff.These may include mergers, recapitalizations,voter referendums, regulatory action, or antici-pated operating developments. Ratings appearon CreditWatch when such an event or a devia-tion from an expected trend occurs and addi-tional information is necessary to evaluate thecurrent rating. A listing, however, does notmean a rating change is inevitable, and wheneverpossible, a range of alternative ratings will beshown. CreditWatch is not intended to includeall ratings under review, and rating changesmay occur without the ratings having firstappeared on CreditWatch. The “positive” designation means that a rating may be raised;“negative” means a rating may be lowered; and“developing” means that a rating may beraised, lowered, or affirmed.

Dual Ratings DefinitionsStandard & Poor’s assigns “dual” ratings to alldebt issues that have a put option or demandfeature as part of their structure. The first rat-ing addresses the likelihood of repayment of



principal and interest as due, and the secondrating addresses only the demand feature. Thelong-term debt rating symbols are used forbonds to denote the long-term maturity and thecommercial paper rating symbols for the putoption (for example, ‘AAA/A-1+’). With short-term demand debt, Standard & Poor’s note rat-ing symbols are used with the commercial.

Rating Terminology

Credit Assessment Credit assessments are preliminary indicators ofcreditworthiness expressed in either a broad rat-ing category or in descriptive terms. They pro-vide an evaluation of the general strengths andweaknesses of an issuer, obligor, a proposedfinancing structure, or elements of such struc-tures. Credit assessments represent a point-in-time evaluation and are generally confidential.Standard & Poor’s does not maintain ongoingsurveillance on credit assessments.

Credit Estimate A credit estimate is a confidential indication pro-vided to a third party of the likely issuer creditrating on an unrated company. The rating esti-mate is based on input from a variety of sourcesincluding Credit Model, where applicable, andabbreviated methodology that draws on analyti-cal experience and industry knowledge of theStandard & Poor’s analysts(s) specializing in theindustry in which the company operates. Theseestimates do not involved direct contact with thecompany or the in-depth insight into competitive,financial, or strategic issues that such contactallows. Standard & Poor’s does not maintainongoing surveillance on Credit Estimates, but canperform periodic updates upon request.

Credit Evaluation Credit evaluation is used widely as a generic termin evaluating the creditworthiness of nonrated

instruments. It is often used in conjunction withindividual loans in CMBS transactions. It is alsoused as a general term, interchangeable with cred-it opinion and credit analysis.

Public Information (Pi) Rating Ratings with a ‘pi’ subscript are based on ananalysis of an issuer’s published financialinformation, as well as additional informationin the public domain. They do not, however,reflect in-depth meetings with an issuer’s man-agement and are therefore based on less-com-prehensive information than ratings without a‘pi’ subscript. Ratings with a ‘pi’ subscript arereviewed annually based on a new year’sfinancial statements, but may be reviewed onan interim basis if a major event occurs thatmay affect the issuer’s credit quality.

Shadow Rating Shadow ratings are used in Public Finance andStructured Finance for issues backed by bondinsurance to assess risks being taken by themonoline bond insurers.

Spurs (Standard & Poor’s Underlying Rating) This is a rating of a stand-alone capacity ofan issuer to pay debt service on a credit-enhanced debt issue, without giving effect tothe enhancement that applies to it. These rat-ings are published only at the request of thedebt issuer/obligor with the designation SPURto distinguish them from the credit-enhancedrating that applies to the debt issue. As long as the SPUR rating is outstanding,Standard & Poor’s will maintain surveillanceon the issue.

Stand-Alone Rating A stand-alone rating is the rating that wouldlikely be achieved in the absence of constraintor enhancement by a third party (parent, sub-sidiary, guarantor, or government entity).


The following sample language has been includ-ed to illustrate Standard & Poor’s guarantee cri-teria. The specific language corresponds to thenumbered statements listed in the sidebar dis-cussing guarantees on page 73. The followinglanguage is not a requirement, but is intendedto serve as a guide.1. “This guarantee is a guarantee of payment

and not of collection.”2. “The guarantor hereby waives any require-

ment that the trustee protect, secure, perfect,or insure any security interest or lien or anyproperty subject thereto or exhaust any rightor take any action against any person or anycollateral (including any rights relating tomarshaling of assets).”

3. “The guarantor hereby guarantees that theguaranteed obligations will be paid strictly inaccordance with the terms of the agreementgoverning such guaranteed obligations or anyother agreement relating thereto, regardlessof the value, genuineness, validity, regularity,or enforceability of the guaranteed obliga-tions, and of any law, regulation, or ordernow or hereafter in effect in any jurisdictionaffecting any of such terms or the rights ofthe trustee with respect thereto. The liabilityof the guarantor to the extent herein set forthshall be absolute and unconditional, not sub-ject to any reduction, limitation, impairment,termination, defense, offset, counterclaim, orrecoupment whatsoever (all of which arehereby expressly waived by the guarantor),whether by reason of any claim of any char-acter whatsoever, including, without limita-tion, any claim of waiver, release, surrender,alteration, or compromise, or by reason ofany liability at any time to the guarantor orotherwise, whether based on any obligationsor any other agreement or otherwise, andhowsoever arising, whether out of action orinaction or otherwise, and whether resultingfrom default, willful misconduct, negligence,

or otherwise, and without limiting the fore-going irrespective of:a) any lack of validity or enforceability ofany agreement or instrument relating to theguaranteed obligations;b) any change in the time, manner, or placeof payment of, or in any other term inrespect of, all or any of the guaranteed obli-gations, or any other amendment or waiverof or consent to any departure from anyother agreement relating to any guaranteedobligations; any change in the time, manner,or place of payment of, or in any other termin respect of, all or any of the guaranteedobligations, or any other amendment orwaiver of or consent to any departure fromany other agreement relating to any guaran-teed obligations;c) any increase in, addition to, exchange orrelease of, or nonperfection of any lien on orsecurity interest in, any collateral, or anyrelease or amendment or waiver of or con-sent to any departure from or failure toenforce any other guarantee, for all or any ofthe indebtedness;d) any other circumstance that might other-wise constitute a defense available to, or adischarge of, the primary obligor in respectof the guaranteed obligations or the guaran-tor in respect hereof;e) the absence of any action on the part ofthe trustee to obtain payment of the guaran-teed obligations from the primary obligor;f) any insolvency, bankruptcy, reorganization,or dissolution, or any proceeding of the pri-mary obligor or the guarantor, including,without limitation, rejection of the guaran-teed obligations in such bankruptcy; org) the absence of notice or any delay in anyaction to enforce any guaranteed obligationsor to exercise any right or remedy against theguarantor or the primary obligor, whetherhereunder, under any guaranteed obligations


Sample Guarantee

or any agreement or any indulgence, compro-mise, or extension granted.”

4. “Guarantor further agrees that, to the extentthat the primary obligor or the guarantormakes a payment or payments to the trustee,which payment or payments or any partthereof are subsequently invalidated, declaredto be fraudulent or preferential, set aside,and/or required to be repaid to the primaryobligor or the guarantor or their respectiveestate, trustee, receiver, or any other partyunder any bankruptcy law, state or federallaw, common law, or equitable cause, then tothe extent of such payment or repayment,this guarantee and the advances or partthereof that have been paid, reduced, or sat-isfied by such amount shall be reinstated andcontinued in full force and effect as of thedate such initial payment, reduction, or satis-faction occurred.”

5. “Guarantor shall have no rights (direct orindirect) of subrogation, contribution, reim-bursement, indemnification, or other rights

of payment or recovery from any person orentity (including, without limitation, the pri-mary obligor) for any payments made by theguarantor hereunder, and the guarantor here-by waives and releases, absolutely andunconditionally, any such rights of subroga-tion, contribution, reimbursement, indemnifi-cation and other rights or recovery that itmay now have or hereafter acquire.”

6. “This guarantee shall be binding upon andshall inure to the benefit of the parties heretoand their respective successors and assigns,including, without limitation, the trustee.”

7. “No waiver of any provision of this guar-antee and no consent to any departure bythe guarantor therefrom shall be effectiveunless it is in writing and consented to bythe trustee and 100% of the holders of therated securities, and then such a waiver orconsent shall be effective only in the specif-ic instance and for the specific purpose forwhich given.”


Documents

Property/Casualty EditionInsurance Ratings Criteria www ... · standardandpoors.com. We will continue to update our property/casualty insurance ratings criteria ... It was then that