Best Study Analyzes Catastrophe Rating Methodology

A.M. Best Co. has issued a study, which concludes that catastrophic loss, both natural and man-made, is “the number one threat to the financial strength and credit quality of property and casualty insurers due to the significant, rapid and unexpected impact that can occur.”

Best noted: “While many other exposures can affect solvency, no single event can affect policyholder and debt-holder security more instantaneously than catastrophes. Moreover, immediately following a significant event, the company retains its exposure base and subsequent events can occur prior to the implementation of any risk mitigation strategies. Of concern is the rapid escalation in insured exposures over the past decade.”

The subject is a timely one. Best is concerned about the increased frequency and severity of losses over the past five years, which are “challenging insurers and reinsurers to further improve their catastrophe risk management systems and controls, and provide stronger capitalization to support the risk.”

As a result, Best said it has “been increasing its surveillance of the catastrophe exposures of primary insurers and reinsurers alike and continues to refine the methodology for evaluating insurers’ financial strength to reflect their ability to manage the potential losses. Insurers knowingly accept risk with the intent of diversifying the loss, and in order to maintain their ratings, they must demonstrate their financial wherewithal to absorb the potential loss.”

The newly released methodology report details Best’s catastrophe stress test and discusses the analysis of the capital requirements to support catastrophe risk.

“Today, most insurers utilize sophisticated catastrophe modeling tools to provided loss estimates,” the bulletin continued. “The hurricane events of 2004 and 2005 have reminded us that while the models are extraordinarily useful in the analytical and underwriting process, they are only tools and cannot be relied upon solely for the management of maximum exposures.”

Although Best indicated that it “still believes that the catastrophe models are a valuable tool in monitoring the normal distribution of potential catastrophe losses, and will continue to utilize modeled output in its evaluation of capitalization through Best’s Capital Adequacy Ratio (BCAR),” it also believes that “careful monitoring of zonal aggregates is critical to understanding maximum potential loss.

“Historically, A.M. Best analysts have gathered information through the Supplemental Rating Questionnaire (SRQ) or other similar requests for information regarding which items are included in the modeled output,” the bulletin continued However, best said that beginning with the 2006 data requests, it “will require certain model options to be selected and material sources of catastrophe risk to be included in the loss estimations. A.M. Best analysts also will review aggregate-insured value data by territory and engage management in discussion of maximum exposure and risk appetite.”

For more information on A.M. Best’s catastrophe analysis, access the full methodology report at www.ambest.com/ratings/methodology.asp.