Rating agency A.M. Best has changed a proposed update to its Best’s Capital Adequacy Ratio (BCAR) that would have seen catastrophe risk become a direct capital requirement and has also reduced the emphasis on catastrophe tail risks in the capital adequacy calculation.
A.M. Best published a draft update to its BCAR methodology earlier this year, which proposed making catastrophe risks held on the balance-sheet more of a focus for insurance and reinsurance company capital adequacy calculations.
A.M. Best’s BCAR is used to assess the strength of an insurance or reinsurance balance sheet, and is part of the overall methodology the firm uses to assign ratings to re/insurance companies.
The original draft could have had implications for the insurance-linked securities (ILS) market, perhaps resulting in a change in demand for ILS backed reinsurance protection, due to catastrophe risks no longer being mitigated via diversification with other types of risks, cat risks being treated as a separate category under new BCAR methodology and tail-risks perhaps needing more protection.
However, after receiving feedback on the original draft BCAR methodology update, A.M. Best has updated the proposal and moved catastrophe risk from becoming a direct capital requirement to “being included as part of the covariance adjustment in the net required capital calculation.”
A.M Best explains; “This change was made after reviewing the assumption that catastrophe risk is correlated to other risks. The net PML for each confidence level uses the per-occurrence all-perils combined on a pre-tax basis. This change has generally resulted in lower net required capital.”
Additionally, A.M. Best has updated the proposed treatment of catastrophe tail-risk, removing the 1-in-500 and 1-in-1000 year return period confidence intervals and replacing them with 1-in-250.
The rating agency explains that this is “Consistent with a commonly used industry practice for capital measurement and the measurement of catastrophe tail risk.”
And explains; “Industry feedback was consistent in the concern of utilizing these lower probability tail events for capital measurement due to limited availability and reliability of model data, which raised the potential for greater volatility in the rating process.”
The 1-in-500 year return period will still be assessed under the BCAR model but will not be used for measuring capital adequacy, A.M. Best said.
The updates have mixed potential impacts for ILS demand, with the removal of the assessment of longer-tail catastrophe exposures perhaps resulting in less demand than there could have been for remote tail-risk protection, while the change to catastrophe risk treatment as direct capital adequacy could have made ILS less attractive than traditional reinsurance coverage.
So overall the direct impact to ILS market demand now seems balanced, however as a whole there is an increased focus on ensuring capital adequacy for re/insurers bearing large amounts of catastrophe risk on the balance-sheet, which could result in some increased need for protection, some of which may fall to collateralised markets and ILS such as catastrophe bonds.
Generally any change to rating criteria that means insurance and reinsurance firms have to be more stringently assessed on catastrophe exposure will likely result in more focus on how risk transfer and risk capital can assist, and overall that is surely positive for ILS markets.
You can read A.M. Best’s latest release and download the updated criteria proposal here. A.M. Best is seeking feedback on its BCAR update proposal by March 2017.