Included in the report are the following:

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1 Criteria Report Non-life Insurance Ratings Criteria Analysts Chris Waterman Greg Carter Geoff Mayne Keith Buckley This report outlines the methodology used by Fitch to analyse the credit quality and financial strength of non-life insurance companies outside of the United States. For analysis of US-based non-life insurance companies, please see our separate criteria paper Property/Casualty Insurance Rating Criteria (U.S.). The methodology directly supports Fitch s assignment of Insurer Financial Strength (IFS), long and short-term issuer, and fixed income security ratings. The intent of this report is to provide insight into the rating methodology for all key parties involved in the credit rating process, including the rated entities, users of the IFS and debt ratings such as institutional investors and insurance agents/brokers, and ratings advisory personnel at investment banker firms. Included in the report are the following: A description of Fitch s general ratings methodology for non-life insurers A highlighted discussion of key differences between Fitch s IFS and debt ratings Ratings scales both IFS and fixed income security Appendix I: Key financial ratios and their definitions Appendix II: Sample agenda used by Fitch for management review meetings Appendix III: List of information commonly requested of management to support the ratings process Fitch recommends that this report be read in conjunction with two additional criteria reports. The Relationship Between Insurer Financial Strength and Debt Ratings discusses how Fitch develops the notching between an organisation s IFS and debt ratings. Fitch s Approach To Group Insurance Ratings reviews how Fitch rates insurance organisations with several insurance company subsidiaries. The ratings guidelines outlined in this and the above noted reports are purposely broad in scope recognising that Fitch s analytical process is dynamic, and that each company possesses unique characteristics that cannot be captured by a narrow or overly rigid approach. May 2001

2 0HWKRGRORJ\ Fitch s analyses incorporate an evaluation of the rated company s current financial position as well as an assessment of how the financial position may change in the future. Consequently, our ratings methodology includes an assessment of both quantitative and qualitative factors based on in-depth discussions with senior management. Fitch believes that, in isolation, pure ratio analysis has only a moderate degree of predictive value. Fitch s insurance ratings generally include an approximate 60% quantitative and 40% qualitative element, though such weightings can vary drastically given unique circumstances. The evaluation of financial strength and credit quality centres on the ability of the company to meet all of its obligations. The company s ability to meet its obligations is evaluated by Fitch under a variety of stress scenarios, not just the most likely scenario. In all cases, both the perceived margin of safety, and the stability/volatility of that margin of safety, play important roles in the evaluation of credit quality in the insurance industry. Incorporated into Fitch s analysis is a review of the company specifically, as well as the macro trends affecting the industry in general. Rating determinations are based on factors which may vary by company or market. Fitch s rating methodology focuses on the following five areas of analysis: Industry Review Operational Review Organisational Review Management Review Financial Review Industry Review The starting point for Fitch s ratings is a thorough understanding of the industry segment(s) in which the insurer operates. One of Fitch s goals is to judge the extent industry dynamics can impact the ratings levels that individual insurers operating in a given industry segment can achieve. Fitch also uses its industry analysis to allow it to make better judgements on the unique attributes of individual insurers by being able to understand them on a relative as well as absolute basis. Fitch s specific evaluation of the non-life insurance industry focuses on: Level of competition in specific sectors, and how variable competition has been over time The basis for competitive advantage in the sector Barriers to entry and threats of new products Relative bargaining power of insurers relative to that of buyers and intermediaries The potential tail of losses and ability to make accurate pricing decisions, as well as exposure to large unexpected losses Regulatory, legal and accounting environment and framework Fitch believes that non-life is among the riskier insurance industry segments compared to life, health, or financial guarantee insurance. This reflects the volatility of year-to-year results, intense competition in most sectors, challenges in predicting losses for products with long reporting and claims settlement tails, and exposures to large losses such as property catastrophes. In a number of countries classes such as household, motor and employers liability insurance are regulated from an availability and rate perspective, making it hard to exit or adjust prices if problems develop. Positively, non-life insurers face limited competition from outside the industry. Further, the demand for a number of products is supported by third party requirements that individuals and companies carry certain types of insurance. For example, employers in many territories are required by law to provide employers liability insurance to protect injured workers. The greatest external threat has been movements since the late 1980s for large and mid-sized commercial policyholders to self-insure. Competition in most sectors has been intense and at times irrational. Ambitious growth plans have often led to buying of market share. Over the last two decades, de-regulation and removal of tariff regimes have led to fierce competition in a number of international markets. Nonetheless, chronic under-pricing of household insurance, and short-term periods of volatility in motor, add to industry risks. Due to lower barriers to entry, the reinsurance sector experiences ebbs and flows of naive capital that have led to a particularly high level of cyclical earnings volatility. This volatility was exacerbated by the crisis of capacity during the early 1990s as Lloyd s of London was struggling to survive. In general, Fitch believes that insurers selling long-tail products, such as liability classes, are exposed to greater industry risk than those in shorter tail sectors. The longer period over which actuaries need to predict losses increases the risk of prolonged pricing errors. In such a case, once inadequacies are detected, the cumulative effect on the balance sheet can be significant. However, the relative risk of short and longtail classes is not absolute, as short-tail property classes such as household insurance are exposed to potentially Non-life Insurance Rating Criteria, May

3 large losses from natural catastrophes, such as windstorm, flooding or earthquake. Non-life insurers can achieve ratings at any level, including AAA for a select number of the highest quality carriers. However, most of the top tier players will achieve IFS ratings no higher than the broader AA range reflecting generally high industry risks. Holding company debt ratings of the top tier players will typically be no higher than AA-, with most falling in the broader A range. Median IFS ratings for the middle-tier players will fall in the broader A range, with debt ratings in the BBB range. IFS ratings of lower tier players will generally be no higher than the broader BBB range, with most falling below the secure category at BB and below. For specific detail on the US industry please refer to the Fitch special report Review & Outlook: Property/Casualty Insurance. Operational Review Fitch s operational review focuses on a given company s unique competitive strengths and weaknesses, operating strategies, and business mix. Fitch s analysis focuses on both the historical and current business position, and how it is expected to change over time. Fitch believes that its operational analysis is among the most critical parts of its ratings review. Companies that have strong balance sheets and acceptable risk exposures can provide near-term financial strength. However, for high levels of credit quality and financial strength to be maintained over the long-term, the company must exhibit favourable operating characteristics. In fact, at the highest end of the rating scale (AAA to AA-), at which solvency risks are generally very low, differences in the operating profile of individual companies are typically the most influential ratings factor. Included in Fitch s operational review is an evaluation of: Underwriting expertise and market knowledge Distribution capabilities and mix Classes of business and changes in mix Market share and growth Brand name recognition and franchise value Expense efficiencies and operational scale Product and geographical mix Unique product offerings available through specialised underwriting capabilities Administrative and technological capabilities The operational review includes a significant degree of qualitative judgement. There is a delicate balance that needs to be maintained between attaining growth and market share, and maintaining underwriting discipline. Since non-life insurers do not know their largest cost loss and loss adjustment expenses at the time policies are sold, insurers need to exercise extra care when growing in a competitive environment. Thus, Fitch places underwriting expertise and market knowledge as the most important operational attributes of a highly rated non-life insurer. Organisational Review Due to the high level of solvency regulation within the insurance industry, legal organisational structure can have a significant impact on capital management, cash flows and the overall credit quality of the parent and individually rated insurance company subsidiaries. The typical organisational structure consists of a holding company whose principal assets represent ownership in subsidiary operating companies, including insurance companies and other related entities. Fitch first evaluates any rated entity on a free-standing basis. However, Fitch then makes adjustments based on affiliate relationships. These adjustments, which can be significant, are affected by the following: Parent financial strength and financial flexibility Upstream dividend requirements, and availability of parent capital contributions Potential need to divert capital to support underperforming affiliates Business synergies with parent or affiliates Strengths and weaknesses of subsidiary companies Formal guarantees or support agreements; track record of affiliate support The above issues are discussed in much greater detail in the criteria reports The Relationship Between Insurer Financial Strength and Debt Ratings and Fitch s Approach to Group Insurer Ratings. Management Review One of the most difficult, yet critical aspects of Fitch s rating process is the level of confidence we develop in the management team and its stated strategies. Fitch has found that the ability of management to establish a performance-based culture, and have in place an appropriate risk/reward system, is a key determinant to overall success. 3 Non-life Insurance Rating Criteria, May 2001

4 Our specific evaluation of management focuses on the following: Strategic vision Appetite for risk Credibility and track record for meeting expectations Controls and risk management capabilities Depth, breadth, and succession plans Accomplishments of key executives Financial Review Fitch s financial review includes the calculation of numerous financial ratios and other quantitative measurements. These are evaluated based on industry norms, specific rating benchmarks, prior time periods and expectations developed by Fitch specific to the rated entity. Though the financial review is largely a quantitative exercise, the interpretation of the results and weighing them into the final rating includes significant elements of subjectivity and qualitative judgement. Since capital & surplus plays an important role in Fitch s financial ratio analysis, and accounting practices can vary significantly by country, Fitch makes adjustments to a company s reported capital & surplus in order to more accurately reflect true levels of capitalisation and to provide better comparability in its financial analysis across international boundaries. Adjustments made to a company s reported capital & surplus include the addition of non-specific liability items such as contingency, catastrophe and equalisation reserves. In addition, Fitch adjusts capital & surplus, both upwards and downwards, to reflect the difference between the net market value and book value of investments where a company reports investments at book value. The adjustment of capital & surplus for unrealised gains/losses which are not reflected in a company s balance sheet is a very important feature of Fitch s financial analysis as these values can be material and have a significant impact on many of the key quantitative financial tests measuring leverage and liquidity. Fitch examines both audited regulatory filings and Generally Accepted Accounting Principles (GAAP)- based financial statements where these are published. In addition, financial statements prepared using other internationally accepted accounting principles are considered, as are unaudited financial statements, management reports, actuarial evaluations and company projections are assessed when available. Fitch always tries to understand major differences in reported results under different forms of accounting. The financial review is broken into seven main segments: Underwriting quality Profitability Investments and liquidity Reinsurance utilisation Loss reserve adequacy Capital adequacy Financial flexibility Underwriting Quality: The evaluation of underwriting quality, especially for insurers in higher risk classes of business, is the first part of the financial review and in many ways the most important. In conducting its review, Fitch recognises that the need for sophisticated underwriting processes can vary dramatically by class of business. Fitch s goal is to judge the overall health of the book of business, and management s understanding of its risks and ability to control them. Key areas considered include: Underwriting expertise in each class of business Targeted pricing margins including impact of investment income on pricing decisions Actuarial pricing credibility Appropriate style of underwriting based on nature of risks (i.e. individually underwritten, template underwritten, etc.) Pricing flexibility given competitive and regulatory environment Exposure to large losses such as property catastrophes Balance of premium growth and underwriting discipline Controls over any third party underwriters, such as managing general agents Claims management and expertise Expense efficiencies, and impact of ceding commissions on expense ratios Fitch measures underwriting performance using two common ratios the loss ratio and the expense ratio. To properly interpret these ratios, Fitch considers the company s business mix, pricing strategy, accounting practices, distribution approach and reserving approach. Fitch examines these ratios for the company as a whole, and by product and market segment. Fitch also looks at Non-life Insurance Rating Criteria, May

5 underwriting results both before and after the impact of ceded reinsurance, as well as on a calendar and accident year basis. The combination of the loss and expense ratios is referred to as the combined ratio. A combined ratio below 100% translates into an underwriting profit, and above 100% represents an underwriting loss. However, due to the limited ability to earn investment income between policy issuance and claim payments, for some short-tail classes a result well below 100% is needed to attain adequate returns. Conversely, for long-tail classes that generate significant investment income, a result well above 100% can still deliver an adequate return. Fitch believes long-tail writers should take care when factoring investment income in pricing to adequately consider uncertainties in predicting loss costs. Fitch also evaluates underwriting quality in the context of growth in premiums and revenues. Fitch tries to understand how premium growth is influenced by changes in pricing versus growth in exposures. Fitch generally prefers to see reasonably steady, even growth trends, and is concerned by both excessive growth and negative growth. Growth is evaluated in the context of market conditions and strategic initiatives of the insurer. Profitability: The focus of Fitch s analysis of profitability is to understand the sources of profits, the level of profits on both and absolute and relative basis and potential variability in profitability. Profits for nonlife insurers are sourced from two primary functional areas -- underwriting and investment income. As indicated above, profits from underwriting are generated when operating revenues (generally premiums) exceed the sum of losses and administrative expenses. The underwriting margin, and its volatility, generally correlates with the level of risk that is being assumed. Profits derived from investments can take the form of interest, dividends and capital gains and can vary as to their taxable nature. The level of investment earnings is dictated by the investment allocation strategy and the quality of management. Like underwriting income, investment returns and their volatility are also correlated with the level of risk assumed. Fitch measures overall profitability (underwriting and investing) by calculating the company s operating ratio, which is the combined ratio less the investment income ratio (investment income divided by premiums earned). Operating margin is evaluated on a consolidated basis and by major product and market. To further understand the quality of earnings, Fitch evaluates the diversification of earnings, including the balance by market, product, and regulatory jurisdiction. In general, earnings that are well diversified tend to be less volatile. Fitch also calculates the following standard profitability ratios: return on assets (ROA), return on revenue (ROR), and return on equity and surplus (ROE and ROS). Fitch is very careful in interpreting the ROE and ROS ratios, since they are influenced by not only overall profitability levels, but also the degree of operating and financial leverage. As discussed below, a high level of leverage is a negative ratings attribute. Therefore, strong ROE and ROS ratios driven mainly by high leverage are not indicative of a strong overall profitability from a ratings perspective. Investments/Liquidity: Fitch s analysis of the investment portfolio focuses on credit risk, market risk, liquidity and historical performance. The investment portfolio is evaluated in the context of the liabilities based on the matching principle, with recognition, however, that most non-life insurers do not match to the extent of their life counterparts. As part of Fitch s analysis, the company s investment guidelines and management controls are also evaluated to understand how the investment portfolio may change over time. Fitch examines credit risk by looking at the company s exposure to higher risk investments relative to the total investment portfolio and capital base. Overall diversification of the investment portfolio by major asset class and industry sector is also evaluated to identify any concentration issues. Market risk is evaluated to identify potential changes in asset valuation due to a change in market conditions, including the equity markets, real estate markets and the interest rate environment. Equity securities are also evaluated as to diversity and risk profile, and the impact on the volatility of capital levels is considered. Historical investment performance is evaluated to determine how well the company s investment strategies are executed. Fitch examines the company s investment yield, total return, duration and maturity structure, and historical default experience. Volatility of investment valuations is considered in the context of both book value and underlying market (liquidation) values. In short-tail insurance sectors, liquidity is particularly important. Fitch judges liquidity based on the marketability of the investments. The manner in which the company values its assets on the balance sheet is also closely examined. For classes exposed to 5 Non-life Insurance Rating Criteria, May 2001

6 catastrophic loss, Fitch reviews how an insurer would plan to raise sufficient liquidity to fund claim costs. Fitch evaluates trends in operating and underwriting cash flows to judge liquidity at the operating company level. Fitch also considers cash flows in the context of future levels of investment income generated by a shrinking or growing portfolio. Reinsurance Utilisation: In assessing an insurer s use of reinsurance (or reinsurer s use of retrocessions), Fitch s goal is to determine if capital is adequately protected from large loss exposures, and to judge if the ceding company s overall operating risks have been reduced or heightened. Further, Fitch also looks for cases in which financial reinsurance is being used to hide or delay the reporting of emerging problems that may ultimately negatively impact performance or solvency. In the traditional sense, reinsurance is used as a defensive tool to lay off risks that the ceding company does not want to expose to its earnings or capital. When reinsurance is used defensively, Fitch s goal is to gain comfort that: Sufficient amounts and types of reinsurance are being purchased to limit net loss exposures given the unique characteristics of the book Reinsurance is available when needed The cost of purchasing reinsurance does not excessively drive down the ceding company s profitability to inadequate levels, and weaken its competitive pricing posture The financial strength of reinsurers is strong, limiting the risk of uncollectible balances due to insolvency of the reinsurer. Exposure to possible collection disputes with troubled or healthy reinsurers is not excessive Reinsurance can also be used aggressively and potentially add to risk. In such cases, Fitch examines why the reinsurance approach is being used, and stresses what would happen if the programme was unwound or developed adversely. Examples of aggressive use of reinsurance include excessive cessions under quotashare treaties simply to earn ceding commissions, and use of finite or other financial reinsurance that smooth results rather than transfer risk as the core part of the reinsurance programme. Loss Reserve Adequacy: The most challenging area in analysing a non-life insurer, and the area most susceptible to analytical error, is the evaluation of loss reserve adequacy. That said, losses resulting from strengthening of reserves for previously undetected deficiencies (i.e. adverse reserve development) have been the most common direct cause of insolvency. Thus, loss reserve adequacy is a critical part of the financial review, and a demonstrated ability to maintain an adequate reserve position is a crucial characteristic for a highly rated insurer. The greatest challenge in assessing loss reserve adequacy is that the data available to conduct the review, be it the information available from statutory returns, or loss development triangles available from management as used for internal analysis, are extremely difficult to interpret. Trends observed from this data can be influenced by a multitude of causes, including changes in business mix, underwriting practices, claims management, reinsurance arrangements, policy terms and other factors, making the ability to draw solid conclusions very difficult. Fitch makes extensive use of actuarial studies prepared by the insurer s independent actuaries. While the analysis of reserve adequacy includes a robust quantitative element, much of Fitch s reserve review is qualitative in nature. Accordingly, our review focuses on the following: Statistical analysis of statutory filing data or other quantitative data Historical track record in establishing adequate reserves Management s reserving targets relative to the point estimate on the actuarial range (high, low, middle) Key reserving assumptions Management s propensity to reflect expected future improvements (such as claim handling enhancements designed to lower claim costs) in current reserves before proven Speed at which negative trends in frequency or severity are reflected in reserves General market and competitive pricing environment, and propensity of management to carry weaker reserves during down cycles Use of discounting, financial reinsurance or accounting techniques that reduce carried reserves Comparison of company loss development trends relative to industry and peers There is significant overlap in Fitch s qualitative analysis of underwriting quality and reserve adequacy, as Fitch believes the two generally go hand in hand. Most insurers with lax underwriting standards will also have ineffective reserving standards, and vice versa. Also, experience on prior years business influences pricing targets on current business. Inadequate reserving can thus result in poor pricing decisions on current and future business. Non-life Insurance Rating Criteria, May

7 Fitch s evaluation of capital adequacy and profitability are also closely linked with its assessment of reserve adequacy. Reserve deficiencies lead to an overstatement of both historical profits (often over a multi-year period) and capitalisation. Capital Adequacy: Fitch s analysis of capital adequacy first focuses on the level and quality of the insurer s statutory capital position at the operating company level. Capital adequacy is evaluated on a legal entity basis and on a consolidated statutory basis in the case of a group. The review incorporates both risk-based and traditional measures. Fitch evaluates the level of capital in relation to a company s risk exposures, including investments, underwriting, business and reinsurance. Future capital needs based on business growth and other factors are also considered in Fitch s analysis. Fitch calculates operating leverage ratios on a gross, net and ceded basis. In evaluating the quality of the capital position, Fitch considers reserve adequacy, asset valuation, goodwill, accounting practices, financial and other reinsurance arrangements, and other off-balance sheet exposures (such as guarantee fund assessments). Capital adequacy is also considered at the parent holding company. In most cases when debt is issued at the holding company level, the proceeds are then in turn contributed to the insurance company, where it is treated as statutory capital for solvency purposes. This is known as double leverage. While the use of double leverage does improve capital adequacy at the subsidiary level, it also increases financial risk at the holding company and represents a potential future call on capital at the operating company level. Fitch evaluates the amount of debt outstanding relative to capital and cash flow, its purpose, and potential risks associated with debt service and repayment regardless of where the debt is issued. Financial Flexibility: Financial flexibility, or the company s ability to access internal and external capital sources, is an important ratings factor. In good times, the ability to access capital to support growth is critical to maximising the franchise value while maintaining capital adequacy. In bad times, maintaining the confidence of the capital markets and lenders can prove critical in allowing a company to avoid problems such as an inability to refinance maturing debt. Financial flexibility is derived first from the overall quality and reputation of the company as reflected in all of the ratings factors discussed throughout this report. However, financial flexibility is also strongly linked to the company s financial leverage, debt service coverage and liquidity. Fitch uses traditional balance sheet measures of financial leverage including the ratios of debt to equity, debt plus trust preferred to equity, debt to total capitalisation, debt plus trust preferred to total capitalisation, and double leverage. If necessary, these balance sheet measures are adjusted to take into account quality of capital issues. The debt maturity structure is also evaluated to determine the amount and timing of debt repayment (i.e., refinancing risk). In general, Fitch believes that an appropriate mix of short-term and long-term debt is that which is consistent with its intended use (matching principle). With regard to short-term debt, such as commercial paper programmes, Fitch expects companies to maintain backup bank facilities and/or cash balances at 100% of commercial paper outstanding to cover short-term disruptions in the commercial paper markets. However, for the highest rated issuers (F1+), Fitch will allow lower levels of backup (as low as 75%), recognising the low likelihood of F1+ issuers being unable to refinance a majority of their maturities, even under the most adverse market conditions. Debt service capability and overall liquidity is largely dependent upon the ability of the operating subsidiaries to upstream dividends and other payments. There are three primary methods for operating subsidiaries to provide funds to their holding companies -- stockholder dividends, management and other administrative fees, and tax-sharing payments. Off balance sheet sources of liquidity, including committed and uncommitted lines of credit, asset securitisation and other funding arrangements, are also considered. With regard to lines of credit and other bank facilities, Fitch reviews each company s bank agreements, with a special emphasis on the facility s tenor, financial covenants, and any material adverse change language. After determining the levels of funds both actually provided to and available to the holding company, Fitch will determine the debt service coverage profile of the organisation. Fitch calculates various interest and fixed charge coverage ratios based on operating earnings, cash flow and statutory dividends, as well as various other methods. 7 Non-life Insurance Rating Criteria, May 2001

8 Types of Insurance Industry Ratings There are two basic types of ratings that Fitch will provide for non-life organisations. Insurer Financial Strength Ratings provide an assessment of the financial strength of an insurance company and its capacity to meet senior obligations to policyholders and contractholders on a timely basis. The financial strength rating is assigned to the company itself, and no liabilities or obligations of the insurer are specifically rated unless otherwise stated. They are pegged at the level of senior policyholder and contractholder obligations. The financial strength rating does not address the willingness of management to honour company obligations, nor does the rating address the quality of a company s claims handling services. In the context of the financial strength rating, the timeliness of payments is considered relative to both contract and/or policy terms and also recognises the possibility of acceptable delays caused by circumstances unique to the insurance industry, including claims reviews, fraud investigations and coverage disputes. Issuer and Debt Ratings are assigned to the issuer and to specific classes of debt and preferred stock securities. Long and short-term issuer ratings are assigned to the company itself, and provide an assessment of overall credit quality at the unsecured senior level. Issue ratings are assigned to specific issuances of debt and preferred stock. They reflect not only the overall credit quality of the issuer, but unique terms and conditions associated with the security, including its seniority ranking in the event of a default. Investors use fixed income security and issuer ratings as one of the most critical factors in the investment decision-making process. They are also used by other creditors to assess counterparty risk. The relationship between issuer/fixed income security ratings and IFS ratings is influenced by several factors. The most important is subordination. Because an insurer s obligation to pay its claim and benefit obligations ranks senior to all other obligations, the insurer financial strength ratings will typically be the highest ratings assigned within the organisation. This means that the financial strength rating is generally the starting point for all other ratings. In most companies that employ financial leverage, the parent company is a holding company that issues debt while the subsidiary operating companies remain debt free. Under this type of structure, the ratings assigned to the parent company debt are generally lower than financial strength ratings, reflecting the subordinate status of debt obligations and regulatory restrictions regarding dividend payments and asset transfers. The notching between debt and IFS ratings is primarily a function of where the ratings sit on the credit rating scale, the level of financial leverage, coverage of debt service provided by subsidiary operations and upstream dividends. In a typical holding company structure, the notching is generally one full rating category (e.g., holding company debt rated BBB+, financial strength rated A+ ). However notching narrows at the higher end of the rating scale, when financial leverage is conservative and fixed charge coverage is strong, and widens in the opposite cases. In a small number of countries, bondholders rank pari passu with policyholders and the notching between IFS and debts ratings is correspondingly reduced. For more information see Fitch s Special Report The Relationship Between Insurer Financial Strength and Debt Ratings. Non-life Insurance Rating Criteria, May

9 Rating Scales & Definitions Fitch uses the same ratings symbols for both IFS Ratings and credit ratings assigned to debt instruments in the broader corporate finance, structured finance and public finance areas. However, the definitions associated with IFS Rating reflect the unique aspects of the insurance industry. Insurer Financial Strength Ratings Ratings of BBB- and higher are considered to be Secure, and those of BB+ and lower are considered to be Vulnerable. Ratings in the AA through CCC categories may be amended with a (+) or (-) sign to show relative standing within the major rating category. AAA Exceptionally Strong. Companies assigned this highest rating are viewed as possessing exceptionally strong capacity to meet policyholder and contract obligations. For such companies, risk factors are minimal and the impact of any adverse business and economic factors is expected to be extremely small. AA Very Strong. Companies are viewed as possessing very strong capacity to meet policyholder and contract obligations. Risk factors are modest, and the impact of any adverse business and economic factors is expected to be very small. A Strong. Companies are viewed as possessing strong capacity to meet policyholder and contract obligations. Risk factors are moderate, and the impact of any adverse business and economic factors is expected to be small. BBB Good. Companies are viewed as possessing good capacity to meet policyholder and contract obligations. Risk factors are somewhat high, and the impact of any adverse business and economic factors is expected to be material, yet manageable. BB Moderately Weak. Companies are viewed as moderately weak with an uncertain capacity to meet policyholder and contract obligations. Though positive factors are present, overall risk factors are high, and the impact of any adverse business and economic factors is expected to be significant. B Weak. Companies are viewed as weak with a poor capacity to meet policyholder and contract obligations. Risk factors are very high, and the impact of any adverse business and economic factors is expected to be very significant. CCC, CC, C Very Weak. Companies rated in any of these three categories are viewed as very weak with a very poor capacity to meet policyholder and contract obligations. Risk factors are extremely high, and the impact of any adverse business and economic factors is expected to be insurmountable. A CC rating indicates that some form of insolvency or liquidity impairment appears probable. A C rating signals that insolvency or a liquidity impairment appears imminent. DDD, DD, D Distressed. These ratings are assigned to companies that have either failed to make payments on their obligations in a timely manner, are deemed to be insolvent, or have been subjected to some form of regulatory intervention. Within the DDD-D range, those companies rated DDD have the highest prospects for resumption of business operations or, if liquidated or wound down, of having a vast majority of their obligations to policyholders and contractholders ultimately paid off, though on a delayed basis (with recoveries expected in the range of %). Those rated DD show a much lower likelihood of ultimately paying off material amounts of their obligations in a liquidation (in a range of 50-90%). Those rated D are ultimately expected to have very limited liquid assets available to fund obligations, and therefore any ultimate payoffs would be quite modest (at under 50%). Long-Term Credit Ratings Ratings of BBB- and higher are considered to be Investment Grade, and those of BB+ and lower are considered to be Speculative Grade. AAA Highest credit quality. AAA ratings denote the lowest expectation of credit risk. They are assigned only in cases of exceptionally strong capacity for timely payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events. AA Very high credit quality. AA ratings denote a very low expectation of credit risk. They indicate very strong capacity for timely payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events. A High credit quality. A ratings denote a low expectation of credit risk. The capacity for timely payment of financial commitments is considered strong. 9 Non-life Insurance Rating Criteria, May 2001

10 This capacity may, nevertheless, be more vulnerable to changes in circumstances or in economic conditions than is the case for higher ratings. BBB Good credit quality. BBB ratings indicate that there is currently a low expectation of credit risk. The capacity for timely payment of financial commitments is considered adequate, but adverse changes in circumstances and in economic conditions are more likely to impair this capacity. This is the lowest investment-grade category. BB Speculative. BB ratings indicate that there is a possibility of credit risk developing, particularly as the result of adverse economic change over time; however, business or financial alternatives may be available to allow financial commitments to be met. Securities rated in this category are not investment grade. B Highly speculative. B ratings indicate that significant credit risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is contingent upon a sustained, favourable business and economic environment. CCC, CC, C High default risk. Default is a real possibility. Capacity for meeting financial commitments is solely reliant upon sustained, favourable business or economic developments. A CC rating indicates that default of some kind appears probable. C ratings signal imminent default. DDD, DD, D Default. The ratings of obligations in this category are based on their prospects for achieving partial or full recovery in a reorganisation or liquidation of the obligor. While expected recovery values are highly speculative and cannot be estimated with any precision, the following serve as general guidelines. DDD obligations have the highest potential for recovery, around 90% - 100% of outstanding amounts and accrued interest. "DD indicates potential recoveries in the range of 50% - 90% and D the lowest recovery potential, i.e., below 50%. Entities rated in this category have defaulted on some or all of their obligations. Entities rated DDD have the highest prospect for resumption of performance or continued operation with or without a formal reorganisation process. Entities rated DD and D are generally undergoing a formal reorganisation or liquidation process; those rated DD are likely to satisfy a higher portion of their outstanding obligations, while entities rated D have a poor prospect of repaying all obligations. Ratings scales and definitions for Fitch s short-term ratings can be found at Non-life Insurance Rating Criteria, May

11 Appendix I: Financial Ratios & Definitions The following is a discussion of some of the key financial ratios used by Fitch in its financial review. Financial ratios are evaluated relative to industry norms, specific rating benchmarks, and expectations developed by Fitch specific to the rated entity. Fitch typically looks at a time series made up of at least five years of historical data, together with projections of one to three years. Underwriting Quality and Profitability Loss Ratio measures the magnitude of incurred loss and loss adjustment expense for the current calendar year relative to premiums earned. Loss and loss adjustment expenses represent the largest expense item for most non-life insurers. Variances among insurers can be due to differences in: the level of rate adequacy, the tail of the book, pricing strategy with respect to expense/loss ratio mix, adverse loss items (i.e. catastrophes), and development of prior years business and changes in relative loss reserve strength. Underwriting Expense Ratio measures the level of underwriting expenses, such as commissions, salaries and overhead, relative to premiums written. Since under statutory accounting principles expenses are recognised when incurred, a comparison of expenses to written premiums as opposed to earned premiums provides a better matching of costs to volume. Variances among insurers can be due to differences in: distribution system costs (agency, direct, underwriting manager), the nature of the book and varying needs to underwrite each risk, pricing strategy with respect to expense/loss ratio mix, level of fixed versus variable costs, cost efficiencies and productivity, profit sharing and contingent commission arrangements, and ceding commission levels. Combined Ratio measures overall underwriting profitability, after the impact of losses, loss adjustment expenses, underwriting expenses, and policyholder dividends. A combined ratio less than 100% usually indicates an underwriting profit. Typically, lower combined ratios are required for companies writing short-tail classes generating modest investment income levels, or in which the book is exposed to periodic catastrophic or other large losses that need to be priced into income over longer periods of time. Operating Ratio measures operating profitability, which is the sum of underwriting and pre-tax investment income, excluding realised and unrealised capital gains or losses. The ratio is the combined ratio less the ratio of investment income to earned premiums. Due to the combining of underwriting and investment earnings, the ratio is fairly comparable across both long and short-tail classes of business. However, several factors can make comparisons among companies difficult, including: differences in operating leverage and the amount of investment earnings derived from invested assets supporting capital & surplus; differences in investment strategies, especially with respect to the taxable/taxexempt mix and allocations to lower income/higher capital gain producing investments such as common stocks; and strong growth in long-tail classes for which reserves and invested asset balances have not yet accumulated to levels reflective of a mature book. Return on Capital & Surplus measures a company s after-tax net income relative to mean capital & surplus, or equity, levels, and indicates both overall profitability and the ability of a company s operations to grow capital & surplus organically. Variances among companies are explained by both differences in operating profitability and differences in net operating and/or financial leverage. For a profitable company, a less favourable (i.e. higher) leverage position will result in a more favourable result on this test. Return on Assets measures a company s pre-tax, prepolicyholder dividend operating profitability relative to mean assets. It is accordingly less sensitive to differences in operating leverage than the Return On Capital & Surplus/Equity ratio above. Acceptable levels for this ratio will generally be lower for long-tail writers and higher for short-tail writers reflecting natural differences in the build up of loss reserves. Premium Growth Rate is a useful measure when compared to peers and judged relative to cyclical industry trends. Companies exhibiting above-average growth rates may be the result of underpricing their products. Premium growth is also a useful measure of franchise value, as negative growth can be a sign of an eroding franchise. The ratio is influenced by both changes in rate adequacy and changes in volume, so care is taken in interpreting this ratio. Investment and Liquidity Non-investment Grade Bonds as a % of Capital & Surplus measures the capital & surplus exposure to bonds below investment grade (rated lower than BBB-) which carry above average credit risks. Unaffiliated Common Stocks as a % of Capital & Surplus measures the capital & surplus exposure to common stock investments. Since common stocks are both subject to price volatility and are carried at market values, a high level of common stocks potentially adds an element of volatility to reported capital & surplus levels. 11 Non-life Insurance Rating Criteria, May 2001

12 Investments in Affiliates as a % of Capital & Surplus measures the capital & surplus exposure to affiliated investments. High levels of affiliated investments can reduce liquidity, expose capital & surplus to fluctuations (if common stock), and potentially signal a "stacking" of capital within the organisation. Cash Flow Ratio measures operating cash flow as a percentage of cash premiums collected in the year and indicates the relative strength of a company's cash flows expressed as a margin of premium inflows. The ratio should be evaluated both in absolute terms and from the perspective of a trend. Positive, higher values are preferred. Liquid Assets To Liabilities measures the portion of a company's net liabilities covered by cash and unaffiliated bond, stock and short-term invested asset balances. Higher values indicate better levels of liquidity. Investment Yield is calculated as net investment income (excluding realised and unrealised capital gains or losses) as a percentage of the mean beginning and ending cash and investments and accrued investment income (net invested assets). It is a measurement of investment performance. Acceptable values vary over time depending on market conditions. Deviations among companies can be explained by differences in: the taxable/tax exempt mix, the credit quality and resultant yield characteristics of the bond portfolio, concentrations in higher return/lower yielding common stocks, the level of investment expenses, and the quality of portfolio management. Ceded Reinsurance Exposures Retention Ratio measures the percentage of gross premiums written retained after premiums are ceded to purchase reinsurance protections. The amount of reinsurance necessary to protect capital & surplus from large losses varies significantly by class of business and the nature of loss exposures, as well as the absolute size of an insurer's capital base relative to its single risk and aggregate policy limits. Industry retentions generally average close to 70% but will vary according to the company s class of business and the availability of appropriately priced reinsurance or retrocessional capacity. Unusually high or low retention levels could signal that inadequate reinsurance protections are in place, or that reinsurance is used for financial or other reasons beside risk spreading. Reinsurance Recoverables to Capital & Surplus measures a company's exposure to credit losses on ceded reinsurance recoverables. The ratio includes recoverables from all reinsurers. Generally, recoverables from affiliates are considered to carry low levels of risk. The ratio should also be interpreted in light of the credit quality of reinsurers, the stability of the relationship between insurer and reinsurer, historical collection patterns, and any security held in the form of letters of credit, trust accounts, or funds withheld. Acceptable levels for this ratio will generally be higher for long-tail writers and lower for short-tail writers reflecting natural differences in the build up of ceded loss reserves. Loss Reserve Adequacy Reserve Development to Prior Year Loss Reserves measures a company's one-year loss reserve development as a percentage of prior years' loss reserves on an underwriting year basis, and indicates the historical accuracy with which loss reserve levels were set. Negative numbers indicate redundancies and positive numbers indicate deficiencies. This analysis is supplemented with a more detailed evaluation of paid and incurred loss trends in order to judge current reserve adequacy. Reserve Development to Capital & Surplus measures a company's one-year loss reserve development as a percent of prior years' capital & surplus, and indicates the extent capital & surplus was either under or overstated due to reserving errors. Reserve Development to Earned Premium measures a company's one-year loss reserve development as a percent of net premiums, and indicates the extent the current calendar year loss ratio was influenced by development on prior years business. Loss Reserves as a Percent of Net Earned Premiums measures the level of reserves held relative to premium volume. The ratio can be calculated relative to current year s premiums and average premiums over the past several years. The ratio is best viewed on a trend basis. Declines in the ratio can indicate a decline in reserve adequacy. However, the ratio is also highly sensitive to changes in business mix and pricing adequacy. Capital Adequacy Net Premiums Written To Capital & Surplus indicates a company's net operating leverage on current business written, and measures the exposure of capital & surplus to pricing errors. Acceptable levels of net operating leverage vary by class of business, with long-tail classes often requiring lower levels of net underwriting leverage due to their greater exposure to pricing errors. In addition, to the extent premiums are written under retrospectively rated or profit/loss sharing plans that allow the insurer to share the burden of any pricing errors, higher levels of leverage may be acceptable. Non-life Insurance Rating Criteria, May

13 Since net premiums written are influenced by both volume and rate adequacy, interpretations must be made carefully since an adverse decline in rate adequacy could lead to apparent improvements in this ratio. Net Leverage indicates a company s net operating leverage on current business written, as well as liabilities from business written in current and previous years that have not yet run off. The ratio is calculated by dividing the sum of net premiums written and total liabilities by capital & surplus, and it measures the exposure of capital & surplus to both pricing and reserving errors. Acceptable levels for this ratio will generally be higher for long-tail writers and lower for short-tail writers reflecting natural differences in the build up of loss reserves. Gross Leverage indicates a company s overall gross operating leverage, combining both net and unaffiliated ceded premium and liability exposures. The ratio is calculated by dividing the sum of gross premiums written (direct plus assumed) and gross liabilities (total liabilities plus reinsurance recoverables on loss and unearned premium reserves) by capital & surplus. The ratio measures the exposure of capital & surplus to pricing errors, reserving errors, and credit losses on uncollectible reinsurance recoverables. Acceptable levels for this ratio will generally be higher for long-tail writers and lower for short-tail writers reflecting natural differences in the build up of loss reserves. Financial Leverage and Coverage Debt to Total Capital (Debt + Capital & Surplus) measures the use of financial leverage within the total capital structure. Special care is taken in assessing the quality of reported equity, taking into consideration the portion supported by intangible assets such as goodwill. This ratio may be adjusted to account for hybrid securities, which possess both debt and equity characteristics, and liquid assets maintained at the holding company. Fixed Charge Coverage Ratios are calculated on both an operating earnings and cash flow basis to judge economic resources available to pay interest expense (including the interest portion of rent expense) and preferred dividends. Coverage ratios are also calculated to reflect dividend restrictions from regulated entities. Interest Coverage Ratios are calculated on both an earnings and cash flow basis to judge economic resources available to pay interest expense associated with outstanding debt. Coverage ratios are also calculated to reflect dividend restrictions from regulated entities. 13 Non-life Insurance Rating Criteria, May 2001

14 Appendix II: Sample Agenda The following is a sample meeting agenda used by Fitch when conducting its management review. Time frames are shown for an initial meeting, and can typically be shortened for update reviews. Fitch typically asks to meet with the Chief Executive Officer/President, Chief Financial Officer and Chief Operating Officer, as well as functional business unit heads responsible for the key areas of discussion. Corporate Overview 1 Hour Company overview and history Management and organisational structure Key strategic objectives Financial goals Recent developments Acquisition strategies Operational and Underwriting Review 2 Hours This section should be broken up by major operating segment, and should include not only the specific nonlife companies being rated, but also discussions of any major affiliated operations that could influence the rating. Classes of business and mix Product review and pricing targets Underwriting approach and system of controls Competitive strategies and both recent and expected changes in competitive environment Distribution strategy Growth plans Administration and technology review Regulatory environment and issues Claims management Underwriting and operating results (historical & projected) Financial Review 1 Hour Operating performance, both for overall company and by product and market Operating company capitalisation, including both targets and strategy Financial leverage, including long and short-term debt strategies, stock repurchase and dividend programmes, use of hybrid securities and management of debt maturities Cash flow analysis, including upstream dividend strategies Financial budgets and projections Review of off balance sheet assets and/or liabilities Investment and Liquidity Review 1 Hour Investment policy Portfolio strategy Portfolio mix Recent results relative to benchmarks Asset-liability management Liquidity review, including both subsidiaries and holding company Reserve Review 1 Hour Methodology Adequacy analysis (quantitative measurements) Development trends Review of latent exposures, including asbestos and environmental Relationship of actuarial reserving and pricing reviews Discussion of external or internal reserve studies Reinsurance & Large Loss Review 1 Hour Current programme Changes in programme pricing Probable maximum loss analysis Security and collection issues Detailed discussion of any finite programmes Additional Topics 1 Hour Legal and regulatory review Accounting and tax issues Management controls and corporate governance Other topics to be determined on a case by case basis. Non-life Insurance Rating Criteria, May

15 Appendix III: Sample Information Request 1) The following information is typically requested on an annual basis: Annual statutory statements for every major insurance subsidiary, and for the combined group Consolidated GAAP financial statements including balance sheets, income statements, cash flows and notes Financial projections (summary income statements, balance sheets and capital ratios). Independent and internal reserve appraisal reports, including narrative of process used to establish and monitor loss reserves Distribution of assets by quality ranking, industry category, concentrations and other categories perceived to be important. Description of ceded reinsurance programmes, probable maximum loss analysis, and list of major reinsurers on both current programmes and for which there are recoverables List of major distribution sources and major customers 2) The following information is typically requested on a quarterly basis: Statutory statements (where produced) GAAP financial statements (where produced) Quarterly internal management accounts 3) The following information is requested as part of the initial ratings review, with updates requested whenever material changes are made: Annual statutory and GAAP financial statements for past six years History of the company focusing on major milestones. Senior management biographies Investment policy and guidelines Organisational charts covering corporate structure and principal executive reporting lines Descriptive material on each business segment, including product descriptions and strategy Bank agreements Offering memorandum or prospectus, if applicable 15 Non-life Insurance Rating Criteria, May 2001