Evolving Criteria - Reinsurance Thought Leadership | Aon Benfield

Evolving Criteria
Keeping Pace with Rating Agency, ERM
and Regulatory Developments
Autumn 2010
reDEFINING
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Contents
3 | Rating Trends
5 | Criteria Updates
9 | Rating Agency Key Concerns
13 | ERM Expectations
16 | Regulatory Update
22 | Conclusion
Executive Summary
Keeping Pace with Rating Agency, ERM and Regulatory Developments
Due to record levels of capital, the insurance industry
remains plagued by an ongoing soft cycle. First half
2010 insurer capital is commensurate with 2007 peak
capital levels, leading to excess supply of insurance
risk capital. This, coupled with weakened demand
from continuing difficult economic conditions, has
resulted in declining premiums and profitability. The
rating agencies are more or less split in terms of
industry outlooks between negative and stable, with
rating upgrades and downgrades neutral. Given this
environment, the question remains: will the industry
stabilize or continue to worsen over the near term?
Adding to current pressure on results and ratings,
companies are dealing with continuously evolving
rating agency criteria as well as numerous proposed
regulatory changes globally. The likely impact is that
companies will need to hold more capital due to these
changes, further impacting capital adequacy, ratings
and profitability metrics. The uncertainty surrounding
these changes, particularly in regards to Solvency II, is
making it difficult for companies to predict capital
needs in the near term.
Exhibit 1: Change in Insurer Capital
2007
-29% 34%
2008
2009
2%
1H 2010E
Enterprise Risk Management (ERM) continues to be a
hot topic and companies are investing significantly in
developing their overall risk management framework
and internal capital models. Standard & Poor’s (S&P)
recently issued an exposure draft of proposed criteria in
terms of economic capital model (ECM) reviews, which
are onerous. Further, S&P indicated that even if the
internal capital model shows lower capital
requirements, it will have a limited impact on S&P
capital requirements.

Rating Trends
The major rating agencies have somewhat of a mixed
viewpoint on the insurance industry. Exhibit 2 shows
their respective outlooks for the various sectors, noting
that no rating agency currently has a positive outlook
for any line. However, this is a modest improvement
compared to last year as Fitch changed its outlook on
reinsurance from negative to stable and A.M. Best
changed its life and annuity outlook similarly. The
rating agencies view the industry outlooks as their
“guidance” on the likely direction of rating actions
during the next year.
Most rating agencies have a negative outlook on the
commercial lines sector, given concern over continued
price competition forced by a historic level of supply with
lagging demand from the 2008 and 2009 financial crisis,
combined with weaker investment earnings. These
negative rating factors are not expected to change in the
near term until a broad economic recovery gains
momentum. Likewise, concern regarding the tough
competitive conditions throughout the industry and
recent weak operating performance are the leading
reasons for negative outlooks on the health sector. While
health care reform will have an impact on U.S. health
Exhibit 2: Current Industry Outlook (Sept 2010)
Sector A.M. Best Fitch Moody's S&P
Personal Lines Stable Negative Stable Negative
Commercial Lines Stable Negative Negative Negative
Reinsurance Stable Stable Negative Stable
Health Negative Negative Negative Negative
Life Insurance Stable Negative Stable Negative
insurers, many of the changes it will bring are uncertain
at this point, and as such is not the leading factor in the
rating outlooks. Conversely, three rating agencies have a
stable outlook on the reinsurance sector, reflecting their
view that reinsurers have very strong capitalization and
are well-positioned for continued profitability. These
results are driven by relatively more stable pricing trends,
conservative investment portfolios and leading risk
management capabilities.
Exhibit 3 shows the percentage of rating changes that
were upgrades for each year since 2004 for A.M. Best,
Moody’s and S&P. Overall, the trend from 2004 to 2007
is fairly consistent across the rating agencies as the
Aon Benfield
percentage of upgrades increased each year, transitioning
from “downgrade” years in 2004 and 2005 to “upgrade”
years in 2006 and 2007. However, from 2008 through
June 2010 the correlation among rating agency
disappears. A.M. Best rating activity has been stable with
the percentage of upgrades around 50 percent each
period. For Moody’s, rating activity is balanced in 2008
and 2010 year-to-date with 50 percent of rating changes
being upgrades; however, 2009 was a clear downgrade
year as a number of companies had their ratings lowered
as a fallout to the financial crisis. Separately, S&P shows a
declining trend as the percentage of upgrades has
decreased each of the last three years.
Exhibit 3: Percentage of Upgrade Rating Actions
100%
80%
60%
40%
20%
0%
4.0%
2004
2.1%
2005
A.M. Best
2.6%
2006
Moody's
0.5%
2007
-2.3%
2008
-3.5%
2009
2010YTD
S&P Change in DWP
Upgrade and downgrade activity for Fitch was not publicly available.
Charted against this backdrop is the one-year change in
Direct Written Premium (DWP). Starting in 2005 and
ending in 2007, the trend towards upgrades occurred
after the beginning of the current soft market, as
evidenced by the corresponding decline in DWP over
that time horizon. Further, the current stabilization of
downgrades in 2010 is occurring while premiums are
still declining. There appears to be a delay between
cycle changes and corresponding rating changes, and
as the current soft cycle continues, we should expect
more downgrades to occur.
The recent downgrades were primarily driven by
consistent poor underwriting results rather than one
single event loss. On average, the companies which
were downgraded had a one-year and five-year average
combined ratio that was more than 10 points higher
than the companies who had their ratings affirmed.
3

Evolving Criteria
Observations on A.M. Best
“A-” Rating Activity
To further deconstruct rating trends, Aon Benfield
performed a focused review of rating activity for the
U.S.-based “A-“ rated companies for the years 2005 to
2010. The study was focused on A.M. Best and the
U.S. market because of the number of company
ratings and corresponding availability of data for this
segment. In addition, the target focus was on “A-”
ratings, as many companies view an “A-“ rating as a
key benchmark and/or threshold to effectively operate
within their marketplace. This is especially true for the
reinsurance and U.S. commercial markets where many
strive to achieve an “A-” or better rating from multiple
rating agencies.
During this time period, 100 companies were upgraded
from “B++” to “A-”. However, only 56 percent achieved
the upgrade based upon their “own merit”. In other
words, these companies were upgraded on account of
their core operating performance and not due to an
affiliation, capital infusion, merger, or other transaction.
Exhibit 4 provides a summary of the median results of
key financial ratios reported by “own merit” companies
in the year of their upgrade.
Exhibit 4: Median Results Reported by
“Own Merit” Companies
4
Median 1 Year 3 Year 5 Year
Combined Ratio 88% 90% 91%
Operating ROR 20% 16% 16%
BCAR 232%
It is clear that rating activity has been driven by
operating performance as companies that were
downgraded significantly underperformed their peers.
The downgraded peer group reported five-year average
combined ratios that were on average 12 points higher
than companies who had no ratings movement, and 17
points higher than the upgraded peer group.
Downgraded companies were also much more highly
levered than the other peer groups. Capital adequacy
remains important as evidenced by overall lower BCAR
scores for the downgraded peer group.
Exhibit 5: Median Results Reported
Key Metrics –
Median
“A-” to “B++”
Downgrades
(Year of
Downgrade)
All “A-” Rating
Units Through
June 30, 2010
“B++” to “A-”
“Own Merit”
Upgrades (Year
of Upgrade)
Total Companies 45 284 56
Combined Ratio 119% 99% 88%
5 Year
Combined Ratio
108% 96% 91%
Operating ROR -12% 12% 20%
5 Year
Operating ROR
1% 13% 16%
NWP / PHS 1.2x 0.7x 1.0x
BCAR 165% 246% 232%
Looking at longer-term trends, we identified 190
companies whose ratings were downgraded from “A-”
from January 2000 to June 2010. The subsequent rating
history of those companies is segregated as follows:
> 87 companies’ ratings, or 46 percent, have remained
the same or improved but are still below “A-”
> 63 companies’ ratings, or 33 percent, have been
downgraded further and/or withdrawn
> 40 companies’ ratings, or 21 percent, have achieved
an “A-“ or higher rating
It is noteworthy to mention that of the 40 companies
that regained a rating of “A-” or higher, only 20 (or
11 percent of the total) were upgraded based
primarily upon their “own merit” and on average, it
took five years.
Also, the same trends are applicable to “A” and “A+”
companies who were downgraded over the same time
period. These companies that were downgraded also
performed significantly worse than their peers in terms
of higher combined ratios by, on average, 10 points, and
lower rates of return (ROR) by, on average, 10-15 points.
Underwriting profitability is paramount to achieving an
upgrade and avoiding a downgrade, and for companies
currently on a downgrade trend this is even more
important as it takes many years to regain an original
rating, and many companies continue to get
downgraded after the initial rating change.

Criteria Updates
Looking back over the last decade, there have been a
number of rating agency and regulatory criteria
developments that have had a significant impact on
how the industry operates today. These include A.M.
Best introducing a catastrophe stress test, Fitch
incorporating Prism, their updated suite of U.S. and
non-U.S. capital models, and S&P adding ERM as a new
category to their rating evaluation process. At the same
time, Solvency II was introduced by EU regulators and
many other jurisdictions are following its lead. The
rating agencies and regulators are in a unique position
to identify developing trends and best practices across
Exhibit 6: Rating Agency Criteria Development Timeline
S&P – Gauging the
Impact of Unrealized
Losses on Insurers
Financial Strength
June
2009
July
2009
A.M. Best – Natural
Cat Stress Test
Methodology Refined
Aug
2009
A.M. Best – Rating
Surplus Note and Insurance
Trust-Preferred CDOs
A.M. Best –
Updated Understanding
BCAR Score for
Property & Casualty
Insurers
Sept
2009
A.M. Best – The Treatment
of Terrorism Risk in the
Rating Evaluation
Oct
2009
S&P – ERM
Assessing
Management’s
Commitment to
the Execution
of ERM
Processes
Nov
2009
A.M. Best – Rating Members
of Insurance Groups
Dec
2009
Fitch – Insurance
Rating Methodology
Fitch – Equity Credit
for Hybrids & Other
Capital Securities
Aon Benfield
the industry and use that perspective to put forth new
criteria. While many of the criteria developments have
been incorporated within the industry for many years,
rating agencies continually reassess their current
methodology and introduce new criteria. The timeline
below depicts rating agency criteria development from
June 2009 through June 2010 and illustrates that rating
agency criteria continually evolves.
Many of the new methodology updates will influence
how companies operate and prepare for rating agency
discussions. The following pages summarize key criteria
developments over the past year.
S&P – Holding Company
Hybrid Capital Issue
Features: Update on
Dividend Stoppers,
Look-backs and Pushers
S&P – Holding Company
Clarification of the Equity
Content Categories Used for
Bank and Insurance Hybrid
Jan
2010
S&P – ERM
Expanded
Definition
of Adequate
Classification in
ERM Scores
Feb
2010
March
2010
Fitch – Approach to
Rating Insurance Groups
S&P – Assumptions
for 2010 Interest
Rate Scenarios
S&P – ERM
Refined Methodology for
Assessing an Insurer’s
Risk Appetite
S&P – Methodology
for Incorporating
Incremental
Stress Factors
Fitch – Non-Life
Insurance Rating
Methodology
April
2010
A.M. Best –
Equity Credit
for Hybrid
Securities
A.M. Best –
Draft: Rating
New Company
Formations
Fitch – Introduced
“Total Financing
and Commitment
Ratio”
May
2010
Moody’s – Rating
Methodology
for Property &
Casualty Insurers
S&P – ERM
Methodology
for Assessing
Insurers
Economic
Capital Models
(request for
comment)
June
2010
S&P – Refined
Methodology for
Analyzing Insurer
Capital Adequacy
5

Evolving Criteria
A.M. Best
A.M. Best released a number of methodology criteria
papers during the past year and many were updates to
existing criteria. For example, A.M. Best updated the
catastrophe stress test calculation by lessening the
impact on credit and reserve risk. The rating agency
also stated a greater tolerance for a lower stress BCAR
score. These changes eased the capital requirements for
companies with material catastrophe exposure as
compared to the previous approach. A.M. Best made
minor updates to methodology criteria regarding
treatment of terrorism risk and rating insurance groups
among others.
In April 2010, A.M. Best released a draft criteria paper
regarding new company formations. The framework of
this criteria paper was built off the initial criteria
methodology released in March 2004, but with one very
important distinction. In the current draft methodology,
A.M. Best introduces the use of contingent capital to
support upfront capital requirements. Historically,
A.M. Best required a new company to raise initial capital
that would support the first five years of operations (at
the appropriate capital adequacy level) without the need
for additional capital contributions. Coupled with other
new company requirements, such as a 50 percent
growth charge applied to reserve and premium risk, this
created a high capital hurdle to obtain an initial rating of
“A-” or higher. However, the current draft methodology
puts forth consideration for use of contingent capital in
years four and five to support initial capital requirements.
Specifically, companies will be able to reduce initial
on-balance sheet capital requirements if the following
conditions exist (credit for contingent capital):
> Fully executed, binding legal agreement
> Irrevocable for the term of the agreement
> Must be equity capital
> Drawdown of capital must be unrestricted
> Must have on-demand access to capital (within 20
business days)
> A risk-adjusted capital surcharge of 10 percent on
the outstanding balance of the capital commitment
will be assessed in the initial and subsequent BCARs
6
Given the current market environment, which is more
geared toward mergers and acquisitions and less
toward new company formations, the impact of this
proposed criteria change is yet to be seen.
Additionally, A.M. Best has a new draft methodology
that addresses transfer and convertibility risk, which
evaluates the likelihood of a sovereign disrupting the
ability to convert local currency into foreign currency
and/or transfer funds to nonresident creditors. In
assessing transfer and convertibility risk, A.M. Best
reviews a government’s current capital and trade
controls, a country’s integration into the global
economy, the strength of the local rule of law, and a
sovereign’s use of price controls. The criteria may
impact holding company issuer credit ratings and debt
ratings, but is not expected to impact operating
company financial strength ratings since it is designed
to evaluate the ability to meet policyholder claims,
which are normally in local currency.
Fitch
In December 2009, Fitch published a new global
master criteria report detailing their insurance rating
methodology for insurance organizations. This master
criteria was then supplemented by various sector
specific criteria including a global non-life insurance
rating methodology published in March 2010. Fitch has
stated that they must review their criteria a minimum
of every three years.
The main change in the new master criteria is the
introduction of the total financing and commitment
ratio (TFC) relative to capital as part of the analysis of
the financial profile of a company.
This is a comprehensive measure of debt-related
leverage, making use of a broad definition of debt to
include essentially all financing activities. This definition
includes various financing types such as long-term
notes, bank borrowings, commercial paper, repurchase
agreements, “match-funded” debt at the holding
company, letters of credit, securitizations, and
guarantees of other debt issued by other entities.
This ratio is designed to measure the debt, financing and
capital markets “footprint” of an organization, and its
overall reliance and ongoing access to funding sources.

The measure is intended to flag those companies that
have an above-average reliance on the capital markets for
funding, which would trigger further analysis by Fitch to
understand the relative risk of the company’s various
funding activities. Such additional analysis would involve
leverage relative to capital, ability to refinance, potential
calls on liquidity, and additional potential losses of capital.
Fitch notes that the usefulness of the TFC ratio is to
identify and further analyze outliers. For example,
industry average TFC ratio is below 0.5x, while AIG’s TFC
ratio leading into the financial crisis was more than 8.8x.
Moody’s
In May 2010, Moody’s Investor Service updated their
global rating methodology for property & casualty
insurers, last published in July 2008. The core principles
of Moody’s approach remain similar, but Moody’s views
the updated framework as better reflecting the
changing landscape of the global property & casualty
industry and the way in which Moody’s applies its
methodologies.
Compared to the previous methodology, the three
main changes include:
1. The elaboration of the components of operating
environment and the inclusion of operating
environment metrics in two categories.
> Insurance systemic risk/country risk considers:
• Economic strength — combination of several
factors but primarily GDP per capital
• Institutional strength — robustness of
institutions and predictability of policies
• Susceptibility to event risk — the risk of a direct
and immediate credit threat; considers exposures
to financial, economic and political stress
> Insurance market development (development of
the insurance sector in a given country):
• Insurance penetration — significance of
insurance market in the national economy
• Insurance density (percentile rank) — utilization
of insurance on a per capita basis
Aon Benfield
2. Amended a number of the financial metrics used to
analyze key rating factors, including: market position,
asset quality, capital adequacy, profitability, reserve
adequacy, and financial flexibility. Of the changes
made to Moody’s rating scorecard, the most material
has been the addition of a new metric to financial
flexibility: total leverage ratio. This examines the
total debt profile of the group that also incorporates
operating debt.
3. The metrics used to analyze key rating factors now
include ranges for rating categories below Baa.
It should be noted that Moody’s stated they do not
anticipate changes to public ratings as a result of these
updates to their methodology.
Standard & Poor’s
In January 2010, S&P expanded their ERM categories
with the aim to provide differentiation within the
“Adequate” category. The new classifications created
three levels: (1) Adequate, (2) Adequate with strong
risk controls and (3) Adequate with positive trend.
Exhibit 7: S&P ERM Ratings for Global Non-Life
and Life Industries
Number of Companies
200
150
100
50
0
Excellent
Strong
Adequate
(Positive)
Adequate
(Strong
Controls)
Adequate
Weak
Companies who are deemed “Adequate with strong risk
controls” display the characteristics of “Adequate” plus
strong controls over all of its material risks. Further,
companies who are labeled “Adequate with positive
trend” display all of the characteristics of “Adequate with
strong risk controls” plus risk management culture scores
that are at least “Strong”. These companies are expected
to progress to a “Strong” ERM score within 24 months.
7

Evolving Criteria
In June 2010, S&P updated their Enhanced Capital
Model by outlining customized risk factors by global
geographic regions. The model was updated to include
regional specific risk charges for Asia Pacific, Latin
America and Canada.
While S&P specifically noted they do not anticipate this
criteria update to result in rating changes, there were
some notable increases when compared to the previous
risk factors. The most affected risk charges were asset
related, such as the charges for common equity, preferred
equity and reinsurance recoverables. Aon Benfield
estimated these changes to increase net required capital
by three to seven percent for the industry; however, it will
vary by company depending on risk characteristics.
In May 2010, S&P introduced their draft methodology on
economic capital model (ECM) reviews, or Level III ERM
reviews, and requested comments on the paper by
August 9, 2010.
8
S&P stated that they believe ECM reviews to be the next
step in the credit analysis, and they will deepen their
assessment of a company’s risk management. S&P views
it will help connect risk management with strategic
decision making and advance analysis of each insurer’s
capital needs, thus developing a more accurate and
forward-looking view of financial strength.
A company’s ECM will be incorporated in the capital
adequacy analysis by blending the results of S&P’s
Enhanced Capital Model results and the company’s
ECM results. Following their review of the internal
model, S&P proposes to utilize a credibility factor, the
M-factor, which is an indication of its level of
confidence in the insurer’s ECM. S&P will then refine
their view of capital adequacy by using the combined
result. It should be noted that any M-factor adjustment
is limited to one rating category of capital relief.
The potential implications of S&P’s draft ECM
methodology are discussed in the ERM Expectations
section on page 13.

Rating Agency Key Concerns
Capital adequacy improved significantly for P&C insurers
in 2009, rebounding from the drop in 2008. However,
rating agencies remain cautious as evidenced by
negative outlooks across a number of sectors. Similar to
recent years, the theme of key rating agency concerns
remain consistent, namely pricing pressure/soft cycle
management, reserve adequacy, profitability trends,
investments/liquidity, catastrophe management, and
regulatory developments. The following pages explore
the first three key concerns in more detail.
Pricing Pressure
While balance sheets rebounded, the downturn in the
economy led to lower payrolls as most industries faced
lower sales and production, reducing the demand for
many insurance products and delaying the market
hardening that was expected to happen during 2009.
Pricing, especially for commercial lines, continues to be
of concern among rating agencies.
Exhibit 8: U.S. P&C Industry Aggregate
Capital Adequacy
$ Billions
80
60
40
20
0
-20
-40
-60
-80
2007
2008
Redundancy/Deficiency at the
S&P “A” Rating Level ($ Billions)
A.M. Best BCAR Score
2009
260
240
220
200
180
160
140
120
100
BCAR Score
Aon Benfield
Exhibit 9 depicts quarter-over-quarter changes
in the U.S. industry DWP. Midway through 2008
was the inflection point where personal lines
rates stopped decreasing, placing significant
pressure on the commercial lines. Since that point,
commercial lines DWP continue to decline.
Exhibit 9: U.S. Industry Aggregate Quarterover-Quarter
Change in DWP
Industry
15%
Commercial
Personal
10%
5%
0%
-5%
-10%
2003
2004
2005
2006
2007
2008
2009 2010
As shown in Exhibit 10, the Council of Insurance Agents
and Brokers (CIAB), Market Scout and Advisen have
indicated 20 consecutive quarters of declining rates.
While Commercial Lines Insurance Pricing Survey
(CLIPS), administered by Towers Watson, and Aon
Benfield’s results from quarterly conference calls show
some recent quarters with modest growth indications.
These do not cover modest inflation and may also
reflect some optimism from reporting companies.
In the second half of 2008, A.M. Best released a special
report entitled Few Companies Excel at Managing
through Market Cycles, which concluded insurers that
performed best focused on underwriting to drive
profits. Bottom performers were unable to grow as
much as top performers during hard market years,
finding themselves less well positioned after the last
soft market. Aon Benfield Analytics replicated the cycle
management analysis discussed in this report on all U.S.
companies’ 2009 financials and found that only 15
percent of the population achieved strong cycle
management as defined within the original study.
9

Evolving Criteria
Exhibit 10: Quarterly Rate Changes
10
CIAB (GL) Market Scout Advisen CLIPS All Co. Avg
Q2 2005 -10.0% -2.3% -7.1% -2.0%
Q3 2005 -7.7% -5.3% -8.3% -2.0%
Q4 2005 -4.7% -4.7% -6.6% -2.0%
Q1 2006 -6.0% -5.7% -4.4% -2.0%
Q2 2006 -5.6% -6.0% -2.1% -1.0%
Q3 2006 -6.3% -9.0% -0.4% -1.0%
Q4 2006 -8.4% -8.7% -1.3% -3.0%
Aon Benfield Company Sample
Specialty
Co. Avg
Standard
Co. Avg
Q1 2007 -10.5% -10.3% -2.0% -4.0% -3.9% -5.2% -3.0%
Q2 2007 -11.4% -13.0% -2.5% -5.0% -6.0% -8.0% -4.8%
Q3 2007 -12.1% -15.0% -2.9% -5.0% -7.5% -9.4% -5.4%
Q4 2007 -12.2% -15.3% -3.6% -6.0% -7.1% -7.4% -5.8%
Q1 2008 -12.6% -13.7% -5.4% -6.0% -6.6% -6.9% -5.5%
Q2 2008 -11.9% -11.3% -6.0% -6.0% -7.6% -7.8% -5.9%
Q3 2008 -9.7% -10.3% -6.9% -5.0% -5.8% -6.0% -4.9%
Q4 2008 -5.8% -9.0% -6.4% -3.0% -3.6% -4.4% -2.6%
Q1 2009 -4.2% -8.0% -3.9% 0.0% -0.6% -0.8% -0.5%
Q2 2009 -4.9% -6.3% -2.8% 1.0% 0.6% 0.0% 1.2%
Q3 2009 -4.7% -5.0% -1.7% 0.0% 0.7% 0.6% 0.9%
Q4 2009 -5.6% -4.7% -1.7% 0.0% 0.9% 0.9% 0.5%
Q1 2010 -4.9% -4.3% -2.4% -0.1% -1.0% 0.7%

Cycle management strategy is often a component of a
company’s ERM discussion with rating agencies. As part of
this discussion, rating agencies are looking to understand
a company’s cycle management approach, such as:
> How does the insurer measure and monitor
the cycle and then apply this information in its
decision making?
> Are the insurer’s underwriting, pricing and claim
management functions robust?
> Is the insurer’s compensation structure aligned with
the company’s cycle management strategy?
Rating agencies want companies to articulate how they
are effectively balancing growth and long-term
profitability. Companies that are growing aggressively
in the soft market need to be prepared to discuss why
they believe they can do so profitably.
Reserve Adequacy
In the past few years, P&C insurers have released
significant amounts of loss reserves as overall market
conditions continued to decline. While most of the
rating agencies still believe the overall industry is
adequately reserved, there is concern that individual
companies could be under-reserved, especially as it
relates to the most recent accident years. Further,
underwriting results will be constrained going forward
without additional reserve releases.
Exhibit 11: U.S. Industry Aggregate 2009 One-Year
Accident Year Reserve Development
Accident Year One-Year Development
Prior 4,615,902
2000 162,619
2001 258,944
2002 52,590
2003 (624,284)
2004 (1,438,448)
2005 (2,452,720)
2006 (9,502,826)
2007 (9,000,441)
2008 (621,711)
2009 XXX
Totals (18,550,375)
Aon Benfield
In 2009, U.S. P&C industry statutory results benefited
from $18.6 billion of reserve releases, leading to 4.3
points of calendar year loss ratio improvement. As
shown in Exhibit 11, accident years 2006 and 2007
accounted for the bulk of redundancies, while older
accident years still have a drag on calendar year results.
Further, first quarter 2010 combined ratios benefited
from 5.2 points of favorable loss development. Again,
the majority of reserve releases were from recent
accident years, sparking concerns about a possible
future reversal as these years mature.
S&P published a paper in June 2010 entitled Why U.S.
Property/Casualty Insurers Might Have to Put the Brakes
on Reserve Releases. S&P believes that future reserve
adequacy will depend heavily on the length of the
current soft cycle, as well as the effectiveness of the risk
controls and tools that have been developed in recent
years under companies’ ERM frameworks.
In August 2010, Fitch also reported on this topic in a
special report called Property/Casualty Industry Loss
Reserve Adequacy — Are Redundancies Exhausted? Fitch
concludes that the U.S. industry’s reserves are
approximately one to two percent redundant at
year-end 2009, which is a similar position to year-end
2008. They also believe that the more recent accident
years of 2007-2009 are adequately reserved, although
caution that they do not think it is likely they will
produce redundancies in the future.
Moody’s has similar conclusions in their August 2010
report entitled U.S. P&C Insurers Harvest Significant
Reserve Redundancy. They note the soft market cycle as
P&C insurers’ primary obstacle to building reserves at
the same level as recent years. Additionally, they believe
that reserves are still redundant as of year-end 2009,
but expect that as reserve releases slow, insurers will
either raise rates or experience continued pressure on
underwriting results.
Lastly, A.M. Best presented during their industry
conference that loss reserve adequacy was eroding
as they estimated industry reserves moved from a
$3 billion redundancy at year-end 2008 to a $4 billion
deficit by year-end 2009.
As evidenced by the various commentaries by all the
major rating agencies, it is clear reserve adequacy is a
key concern as the industry continues along a soft
market cycle.
11

Evolving Criteria
Profitability Trends
Rating agencies have become increasingly focused on
companies’ ability to underwrite profitably. P&C insurers
are facing several impediments to earnings, including an
extended soft market cycle, weak economic conditions,
inadequate rates due to government restrictions, and
catastrophe frequency losses.
Exhibit 12: Percentage of Companies
Reporting Combined Ratios Greater Than
110 Percent and Below 100 Percent
70%
60%
50%
40%
30%
20%
10%
0%
12
less than 100% CR
greater than 110% CR
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
The gray line on the graph above depicts the percentage
of companies that reported a combined ratio below 100
percent. For example, in 2006 64.5 percent of
companies within the U.S. P&C industry reported a
combined ratio below 100 percent. At year-end 2009,
this percentage dropped to 46.1 percent. Conversely,
the green line shows the percentage of companies that
reported a combined ratio above 110 percent. This
inherently has a negative correlation to the percentage
reporting a combined ratio below 100 percent (gray
line), but we chose a 10 point buffer to segment the
percentage of poor performers versus companies that
reported results only slightly above a 100 percent
combined ratio. As expected, over the last ten years, the
trough was 2006 when only 20.7 percent of companies
reported a combined ratio above 110 percent, but this
percentage increased to 30.6 percent in 2009. Whereas
profitability trends are often the catalyst to rating
actions, this graph depicts a weakening trend on a by
company basis that is sometimes masked when looking
at industry aggregate results.
This concern is evidenced in several negative rating
actions taken against well-capitalized companies that
have performed poorly in comparison to their peers. In
fact, 11 of 26 downgrades by A.M. Best in 2010 showed
more than a 10 percent improvement in BCAR yearover-year.
Further, shrinking premium bases are placing
pressure on expense ratios and thus profitability. The
median net expense ratio for the U.S. P&C industry in
2009 was 30.7 percent, which is 3.5 points higher than
2006 and 7.0 points higher than five years ago.
Lastly, given these profitability trends, we have seen an
increased focus on companies’ ability to achieve
projections presented to rating agencies.
The detailed pricing, reserving and profitability
analyses are based on U.S. data due to general
availability and accessibility of information. However,
the underlying trends are applicable globally as many
other markets are facing the same pricing pressures as
in the U.S., and the rating agencies have the same
concerns globally.
S&P issued a report about the U.K. non-life market,
noting declining profitability has largely been masked
by reserve releases overall. Further, investment returns
have been limited by the current low interest rates and
the conservative investment strategies that insurers
have maintained over the course of the financial turmoil
of the past two or three years. A.M. Best noted that
European multi-line insurers are relying on life business
to help offset a struggling soft market. However, this is
not the case in Asia as capacity and demand remains
sufficient due to expansion, though not to the same
levels as in the prior years. Further, many global
companies reiterated in recent earnings calls these
prevailing issues impacting overall profitability, with
little hope on the horizon.
The global reinsurance industry is experiencing similar
trends, and we expect continued pressure on
downward rates will be evident throughout all property
catastrophe segments (even beyond the U.S.) as supply
continues to exceed demand. Further, across most
non-catastrophe lines globally, pricing is flat to slightly
down with the exception of a few lines.

ERM Expectations
ERM continues to play a significant role in how the
insurance industry manages its operations broadly, and
in understanding the risks associated with those
operations specifically. Rating agencies elevated the
awareness of ERM with specific ratings criteria
introduced as far back as 2005. Regulatory influences
have also been in play particularly with the pending
Solvency II regime. External forces aside, some industry
practitioners have benefited from their ERM
frameworks for several years now. Many organizations
have full-time chief risk officers or equivalent ERM
leadership in their firm, with some industry surveys
suggesting more than half of insurers with such roles in
place. Moreover, economic capital modeling still plays
a prominent role with insurers to understand risks,
optimize reinsurance and make capital allocation
decisions. All signs indicate that expectations for ERM
are rising, along with related resources and technology.
Rating Agency and Regulatory Influences
S&P continues to be active in clarifying their criteria for
ERM and capital during the past 12 months. One of the
more prominent updates was the criteria draft for
formal ECM reviews (or Level III ERM reviews) noted
previously. Refinement to Level III criteria is expected in
the coming months, followed by formal ECM reviews
beginning later in 2010 or early 2011. This update by
S&P is viewed as a logical progression in the review of
ERM, an enhanced understanding of insurer’s capital
needs and ultimately improved ratings decisions. Early
indications suggest that ECM reviews that are not
deemed credible will be a limiting factor to ERM scores.
Yet S&P has indicated that in some cases a credible
ECM may warrant capital relief in their view, and
ultimately positive ratings traction. Additional clarity is
needed before any definitive statements in that regard
can be made; however, what is clear is ERM will remain
a driving force for pending ratings evaluations.
Thus far, A.M. Best has not updated their ERM criteria
since their paper Risk Management and the Ratings
Process for Insurance Companies was released in January
2008, nor have we seen any recent and significant
updates or clarifications on ERM from other major
rating agencies. A.M. Best has stated plans to release a
criteria paper that discusses their approach for
evaluating ERM capabilities for small and medium-sized
Aon Benfield
companies with varying levels of complexity. Overall,
we expect ERM to remain a key factor in the ratings
review processes among all rating agencies, particularly
in understanding how ERM supports management’s
strategic objectives, risk tolerances and risk preferences.
The Solvency II regime and particularly Pillar II has ERM
underpinnings to it. Further tweaking is expected to
Solvency II requirements prior to companies going live
in 2013. However, most of that tweaking is currently
focused on Pillar I (capital requirements and related
calculations). Less debated, but arguably of similar
importance is Pillar II (governance and risk
management). Pillar II’s focus is on such topics as risk
control and self assessment, supervisory review, risk
governance, and general risk management
effectiveness. These topics all relate to the ERM ideal,
and those organizations viewed to have relatively weak
ERM constructs run the risk of regulators requiring
additional capital and oversight; a precarious and costly
situation that most insurers would like to avoid.
External stakeholders continue to influence and
elevate expectations of ERM. However, the industry is
well-positioned to be at the forefront and raising the
bar of what constitutes robust ERM. Indeed, best
practices from today will become standard practices
tomorrow. Those insurers who embrace this concept
and push innovative risk intelligence will create their
own competitive advantages, and as a by-product
appease external influencers such as rating agencies
and regulators.
Key Trends in ERM
Aon Benfield has identified three areas of ERM that
seem to garner more attention on a consistent basis
across the industry: risk appetite refinement,
understanding emerging risks and risk modeling.
Risk Appetite Refinement
A key element of risk governance and risk oversight is to
prescribe the extent of risk an organization is willing to
take. This risk tolerance is predicated on understanding
the firm’s capacity or ability to assume various risks.
One part of risk bearing capacity is from a quantitative
perspective such as available capital or surplus. The
second is from a qualitative perspective and comes
13

Evolving Criteria
from knowledge, systems, tools, and resources that
collectively facilitate an understanding of risk for the
insurer. Once this capacity is understood, the insurer is
positioned to establish its tolerance for risk.
Exhibit 13: Applying Risk Tolerance
14
Alt.
Assets
E&O
Cat
Munis
Casualty
D&O
Risk Bearing Capacity
Equities
Credit
Emerging
Markets
REITS
Risk Tolerance = the “Box”
M&A
Aviation
Surety
Risk Appetite = How you
decide what you put in the box
Unlike the holistic understanding of ERM, traditional
risk management tends to view risks in a
compartmentalized fashion. This traditional approach
has also carried over to risk tolerance definitions. For
example, most insurers have a clear understanding of
insurance risk and asset risk independently (e.g.,
catastrophe PML targets vs. investment benchmark
tracking error targets), but less on an aggregated basis.
Advanced practitioners also view risk tolerance as a
single, aggregate measure across all risk types,
contemplating how risks interact and correlate with
one another. Economic capital modeling is one tool
that can help an insurer understand and develop their
risk tolerance, articulate that tolerance and monitor its
adherence over time.
The most common articulation of risk tolerance is a
fraction of capital or earnings. Aon Benfield has noticed
a typical tolerance range of 10-25 percent of equity
capital at risk over a one-year period, with reinsurers
more willing to be at the higher end of the range.
Some companies keep constraints with respect to a
target financial strength rating or a risk-based capital
threshold as well. No matter how it’s articulated, risk
tolerance establishes a common understanding
between management, the board of directors and
external stakeholders to the boundaries the insurer can
operate within.
After understanding risk bearing capacity and
establishing risk tolerance, management must determine
its risk appetite and risk preferences. Companies with
robust ERM use risk appetite as a means to prescribe the
method to evaluate risk and what risks it wishes to
entertain. This decision making process also starts at the
corporate level in light of strategy and planning, but
ultimately transcends to the point of sale via established
limits, guidelines and standards of practice. Those
insurers with robust ERM tend to refine their risk appetite
and potentially their risk tolerance as market
characteristics evolve. Rate adequacy, tort concerns and
economic conditions are examples of dynamic variables
that may indicate a favorable risk opportunity today that
was less favorable the prior period.
Understanding Emerging Risks
Perhaps the most critical and potentially the most
damaging risks that an organization faces are those that
are unknown. The emergence of asbestos and
environmental claims continues to teach valuable
lessons to the industry. The credit market disruption
and related housing crisis leading up to the financial
market collapse in 2008 are other risks that hindsight
shows presented early warning signs that were
overlooked by many. These risks might not have been
avoided in their entirety, but with more effective
environmental scanning processes and early warning
systems, the impact of these risks may have been
reduced to acceptable ranges.
Aon Benfield finds that the subject of emerging risks
has become a standard agenda item at company risk
committee meetings and is regularly discussed at board
level risk reviews. Emerging risks are now tracked in the
same manner as fully emerged risks. This may include
assigning a risk owner, creating a detailed risk profile,
employing risk mitigation procedures and controls, and
to the extent possible, developing reasonable estimates
of related potential loss.

An established risk discovery process enables insurers
to identify emerging risks better. This includes
mapping activities crucial to the operations of the
business and frequent exploration of trends across
science and technology, medicine, economics,
regulation, and geo-politics. Measuring the impact of
emerging risks is very subjective in the early stages of
discovery, but should at least include collective
perspectives of all leaders and functions of the
company. Once risk traits are understood for an
emerging risk, proxies of development trends based
on established risks with similar traits can be applied.
This facilitates an early estimation of how long a risk
may take to fully emerge and the financial implications
once that emergence is realized.
A formal emerging risk management process is crucial
to an effective ERM process, and has become a staple
for industry leaders in this space. Our research shows
that investors tend to reward insurers with higher
multiples when those insurers have shown an ability to
avoid loss due to the unexpected. Likewise, rating
agencies and regulators are less likely to provide
favorable opinions when emerging risk management
processes are not deemed effective and not embedded
in ERM frameworks of the insurers they evaluate.
Exhibit 14: Stochastic ECM Application Spectrum
Reinsurance
Management
Regional carrier with
few product offerings
Catastrophe
Management
Aon Benfield
Risk Modeling
Internal capital modeling is becoming a standard ERM
tool for the industry. Yet, there still lacks any standard
in how ECMs are applied. For non-life insurers, some
suggest that ECMs are best suited for reinsurance
purchase decisions, while others claim to use ECM as
the primary driver of strategic decision making.
As the graph below indicates, larger and more complex
organizations may need ECM to fully understand how
their varied risks interplay with one another. For these
firms factor-based models may not adequately quantify
their unique risk profile and how best to allocate capital
for general operations. For smaller companies, with a
limited product and geographic footprint, an elaborate
and fully stochastic ECM tool used beyond reinsurance
management decisions may be no more informative
than a factor-based approach employed by rating
agencies. However, there is a growing appreciation in
the industry that overreliance on any risk model
(including catastrophe models) can be dangerous no
matter the size and scope of the company.
Each period provides new data points to consider that
may enrich the modeling analytics and the outputs it
provides. But companies with robust ERM understand
the limitations of models, and never overlook the
importance of insight and judgment that an
experienced management team brings to the risk
management process.
Operational
Management
Multinational carrier with
extensive product offerings
Strategy
Automation
15

Evolving Criteria
Regulatory Update
In the aftermath of the 2008-2009 financial markets
crisis, regulatory regimes globally began reassessing
their approaches to regulation of the insurance
industry. Even though the banking industry stole the
headlines, the insurance industry was grouped in with
overall financial services companies in terms of needing
additional regulatory oversight.
Since then, most developed countries have published
numerous proposed enhancements to their regulation
of the insurance industry or the broader financial
services industry. The key themes include more robust
capital requirements, trend towards internal capital
modeling, trend towards de-risking of the balance
sheet and fair value approaches, and additional
governmental oversight. The primary difficulty for
many insurers is that little guidance has been finalized,
and therefore, companies are struggling to assess the
ultimate impact of proposed regulatory changes.
Globally the proposed enhancements are voluminous,
so we will focus on the U.S. and Europe (Solvency II),
and highlight important changes in other key regions.
U.S.
In July 2010, the Dodd-Frank Wall Street Reform and
Consumer Protection Act (the Dodd-Frank Act) was
passed by the U.S. Congress. There are certain
provisions of the Dodd-Frank Act applicable to credit
rating agencies that are effective immediately and are
impacting current as well as evolving ratings criteria.
Only time will tell the full impact of this legislation on
rating agencies and therefore the industry.
The Dodd-Frank Act repeals Rule 436(g) under the
Securities Act of 1933, which relates to U.S. public
offerings registered under the Securities Act. This rule
initially provided that credit ratings assigned by a
Nationally Registered Statistical Rating Organization
(NRSRO) are not considered a part of registration
statement prepared or certified by an “expert”.
Historically, credit rating agencies had never been
treated as experts under the Securities Act. However,
going forward, issuers will need consent from credit
rating agencies to use their ratings in any Securities Act
registration statement and any related prospectuses. If
a rating agency were to provide consent, they would
be potentially exposed to “expert” liability under
section 11 of the Securities Act, and the major credit
16
rating agencies have all indicated that as such, they will
not allow their ratings to be used in prospectuses and
registration statements.
In addition, the Dodd-Frank Act removed the
exemption for credit rating agencies from the SEC’s
Fair Disclosure Rule (Regulation FD) within 90 days of
the enactment of the Act. The exemption for credit
rating agencies from Regulation FD permits issuers to
provide the credit rating agencies with material
non-public information without requiring public
disclosure of such information. The rating agencies are
waiting to see if a confidentiality agreement or other
measure is available to continue to allow companies to
disclose non-public information to the rating agencies
as part of the analysis.
These changes could impact how rating agencies are
currently and prospectively evaluating the insurance
industry. As mentioned earlier, S&P will review
companies’ internal ECMs that meet certain stated
criteria as part of the ERM analysis. S&P requires that a
company must provide substantial detail behind their
capital model in order for S&P to review it. If the
Regulation FD repeal is upheld, companies who provide
information on their ECMs to S&P would potentially be
required to disclose this information to the public.
Needless to say, most companies would not want such
level of detail on their internal capital models in the
public domain.
Further, as part of the annual ratings review process,
the rating agencies obtain a significant amount of
information necessary to analyze the company that is
not in the public domain such as catastrophe probable
maximum losses (PMLs) and prospective pro-forma
financial statements. If the rating agencies would be
required to disclose such information, it seems likely
that most companies would not share this with the
rating agencies, meaning rating agencies would need
to make many more assumptions going forward.
Given these legislative developments, there is an added
element of uncertainty in regards to how current and
proposed criteria, as well as the overall rating process,
will be impacted by the Dodd-Frank Act.

On the insurance regulatory front, the NAIC recently
introduced the Solvency Modernization Initiative
(SMI), which proposes a critical self-examination of
the U.S. solvency regulation framework. This will be
the first overall review of the risk-based capital (RBC)
system since the 1990s, though annually the NAIC
does update underlying capital factors for recent
trends. The five key areas being reviewed are: capital
requirements, international accounting, group
supervision issues, valuation issues, and reinsurance.
The key considerations at this point include:
> Articulating U.S. solvency framework in one document
> Improving tools related to economic capital, ERM
and internal models in the RBC requirements
> Evaluating RBC to incorporate additional risk and
issues related to recalibration
> Corporate governance and risk management focus
As part of the SMI, the International Solvency Working
Group is examining Solvency II to determine whether
the U.S. could adopt a similar ECM. The working group
is currently considering the following:
> Using statistical measures to define the U.S. RBC
system
> Incorporating missing risks in the U.S. RBC system
such as catastrophe, liquidity, operational, Foreign
Exchange, and other
> Having internal models be subject to quality tests
and be preapproved by regulators
> Grouping capital questions including how to
address non-regulated or non-insurance affiliates,
diversification credits, etc.
Aon Benfield
Further, the NAIC has been considering the inclusion of
a specific catastrophe risk charge in the RBC system
over the past few years, and it recently reemerged on
the agenda. There is current discussion regarding
additional disclosure for 1 in 250, 500, 1000 year
events as well as additional disclosure on modeling
options and assumptions (demand surge, fire following
earthquake, etc.). The proposal also discusses an
increased focus on completeness and accuracy of
exposure data input into the cat modeling process. As
for the specific catastrophe charge, the NAIC is
considering separate charges for hurricane and
earthquake perils based upon a company’s 100-year
modeled net PML though with a covariance benefit.
The proposal does not include a tax benefit; however,
the NAIC is considering premium offsets to reduce
premium capital charges. Interestingly, the RBC is the
only regulatory solvency model in a significant
insurance market, apart from China, that does not
include a specific catastrophe risk charge. However,
approximately 95 percent of the U.S. market is rated by
A.M. Best, who does include a specific catastrophe
charge in their BCAR model.
The SMI has established a road map, and expects all
major policy decisions to be completed by the end of
2012; at which time the NAIC, through various
committees, can then choose to proceed as
appropriate.
Solvency II
As Solvency II nears its anticipated implementation in
2013, much of the final guidance remains undecided.
The fifth quantitative impact study (QIS 5) takes place
between August and November 2010 to analyze the
Committee of European Insurance and Occupational
Pensions Supervisors’ (CEIOPS) April 2010 proposal.
The current QIS 5 specifications are less onerous than
the proposals made by CEIOPS, and were welcomed by
the industry, which feared that the initial proposals
would lead to a dramatic increase in required capital.
However, since its release in mid-April 2010, sharp
comments were raised by CEIOPS (threatening the use
of capital add-ons), rating agencies and investment
bankers that the current proposal was too soft, so it
remains to be seen what the final quantitative
requirements are for Solvency II.
17

Evolving Criteria
Solvency II is similar to the Basel II banking regulation
by way of its three-pillar approach — Pillar 1 being the
quantitative calculation of required and available
capital; Pillar 2 the qualitative justification to the
regulator (own risk and solvency assessment); and Pillar
3 the disclosure requirements to all stakeholders.
Guidance for Pillars 2 and 3 has not yet been published,
so the industry does not have firm direction on those
requirements.
Natural and man-made catastrophe risk is calculated in
the Standard Formula via a complex spreadsheet based
on CRESTA zone exposures for natural catastrophes or
via scenarios for man-made catastrophes. Output from
commercial catastrophe models will only be accepted
through a partial internal model. Insurers will be able to
apply their own existing catastrophe reinsurance
program and will have to show the regulator how they
apply this to arrive at net exposures. Both proportional
and non-proportional reinsurance for insurance
companies are adequately reflected in the Standard
Formula for catastrophe risk. Companies with material
cat exposures outside the EU will be forced into a
partial internal model.
Elsewhere in the Standard Formula, reinsurance is
inconsistently reflected in the standard model. In QIS 4,
only a proportional reduction in premium and reserve
risk was allowed. However, in QIS 5 proportional and
non-proportional reinsurance can be introduced, but
the methodology for non-proportional reinsurance has
a limited impact. This could lead companies to retain
more risk as the benefit of some forms of reinsurance is
not fully credited in terms of capital relief in the
Standard Formula. However, companies who use
internal models will be able to reflect the true value of
reinsurance in their capital models.
Solvency II is likely to result in a significant increase in
regulatory capital for many companies. Some of this
increase will be offset by an increasing amount of
available capital as a result of Fair Value estimates of
liabilities, including discounting. Overall, Aon Benfield
estimates that the average solvency ratio for the
non-life industry will reduce from about 250 percent
(Solvency I) to about 140 percent. Many companies are
planning to use internal capital models, which will likely
be much more representative than the Standard
Formula, and will also likely lead in most cases to
significantly lower capital requirements.
18
Further, in the recent QIS 5 proposal, the balance sheet
of an insurer is valued from a Fair Value perspective. On
a very summary level, this includes the following:
> All liabilities, life and non-life, will be valued on a
pure prospective basis, i.e., present value of future
cash-flows relating to the existing contracts and a
risk margin
> The discount rate is based upon the swap rate plus a
liquidity premium, depending on the nature of the
liabilities
> Non-life pre-claims liabilities (unearned premiums)
will be valued based upon the expected cash flows
(premiums, claims and expenses) for the contracts
that have already been written or for which there is a
contractual obligation
> The risk margin is added to the best estimate basis to
make the liabilities transferable
A Fair Value approach has consequences on the
recognition of profits (the difference between the Fair
Value of the assets and the liabilities):
> Any positive difference at inception between the
present value of future premiums, future cash-outgo
and risk margin will be recognized as profit
> This is also applicable to non-life insurance and
the valuation of the pre-claims liabilities results
in a profit recognition at the time of writing the
contract (disregarding the start of the exposure
period of the contract)
Interestingly, the International Accounting Standards
Board (IASB) released an Exposure Draft (ED) on
insurance contracts on July 30, 2010, and the
proposed Fair Value accounting measures differ from
those in Solvency II, however, with similar
implementation timeframes. In a Solvency II’s
economic value balance sheet, the liabilities can be
detailed in three building blocks:
> The unbiased, probability-weighted average of
future cash-flows (“best estimate”)
> An incorporation of the time value of money
(“discounting”)
> A risk margin

Since this leads to immediate profit recognition, the
IASB and U.S. Financial Accounting Standards Board
(FASB) have introduced a fourth building block that
avoids the possibility that any profit would be
recognized up-front, the so-called “residual” margin.
In regard to the risk margin, Solvency II provides
detailed guidance on risks and methods to be used.
Solvency II requires, for example, that the cost of
capital method (six percent) will be used for the
determination of the risk margin. In the ED, the IASB
limits the permitted methods to three techniques
without giving much guidance: the confidence interval
(VaR), the conditional tail expectation (TVaR) and the
cost of capital (economic capital). To complicate
matters more, the FASB decided that the measurement
of an insurance contract should not include a separate
risk margin, but the residual and risk margin will be
combined in a composite margin.
The granularity for calculating the risk margin is also
different. For Solvency II, the risk margin should take into
account diversification between lines of business. The
IASB proposes the risk adjustment is determined for a
portfolio of contracts that are subject to broadly similar
risks and managed together as a single pool.
Diversification benefit between portfolios is not allowed.
Further, for short duration contracts (most non-life
contracts with a contract term of one year or less), instead
of the four building blocks method, the IASB decided to
require an “unearned premium” (after deduction of
incremental acquisition costs) approach for the valuation
of the pre-claims liability. Solvency II does not require a
different treatment for short and long duration contracts
and pre-claims liabilities have to be calculated based upon
the three building block approach.
Given this, there is a possibility that reserves will be
calculated differently under Solvency II and IFRS (with
the FASB still in disagreement with the IASB over
certain elements), which further complicates planning
for insurers and adds another element of uncertainty.
Other Regimes
Aon Benfield
Bermuda
A key objective of the Bermuda Monetary Authority
(BMA) is to develop an insurance framework that meets
or exceeds international standards. The stated aim of
the past two years is achieving Regulatory Equivalence
with the U.S. and U.K./Europe, and equivalency with
the Solvency II directive is core to this. The BMA,
however, plans to adapt Solvency II to the Bermuda
market rather than duplicate it. The key steps that
should assist with this include:
> The BMA’s proposals for enhanced disclosures were
defined in a consultation paper on disclosures and
transparency in June 2009
> Class 4 companies now prepare GAAP statements
that the BMA is publishing
> Class 3B companies will have similar requirements
in 2010
> An internal capital model framework for Class 4
companies was established in July 2009 and the
BMA continues to develop this
> A pilot implementation of the application and
review process with selected Class 4 companies was
announced in June 2010
> Pilot companies allowed to use their own internal
capital models, once reviewed and approved by the
BMA, to determine regulatory capital requirements
Canada
The Office of the Superintendent of Financial
Institutions (OSFI) is currently considering allowing
companies to use internal economic capital models in
lieu of the Minimum Capital Test (MCT), and the target
date is 2012 with the following restraints: internal
capital models must not be used to generate a lower
capital benefit over MCT; must at parallel run with
MCT for three years; requires regulatory approval on a
case-by-case basis. Also, OSFI is removing many of the
rules-based guidelines by moving towards a more
risk-based approach where corporate governance
needs to be formalized for companies. Without specific
19

Evolving Criteria
rules, the assessment of the company’s risk profile
becomes less clear and must rely on OSFI’s relationmanager’s
ability to assess according to the risk-based
guidelines provided. The objective is to eventually
move to an international standard regime where there
will be cooperative and mutual recognition of other
jurisdiction regulatory systems. OSFI has indicated that
the current factor-based solvency models work
effectively and has no plans to move to Solvency II.
Finally, Canada will implement IFRS for year
commencing in 2011, though the move to IFRS will be
challenging for companies as many of the accounting
issues with the IFRS have not been finalized.
Japan
No structural change was made to the solvency margin
criteria; however, the Financial Services Agency (FSA) is
asking insurers to calculate their solvency margin ratio
based on the current market value of their assets and
liabilities. The objective of this market value-based
measurement of the solvency margin ratio is to better
reflect the financial position of insurance companies.
This move was triggered by the global financial crisis, in
particular, the collapse of Yamato Life Insurance Co. The
new standard includes a requirement that insurers
double their estimates for potential losses on securitized
financial products. The new rule also limits the
inclusion of reserves in calculating capital. The
estimated impact on insurers (estimated by FSA) is that
solvency ratios of major general insurers will decrease
by about 30 percent. Insurers should start to “field
test” the new calculation method FSA aims to
implement in the new standard with the 2012 fiscal
year reporting.
20
Lloyd’s
Implementation of the Solvency II framework remains
one of Lloyd’s biggest challenges. Lloyd’s has secured
FSA’s agreement, in principle, that current basis of
supervision will be maintained as far as possible
under Solvency II, which is necessary to maintain
Lloyd’s rating. Solvency II is intended to be
implemented, where possible, in a way that protects
or enhances Lloyd’s capital structure and efficiency.
Lloyd’s is currently working closely with FSA to gain
approval for their internal capital model. Lloyd’s
plans to enhance risk management in response to
Solvency II, and as part of the ongoing development
of Lloyd’s risk management capability; they
developed detailed implementation plans in late
2009. Lloyd’s will focus on key areas such as risk
governance, risk framework, risk appetite, and risk
culture. At the S&P Insurance Market Seminar on
June 29, 2010, Tom Bolt, Lloyd’s Franchise Director,
stated that Lloyd’s carriers’ 2010 bill for Solvency II
implementation was GBP51 million and suggested
that the introduction of the direction may put
pressure on some participants to consider
consolidation.
Latin America
Mexican Insurance Commission (CNSF) has announced
its intention to implement Solvency II type regulation
in 2012. The regulation will be based on European
Solvency II model, but with certain features modified
for the Mexican insurance industry. Under the new
regulation, capitalization will be based on portfolio risk,
while valuation of assets and liabilities will be based on
economic principles. Insurers would most likely be
required to adopt IFRS accounting standard in valuation
of assets and liabilities. Present supervision in Mexico is
insensitive to market risk, which is believed to have
contributed to the financial woes some insurance firms
went through in the past.

Similarly, Chile is exploring changing to a Solvency II
type regime. While Chile’s current regulatory capital
model is factor-based and calculated using net written
premiums and net reserves excluding a specific PML
charge, the rule is to reserve the equivalent to 10
percent of retained Total Insured Value (TIV) in critical
Zone Aggregates for buildings and contents and 15
percent of retained TIV in Critical Zone for Engineering.
If the limit is ceded through a catastrophe excess of loss
reinsurance agreement, the reserve must be 110
percent of the retention of the program. As such, much
of the Chilean earthquake exposure was ceded to the
global reinsurance market, limiting the local impact of
the losses from the 2010 earthquake.
Several emerging markets in Latin America and the
Caribbean are also tightly managing catastrophe
charges. In Jamaica, companies’ windstorm and
earthquake retentions are subject to a maximum of five
percent of capital and surplus at the 1 in 500 year return
period. In Trinidad and Tobago, companies must set a
catastrophe reserve fund for all property insurers. A
minimum of 10 percent of after-tax profits for the class
shall be set aside each year until the fund is equivalent to
100 percent of the company’s property net written
premiums, and it can only be drawn upon after a
catastrophe that causes an ultimate net loss to the
company of 10 percent of its capital and free reserves.
Mexican insurance companies can only obtain 50
percent credit for excess of loss catastrophe
reinsurance, but 100 percent credit for pro-rata
(provided the event limits are at least the 1:1,500 PML).
Colombian companies must buy up to 15 percent of
key zone retained TIV, and pro-ratas cannot have event
limits (to receive pro-rata treatment of the premium
cession). Colombian companies must reserve 40
percent of retained premium income, so pro-rata
treatment of premium ceded under pro-rata treaties is
important. Peru gets full credit for limit purchased on
an excess of loss basis in reducing 1:1,000 year PML.
Mexico was the first country in Latin America to
move to a modeled loss approach and has been
followed by Peru, and there are ongoing discussions
in Colombia regarding a potential change to a
modeled loss approach.
Aon Benfield
These more stringent capital requirements, and
allowances for reinsurance purchases, should help
companies manage capital, and the rebound of the
local economy, subsequent to a significant catastrophic
event. Conversely, outside Latin America, most of the
emerging markets do not yet have formal regulatory
capital requirements, and those that do, have not
incorporated a specific catastrophe charge. As noted
above and depicted below, the majority of developed
markets (and global rating agencies) require companies
to hold a stated amount of capital for catastrophe risk,
though the specific requirements vary. In many cases,
the emerging markets are equally as susceptible to
catastrophic events and have struggling economies,
though overall less take-up rates of insurance as
witnessed in Haiti. These economies have not yet been
tested in terms of how conservative their insurance
industry manages its catastrophe risk.
Exhibit 15: Catastrophe Criteria
Capital Model One Year Development Basis
Australia 1:250 Single Peril Occurrence
Bermuda 1:100 TVaR All Perils Aggregate
Canada 1:370 Earthquake Occurrence
China None n/a
Japan Greater of:
1:250 Earthquake
1:70 Wind
Lloyd’s
RDS and 1 in 200 year all risk
estimate within the ICA
Occurrence
Aggregate
Solvency I None n/a
Solvency II 1:200 All Perils Aggregate
U.K.
None for ECR; however ICA includes
a 1 in 200 year all risk estimate
n/a
U.S. None n/a
A.M. Best BCAR Greater of:
1:100 Wind
1:250 Earthquake
Occurrence
S&P Enhanced 1:250 All Perils Aggregate
21

Evolving Criteria
Conclusion
The global insurance industry is in a precarious
position. While continued downwards pricing pressure
is negatively impacting many companies’ profitability,
rating agencies and regulators alike refine criteria and
capital requirements, which could place additional
pressure on an already struggling industry. While many
of the proposed changes aim to improve the overall
analysis of the industry, companies will have to dedicate
significant resources to the understanding and
development of ERM, internal capital models and
accounting frameworks. Further impacting this is the
overall uncertainty surrounding many of the proposed
changes, making some companies question whether or
not such an investment is worth it.
The Dodd-Frank Act also has the potential impact to
change the way in which the rating agencies currently
analyze insurance companies. It remains to be seen
what their role will be going forward, and how they
can continue to undertake the current analysis given
the potential that companies will no longer disclose
non-public data, as well as the rating agencies’
unwillingness to expose themselves to expert liability.
Other rating agencies could emerge that would be
willing to take on such a liability and insure themselves
appropriately.
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The trend towards Solvency II and similar frameworks
globally, coupled with the proposed fair valuing
accounting provisions, also has the potential to
drastically change how analysts and investors view and
understand the industry. The additional volatility being
introduced by fair value accounting could damper
valuations further, as current price to book ratios
already remain well below historic levels. Reinsurance
will continue to play an important role in managing this
volatility as companies will look for ways to limit this
quarter over quarter. QIS 5 in Solvency II provided
more capital credit for reinsurance than in the previous
QIS studies, though companies will see the most
meaningful benefit from reinsurance in their internal
capital models.

For more information on the Evolving Criteria report or our analytic
capabilities, please contact your local Aon Benfield broker or:
Kelly Superczynski, CPA
Head of Global Rating Agency Advisory,
Aon Benfield Analytics
+1 312 381 5351
kelly.superczynski@aonbenfield.com
Patrick Matthews, CFA
Head of U.S. Rating Agency Advisory,
Aon Benfield Analytics
+1 215 751 1591
patrick.matthews@aonbenfield.com
Christopher Myers, CFA, FRM
Head of U.K. and EMEA Rating Agency Advisory
and Head of Global ERM, Aon Benfield Analytics
+1 973 966 3558
+44 (0)20 7088 0044
christopher.myers@aonbenfield.com
About Aon Benfield
Sources: A.M. Best, S&P, Fitch, Moody’s, AXCO, SNL Financial, and Aon Benfield Analyics.
Aon Benfield
As the industry leader in treaty, facultative and capital markets, Aon Benfield is redefining the role of the reinsurance intermediary
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