NEW YORK -- A.M. Best Co. has introduced a new analytical model that provides a common standard for insurance companies worldwide to assess and manage risk and capital demands. The A.M. Best Enterprise Risk Model (Best's ERM), developed with Seabury Insurance Capital LLC, an advisory firm that specializes in the insurance and financial services industry, provides a view of an insurance enterprise's financial risk and gives insurers a systematic and scientific approach to managing it.
A number of major insurance organizations worldwide are participating in the beta test of Best's ERM. Following this test period, A.M. Best will begin to phase the model into its rating process. Analytical tools, such as the enterprise risk model and Best's Capital Adequacy Ratio (BCAR), help analysts to understand how well a company's asset, underwriting, and business risks are supported by its level of capital.
Best's ERM is based on value-at-risk (VaR) concepts that are widely used among commercial banks, investment banks, and asset management companies. Given financial services diversification and convergence, A.M. Best anticipates that the trend toward VaR analysis among insurers will grow, and views the integration of new analytics as essential to maintain the integrity of its insurer financial strength rating methodology. By incorporating VaR concepts, Best's ERM captures and considers standard risks associated with the financial services community at large, including both insurance and non-insurance risks. A.M. Best views the ERM as an important new tool that will complement its existing analytics, including BCAR, which will be maintained.
"Best's new enterprise model, together with BCAR, provides a comprehensive and dynamic view of insurers' capital adequacy," Michael Albanese, group vice president of A.M. Best's Global Financial Services, said. "This model," Albanese added, "affords a much-needed, macro-level view of an organization by quantifying the risk to its future surplus arising from changes in underlying variables such as credit or market risk. It also quantifies for an organization the benefits of its diversification."
Although the ability to identify diversification benefits offers enormous advantages for an insurer, not all models in use recognize those benefits. Among the models that do, some have a built-in, static assumption about the correlation between an insurer's assets and liabilities. The higher the correlation, the higher the risk. As a result, no matter how well a company diversifies and structures its business, it is not necessarily viewed any more favorably from a risk-based capital standard than a company that pays no attention to diversification and intelligent structuring.
"Best's Enterprise Risk Model is a rating as well as risk management tool," explained Timothy Freestone, Seabury's managing partner. "It will provide both A.M. Best and insurance companies with added insight into the risk-adjusted value of earnings. Insurers can use the A.M. Best Enterprise Risk Model to identify with greater accuracy their diversification benefits and to operate with a more efficient level of capital that will enable them to meet the needs of their policyholders and deliver higher returns on capital for shareholders."
The new model calculates both the risk of the public and private assets that tend to dominate insurance companies' investment portfolios as well as companies' insurance liabilities.
Most importantly, Best's ERM aggregates all of an insurance enterprise's financial risks into a single composite score for much greater transparency of relative risks between insurance companies.
