Two major rating agencies revealed details of their latest efforts to revise their capital models last week, with both assuring carriers that the changes will not immediately impact ratings.
Fitch Ratings provided extensive disclosure of a dynamic global economic capital model, known as PRISM, which it will start using next year.
Unlike static factor-based models, dynamic models–such as the one Fitch will use to rate insurers and reinsurers–assess the ability of companies to withstand multiple stresses to underwriting and investment results simultaneously by running thousands of computer simulations of possible future environments.
Such dynamic models can capture the interaction of asset and liability risks, give benefits for diversification, and increase required capital to recognize risk correlations.
Last week, Standard & Poor's also gave an advance peek at major revisions to its latest capital model–a static factor-based model–during the New York-based rating agency's annual conference.
At Fitch in Chicago, Keith Buckley, group managing director and global head of insurance, said his firm's PRISM model "represents the first global stochastic economic capital model from any of the major credit ratings agencies in insurance." (Dynamic models with probabilities attached to prospective outcomes are referred to as "stochastic models.")
A notable feature of PRISM is that while it uses local market data, the model measures capital adequacy across sectors and countries on a consistent basis. That means that model outputs (required capital curves) will allow Fitch to compare different types of insurers–such as a U.S. auto insurer with a German life insurer.
Initially the model will focus on insurers and reinsurers in the life and annuity, property-casualty, and health sectors in France, Germany, the United Kingdom and the United States, but Fitch intends to expand to other countries and lines (such as title and managed care) in future years.
Fitch will use PRISM for two aspects of its overall rating analysis–first, to evaluate the capital adequacy of insurers and, going forward, to form a part of Fitch's assessment of insurers' enterprise risk management. (A report outlining Fitch's ERM methodology will be published in the third quarter.)
To evaluate capital adequacy, Fitch said its analysts will not use PRISM in isolation but will give credence to an insurer's own in-house model, if one exists. "The knowledge gained in developing PRISM has put us in an advantageous position to interpret insurers' own capital models," Mr. Buckley said.
Besides PRISM and in-house models, Fitch also will look at regulatory capital requirements. The weighting given to each will depend on various factors, including how much capital is above the regulatory minimum and the degree of comfort that Fitch has with an insurer's own model.
Fitch published an 11-page report explaining its approach to incorporating "in-house" insurer models, along with two reports on PRISM itself–a 16-page executive summary and a 370-page technical document. The documents are available at www.fitchratings.com/prism.
Fitch is seeking feedback on the new method by July 10 from insurance companies, investors, brokers, investment bankers and regulatory bodies.
After a comment period, PRISM is set to be finalized in early 2007. Upgrades indicated based on PRISM will be given immediately, while insurers whose capital falls short of ratings' expectations will be extended a "reasonable cure period" until any downgrade is made.
While S&P will not introduce a dynamic simulation model, instead sticking with a static factor-based model, the S&P model is nonetheless undergoing a massive overhaul including changes to pricing risk and reserve volatility factors, S&P analysts said at their conference.
A full report on the model changes is scheduled to be released in July, S&P said, noting that it will start using the updated model in 2007, after a comment period and finalization later this year. Even then, however, the model will be run simultaneously with the old one, S&P said, noting analysts will start to rely on new model results only after they gain confidence in its indications.
"We do not see this exercise as an opportunity to raise the industry's overall capital requirements substantially, though requirements in certain lines of business and certain geographies could increase, and others might decrease," S&P wrote in a nine-page preview report.
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