S&P - Public Finance Criteria (2007). - The Global Clearinghouse

Bond Insuranceinvolves a formal business “relationship” with a primaryinsurer could lead to a rating higher than ‘AA’.An example of this approach would be a primarycompany investing directly in the reinsurer. In thisscenario, it is our opinion that the ceding primarycompany would not adversely select against a companywhere it had an equity investment. The reinsurermight be limited to serving as a captive reinsurerto the investing primary insurer or could be able tooffer reinsurance capacity to other primary insurers.Another example would involve a monoline reinsurerthat is established as a captive reinsurer withno investment by a primary bond insurer. It couldreceive an ‘AAA’ rating if both companies have acommon parental ownership, the business it is cededis of investment-grade quality, and it meets all ofStandard & Poor’s ‘AAA’ criteria. In this scenario, itis our opinion that the ceding primary companywould not adversely select against an affiliate companydue to parental oversight and what, in someinstances, could be significant dependence on thereinsurer to support the rating of the primary insurer.Standard & Poor’s Capital Adequacy ModelOverviewFor ‘AAA’ rated financial guarantors, who by definitionhave extremely strong financial security characteristics,the capital adequacy model demonstrates thatthe bond insurer will remain solvent through, and following,an extremely stressful claims-paying environment.Assumptions remain the same for ‘AA’ and ‘A’rated bond insurers, although capital adequacy resultswill obviously differ. Using the same worst-caseassumptions, ‘AA’ bond insurers are expected to bemarginally or borderline solvent through, and at theconclusion of, the stressful claims-paying environment.Bond insurers rated ‘A’ are not expected to remain solventthrough the worst-case scenario; rather, theymust have capital resources of about 80% of theexpected claims.The Standard & Poor’s capital adequacy modelhas been in use for 20 years and has seen numerousmodifications and changes in assumptions over theyears. As risks or business conditions evolve, themodel is brought up to date. Changes can rangefrom higher or lower capital charges to reflectchanges in the risk of a sector, to changes associatedwith how much credit a bond insurer willreceive in connection with the business that it cedesto a multiline reinsurer. Driving any change is theunderlying intention of capturing a “worst-case”situation for that particular issue.Our capital adequacy model is a seven-year proforma balance sheet and profit and loss statementprojection using worst-case assumptions for all revenue,expense, asset, and liability categories. Revenue,for example, is adjusted to reflect the decline in premiumsdue to the runoff of the insured book of businessand an assumed cessation of new business activityat the start of a severe claims-paying period.Revenue is also adjusted by a decline in investmentincome, reflecting assumed defaults within the investmentportfolio as well as the sale of investments tooffset investment liquidations made to pay claims.For expenses, the most notable adjustment is made toclaims. Whereas claims typically equate to a fractionof premiums earned in a normal year, worst-caseassumptions cause claims in the pro forma exercise togenerate substantial income statement net losses.Reinsurance will moderate the claims, although reinsuranceobligations are discounted to reflect creditquality and willingness to pay issues. Operatingexpenses are assumed to decline at the start of theperiod of stress under the assumption that a halt tonew business activity would correspondingly reduceexpenses in the sales and marketing functions. Thebalance sheet is adjusted to reflect income statementactivity. Policyholder surplus will reflect not onlyincome statement results but gains to surplus duringthe stress period associated with some soft capitalfacilities such a contingent preferred stock trusts.Capital adequacy model usesThe capital adequacy model, along with its variouscomponents, has a multitude of uses. First and foremost,the model is a key rating determinant.Without an acceptable result or a reasonable planto cure a shortfall, ratings are in jeopardy.Nevertheless, it is extremely important to underscorethe point that the capital adequacy model isnot the sole rating determinant. In fact, most bondinsurer rating changes, CreditWatch placements, ornegative outlooks have occurred for reasons otherthan an unacceptable modeling result. These reasonsinclude management missteps, poor executionof strategy, and deterioration in economic viability.Each financial guaranty insurance company is intimatelyfamiliar with the details of the Standard &Poor’s capital adequacy model and has created, andmakes active use of, its own version of the model, asmodeling details and criteria are completely transparent.In conjunction with their strategic plans, theyuse the model for capital planning purposes. It ismost common for a bond insurer’s business to targetand manage to an intended capital model result. Themodel is a tool for the insurers in determining theneed for additional capital or dividend capacity.The capital adequacy model is also a sensitivityanalysis tool. In rapidly developing credit risk situations,such as Hurricane Katrina, the model allowsus to make modifications to the variable in question,such as exposure in a given sector under stress, andtest capital adequacy results against various incrementalchanges for that sector.www.standardandpoors.com307