A.M. BEST METHODOLOGY Criteria – Insurance June 22, 2011 Equity Credit For Hybrid Securities Additional Information The increased use of nontraditional debt securities within the insur- ance industry reflects, in part, the generally more favorable treat- Criteria: ment they receive in the analysis of an issuer’s capital structure by A.M. Best’s Ratings & the Treatment of Debt regulators and rating agencies. The more favorable treatment of hybrid securities relative to traditional debt instruments is princi- Understanding BCAR for pally due to the existence of equity-like features or characteristics. Property/Casualty Insurers Many of these instruments also provide a lower after-tax cost of capital to the issuer, while at the same time they are a less expen- Understanding BCAR for Life & Health Insurers sive form of accessing capital than through the equity markets. Market participants are asking for guidance as to A.M. Best Co.’s perspective on hybrid securities and the amount of equity benefit that may be forthcoming to an organization’s capital structure in the rating process. This methodology summarizes A.M. Best’s treatment of equity credit for hybrid securities issued by insur- Analytical Contacts ance-related entities and highlights the importance of debt-service Andrew Edelsberg, Oldwick capabilities. The assessment focuses on these instruments’ use +1 (908) 439-2200 Ext. 5182 within an entity’s capital structure and their impact on financial [email protected] ratios and the financial flexibility of the entity issuing the hybrid security. The methodology should be read in conjunction with Duncan McColl, CFA, Oldwick A.M. Best’s Ratings & the Treatment of Debt methodology, available +1 (908) 439-2200 Ext. 5826 at www.ambest.com/ratings/methodology. [email protected] Hybrid securities, typically in the form of a preferred stock, trust preferred or convertible security, share basic characteristics asso- ciated with common equity. Hybrids can include a variety of fea- tures that, over time, allow them to exhibit changing proportions of debt and equity characteristics. Equity Credit Treatment Conventional balance sheet treatment of certain types of securi- ties by the accounting profession often does not represent a true picture of the risk or financial leverage employed by an organiza- tion. For instance, an issuer may have a large portion of reported equity in the form of traditional preferred stock, which has a rela- tively short duration to maturity. Conversely, an issuer may report a relatively large debt issue on its balance sheet that can and will be converted to common equity over a short period of time. The former is potentially exposed to a major credit event, while the latter ultimately will result in improved financial flexibility. Accordingly, A.M. Best analyzes the features and characteristics of all securities within an issuer’s capital structure and may adjust This criteria report was updated as part Equity Characteristics of the annual review process. No sub- • Permanency of capital; stantive changes were made to the prior edition. • Ability to defer interest or dividend payments; and • Subordination in an issuer’s capital structure (loss protection This criteria report can be found at provided to senior creditors). www.ambest.com/ratings/methodology Copyright © 2011 by A.M. Best Company, Inc. All rights reserved. No part of this report may be reproduced, stored in a retrieval system or transmitted in any form or by any means; electronic, mechanical, photocopying, recording or otherwise. Criteria reported balance sheet financial leverage rities, and in making assessments as to by giving, or possibly removing, equity what form of capital may be present in the credit for certain instruments. future and as to the permanency of that capital. For example, a company may be Senior management of an organization highly focused on maintaining or improv- often focuses on the equity credit that ing general measures of operating per- hybrids can receive in financial leverage formance such as earnings per share or calculations used in the rating process. return on common equity. In such cases, A.M. Best considers numerous factors the company may be unwilling to tolerate including, from a senior creditor’s stand- the dilution caused by the conversion of a point, the loss protection such securities security into common shares, and it may may provide and the favorable impact that in fact issue new debt securities to fund a the ability to defer cash payments on these share repurchase. securities may have on an organization’s ability to service all obligations or to fund In general, A.M. Best grants equity credit, internal growth. comprising up to 20% of a firm’s total capital, for hybrid securities that exhibit While financial leverage remains a critical the characteristics of common equity. The consideration during the rating process, amount of credit given to hybrid securi- A.M. Best believes that the effect of hybrid ties is based on A.M. Best’s belief that the securities on debt-service ability is also a insurance industry, as well as the broader key determinant of debt capacity. In addi- financial services sector, is very sensitive tion to the positive impact these securities to changes in the market’s perception of may have on operating cash flow through an issuer’s financial health. This sensitivity interest-deferral features, cash coverage may expose issuers to sudden changes in also can be tempered or strengthened the cost of capital or a diminished ability materially by a company’s consistency to access the capital markets in general. and sustainability of earnings and alter- As such, A.M. Best takes a conservative nate sources of cash, including cash at the view toward the amount of equity credit an parent holding company level and unre- individual security may receive, as well as stricted dividends from subsidiaries. It is the aggregate credit an issuer may receive. important to note the interaction between Additionally, A.M. Best calculates coverage financial leverage in rating analysis and ratios including hybrid obligations. capital adequacy to support all ratings within an organization. For more informa- As a general guideline, holding companies tion regarding risk-adjusted capital and its with financial leverage ratios less than 35% influence on ratings, please refer to A.M. (adjusted for equity credit) on a consolidated Best’s methodologies, Understanding BCAR basis are considered to have an acceptable for Life & Health Insurers and Understanding level of debt and hybrids for “a-” or higher BCAR for Property/Casualty Insurers at www. issuer credit ratings (ICRs); the range of 35% ambest.com/ratings/methodology. to less than 45% is considered acceptable for issuer credit ratings in the “bbb” category; Rating Methodology and leverage ratios greater than 45% are When assessing a specific entity’s capital associated with ICRs of “bb” and below (see structure, A.M. Best reviews the com- Exhibit 2). pany’s history in managing its overall capital base, its funding needs and the Best’s Equity-Debt Continuum sources and types of financing used to The equity-debt continuum shown in Exhibit satisfy its capital requirements. Integral 1 is the starting point in A.M. Best’s analysis to the overall rating process is having an of a hybrid’s equity credit. The focus of the in-depth understanding of management’s continuum is on the features of a particular historical and current strategies toward security and the amount of equity credit it maintaining appropriate levels of capital- may receive. The equity-debt continuum ization and the composition of its capital summarizes A.M. Best’s perspective on how base going forward. This understanding is debt-like or equity-like a given hybrid secu- of particular importance when attempting rity is based on seniority (loss absorption), to quantify equity credit for hybrid secu- maturity (permanency of capital) and the 2 Criteria cash-flow flexibility (deferability) provided While some forms of preferred stock may by its terms and features. receive nearly full equity credit, such as a perpetual noncumulative issue, other In ranking equity-credit-afforded securities forms may not receive any equity credit. For along the continuum, A.M. Best places straight example, issues with a stated duration and debt and securities with a cash put option a short time to maturity expose the issuer at one end and common stock at the other to refinancing or repayment risk. The issuer end. All other securities fall in between, based also may elect to replace these deeply sub- on loss-absorption characteristics and their ordinated obligations with securities having cash-flow flexibility. The placement of securi- a more senior claim in the overall capital ties shown in Appendix 1 reflects A.M. Best’s structure. Also, for lower-rated companies, typical perspective, though rating committees there is a risk that the organization may have flexibility to adjust equity credit attribu- not be able to issue new securities to repay tion based on individual circumstances. maturing issues. Exhibit 1 Exhibit 2 Best’s Equity-Debt Continuum Typical Holding Company Equity 100% 75% 50% 25% 0% Financial Leverage and Interest 0% 25% 50% 75% 100% Debt Coverage Guidelines Debt*/ Interest Classes of Hybrid Securities Issuer Credit Rating Category Capital Coverage** The determination of equity credit for aaa <15% >10X any given security is based on that instru- aa <25 >7X ment’s specific features when compared/ a <35 >5X contrasted with the characteristics of equi- bbb <45 >3X ty: no maturity, no ongoing payments and bb <65 >2X deep subordination. b >65 <2X Below is a brief overview of the major * Long-Term + Short-Term Debt (adjusted for equity credit)/ [Total Shareholder’s Equity + Minority Interest and Other + Pre- classes of hybrid securities from the ferred Stock (Non-Equity) + Long-Term Debt + Short-Term Debt context of features that typically warrant – Unrealized Gain (Loss) on Securities] ** (Pretax Operating Income + Interest Expense)/(Interest equity credit.