A.M. Best's Methodology: Perspective on Operating Leverage.OLDWICK, N.J. -- In forming an overall opinion of a company's balance sheet strengthCothe most important area in determining a company's ability to meet its current and ongoing obligations to policyholdersCoA.M. Best Co. reviews the organization's financial leverage. Financial leverage, through debt or debt-like instruments, may place a call on an insurer's earnings and strain its cash flow. Also, excessive financial leverage at the operating or holding company can lead to financial instability. Generally, the debt portion of an insurer's capital structure is utilized as working capital for its insurance lines. For organizations with debt issuing holding companies atop, dividends from the insurance subsidiaries typically represent a major source of debt service. Diversified enterprises that possess significant noninsurance operations, such as consumer finance and mortgage banking, may require additional funding. If the financing of other operations is to be serviced solely by the noninsurance businesses and meets the eligibility requirements outlined below, A.M. Best would likely consider the debt as operating leverage Operating Leverage A measurement of the degree to which a firm or project relies on fixed rather than variable costs. Notes: The higher the degree of operating leverage, the greater the potential danger from forecasting risk. rather than financial leverage. For organizations that issue debt or debt-like instruments directly from an operating insurance company, amounts eligible for operating leverage treatment generally would involve cases where residual risk Residual risk Related: Unsystematic risk to the insurer is insignificant. Because financial instruments may be issued either by holding companies or by operating companies operating company A business that engages in transactions with outsiders. (or by both), A.M. Best will apply specific tolerances at each operating company as well as on a consolidated basis. If the tolerance is exceeded at an individual operating company or in aggregate, A.M. Best would monitor closely the issuer's penchant for retail notes and/or institutional spread-based (ISB) products and would contemplate lowering the entity's stand-alone rating if growth trends vary substantially from previous expectations. Ultimately, debt obligations viewed by A.M. Best as operating leverage would be excluded fully from the calculation of consolidated financial leverage, unless the tolerance level is exceeded. A.M. Best broadly defines operating leverage as debt (or debt-like instruments) used to fund a specific pool of matched assets. Cash flows from the pool of assets should be sufficient to fund the interest and principal payments associated with the obligations. Additionally, the insurer must possess sound asset/liability and investment risk management capabilities, adhere to adhere to verb 1. follow, keep, maintain, respect, observe, be true, fulfil, obey, heed, keep to, abide by, be loyal, mind, be constant, be faithful 2. low duration mismatch mismatch 1. in blood transfusions and transplantation immunology, an incompatibility between potential donor and recipient. 2. one or more nucleotides in one of the double strands in a nucleic acid molecule without complementary nucleotides in the same position on the other tolerances, and maintain negligible repayment and liquidity risk related to these obligations. A.M. Best has developed specific guidelines guidelines, n.pl a set of standards, criteria, or specifications to be used or followed in the performance of certain tasks. for each operating company of a group and all operating companies combined. In short, A.M. Best would be uncomfortable with a statutory entity or group if the sum of ISB product liabilities, retail notes outstanding, liability for securities lending Securities Lending When a brokerage lends securities owned by its clients to short sellers. Notes: This allows brokers to create additional revenue (commissions) on the short sale transaction. and FHLB FHLB Federal Home Loan Bank loans exceeds 50% of general account "reserves" (defined here as lines 1 through 6.3 of the Life/Health Annual Statement). A.M. Best also will perform a test at the consolidated holding company level to determine the full impact of operating leverage treatment on an organization's published debt-to-capital ratio. Credit for operating leverage will be reduced if the sum of ISB product liabilities, retail notes outstanding, liability for securities lending, FHLB loans and match-funded holding company debt exceeds 35% of consolidated (GAAP GAAP See: Generally Accepted Accounting Principles GAAP See generally accepted accounting principles (GAAP). ) liabilities, excluding separate-account liabilities. Finally, for analytical purposes, A.M. Best will consider the impact of this exercise on the organization's interest coverage ratios. If debt is determined to be operating leverage, then the interest expense associated with those securities is excluded from the denominator denominator the bottom line of a fraction; the base population on which population rates such as birth and death rates are calculated. denominator of the interest coverage calculation. For more information on A.M. Best's rating Best's rating A rating A.M. Best Co. assigns to insurance companies based on the company's ability to meet its obligations to its policyholders. methodologies or to download a copy of this methodology report, visit http://www.ambest.com/ratings/methodology.asp. A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at www.ambest.com. |
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