Criteria -- Taiwan Ratings Corporation Rating Criteria Non-life Insurance Ratings Methodology

Criteria

Taiwan Ratings Corporation Rating Criteria Non-life Insurance Ratings Methodology

(Editor's notes: These criteria have been superseded by the article titled "Criteria | Insurance | General: Interactive Ratings Methodology," published on April 22, 2009)

INTRODUCTION
TRC and Standard & Poor's rating methodology uses a wide variety of both qualitative and quantitative information. While much of the rating process is objective in nature - i.e., drawing on numeric analysis - a large part also is based on subjective analysis and opinion. This subjectivity allows TRC and Standard & Poor's to fully incorporate a variety of non-statistical issues into its analysis and to impute an appropriate "forward-looking" perspective in company ratings. The rating methodology involves detailed analysis in the following areas: industry risk, business review, management and corporate strategy, operating performance, investments, capital adequacy (including reinsurance adequacy and reserve adequacy), liquidity, and financial flexibility. This approach enables TRC and Standard & Poor's to develop ratings that take the differences in the various insurance sectors into account, while maintaining a high level of comparability in the assigned ratings.

INDUSTRY RISK
Industry risk is the environmental framework in which an insurance company operates. TRC and Standard & Poor's attempt to evaluate industry risk based on the types of insurance written (line of business, or sector) and geographic profile of the insurer. For insurers that are part of larger, more diversified groups, TRC and Standard & Poor's will also look at non-insurance-related activities to assess how favourable or unfavourable these industry conditions may be, and the potential impact on the health of the group's non-insurance operations as well. Key points that TRC and Standard & Poor's consider in its analysis of insurance industry risk are:

Potential threat of new entrants in the market
Threat of substitute products or services
Competitiveness/volatility of the sector
The potential "tail" to liabilities (i.e., ease or difficulty in exiting a market) or risk of catastrophic losses
Bargaining power of insurance buyers and suppliers
Strength of regulatory, legal, and accounting frameworks in which the insurer operates

Broadly speaking, the lower the industry risk, the higher the average rating of companies operating in that sector or line(s) of business. Low industry risk implies an operating environment favourable to insurers from a competitive standpoint, a regulatory framework conducive to supporting insurer solvency, and conservative accounting standards. Under these conditions, insurers would be expected to generate more favourable and less volatile operating results and have stronger balance sheets than insurers operating in higher industry risk sectors. However, insurers with high industry risk profiles - i.e., relatively risky business mixes and/or unfavourable operating environments - will not automatically find their ratings "capped" or limited by these circumstances. Nevertheless, TRC and Standard & Poor's analysis recognises that the more onerous conditions are, the more difficult it may be for insurers to demonstrate the kind of business profile, earnings strength/stability, capital resilience, and financial flexibility that characterise very highly rated companies.

BUSINESS REVIEW
In the business review section TRC and Standard & Poor's analyze the insurer's business profile with the aim of evaluating its revenue-generating capacity and its competitive strengths and/or weaknesses. The analysis looks not only at the company's past and present position, but at how TRC and Standard & Poor's believe the company will fare going forward, given its particular characteristics, strategy, and the competitive climate. Additionally, if the insurer is part of a larger group, TRC and Standard & Poor's also will analyse other insurance companies or non-insurance operations, irrespective of whether or not they are rated. This allows TRC and Standard & Poor's to gain a complete understanding of how the rated insurer fits in with the rest of the group, the nature of these related activities, and whether these activities add strength to, or detract from, the company being rated. Key points that TRC and Standard & Poor's consider in its analysis of business review are:

What are the company's competitive strengths and weaknesses
What does the organisation look like - both its legal and functional structures
Diversification of business mix - by geographic region, sector or line of business, distribution source
Growth rates of premiums - in total and by line of business - on both net and gross bases, generally over a five-year period
Market share for the total company and by major lines of business
Quality and spread of distribution channels
Related non-insurance activities of the group

MANAGEMENT & CORPORATE STRATEGY
Whilst management and corporate strategy is one of the most subjective areas in the rating methodology, TRC and Standard & Poor's also believe it is one of the most critical. The quality and credibility of an insurer's senior management team is a key determinant in how successful that company will be going forward. TRC and Standard & Poor's look at three main areas:

The strategic positioning/focus of the insurer
Operational controls & skills
Financial strategies and management's tolerance for risk

On the strategic front, TRC and Standard & Poor's look at the company's aims and goals, how the company intends to reach these goals, how it measures its achievements, and whether plans make sense in light of industry dynamics and the management team's capabilities. Additionally, TRC and Standard & Poor's look at how the company organises its planning process, and how the process is related to managing and measuring company performance. TRC and Standard & Poor's also look at management's operational skills - i.e., their ability to successfully execute their chosen strategies - and assesses their internal control systems. Finally, TRC and Standard & Poor's also look at management's financial risk tolerance- i.e., how various types of balance sheet risk (from investment and underwriting practices, and from choosing a particular capital structure) are measured, controlled, and balanced against other considerations within the organisation. This would include a detailed understanding of management's tolerance and guidelines for maintaining levels of solvency or solvency ratios, and gearing up of the balance sheet with debt.

OPERATING PERFORMANCE
In the operating performance section TRC and Standard & Poor's determine how a company's ability to implement its strategies, capitalise on its strengths, and manage its weaknesses, translates into operating performance. TRC and Standard & Poor's believe healthy operating performance is vital, as internally generated earnings should be the primary source of future capital growth for an insurer. Although TRC and Standard & Poor's evaluation of earnings is primarily driven by quantitative factors, a number of qualitative aspects also play a role. Analysis of operating performance is broken down into two sections. The first section specifically is devoted to an analysis of underwriting performance. In the second section TRC and Standard & Poor's assess the company's overall performance, which incorporates the effect of investment returns and other revenues and expenses in addition to underwriting performance. The analysis of underwriting performance looks at:

Loss ratios - total company and for major sectors or lines of business
Expense ratios
Combined ratios - total company and for major sectors or lines of business
Operating ratios (combined ratios adjusted for investment income as a percentage of net premiums earned)
Effect of reserving and accounting practices on reported figures

Analysis of underwriting results by studying loss ratios, expense ratios, and combined ratios, gives a first impression of earnings strength. However, TRC and Standard & Poor's recognise that very different business mixes with different loss reserve needs - i.e., long- versus short-tail business - often can make superficial comparisons of combined ratios meaningless. Comparisons of operating ratios, which reflect the greater role of investment earnings in long-tail portfolios, allow for greater comparability between portfolios.

Additionally, TRC and Standard & Poor's take into account the fact that a country's accounting and reserve practices can sometimes give a distorted view of the true underlying picture - particularly when discounting of loss reserves is permitted - and the analysis will make adjustments as necessary. The analysis of a company's overall performance focuses on:
Diversity of earnings by business unit, sector, product line, distribution channel
Stability/volatility of earnings
Return on revenue (both pre-tax and post-tax)
Return on assets (both pre-tax and post-tax)
How the strength of reserving/accounting practices may affect reported figures

TRC and Standard & Poor's use return on revenue as the main benchmark for evaluating a non-life insurer's overall profitability from its basic insurance business. In general, this measure gets beyond the impact on underwriting performance resulting from different business mixes (i.e., long- versus short-tail lines), as investment income is included as an additional source of earnings. Return on revenue would also reflect the impact of other, non-underwriting factors such as fee income, debt interest expense on borrowings, and other expenses or revenues, on earnings. Return on revenue typically excludes realised capitals gains, as TRC and Standard & Poor's believe that for many companies capital gains harvesting largely is opportunistic - a function of economic and interest rate conditions.

However, to the extent that companies can demonstrate a consistent strategy of realising capital gains as part of a total investment and operating strategy, TRC and Standard & Poor's will adjust its analysis accordingly.

TRC and Standard & Poor's return on assets measure includes net realised capital gains, as this gives the best overall picture of an insurer's total financial performance. Although many organisations use return on equity as a performance benchmark, TRC and Standard & Poor's tend not to emphasise this ratio as a key indicator of operating results, because it is influenced by the company's capital structure when debt is used. Return on revenue and return on assets are somewhat insulated from this effect.

Quality of earnings also is important. All else being equal, companies with greater earnings diversification and hence, likely greater earnings stability, are viewed more favourably than those with more concentrated profit streams: in the event of an unexpected "shock" a diversified insurer's overall earnings will be more resilient than an insurer that lives or dies by the success of one or two dominant lines. TRC and Standard & Poor's also will consider the effect of different countries' regulatory and tax regimes on both underlying and reported profitability. For example, strong regulation which has helped support industry pricing and benefited insurer profitability will be factored into TRC and Standard & Poor's view of operating performance. In territories where there is a highly structured approach to asset depreciation through the reported income statement, TRC and Standard & Poor's will adjust its analysis to get the best understanding of underlying operating performance as distinct from these investment/accounting issues.

The strength of reserving and accounting practices also can affect reported earnings, and TRC and Standard & Poor's attempt to get beyond the published figures to better evaluate underlying profitability. Where possible, changes in statutorily required equalisation and catastrophe reserves will be stripped out of reported results and will be treated as a direct change to equity. Similarly, TRC and Standard & Poor's remove the effect of unrealised capital gains and losses from "above the line" profits, and takes these items as direct adjustments to equity. For insurers whose loss reserving policies TRC and Standard & Poor's believe are particularly strong or weak, analysis of reported operating results will take this conservatism into account in evaluating the true level of profitability.

Management's approach to accepting, measuring, and managing risk from investment activities
Asset allocation strategies
Asset credit quality
Asset diversification (by asset class, sector, maturity, issuer)
Portfolio liquidity
Investment returns (current yields and total returns)
Asset valuation ("hidden" asset values; market values versus book values)
Capital gains realisation strategies
Asset/liability management
Interest rate and foreign exchange management practices
Use of derivatives and other financial instruments

TRC and Standard & Poor's form an opinion about the health of the invested asset portfolio in terms of asset quality, liquidity, concentration risks, and returns. Strategies for capital gains harvesting are explored in detail, as insurers often differ in how they balance current income against capital gains as part of their total investment strategy. As a key part of understanding this process, TRC and Standard & Poor's must get comfortable with an insurer's approach to asset valuation, particularly for investments where market values are not readily identifiable.

CAPITAL ADEQUACY
TRC and Standard & Poor's focus on capital adequacy in two ways: first, at the level of capital needed by insurers to support their business needs at a given rating level, and second, from a structural/quality of capital perspective. In many cases, analysis will go beyond the insurer being rated and will look at the entire group of which the rated insurer is a part, and will involve holding company analysis as well, where applicable. TRC and Standard & Poor's have developed a sophisticated risk-based capital model which analyses these factors and develops a capital adequacy ratio. The model plays an important role in influencing our view of an insurer's capital strength, but is only one tool in the rating process.

An insurer's rating is not based solely on this one criterion. TRC and Standard & Poor's evaluation of capital adequacy at the operating level attempts to compare an insurer's current and prospective needs for capital against a true "underlying"- as opposed to reported - level of capital within the organisation. Capital considered in the context of the mix and riskiness of the insurer's lines of business and its investment policies, company growth prospects, need to financially support subsidiaries or provide parental dividends, financial gearing, adequacy of reinsurance protection and loss reserves, and a capital cushion to absorb unexpected events. Available capital is viewed as an insurer's reported capital, adjusted, as appropriate, for hidden asset values, asset quality/volatility charges, loss reserve and reinsurance recoverables adequacy, expected sources of new capital, and the aggressiveness/conservatism of accounting standards.

The evaluation of capital adequacy also looks at how highly geared an insurer, or insurance group, may be. Key gearing benchmarks include financial leverage, reserve leverage, and investment leverage. Financial leverage (or gearing) looks at how much of an insurer's capital structure is supported by equity and how much by debt-type instruments. Ratios typically reviewed include:
Debt/capital (capital defined as debt plus equity)
Preference shares/capital
Debt + preference shares/capital
Fixed charge coverage (with and without preference shares dividends, as appropriate)

TRC and Standard & Poor's often will look beyond the rated entity and will evaluate consolidated group gearing to fully assess the overall strength of an organisation's capital structure and the effect of gearing on the insurer being rated. TRC and Standard & Poor's also will consider a company's fixed charge coverage, as particular strength or weakness in this measure may partly mitigate or compound the level of balance sheet risk associated with financial leverage. Preference shares, subordinated debt, and other "hybrid" instruments often have unique qualities and structures, and may exhibit both equity-like and debt-like characteristics; TRC and Standard & Poor's evaluate these instruments individually to determine the best way of addressing each company's particular situation. TRC and Standard & Poor's also consider whether the maturity structure of borrowings is well-balanced or skewed to either the short - or long-term, thus exposing the company to greater risk.

Reserve leverage, defined as loss reserves/equity, examines how exposed an insurer's surplus is to changes (i.e., unexpected reserve deficiencies) in loss reserves. The higher the leverage ratio, the more threatened an insurer's financial strength is to an unexpected loss reserve deficiency or need to strengthen reserves. However, these absolute ratios need to be looked at carefully, as they may be influenced both by a company's business mix and financial reporting standards. The ratio of loss reserves to earned premiums is also analysed, as changes in this ratio may indicate trends in reserving conservatism; however, these ratios also can be affected by changing business mixes and relative strength or weakness of underwriting conditions.

Investment leverage, defined as the ratio of "real" assets (equities and property) to equity, looks at how exposed an insurer's capital is to potentially volatile assets. TRC and Standard & Poor's also will look at the size of investment in subsidiaries and affiliates relative to an insurer's capital, and assess the extent of this "double leveraging". Other "quality of capital" issues which are assessed include the extent to which generous accounting policies may portray an insurer in an overly-positive light (i.e., through over-valued assets, or aggressively-valued goodwill or deferred acquisition costs), use of reinsurance to support capital adequacy, and dilution of capital strength through excessive use of preference shares or hybrid equity instruments.

Finally, within the analysis of capital adequacy, TRC and Standard & Poor's also look at loss reserve adequacy and reinsurance adequacy: Reserve adequacy and quality: For non-life insurers and reinsurers, reserve adequacy is one of the most important components of financial health, yet it is also one of the most difficult to accurately measure and assess. Where possible, TRC and Standard & Poor's attempt to get as complete a picture as possible about an insurer's reserving methodologies and practices, and an understanding of reserve adequacy based on accident or underwriting year development. Insurers in some countries hold significant "hidden" reserves within their technical reserves; where possible.

TRC and Standard & Poor's aim to get an understanding of the size of these reserves and how they are managed. Armed with sufficient information, TRC and Standard & Poor's also will run its own loss reserve development models, based on several well-known industry techniques, to develop its own view of reserve adequacy and sensitivity to certain assumptions.

Reinsurance protection: TRC and Standard & Poor's also assess an insurer's philosophy and practices for reinsurance protection. The analysis considers how dependent the insurer's own business is on reinsurance protection (i.e., is the company a net writer, or does it write large exposures with the expectation of passing off most of the risk to reinsurers), the structure of the programme (including analysis of catastrophe exposures, aggregates, and PMLs), the company's vetting process for choosing its reinsurers, overall quality of the reinsurance programme, and handling/measurement of reinsurance recoverables.

LIQUIDITY
This section combines both qualitative and quantitative analysis. TRC and Standard & Poor's focus on an insurer's three primary sources of liquidity:

Underwriting cash flows
Total operating cash flows
Investment portfolio liquidity

Underwriting cash flows are comprised of premium revenues received, less claims, commissions, and operating expenses paid. Over time, all financially healthy insurers need to demonstrate positive underwriting cash flow ratios. However, TRC and Standard & Poor's recognise that given the nature of some general insurance and reinsurance lines, cash flows may be somewhat volatile year to year. Also, different business mixes between insurers also may contribute to dissimilar underwriting cash flow patterns. Underwriting cash flows may closely track underwriting results for a company writing a short-tail portfolio of business, but writers of long-tail business may find underwriting results affected by reserving issues that do not necessarily carry through to underwriting cash flows in the same year.

Operating cash flows, which should be strong and clearly positive over time, reflect underwriting cash flows, adjusted for investment income and other income received, less payments of policyholder dividends, taxes, and other expenses paid. TRC and Standard & Poor's typically exclude realised capital gains from these calculations, but recognises that different investment strategies between companies and/or regions - i.e., focusing more on capital gains than current income - will affect these ratios. Where appropriate, these differences will be factored into the analysis.

The ability to sell certain investment assets also is a potential source of liquidity; however, the ability to sell these assets - as quickly as desired and/or at the sought-after price - often is dependent on market conditions. Hence, TRC and Standard & Poor's tend to view asset sales as second-tier liquidity. Companies needing to sell significant assets to manage daily operations could well be facing serious problems.

Additionally, TRC and Standard & Poor's also inquire whether the insurer maintains any committed bank lines or credit facilities with financial institutions that could provide access to liquidity on short notice.

FINANCIAL FLEXIBILITY
In this section, where the analysis primarily is qualitative. TRC and Standard & Poor's look at an insurer's potential needs for additional capital or liquidity in the future, and compares it to the sources of additional capital or liquidity that may be available. Restricted access to additional funds may not pose a serious problem for a company, provided its potential needs are equally limited. TRC and Standard & Poor's carefully evaluate situations where an insurer's possible or probable need for future funding may outstrip its access to these funds.

Companies may have a need for extraordinary capital or liquidity to finance rapid growth or acquisitions, support affiliated operations, or manage through unexpected difficult situations. Sources of extra capital or liquidity can be equally varied, and include deep-pocketed parents or related companies, accessing the capital markets (equity and debt markets, either on a local or global scale), sale of non-strategic assets, and additional use of reinsurance.

Lack of access to equity markets per se is not a problem, provided an insurer's need for future extra resources is expected to be fairly limited or can be adequately addressed via other means. TRC and Standard & Poor's rating process does not automatically penalise mutual insurers relative to proprietary companies.

*Potential threat of new entrants in the market
*Threat of substitute products or services *Competitiveness/volatility of the sector
*The potential "tail" to liabilities (i.e., ease or difficulty in exiting a market) or risk of catastrophic losses
*Bargaining power of insurance buyers and suppliers
* Strength of regulatory, legal, and accounting frameworks in which the insurer operates

*What are the company's competitive strengths and weaknesses
*What does the organisation look like - both its legal and functional structures
*Diversification of business mix - by geographic region, sector or line of business, distribution source
*Growth rates of premiums - in total and by line of business - on both net and gross bases, generally over a five-year period
*Market share for the total company and by major lines of business *Quality and spread of distribution channels
*Related non-insurance activities of the group

Additionally, TRC and Standard & Poor's take into account the fact that a country's accounting and reserve practices can sometimes give a distorted view of the true underlying picture - particularly when discounting of loss reserves is permitted - and the analysis will make adjustments as necessary. The analysis of a company's overall performance focuses on:
*Diversity of earnings by business unit, sector, product line, distribution channel
*Stability/volatility of earnings
*Return on revenue (both pre-tax and post-tax)
*Return on assets (both pre-tax and post-tax)
*How the strength of reserving/accounting practices may affect reported figures

Quality of earnings also is important. All else being equal, companies with greater earnings diversification and hence, likely greater earnings stability, are viewed more favourably than those with more concentrated profit streams: in the event of an unexpected "shock‥a diversified insurer's overall earnings will be more resilient than an insurer that lives or dies by the success of one or two dominant lines. TRC and Standard & Poor's also will consider the effect of different countries' regulatory and tax regimes on both underlying and reported profitability. For example, strong regulation which has helped support industry pricing and benefited insurer profitability will be factored into TRC and Standard & Poor's view of operating performance. In territories where there is a highly structured approach to asset depreciation through the reported income statement, TRC and Standard & Poor's will adjust its analysis to get the best understanding of underlying operating performance as distinct from these investment/accounting issues.

INVESTMENTS
Of key importance here is how the insurer's investment strategy fits with its liability profile, and to what extent do investment results contribute to total company earnings. TRC and Standard & Poor's are aware that broad investment strategies may differ between countries -for example, in certain European countries, insurers hold more equities and property than their US counterparts - and will incorporate these regional differences in its evaluation of any individual insurer's particular situation. Regional differences in how insurers value their investments for reporting purposes - market value, amortised cost, lower of cost or market value, or lower of cost or market value ever -also is addressed in the analysis. Key investment issues assessed by TRC and Standard & Poor's include:
* Management's approach to accepting, measuring, and managing risk from investment activities
*Asset allocation strategies
*Asset credit quality
*Asset diversification (by asset class, sector, maturity, issuer)
*Portfolio liquidity
*Investment returns (current yields and total returns)
*Asset valuation ("hidden" asset values; market values versus book values)
*Capital gains realisation strategies
*Asset/liability management
*Interest rate and foreign exchange management practices
*Use of derivatives and other financial instruments

The evaluation of capital adequacy also looks at how highly geared an insurer, or insurance group, may be. Key gearing benchmarks include financial leverage, reserve leverage, and investment leverage. Financial leverage (or gearing) looks at how much of an insurer's capital structure is supported by equity and how much by debt-type instruments. Ratios typically reviewed include:
*Debt/capital (capital defined as debt plus equity)
*Preference shares/capital
*Debt + preference shares/capital
* Fixed charge coverage (with and without preference shares dividends, as appropriate)

LIQUIDITY
This section combines both qualitative and quantitative analysis. TRC and Standard & Poor's focus on an insurer's three primary sources of liquidity:
*Underwriting cash flows
* Total operating cash flows
*Investment portfolio liquidity