What Does Best's Capital Adequacy Relativity Mean?
Best's Capital Adequacy Relativity is a rating of the strength of an insurance company’s balance sheet. Best’s capital adequacy ratio, also known as BCAR, examines an insurer’s leverage, underwriting activities, and financial performance and uses this information to test various scenarios to see how each would impact the insurer’s balance sheet.
Best's Capital Adequacy Relativity Explained
Best's Capital Adequacy Relativity (BCAR) was developed by A.M. Best, a rating agency that focuses on the insurance industry. BCAR depicts the quantitative relationship between an insurance company's balance sheet strength and its operating risks. As the foundation of financial security, balance sheet strength is critical to the determination of a rating unit’s ability to meet its current and ongoing obligations.
BCAR emphasizes the balance sheet because it shows whether an insurer will be able to meet its policy obligations. Underwriting practices, specifically underwriting leverage, determine whether the insurer is underwriting the policies that it should be underwriting, or if it is taking on too much risk. BCAR takes into account the premiums currently written by the insurer, reinsurance coverage, and loss reserves. By establishing a guideline for the net required capital needed to support balance sheet strength, BCAR can assist analysts in differentiating among the financial strength of insurers and in determining whether a rating unit’s capitalization is appropriate for its risk profile.
The basic formula for BCAR is adjusted policyholders’ surplus (APHS) divided by net required capital (NRC). APHS takes into account unearned premiums, assets, loss reserves and reinsurance (equity adjustments), surplus notes and debt service requirements (debt adjustments), and other adjustments such as potential catastrophe losses and future operating losses. NRC components include fixed-income securities, equities, interest rates, credit, loss and loss-adjustment expense reserves, net premiums written, and off balance sheet items.
Limitations of Best's Capital Adequacy Relativity
The analysis of BCAR alone does not decide the balance sheet strength assessment. Other factors that can impact the balance sheet strength analysis include: liquidity, quality of capital, dependence on reinsurance, quality and appropriateness of reinsurance, asset/liability matching, reserve adequacy, stress tests, internal capital models, and the actions or financial condition of an affiliate and/or holding company, which may include a BCAR calculation at the holding company/consolidated level. Similarly, a rating is more than a balance sheet strength assessment and includes evaluations of a rating unit’s operating performance, business profile, and enterprise risk management.
The 2007-2008 financial crisis hit insurance companies hard. Many of them incorrectly priced risk, which led to insurers taking on more risk than they were able to cover with their reserves. A lack of adequate reporting, financial transparency, and regulatory complacency led to insurance regulators not understanding how exposed insurance companies were, and thus not monitoring their insolvency risk properly.