SEE THE STORM BEFORE IT’S COMING Evaluating the strength of an insurance company

INSURANCE

• Insurers’ do not pose the a systemic risk like some banking activities do.

• Insurers do not rely on wholesale market funding for liquidity. They fund themselves through premiums, with long term capital to support risk taking positions.

• Without insurance, no one could afford to take the risks necessary to grow a healthy economy.

Cyclical Industry

• Soft Market: where underwriting is less stringent so it's easier to obtain coverage, there's more competition between companies so the rates drop and it is easier to obtain the coverage so overall, the underwriting standards go down.

• Often during periods of soft insurance markets a lot of claims are filed causing companies to raise underwriting requirements, causing rates to go up, and that would lead to a hard insurance market.

0

10

20

30

40

50

60

70

1971 1976 1981 1986 1991 1996 2001

70

80

90

100

110

120

130

140Insolvencies

Combined Ratio

U.S. P/C Insolvencies vs. Combined Ratio 1971-2002

Source: A.M.Best Co. Special Report “P/C Industry – 2001 Insolvencies”, June 18, 2002

54 companies went insolvent in 1985, peaked in 1992 with 63 insolvencies, started to peak again in 2002 with 43 insolvencies.

Insurance Industry Stats:

• 2001 to 2005 Hard Market - Industry took lots of rate

• 2006 to 2010 Soft Market - Lots of reserve releases

• There have been 550 Property and Casualty Failures since 1970, total paid out – $26.8 billion.

• Combined Ratio of 100 produced an Industry ROE of 1979 = 16% , 2005 = 10% , 2009 = 7%

• PRESSURE = less investment income, more catastrophic claims, litigious society, stressed economy, smaller premiums.

Financial Strength Matters

AGENDA

• Key measurements for assessing insurer financial strength

• Using financial ratings• Key measurements for assessing the overall

health of the P&C insurance industry

Stressors for Troubled Companies

• Catastrophes• Rapid Expansion• Significant Change• Reinsurance Failure• Alleged Fraud• Inadequate Pricing/Reserve• Affiliate Problems• Investment Problems/Overstatement of Assets

Underlying Cause- Internal

• Management risk• Internal governance and control risk• Controller and group risk

Underlying Cause - External

• Economic cycle and condition risk• Social, technical, demographic, political, legal,

tax, etc. risk• Market competition risk• Catastrophe or extreme event risk

Primary Causes of P&C Impairments(1969 to 2008)

Alleged Fraud

Catastrophe Losses

Reinsurance Failure

Deficient Loss Reserves

Rapid Growth

InvestmentProblems/Overstates AssetsMiscellaneous

Impairment of Affiliate

Significant Change inBusiness*A.M Best 2009 Guide to Understanding Insurance Ratings

AIG Has $4.1 Billion Cost on Inadequate Reserves at Property-

Casualty Unit• February 9, 2010: American International Group Inc. said higher-

than-forecast claims costs cut fourth-quarter profit by $4.1 billion, and $2 billion previously designated to repay its bailout will be used to bolster the property-casualty unit. The insurer reached an agreement with the U.S. Treasury Department permitting the company to keep $2 billion of proceeds from the sale of Star Life Insurance Co. and Edison Life Insurance Co., New York-based AIG said today in a statement. Funds will be used by the Chartis property-casualty unit for losses tied to coverage including workers’ compensation and asbestos liability. AIG is adding to reserves, a sign that it underestimated the cost of claims, while rivals including Travelers Cos. have been taking profits after determining they had set aside more funds than necessary.

• Two types of reserves: Case and IBNR

Primary Causes of Life/Health Impairments(1976 to 2008)

Significant Change inBusinessAlleged Fraud

Miscellaneous

Investment Problems

Rapid Growth

Reinsurance Failure

Inadequate Pricing

Affiliate Problems

Recent Cases

• Credit Crisis of 2008– $180 billion in government funding for AIG

• Hurricane Katrina– Insured losses = 47.4 billion

• Hurricane Ike– Insured losses = 12.1 billion

*Look for symptoms before it is too late

Measuring the Financial Health of An Insurance Company

• An insurance policy is only as secure as the company that issues it

• There are qualitative and quantitative measures that are important for testing the health of an insurance company

Profitability Test

• Combined Ratio (after policyholder dividends)– Loss and LAE Ratio – Loss and Loss Adjustments/Net

premiums earned

– Underwriting Expense Ratio- Commissions and U/W Expenses/Net premiums earned

– Policyholder Dividend Ratio- policyholder dividend/net premiums earned

• Reserves are not part the loss ratio until paid.• HO are short tailed so need to run a low 86% c/r.• Auto have long tails and can run at 95% c/r.

Profitability Test

**From a profit perspective, the industry experienced an underwriting profit in three of the last 10 years (2004, 2006, and 2007). Prior to 2004, the property and

casualty market did not produce a combined ratio below 100% since 1978.

Leverage Test

• Underwriting Leverage– Current premium writings– Reliance on reinsurance– Reserves

• Financial Leverage• Asset Leverage

– Asset quality– Diversification– Liquidity

Operational Performance Test

• Underwriting performance• Investment income• Capital gains/losses• Total operating earnings

Qualitative Test

• Internal company risk management• Business profile• Quality of management

% Change in Underwriting Profit

Mean

-70% -30% +25% (Mean) +50%

Simulation Gives Us A New Measure Of Risk

The probability of a decline in underwriting profits (Value-at-Risk) is a useful risk measure.

20% probability of a 30% or greater

decline in underwriting profit

Using Financial Ratings

• Financial strength ratings:– A.M. Best– Standard & Poor’s– Moody’s Investor Services– Fitch Ratings

A.M. Best

• Financial strength ratings– An independent opinion of an insurer’s financial

strength and ability to meet its ongoing insurance policy and contract obligations

• Based on a comprehensive quantitative and qualitative evaluation of a company’s:– Balance sheet strength– Operating performance; and,– Business profile

Best’s Financial Strength Ratings

• A++, A+ Superior• A, A- Excellent• B++, B+ Good• B, B- Fair• C++, C+ Marginal• D Poor• E Regulatory Supervision• F In Liquidation

(3% of Insurance Co’s are A++, 25% A+, 50% A or A-)(Independent agents do not represent anything less than B+)

Secure

Vulnerable

Standard & Poor’s

• S&P Insurer Financial Strength Rating is a current opinion of the financial security characteristics of an insurance organization with respect to its ability to pay under its insurance policies and contracts in accordance with their terms.

S&P Financial Strength Ratings

Highly Likely to Meet Financial Commitments

Extremely Strong AAA

Very Strong AA

Strong A

Good BBB

Vulnerable

Marginal BB

Weak B

Regulation and Oversight

• Credit rating agencies– SEC– IOSCO– NAIC

• Insurance Companies– State insurance departments– State guaranty association– Federal Insurance Office (FIO):

• Lack of information source or knowledge base (evident after 9/11 and Katrina)

The Property & Casualty Industry

2008 Results• $450 billion in net premiums

written

• $1.5 trillion in assets

• $480 billion in policyholders’ surplus

Source: A.M. Best “U.S. Property/Casualty – 2008 Financial Review (4/13/2009)

104.5% 105.3%

92.0%94.3%

97.6%96.4%

98.4%

110.9%109.9%

102.7%

99.8%

104.9%103.5%104.5%

70%

80%

90%

100%

110%

120%

Industry

1994-2007 U.S. Combined Ratio – Home and Auto, Industry

1994-2006 U.S. Net W.P. Growth – Home and Auto, Industry

CAGR 1994-2006CPI: 10.3%

PL Industry: 5.1%

Industry

7.3%

2.0%2.6%

6.6%

9.5%

10.1%

2.0%1.8%

4.1%5.6%5.7%5.7% 5.5%

0.0%

5.0%

10.0%

15.0%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Industry

-10%

-5%

0%

5%

10%

15%

20%

25%

19

70

19

71

19

72

19

73

19

74

19

75

19

76

19

77

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

Current $ Real $

Note: Shaded areas denote hard market periods. Source: A.M. Best, Insurance Information Institute

Strength of Recent Hard Markets by Real NWP Growth

Real NWP Growth During Past 3 Hard Markets

1975-78: 8.6%

1985-87: 14.5%

2001-03: 9.1%

1975-78 1985-87 2001-03

Too Big to Fail?

• Stick to what you know• Insurance ratings can be misleading• Don’t chase extraordinary results• Risk Management and U/W Profit is key• When things go badly, they do so quickly• Some risks cannot be avoided • Affiliated businesses and distribution channels• Expect more Federal regulation of insurance• Avoid the “cheating phase” by posting adequate

reserves which in turn supports accurate rates.

2011 Fitch Outlook

• .9% Growth

• Flat Investment Income

• 103 Combined

• Net Income fall by 30%

• Key to Success is Risk Selection – Underwriting profit is a must.

What Writing Company are you in?