Mactavish Insurance Materiality Analysis

1. Insurance Materiality Analysis (IMA)Introductory Presentation / Q&AAirmic Conference, Birmingham 17th June 2014Rob Smart, Technical DirectorBruce Hepburn, CEO

2. Mactavish Insurance Materiality Analysis Agenda • Introduction • The “insurance arrangement paradox” • Mactavish and Insurance Governance - Background • Insurance Materiality Analysis (IMA) – Key Components • Insurance Materiality Analysis (IMA) – Indicators & Benchmarks • Case Study One: Mid-size • Case Study Two: Large • Interpretation issues • Q&A

3. Mactavish Insurance Materiality Analysis Introduction • CTRL: One billion of cost over-run protection required from the insurance market: a “pain” barrier • Our project then focused on complex risk analysis and disclosure, feeding into the programme re-design with the brokers • It then got placed • And insurance thereby enabled CTRL to happen and this was recognised at the opening event for doing so by the LCR CEO • Insurance enabled risk to be taken, and business to be done • The collaborative process between client and underwriter in understanding the risk is vital to establishing a mutual understanding of value.

4. Mactavish Insurance Materiality Analysis Introduction cont …/ • It is only the subject of “probability” that allows the insurance market to dispense with in-depth case by case risk analysis and rely on portfolio based risk management instead, at the point of inception • But of course it turns to case by case analysis when a large claim occurs • This conventional placement approach when taken too far, whilst reducing frictional costs pre inception, undermines the very value of the insurance product and the value of the roles in arranging the product • There is absolutely no doubt that insurance provides enormous value and the role of arranging it properly is complex and valuable.

5. Mactavish Insurance Materiality Analysis Introduction • So why does insurance get so little focus in the Boardroom? • Why is so much more attention and resource applied to arranging lending facilities or share issues – practically every other type of finance? • We believe it is because of a lack of a requirement for (1) case by case risks analysis comparable with that required for debt and equity, and (2) because of a lack of financial sensitivity analysis alongside (again a key component of funding programmes for debt and equity) • Insurance ismoney • Being contingent, it is in fact more complicated to arrange than most other types of money – since the circumstances under which it pays out have to be agreed and documented.

6. Mactavish Insurance Materiality Analysis Introduction • A key tool to break the cycle is to analyse and communicate insurance in the language of finance, rather than as a commodity purchase. This is where Insurance Materiality Analysis (IMA) comes in • This seminar runs through some of the analysis working to support this argument, but the clarity of the messages above is clear. • Once accepted, there are several consequences in how Boards need to establish a governance framework around insurance placement and to increase focus on disclosure, coverage, placement audits and controls, and contracts to make sure that for strategically important policies the chances of a policy failing to respond is minimised.

7. Mactavish Insurance Materiality Analysis The “Insurance Arrangement Paradox” • IMA’s Central Question: Does Insurance Matter? • If so, why does it not get more attention? Arranging debt/equity Arranging insurance • Relatively secure: business hasthe money • Generally simple contract (at least once it is set up) • Capital providers tend to ask lots of questions and have time to do so • Resource applied & legal review of terms as standard • High level of Board focus, non-commodity • Relatively insecure: promiseof money only • Often complex contract: must define basis of coverage and many ongoing obligations • Capital providers tend to ask few, standard questions in very limited time pre-renewal • Resource applied & legal review of terms can be limited • Low level of Board focus, a commodity and a ‘necessary evil’

8. Mactavish Insurance Materiality Analysis Background: Mactavish and Insurance Governance • IMA is very simple analysis, but central to the whole theme of policy reliability and Insurance Governance, based on: • More businesses are today seriously financially dependent on insurance • Too many major claims are today being delayed / questioned • A working definition of ‘policy failure’: close to full-limit loss for a key class, delayed for 2+ years, quantum reduced by at least 1/3… • Most recent 2014 study (yet to be published), finds that of >400 UK firms: • ~40% had suffered a major/ strategically significant loss in recent years • ~45%of those claims were disputed • ~35months average dispute resolution time (where resolved) • Disputes driven by factors in the following order of prevalence, where only 3&4 are (in part) considered by Law Commission proposals: 1) Coverage; 2) Quantum; 3) Obligation breach; 4) Disclosure • Outcomes suggest that the insurance arrangement paradox does matter

9. Mactavish Insurance Materiality Analysis IMA Components: fundamental questions & answers • IMA approach is built around three simple questions: • How exposed is my business if insurance doesn’t respond or something is not covered by my policies? • How significant might changes to insurance cost be for the business? • How does insurance cost compare to other financing elements of the business? • None of these are, of course, new subjects for an AIRMIC audience – but the IMA seeks to provide a means to analyse & communicate common answers: • Insurance is a business critical tool which needs to work as expected if tested by a large claim • Insurance cost is often material even to large businesses, and is worth ensuring value is obtained as well as cost control • Insurance is often a highly efficient, good value method of financing infrequent/ unexpected events.

10. Mactavish Insurance Materiality Analysis IMA approach – an overview • Two core inputs required for Insurance Materiality Analysis, most of which is typically readily available from financial reports & renewal reports etc. 1. Financial reports 2. Insurance programme structure • All LOBs • Premiums, limits, retentions, layers for each class • Detail of any complicating factors, e.g. captives, cross-line deductibles, average retained losses etc. • Often conduct on major classes only if all that is available (would often exclude minor LOB in any case) • Profit & Loss account • Balance sheet • Cashflow statement • Notes to accounts/ context, e.g.: • Debt component breakdown • Interest payment breakdown • Unused loan facilities • Dividend policy detail • Explanatory notes re: depreciation / amortisation Context & programme structure are key to interpreting results

11. Mactavish Insurance Materiality Analysis IMA approach – Key Measures/ Benchmarks

12. Mactavish Insurance Materiality Analysis Case Study – Mid-Size (simple captive-free example)

13. Mactavish Insurance Materiality Analysis Case Study – Mid-Size (simple captive-free example) • Ability to withstand loss • “Defined policy failure” e.g.: £250m loss funded for 2 years with final settlement reduced by ~£83m • Insurance limits highly material vs. cash, even limiting to PPL due to high technology product – requiring major focus on policy coverage and reliability detail • Although not hugely leveraged, recent debt refinancing at increased cost suggests further debt could be difficult.

14. Mactavish Insurance Materiality Analysis Case Study – Mid-Size (simple captive-free example) Materiality of Insurance Cost - Cost of insurance at nearly 40% of net profit clearly highly material & subject to severe scrutiny - Need to think verycarefully about flagging (and managing) any potential increase in insurance costs.

15. Mactavish Insurance Materiality Analysis Case Study – Mid-Size (simple captive-free example) Efficiency & value of insurance - Overall relative maintenance cost at 0.2% of key LOB limits compares favourably with other capital access costs (as would be expected but a pronounced difference) - Combined with complex PDBI and PPL exposures suggests long-term value and that funding main operational risks through insurance is strategically valid.

16. Mactavish Insurance Materiality Analysis Case Study – Mid-Size (simple captive-free example) • Ability to withstand loss • “Defined policy failure” e.g.: £250m loss funded for 2 years with final settlement reduced by ~£83m • Insurance limits highly material vs. cash, even limiting to PPL due to high technology product – requiring major focus on policy coverage and reliability detail • Although not hugely leveraged, recent debt refinancing at increased cost suggests further debt could be difficult. Materiality of Insurance Cost - Cost of insurance at nearly 40% of net profit clearly highly material & subject to severe scrutiny - Need to think verycarefully about flagging (and managing) any potential increase in insurance costs. Efficiency & value of insurance - Overall relative maintenance cost at 0.2% of key LOB limits compares favourably with other capital access costs (as would be expected but a pronounced difference) - Combined with complex PDBI and PPL exposures suggests long-term value and that funding main operational risks through insurance is strategically valid.

17. Mactavish Insurance Materiality Analysis Case Study 2 – larger business • Ability to withstand loss • “Defined policy failure” e.g.: £500m loss funded for 2 years with final settlement reduced by ~£165m • Low level of existing debt and unused existing facility suggests other capital could be raised at similar cost • Insurance limits material overall but few primary LOB limits/ EMLs above £100m, suggesting some resilience. Significant potential for strategic disruption despite financial strength. • Materiality of Insurance Cost • - At 2% (external spend) or 4% (total cost) of net profit, insurance & risk remain significant spends for the business • Despite difficulty of comparing, cost of <5% of profit remains favourable compared to many smaller / higher risk businesses. • Efficiency & value of insurance • At an overall level, insurance cost is low relative to accessing non-contingent capital within the business (tentative comparison given range of risk events covered) • Most relevant analysis excludes captive costs and excess layers with little premium attaching.

18. Mactavish Insurance Materiality Analysis IMA: Interpretation issues • Like all top-down financial analysis, IMA is subject to some obvious limitations: • Often don’t need all the detail: key messages are what most often matter • Cautious positioning sensible given, e.g.: • Limited comparison potential re benchmarks • Obvious relative cost benefit of contingent vs non-contingent capital • Simplified financial analysis (e.g. avoiding WACC etc.) • Potential for unforseen financial context to alter analysis (e.g. short-term results volatility; known capex plans; unusual funding mechanisms within Group etc.).

19. Mactavish Insurance Materiality Analysis IMA: Questions & Answers • Points of uncertainty around IMA itself? • IMA implications for Insurance Governance, e.g. questions to consider: • Have we maximised what we disclose (and how it is presented) to avoid an accusation of material non-disclosure? • Have we identified potentially contentious sources of claim cost and agreed how they will be treated? • Is policy coverage adapted to our business needs, and sufficiently defined in respect of likely loss scenarios? • Are we aware of and managing compliance with all of our obligations created by the contract? • Are the contract terms fair and reasonable from both a commercial and legal point of view? • Does the placement process allow time and resource to work through the above before renewal?