The Insurance Cycle is Alive and Well and Ready to Kill Your Company: Are Actuaries to Blame?

1. The Insurance Cycle is Alive and Well and Ready to Kill Your Company:Are Actuaries to Blame? Casualty Actuarial Society Ratemaking Seminar New Orleans, LA March 10, 2005 Robert P. Hartwig, Ph.D., CPCU, Senior Vice President & Chief Economist Insurance Information Institute 110 William Street New York, NY 10038 Tel: (212) 346-5520 Fax: (212) 732-1916 bobh@iii.org  www.iii.org

2. Presentation Outline • P/C Financial Overview & Outlook: The Cycle Returns • Premiums • Underwriting Performance • Pricing, Profits • Capital/Capacity • Investments • Financial Strength/Ratings • Will it Be Different This Time Around? • Actuaries: Are They to Blame? • 3 Case Studies: PPA, Homeowners & WC • Investment Income Influence Considerations • Exogenous Influences • Possible Solutions • Summary • Q & A

3. P/C FINANCIAL OVERVIEW

4. Highlights: Property/Casualty,9-Months 2004 vs. 9-Months 2003 Growth rate less than half that of a year earlier An underwriting profit? What’s that? Record Surplus! *2003 surplus figure is as of 12/31/03 **The combined ratio for full-year 2003 was 100.1 Combined < 100

5. CYCLICAL EVIDENCE:PREMIUMS

6. Strength of Recent Hard Markets by NWP Growth* 1975-78 1984-87 2001-04 Real NWP Growth During Past 3 Hard Markets 1975-78: 8.6% 1984-87: 11.2% 2001-04E: 6.8% Premium growth is faltering. Real growth in 2005 will approach ZERO. Note: Shaded areas denote hard market periods. Source: A.M. Best, Insurance Information Institute *2004 based on 1st half results from ISO. 2005 figure is III forecast.

7. CYCLICAL EVIDENCE:UNDERWRITING PERFORMANCE

8. P/C Industry Combined Ratio 2001 = 115.7 2002 = 107.2 2003 = 100.1 2004: 9 mos. = 97.9 2005F = 99 Combined Ratios 1970s: 100.3 1980s: 109.2 1990s: 107.8 2000-04E: 106.5 The industry has just experienced its most remarkable recovery in recent history *9-month result. Sources: A.M. Best; ISO, III

9. Underwriting Gain (Loss)1975-2004F 2004 is likely to produce the first underwriting profit since 1978 $ Billions *Based on 9-month result. Source: A.M. Best, Insurance Information Institute

10. Commercial vs. Personal Lines Combined Ratios Compression of results is due to low interest. Underwriting is now more important in long-tail commercial lines 10-Year Average Combined Ratios* Commercial: 109.9 Personal: 104.4 Source: A.M. Best; Insurance Information Institute *1994-2003 average

11. Combined Ratios:2004 vs. 2005E Combined ratios are expected to change very little in 2005, masking a deterioration of about 2 to 3 points associated with 2004’s catastrophe impacted results Commercial auto, CMP, Inland Marine results remain reasonable, but WC, GL still problematic Source: A.M. Best Review/Preview, January 2005; Insurance Information Institute.

12. Combined Ratio: Reinsurance vs. P/C Industry • 2001’s combined ratio was the worst-ever for reinsurers; 2002 was bad as well. • 2003: Big improvement in primary and reinsurer segments *Through 2004:Q3 Source: A.M. Best, ISO, Reinsurance Association of America, Insurance Information Institute

13. Underwriting Expense Ratio* Insurers are keeping expenses under control *Ratio of expenses incurred to net premiums written. Source: A.M. Best; Insurance Information Institute

14. CYCLICAL EVIDENCE:PROFITABILITY

15. P/C Net Income After Taxes1991-2004E* ($ Millions) • 2001 ROE = -2.6% • 2002 ROE = 1.0% • 2003 ROE = 9.4% • 2004 ROE = 11.5%F *9-Month results; F = Full Year forecast/estimate. Sources: A.M. Best, ISO, Insurance Information Institute.

16. ROE: P/C vs. All Industries 1987–2004E Source: Insurance Information Institute; Fortune

17. ROE vs. Equity Cost of Capital: US P/C Insurance:1991 – 2004F The p/c insurance industry likely achieved its costs of capital in 2004 for the first time in many years +1.6 pts -1.2 pts -10.2 pts -14.6 pts US P/C insurers missed their cost of capital by an average 6.5 points from 1991 to 2003 Source: The Geneva Association, Ins. Information Inst.

18. THE CYCLE LIVES:IT REALLY WILL BE DIFFERENT THIS TIME Won't It?

19. YES!

20. YES!It Be Different This Time Around! • New Management: Benefit of 20/20 Hindsight • Most (re)insurer CEOs have been replaced over past 5 years • New management teams not eager to repeat past mistakes • Management Mantra: Preaching Disciplined UW & Pricing • Information Flow: • Many insurers have now implemented MIS systems that reduce recognition lags & reaction times and increase info flow • Compensation Structure: Not Just Volume Based • Stock incentives playing a lesser role • Strict adherence to UW manual and pricing • Sarbanes-Oxley • CEO/CFO’s personal assets on the line • Board of Directors quality enhanced; less chummy • Reserves become more adequate • Actuaries, UWs, accountants all on board & getting tough

21. YES!It Be Different This Time Around! • Ratings Agencies • Have become de facto regulators • Keeping a tight leash on upgrades and paying a lot of attention to capital/reserve adequacy & profitability-industry disciplined • Investment Analysts • Subject insurers to greater scrutiny • Regulators • Finally waking up • Quasi-Regulators • Spitzer, other AGs, SEC will keep industry on its toes • Tort reform is finallyhappening • Republican Domination of Congress/White House Good for Industry • We’re Better at Anticipating New/Emerging Risks • Better at Managing Existing Risks/Reducing Volatility

22. NO!

23. NO!It Won’t Be DifferentThis Time Around! • Management Never Learns: Hindsight Means Nothing • 80 years of history show management repeats same mistakes • Quarterly earnings and growth targets are still king • Mantra of UW & Pricing discipline is just lip service • P/C Insurance Will Always Be an Impossible Business • Impossible to use past information to determine prices today for a product sold tomorrow for claims that may arise in the distant futureAND expect to be right • Investor Fatigue • Wall Street is fed up with low returns; no capital for you • Capital is now highly opportunistic; not committed to long run • Investments: Still Used to Paper Over Poor UW & Pricing Decisions • Cash flow underwriting is back in vogue (or soon will be)

24. NO!It Won’t Be DifferentThis Time Around! • Regulators Still Asleep at the Switch • E.g., Piling on to Spitzer investigation • Vehement defense on status quo regulatory environment • Still do Bad Job Managing Variability/Volatility • 2004 hurricane season, D&O, Products Liability • Constantly blindsided • Tort Reform: Keep on Dreamin’ • Big loopholes in Class Action Fairness Act • Act was watered down (no atty. fee limits or damage caps) • Forum shopping at the federal level still possible • Republican Congress/White House Don’t Care About Us • Except CAFA, little success in Washington over past few years • Spitzer investigation = opportunity to heap scorn on industry

25. What Wall Street Thinks • *The commercial insurance market is softening as prices decline, particularly in short tail lines, and competition increases. • Company X [name omitted] said that it would reduce pricing for its best customers in what we view as a potentially troubling trend because it’s a slippery slope. • Falling pricing, less restrictive terms and conditions, and a shift innegotiating leverage away from the insurers to the commercial insurance buyers should result in a challenging operating environment for the commercial insurers in 2005, as well as lower premium growth and deteriorating margins • Demand for reinsurance is flat, while supply has increased. Source: Prudential Securities’ P/C insurance analyst, Jay Gelb, March 9, 2005

26. CAUSE FOR CONCERN? THE CYCLE IS A NATURAL BORN KILLER

27. FINANCIAL STRENGTH, SOLVENCY & SECURITY

28. Downgrade/Upgrade Ratio* Downgrade to upgrade ratio is falling (primarily because the number of downgrades is falling; only a small increase in upgrades) Sources: Impairment Rate and Rating Transition Study—1977 to 2002, A.M. Best & Co. *U.S. property/casualty and life/health insurers before 2000; P/C only 2000-2004.

29. P/C Company Insolvency Rates,1993 to 2002 • Insurer insolvencies are increasing • 10-yr industry failure rate: 0.72% • Failure rating for B+ or better rating: 0.49% • Failure rate for D through B rating: 1.29% 10-yr Failure Rate = 0.72% 30 30 38 Source: A.M. Best; Insurance Information Institute

30. Reason for P/C Insolvencies(218 Insolvencies, 1993-2002) Reserve deficiencies account for more than half of all p/c insurers insolvencies Source: A.M. Best, Insurance Information Institute

31. RESERVING PROBLEMS:ARE ACTUARIES TO BLAME?

32. P/C Insurance Industry Reserve Development from Prior Year* Adverse reserve development totaled $47.8 billion from 2000 through 2003 Adverse reserve development is the #1 killer of p/c insurance companies: Strength Matters *Negative numbers indicate favorable development; positive figures represent adverse development. Source: A.M. Best, Morgan Stanley, Dowling & Partners Securities, Prudential Securities, Ins. Info. Inst.

33. CALENDAR Year Loss & ALAE Reserve Development Through 2003* Adverse reserve development is a perpetual problem NA *Negative numbers indicate favorable development; positive figures represent adverse development. Figures represent total development relative initial calendar year reserves Source: A.M. Best; Ins. Info. Inst.

34. ACCIDENT Year Loss & ALAE Reserve Development Through 2003* AY1998-2001 claims source of great pain in the industry NA *Negative numbers indicate favorable development; positive figures represent adverse development. Figures represent total development relative initial accident year reserves Source: A.M. Best; Ins. Info. Inst.

35. P/C Insurance Industry Prior Year Reserve Development by Line, 2002-03* Why did most lines develop so adversely in 2003? Major adverse development in casualty segments Who’s to blame? *Negative numbers indicate favorable development; positive figures represent adverse development. Source: A.M. Best, Ins. Info. Inst.

36. Combined Ratio:Impact of Reserve Changes (Points) Prior-year adverse reserve development totaling nearly $14 billion in 2003 added 3.5 points to the p/c combined ratio in 2002 Source: ISO, A.M. Best, MorganStanley, Prudential Securities.

37. PRICING PROBLEMS:ARE ACTUARIES TO BLAME?

38. POLL: Who’s to Blame for Problem Pricing? (by Applause) • Actuaries • Senior Management of Company • Your Underwriting Department • Your Marketing Department • Regulators

39. Cost of Risk vs. Commercial Lines Combined Ratio Source: RIMS, A.M. Best; Insurance Information Institute

40. World Rate-On-Line Index(1990 = 100) Reinsurance prices rising, limits falling: ROL up significantly, though not as much as after Hurricane Andrew in 1992 Source: Guy Carpenter

41. P/C Soft Spots: % Accounts With Negative Price Change(4th Qtr. 2004) Casualty/Liability/Terrorism Property Significant moderation now evident in the commercial casualty lines Source: Council of Insurance Agents & Brokers; Insurance Information Institute

42. P/C Soft Spots: % Accounts With Negative Price Change(4th Qtr. 2003) Casualty/Liability/Terrorism Property Source: Council of Insurance Agents & Brokers; Insurance Information Institute

43. P/C Soft Spots: % Accounts With Negative Price Change(4th Qtr. 2002) Casualty/Liability/Terrorism Property Source: Council of Insurance Agents & Brokers; Insurance Information Institute

44. Commercial Premium Rate Changes Are Sharply Lower Is moderation due to realization of performance and profit goals, increasing capacity/ capital, or market- share strategies? Source: MarketScout.com

45. A TALE OF THREE PRICING STRATEGIESPPA: Pricing Success StoryWC: Slow MoTrain Wreck?HO: Jury’s Out

46. Private Passenger Auto

47. *Insurance Information Institute Estimates/Forecasts Source: NAIC, Insurance Information Institute Average Expenditures on Auto Insurance Countrywide auto insurance expenditures are expected to rise 1.5% in 2005

48. Private Passenger Auto Combined Ratio PPA is the profit juggernaut of the p/c insurance industry today Average Combined 1993 to 2004= 102.7 Many auto insurers have shown sig-nificant improvements in underwriting performance since mid-2002 Sources: A.M. Best; III

49. Private Passenger Auto:Incurred Loss Ratios, 1999-2004:Q3 Loss ratios for all major coverage are trending downward Source: ISO Fast Track; Insurance Information Institute.

50. Pure Premium Spread: Personal Auto PD Liability, 2000-2004:Q3 Margin necessary to maintain PPA profitability 2003 PPA Combined = 98 2000 PPA Combined = 110 Source: Insurance Information Institute calculations based ISO Fast Track and US BLS data.