Reinsurance Topics: Impact on Insurance Rates

1. Reinsurance Topics: Impact on Insurance Rates Alabama Affordable Homeowners Insurance Commission November 21, 2011 Bob Fox, ACAS, MAAA Director, Catastrophe Actuarial Aon Benfield

2. History of Homeowners Pricing

3. Drivers of Catastrophe Risk Proprietary & Confidential

4. Catastrophe Models in Insurance and Reinsurance • They may not be perfect, but they’re the best tool currently available to assess catastrophe risk Proprietary & Confidential

5. Model Miss: April, 2011 Storms • DOI capping at 1:250 years based on countrywide model estimate • Will this hurt availability? • Is tornado/hail risk changing? Proprietary & Confidential

6. Model Change: RMS Hurricane • Use of multi-model average cuts expected loss reduction in half, to 20% • Fixed expenses of 20-30% limit required premium reduction to 14-16% • Expected loss from other perils (5-10%) limit required premium reduction to 12-15% • Further reduction to reinsurance and capital costs likely, if included in rates and allocated properly • Premium reductions realized ONLY if rates were fully adequate based on prior model “In both Baldwin and Mississippi’s Jackson counties, expected hurricane losses are projected to be more than 40 percent lower under RMS’ new model. That, in turn, could mean an average 34 percent drop in overall premiums in Baldwin County, RMS found.” AL.com, September 4, 2011

7. Property Cat Excess of Loss Reinsurance Proprietary & Confidential

8. Drivers of Reinsurance Premiums

9. Reinsurance Treaty Costs by Region Northeast Hurricane • Lower expected loss • Volatility still high • Somewhat diversifying Midwest Tornado/Hail • Lowest severity • Lower ceded volatility • Diversifying risk Florida Hurricane • High expected loss and volatility • Highest margins • Global PML driver California Earthquake • Low take-up rates • Low expected loss • Extreme volatility • Diversifying risk

10. 60.00% 50.00% 40.00% Actual ROL 30.00% 20.00% 10.00% 0.00% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% Model ROL Aon Benfield Reinsurance Pricing Model

11. Reinsurance Costs Within Alabama • A reasonable allocation of reinsurance costs by state will consider not only ceded expected loss, but also volatility and correlation to industry • A reasonable within-state allocation should consider all of these as well • Insurance is designed for risk sharing, not subsidies Upstate Tornado/Hail • Lower expected loss • Lower ceded volatility • Diversifying risk Downstate Hurricane • Higher expected loss and volatility • Higher margins • Still diversifying

12. Impact of Reinsurance on Insurance Market

13. Reinsurance as an Inexpensive Source of Capital One measure of capital required to support retained cat risk Diversification Benefit: marginal volatility to reinsurer is less than marginal volatility ceded by primary company

14. So Rating Agencies are the Problem? Proprietary & Confidential

15. Aon Benfield Homeowners ROE Study

16. Why Would Anyone Write Homeowners Insurance?

17. Retained Catastrophe Costs Within Alabama Upstate Tornado/Hail • Expected loss higher than previously thought • High retained volatility • Need to diversify risk Downstate Hurricane • May still drive net PML • Risk/return insufficient for admitted insurers • AIUA, E&S writers filling the gaps

18. The Problem of Concentrations • The April storms woke Alabama insurers to the risk of concentrations, even away from the coast • If companies can’t price for tail risk, they will try to reduce it by cutting policies • If returns are perceived as adequate, more companies will share the load on the coast and inland • The more the risk is spread among different companies, the lower capital needs will be for each Proprietary & Confidential