The Tragedy of Corporate Governance in America Impacts and Implications for the Insurance Industry

1. The Tragedy of Corporate Governance in AmericaImpacts and Implications for the Insurance Industry Casualty Actuarial Society of the Northeast Uncasville, CT September 30, 2002 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. Serious Implications for Financial Institutions • Insurers exposed to a wide variety of risks: • Investment risk (as institutional investors) • Insurance risk (surety, D&O, E&O, etc.) • Litigation risk (as both plaintiff & defendant) • Regulatory risk

3. Corporate Governance: Expensive and Hard-Learned Lessons • Crisis of Confidence—skepticism is on the rise • Ratings agencies Analysts Regulators • Investors/Creditors Employees Lawmakers • Regulatory/Legislative Fallout Unclear • Enormous number of investigations under way • SEC, State Attorneys General, IRS, DoJ, etc. • Most new SEC cases are against large companies • Many competing reforms from Congress, SEC, A.G.’s., NYSE, NASDAQ, etc. • Collectively are likely to help, at least somewhat • SEC, Administration & Congressional proposals vary • Surge in shareholder suits well underway

4. Crisis in Corporate Governance Market Malaise Terrorism Weak Profit Performance Market Malaise Geopolitical Instability

5. Houston…We Have a Problem Total Exposure (Life & Non-Life): $3.796 Billion • Enron is the biggest bankruptcy in US history ($31B+) • Equity/debt widely-held as S&P 500 company • Biggest impact in institutional investors/creditors • 11 Congressional investigations • 56 suits against officers & directors • Will spark similar suits Source: Loss estimates from Morgan Stanley as Feb. 8, 2002; Insurance Information Institute.

6. WorldCom to WorldCon?Insurer Exposure Total Exposure (Life & Non-Life): $5.725 Billion* • WorldCom could default on ($29B+) in debt. • Equity/debt widely-held as S&P 500 company • Biggest impact in institutional investors/creditors • SEC/Congressional investigations underway • Suits against officers & directors imminent *As of 7/1/02; Includes $5.4B in debt assuming default, $100 mil D&O, $225 mil CDO (still collateralized). As of 7/1, WCOM debt trading at about $0.15 of par, stock trading at $0.08/share. Equity losses are indeterminant. **Does not include disclosed but unquantified exposure to credit default swaps Source: Insurance Information Institute based in from Moody’s, company announcements, III research.

7. Who’s Who in the Corporate House of Ill-Repute

8. Corporate Hall of Shame

9. Corporate Hall of Shame ???

10. Corporate Hall of Shame

11. Martha Stewart Omnimedia fell by more than 50% after Imclone insider trading scandal broke out This sumptuous New England lobsterbake is available at MarthaStewart.com for just $250!

12. Cynicism is Running High

13. Cynicism is Running High

14. Living High Off the Company Hog Bernie Ebbers, former CEO of WorldCom Dennis Kozlowski, former Tyco CEO

15. Wall Street Conflicts of Interest Breed a Crisis of Confidence

17. Investment Risk

18. WorldCom: From $60/share in to6 Cents in Three Years As of July 1, 2002 Source: Low trade for July 1, 2002.

19. Xerox: From $60/share in to$6.60 Cents in Three Years* As of July 1, 2002 Source: Opening price, July 1, 2002.

20. Risky Business: Yield Spread Rising with Corporate Scandals* Yield Spread Between Long-Term ‘aaa’ Corporates and 10-Year US Treasury Securities Risk premium (2.46 points) reached all time high in Oct. 2001 (Enron problem surfaced) *January 1990 through August 2002 Source: Board of Governors, Federal Reserve System; Insurance Information Institute

21. Insurance Industry Stock and Bond Holdings, 2001 Total Industry Holdings = $3.3 Trillion Total $1531 In Billions P/C $194Life $1,337 Total $1120 P/C $185Life $935 Total $438 P/C $131Life $307 Total $209 P/C $188Life $21 Source: Federal Reserve Flow of Funds Report as of Dec. 31, 2001.

22. Institutional Investor Market in Corporate Equities by Market Value of Holdings, as of December 31, 2001 Total: $7,534.7 billion We’re big enough: Should we cut our losses and run or throw the bums out? Source: Insurance Information Institute from Federal Reserve Flow of Funds Report

23. Institutional Investor Market in Corporate Equities by Amounts Outstanding, as of December 31, 2001 Total: $7,534.7 billion Insurers are the 4th largest holder of corporate stocks Source: Insurance Information Institute from Federal Reserve Flow of Funds Report

24. Institutional Investor Market in Corporate Bonds* By Amounts Outstanding, as of December 31, 2001 Total: $3,730.1 billion Insurers are the largest holder of corporate bonds Life = $1,336.5 (87%) Non-Life = 193.9 (13%) *Includes foreign bonds. Source: Insurance Information Institute from Federal Reserve Flow of Funds Report

25. Insurance Industry: Corporate Equity Holdings, 1995-2001 $1,173B $1,135B In Billions $1,120B $933B $745B $563B Total $450B P/C $186Life $559 P/C $200Life $733 P/C $208Life $965 P/C $185Life $935 P/C $149Life $414 P/C $194Life $941 P/C $134Life $315 Source: Federal Reserve, Flow of Funds Report as of Dec. 31, 2001.

26. Insurance Industry: Corporate Bonds Holdings, 1995-2001 $1,531B In Billions $1,410B $1,3543B $1,301B $1,206B $1,091B Total $993B P/C $160Life $1,046 P/C $171Life $1,130 P/C $181 Life $1,173 P/C $194Life $1,337 P/C $188Life $1,222 P/C $142 Life $949 P/C $123Life $870 Source: Federal Reserve, Flow of Funds Report as of Dec. 31, 2001.

27. Beginning of the End:Bursting of the Tech Bubble

28. Real GDP Growth Economy is experiencing sluggish growth following the recession of 2001 (first recession since 1990/91) Source: US Department of Commerce, Blue Economic Indicators 9/02, Insurance Information Institute.

29. Directors & Officers Coverage

30. The ABC’s of D&O • 3 Components of D&O Coverage • Personal Coverage: protects directors and officers against liability arising out of “wrongful acts” • Corporate Reimbursement Coverage: reimburses organization when legally required/permitted to indemnify D&Os for their “wrongful acts” • Entity Coverage: reimburses for claims made directly against the organization (including those that name no individual insureds) • Today, about 90% have entity coverage today, compared to 30% 5 years ago. Sources: AICPCU, Tillinghast-Towers Perrin, Ins. Info. Inst.

31. The ABC’s of D&O • Duties of Directors & Officers • Duty of Care: • D&Os must exercise “reasonable care” • Courts hold that D&Os are not guarantors of profitability • Directors not required to have special knowledge of business • Duty of Loyalty to Corporation: • Undivided loyalty required (should be no conflicts-of-interest) • Duty of Loyalty to Shareholder: • Prohibits insider trading, for example • Duty of Disclosure: • Officers must disclosure material facts to directors • Officers must disclosure material facts to regulators • Officers must disclosure material facts to creditors or potential creditors • Officers must disclosure material facts to stockholders, bond holders, potential investors

32. Median Total D&O Limits by Business Class ($ Millions) Limits vary considerably by industry Source: Tillinghast-Towers Perrin

33. Median Total D&O Premium by Business Class Premiums vary considerably by industry Source: Tillinghast-Towers Perrin

34. D&O Broker Market Share(by Number of US Retail* Accts as Primary Broker) *Excludes wholsale brokerage activity; Based on sample of 1,976accounts Source: Tillinghast –Towers Perrin

35. INDUSTRY FINANCIALSOverview & Outlook

36. Highlights: Property/Casualty First-Half 2002 ($ Millions) *Comparison with year-end 2001;

37. P/C Net Income After Taxes1991-2002 ($ Millions) • 2001 was the first year ever with a full year net loss • 2002 First Half ROE = 3.3% *I.I.I. estimate based on first half 2002 data. Sources: A.M. Best, ISO, Insurance Information Institute.

38. P/C Net Income After Taxes vs.Net Operating Cash Flow ($ Billions) • Cash flow accounting for insurers makes 2001 look good (+35%) • Accrual method shows worst year-ever! • For insurers, accrual gives much better picture of true state of industry). This SAP is used for regulatory reporting • Reserves are a big part of the difference 2001 2000 2001 2000 Sources: A.M. Best, Guy Carpenter estimates. *NIAT = Prem Earned – Exp Incurred + Inv Inc. **NOCF = Prem Coll – Exp Exp Pd + Inv Inc.

39. Change in P/C Loss Reserves1996-2001 ($ Billions) • Accrual Accounting: Earmings/expenses recorded as they occur or incurred (SAP is a conservative variation of accrual method) • Cash Flow Accounting: Income recognized whenever cash “received,” expenses accounted for only when paid. • Fudging the timing of revenue and expense flows is behind virtually all of the recent earnings restatements Sources: ISO

40. Financial Restatements Filed The number of financial restatements is rising even thought the number of publicly traded companies is falling. *Approximate Sources: Huron Consulting Group

41. Market Share forPrimary D&O Coverage Source: Tillinghast-Towers Perrin

42. EPS Growth: Turning the Corner? Annual % Increase in Operating Earnings per Share 1st Quarter 2002 Summary* Operating EPS: +83.3% NPW: +37.0% Loss Ratio: 66.0% (-3.7 pts) Expense Ratio: 27.6% (-1.4 pts) Combined Ratio: 93.8% (-5.1 pts) ROE: 11.9% (+3.3 pts) *Compared to 1st quarter 2001. Source: Company financial statements; Merrill Lynch

43. Growth in Net Premiums Written (All P/C Lines) 2000: 5.1% 2001: 8.1% 2002: 12.0(est.) The underwriting cycle went AWOL in the 1990s. It’s Back! *Estimate based on first half 2002 results. Source: A.M. Best, Insurance Information Institute

44. P/C Industry Combined Ratio Combined Ratios 1970s: 100.3 1980s: 109.2 1990s: 107.7 2000s: 110.4 2001 = 115.7 2002E = 105.0 Sources: A.M. Best; III * Based on III 2002 Groundhog Forecast

45. Combined Ratio: Reinsurance vs. P/C Industry 2001’s combined ratio was the worst-ever for reinsurers *First Quarter 2002 figures. Source: A.M. Best, ISO, Reinsurance Association of America, Insurance Information Institute

46. Underwriting Gain (Loss)1975-2002* $ Billions P-C insurers paid $53 billion more in claims & expenses than they collected in premiums in 2001 *Annualized estimate based on first half 2002 data. Source: A.M. Best, Insurance Information Institute

47. ROE: P/C vs. All Industries 1987–2002* *2002 figures are estimates; p/c figure based on first-half 2002 data. Source: Insurance Information Institute; Fortune

48. Policyholder Surplus: 1975-2002* Surplus Peaked at $336.3 Billion in 1999 • Surplus decreased 8.7% in 2001 to $289.6 Billion. • Surplus rose 1.9% in the 1st quarter of 2002 • Surplus is now lower than at year-end 1997. Billions (US$) “Surplus” is a measure of underwriting capacity. It is analogous to “Owners Equity” or “Net Worth” in non-insurance organizations *As of 1st quarter 2002 Source: A.M. Best, Insurance Information Institute

49. Insurer Stocks: Outperforming the S&P 500 Total Return 2002 YTD Through September 27, 2002 Source: SNL Securities, Insurance Information Institute

50. Insurer Stocks: Outperforming the S&P 500 Total Return 2002 YTD Through September 27, 2002 Source: SNL Securities, Insurance Information Institute