INDUSTRY FOCUS: Insurance Companies

1. INDUSTRY FOCUS: Insurance Companies Presented by Lynn OstremPresident, Crow River Investment ClubAssoc. Director, NAIC Mpls/St. Paul Chapter

2. Class Summary PART ONE: How Insurance Companies Work PART TWO: Focus on Life & Health PART THREE: Focus on Property & Casualty PART FOUR: Working with Industry Ratios PART FIVE: Finding Industry Resources PART SIX: Insurance Study Candidates– The 1st Cut BREAK PART SEVEN: Paring Down our Choices And Finally…YOU GET TO CHOOSE!

3. Class Materials All class materials can be found at: www.bivio.com/crowriver Club Folders | Insurance Industry Study

4. PART ONE HOW INSURANCE COMPANIES WORK

5. Welcome to the Wonderful World of Insurance! • Important part of the U.S. economy • Affects the lives of most Americans • Maturing and saturated industry • Understanding future drivers is key • Population is aging • Over 65 group will grow from 12% now to 20% by the year 2030

6. The Game of Risk • The Big Insurance Bet: You say, "I bet you $300.00 that I'll die this year." The insurance company says "I'll bet you $100,000.00 you don't." (I hope they win!) • Spread the Risk • If we know 1 in 2000 will die • Risk is spread among 2000 families

7. Risk Diversification • Risks are: • sickness (health insurance) • house fires (home owner's insurance) • physical injury (disability insurance) • car accidents (automobile insurance) • medical mistakes (malpractice insurance) • bizarre incidents (casualty other) • and even re-insurance!

8. How it works • Insurers collect premiums • Invest those premiums • Some earn fees on services, too • An insurer’s prosperity depends largely on its ability to quantify the ultimate cost of claims from the risks that it assumes. • Reserves too high – Profits appear low • Reserves too low – Profits appear inflated

9. How it works • Premiums = S ales; #1 source of revenue • Premium Written vs. Premiums Earned • $1,200 for a 12 month policy (written) • $100 for 12 months (earned) • Investment Income; 2nd source of revenue • Realized Investment Gains; 3rd source

10. Expenses Expense components for:

11. Income Statement Comparison

12. Ownership Structures • Mutual Insurance Company • Owned by policyholders • Earnings belong policyholders • Distributed as dividends or reduced premiums • Solely exists for the benefit of its policyholders • Capital is Policyholder Surplus • Aren’t required to provide financial information

13. Ownership Structures • Stock Insurance Company • Owned by shareholders • Earnings belong shareholders • Distributed as dividends • Exists to make a profit for shareholders • Capital is Shareholder Equity • Financials are disclosed to the public • Can sell stock when they need capital

14. Demutualization • Demutualization occurs when a mutual company converts to a stock company • Up Side: Access to Capital • Down Side: Conflict of Interest

15. Two Accounting Methods • Statutory Accounting Principles (SAP) • Requires immediate expensing of all costs • Best used to gauge financial stability • Reported to policyholders & regulators • Generally Accepted Accounting Principles (GAAP) • Attempts to match income & expenses • Best used to determine earnings growth • Reports to everybody!

16. Regulation • Governing Body: National Assoc. of Insurance Commissioners (NAIC) • Serves 3 primary functions: • Monitor financial condition & claims paying ability • Serve as watchdogs, watching for overcharges and discrimination • Ensure that essential insurance coverage is readily available for all consumers

17. PART TWO Focus on Life & Health Insurance

18. Life & Health Insurance Players Types of Insurance • Term Life • Predetermined Period • No Benefits at the End • Whole Life • Period - Life of the Insured • Savings Component

19. Life & Health Insurance Players • 1,500 L&H Insurers in the U.S. (as of 6/2004) • Top 10 Players – • Controlled 71% of the industry’s $880.1 billion in assets • Top 5 Players – • Controlled 52% of the industry’s assets • Top 2 Players – • TIAA/CREF & Hartford Life controlled 37% of the industry’s assets

20. PART THREE Focus on Property & Casualty Insurance

21. How the P&C Industry Works • Lines of Coverage (Per A.M. Best): • Misc. Other 24% • Personal Auto Liability 22% • Personal Auto Physical Damage 15% • Homeowners Insurance 11% • Workers’ Comp 10% • Commercial Multi-Peril 7% • Commercial Auto 5% • Reinsurance 4% • Accident & Health 4% 100%

22. How the P&C Industry Works • Catastrophic Loss– • defined as an event or series of events that produce $2.5 million or more in insured losses. • 2003 – 9 catastrophes, $529 million • 2002 – 25 catastrophes, $5.9 billion • 2001 – 20 catastrophes, $28.1 billion ($9 billion for 9/11)

23. How the P&C Industry Works • 10 largest write 28% of the premiums • 5 largest write 20% • 2 largest State Farm and Allstate write 14%

24. How the P&C Industry Works • Based on A.M. Best, total assets of the P&C industry were estimated at $1.1 trillion: • Bonds accounted for 67% • Common stocks 16% • Mortgage loans & real estate 9% • Cash and equivalents 7% • Preferred stocks 1% 100%

25. PART FOUR Working with Industry Ratios

26. Ratios • Three primary factors are important to consider when analyzing a life insurer: • Profitability (its ability to make money), • Liquidity (its ability to convert assets into cash • to pay policyholder obligations), and • Leverage (the extent to which the insurer uses • its capital to produce business).

27. Profitability Return on Assets (ROA) • Net Income / Avg. Total Assets • Average for L&H is 0.4%-0.9%P&C .5%-2% Return on Equity (ROE) • Net Income / Avg. Shareholders’ Equity • Average for most L&H is 9%-15%P&C 8%-18%

28. Profitability Net Investment Yield • Net Investment Income / Average Invested Assets • Average L&H is 4%-10%Average P&C is 4%-12% Return on Revenues (ROR) (L&H Only) • Net Income / Total Revenues • Average for L&H is 2%-5%

29. Profitability Combined Ratio (P&C Only) • Loss Ratio—Loss/Loss Adj. Expenses / Earned Premiums (+) • Expense Ratio—Other Underwriting Expenses / Written Premiums (+) • Dividend Ratio—Policyholders’ dividends / Earned Premiums (=) Combined Ratio!

30. Profitability Combined Ratio (P&C Only) • 100% is break-even • <100% - indicates a profit • >100% - indicates a loss 1952 to 1998 – industry earned a profit in 15 out of 47 years! 1H 2003 was 99.8% (first time since 1978) 1H 2002 was 105.1%

31. Liquidity Positive Cash Flow Current Ratio • Total Liabilities / Total Assets Financial Strength • See Value Line’s Financial Strength Rating (bottom right corner) • See S&P Stock Report Investability Quotient Percentile

32. Leverage Reserve Account Minimum Surplus

33. Drilling Down Other Considerations for All Insurers: • The Profitability of Underwriting • The Rate of Premium Growth • Reinsurance • Allocation Strategy

34. PART FIVE Finding Industry Resources

35. Finding Industry Information Resources • S&P Industry Surveys/Reference Section • Mergent’s Industry Reports • Value Line’s Industry Page • S&P Stock Report Sub-Industry Page • Google Search • Company Annual Reports/10K • Searching NAIC Website • Crow River Website/Research Section

36. Finding Stocks for your Industry Study • Primary— • S&P Industry Surveys • Value Line • Toolkit’s OPS Industry Feature • Secondary-- • Yahoo, MSN, Quicken, etc.

37. Deciding on the Data for your Study • Primary— • Company Financial Statements • S&P Stock Report • S&P Compustat Data Files (OPS) • Value Line Survey Page • Combination

38. PART SIX Insurance Stock Candidates The 1st Cut

39. S&P Industry Surveys

40. AFL AMH DFG L&H PL MET LNC

41. PRU SFG TMK L&H UCI UNM

42. AFC AFG AIG Multi Line HCC HIG HMN

43. LTR UTR Multi Line

44. ACE ALL ABK P&C BER CINF CB

45. FNF FAF LFG P&C MBI OCAS ORI

46. PHLY PGR RLI P&C STC SAFC SIGI

47. XL ZNT P&C

48. RE AOC BRO Reinsurance  Brokers AJG HRH MMC

49. AFL MET That leaves us with these L&H stocks… TMK PL SFG

50. Only Multi-Line stock… AIG