Trends in the Property Casualty Insurance Industry

1. Trends in the Property Casualty Insurance Industry Hankamer School of Business Baylor University October 2, 2003 Joan Lamm-Tennant, PhD Gen Re Capital Consultants

2. Trends In The Property Casualty Insurance Industry • Insurance Industry Financial Summary – Looking Good • Now Let’s Look Beyond The Financial Summary At Underlying Trends • Evolution in Risk Management • Summary and A Look Into The Future

3. Things are looking goodYou really like me

4. Highlights: Property / Casualty 6 Months 2003 2003 2002 Change Net Written Premium $ 214.9 $ 182.4 +16.7% Loss & LAE 150.3 134.3 +11.9% Net UW Gain (Loss) (2.1) (11.9) -82.3% Net Inv. Income 20.7 17.8 +16.3% Net Income (a.t.) 18.6 4.6 +300.4% Surplus* 319.7 285.2 +12.2% Combined Ratio** 99.3 107.2 -7.9 pts. * Comparison with year-end 2002. Comparable 2nd quarter figure is 282.9 ** Comparison is with full year 2002 combined ratio. Comparable quarter 2002 figure is 105.0 Source: Insurance Information Institute (amounts in billions)

5. World Trade Center Loss U.S. Property / Casualty Industry Combined Ratio 1955 to June 30, 2003 Average Combined Ratio 1955 - 2002 104.3% 1955 - 1979 100.1% 1980 - 2002 108.8% 116.0% 118.0% 116.3% 115.7% As of June 2003 the industry reported a combined ratio of 99.3. This is the first time in the past five years that the industry reported a combined under 100 mid year. * as of 6/30/03 Source: III

6. Property / Casualty Net Income After Taxes 1991 - 2003 * * As of 6/30/03 Sources: A.M. Best, ISO, Insurance Information Institute. (amounts in billions)

7. Policyholder Surplus 1975 - 2003 * Surplus (capacity) peaked at $336.3 billion in mid-1999 and then fell 15.2% ($51 billion) to $285.2 billion by 2002. In 2003 surplus is $319.7 billion; an increase of $34.5 billion or (12.2%) over 2003. *Second Quarter Source: A.M. Best, Insurance Information Institute (amounts in billions)

8. What Is My Point in this Section? • Premium is Up • Underwriting Result is Improved • Surplus is Growing • Look’s Like the Industry is Doing Well …

9. Summary Numbers Don’t Tell the Whole Story Risky Business Are We Exposed or Are We Protected?

10. Now Let’s Look Beyond The Financial Summary • Economic Value Gap • Are Rates Holding? • Loss Trends • Emerging Exposures • Reserve Shortfall • Investment Results • Credit Quality – Insurers and Reinsurer • Insolvencies

11. Economic Value GapROE vs. Cost of Capital: PC Industry 1991- 2003F* There has been enormous gap between the industry’s cost of capital and its ROE. US P/C insurers have missed their cost of capital by an average 6.6 points from 1991 to 2002. 6.8. pts 14.6 pts If we do end 2003 with 11.6% ROE, we will be breaking even but not yet creating economic value. Source: The Geneva Association, Ins. Information Inst.

12. Are Rates Holding?Strength of Recent Hard Markets by Real NWP Growth 1985-87 2001-03 1975-78 Real NWP Growth During Past 3 Hard Markets 1975-78: 8.6% 1985-87: 14.5% 2001-03: 9.1% Note: Shaded areas denote hard market periods. Source: A.M. Best, Insurance Information Institute

13. Loss Trends • Four Problematic Lines of Business • Medical Malpractice • Product Liability • Workers’ Compensation • Homeowners

14. Loss TrendsLine of Business CRs Needed for Profitability Source: A.M. Best * Reflects break-even accident year results including investment income on current writings. Break-even figures are calculated using a 4% interest rate.

15. Loss TrendsAverage Jury Awards 1994 vs. 2001 *Figure is for 2000 (latest available) Source: Jury Verdict Research; Insurance Information Institute.

16. Loss TrendsMed Mal: Losses & Exp Paid vs. Premiums Earned Source: Computed from A.M. Best data by the Insurance Information Institute

17. (Re)Emerging Exposures • Asbestos • “Toxic” Mold • Construction Defects • Obesity – Patron Suits

18. Obesity – Patron Suits • Are the food service & manufacturing industry’s vulnerable to suits over obesity? • McDonald’s sued in late 2002 over allegations that their food makes people fat • Kraft sued earlier this year over trans fats in Oreo cookies

19. Takeaways At This Points • ROEs might be at breakeven relative to cost of capital • BUT when will the PC industry become Economic Generators • What – you want more rate • Auto, package property, large account property look good but • Homeowners needs work • Workers compensation still has some problems • Medical utilization and inflation is a real concern • Then there is Property Liability and Tort

20. What do you mean there is more !!!

21. YES, There Is More • Economic Value Gap • Are Rates Holding? • Loss Trends • Emerging Exposures • Reserve Shortfall • Investment Results • Credit Quality – Insurers and Reinsurer • Insolvencies

22. Reserve Deficiency, by Line(AY 1992-2001, as of 12/01) *Occurrence and claims made Source: Morgan Stanley

23. Reserve DeficienciesAdverse Loss Development • A number of companies reported reserve increases in excess of $1B • AIG – Q4 2002 $2.8B increase in excess casualty and D&O • Travelers – Q4 2002 $2B primarily for asbestos • Employers Re – Q4 2002 $2.5B in several liability segments, workers compensation and asbestos

24. Reserve Deficiencies Nothing Good Happens When Reserves are Deficient • Profitability of Current Business Is Misleading • Continue to Underprice Risk • Target Rate Increases Are Too Low • Terms and Conditions Are Likely to Be Too Broad • Write More Unprofitable Business • True Adverse Selection • Losses Compound Across Accident Years Before Mistake Is Recognized • Lose Prestige and Respect in the Marketplace • Pay Too Much in Taxes • Very Painful to Fix

25. Investment ResultsInterest Rates: Lower Than They’ve Been in Decades • While investment income is up in 2003 for the PC insurance industry it is due to the reinvestment of very strong cash flows from underwriting. • Rates remain relatively low. *As of April 21, 2003. Source: Board of Governors, Federal Reserve System; Insurance Information Institute

26. Investment ResultsTotal Investment Returns of U.S. PC Industry Total Investment Returns (1979 to 2002) $81 billion $17.8 billion (amounts in billions)

27. Credit QualityS&P Downgrades of PC Insurers – Jan 03 to Sept 03 • Of Of the 484 companies rated by S&P, 94 were downgraded (7 were upgraded) • For example, of the 94 companies downgraded, 17 were downgraded from AA+ to AA; 4 were downgraded from AA to AA- and 10 went from a AA- to A+ with another 5 going from AA- to A

28. Credit QualityS&P Financial Reinsurance Downgrades AAA AA+ AA AA- A+ A A- <BBB+ Outlook General Re X Stable Swiss Re |---------------------------------X Stable Chubb Re |---------------------------------X Stable Employers Re |----------------------------------------------------------------------X Negative Munich Re |----------------------------------------------------------------------X Stable - American Re |---------------------------------------------------------------------------------------X Stable Hannover Re |-----------------------------------X Negative Transatlantic Re X Stable XL Re X Stable Partner Re |-----------------X Stable Hartford P/C Group |-----------------X Stable AXA Re |-----------------X Stable Converium Re |----------------------------------------------------X Stable Everest Re X Stable SCOR |--------------------------------------------------------------------X Watch / Dev Gerling Global Re |--------------------------------------------------------------------X Withdrawn ACE Tempest Re X Negative IPC Holdings X Stable W.R. Berkley X Negative Lloyd’s |-------------X Stable Trenwick Amer Re |------------------------------------------------X Withdrawn Renaissance Re X--------------| Stable PXRE Reins X Negative Axis Re X Stable Endurance Re X Stable Montpelier Re X Stable PMA Capital |------------------X Negative CNA |------------------X Negative As of September 2003

29. Credit Risk and Reinsurance Recoverables

30. Credit Risk and Reinsurance Recoverables

31. U.S. P/C Insolvencies vs. Combined Ratio 1971-2002 10-yr failure rate is 0.72% but in 2002 the rate is 1.33% 30 companies went insolvent in 1992, peaked in 1992 with 63 insolvencies Source: A.M.Best Co. Special Report “P/C Industry – 2001 Insolvencies”, June 18, 2002

32. Causes of Insolvency • Deficient Loss Reserves • Inadequate Pricing • Rising Loss Cost Trends • Catastrophes • Cheap Reinsurance Protection • Cash Flow Underwriting • Aggressive Growth • Fraud • Overstated Assets

33. Bringing It All Together • Industry Results are Much, Much Better • We might breaking even in 2003 – no longer an economic detractor • Remember, not all lines are producing profits so we have work yet to do • Rates are still hardening • But can we hold them • Adverse reserve development continues to be a drag • Investments cannot support underwriting • (Re)emerging exposures—we must keep a watch on these! • Keep an eye on credit quality when placing your business • Focus and discipline are key

34. Trends In The Property Casualty Insurance Industry • Insurance Industry Financial Summary – Looking Good • Now Let’s Look Beyond The Financial Summary At Underlying Trends • Evolution in Risk Management • Summary and A Look Into The Future

35. Evolution In Risk Management - New Disciplines

36. Evolving Disciplines in Risk Management • Managing for Profitability versus Growth • Advance Risk Metrics • Delaying Claims Payments – Market Consequences

37. Managing Profitability versus Growth Let’s Do the Math Still looking for photo

38. Managing Profitability versus Growth What combined ratio is needed to provide a “fair” “risk-adjusted” return on capital given leverage and given investment income?

39. Underwriting Profitability Is Critical Source: Dowling & Partners, “Underwriting Profit is Essential”

40. OK … So How Do We Change The Culture To Manage Profitability as Opposed To Growth • Reward profitability not growth through compensation schemes • Build skills • Advance risk metrics • Improve both the quality and quantity of data

41. Evolving Disciplines in Risk Management • Managing for Profitability versus Growth • Advance Risk Metrics • Delaying Claims Payments – Market Consequences

42. Realistic Risk Choices Depend On Our Ability To See The Complete Range of Outcomes Stress testing may give you a false sense of confidence that you are seeing the complete range. Simulation may appear complex but it can be very insightful. Mean -70% -30% +25% (Mean) +50% % Change in Underwriting Profit

43. Simulation Gives Us A New Measure Of Risk The probability of a decline in underwriting profits (Value-at-Risk) is a useful risk measure. Mean 20% probability of a 30% or greater decline in underwriting profit -70% -30% +25% (Mean) +50% % Change in Underwriting Profit

44. Simulation - An Insightful Way To Understand The Drivers of Unacceptable Results “Bottom up” modeling allows us to explore in detail the root causes of risks. Interest Rate Spike Probability East Coast Storm Adverse Reserve Development Equity Market Declines -70% -30% % Change in Underwriting Profit

45. Taking It Even Further…… Portfolio Analytics Return on Surplus Percentile Distribution Combined Ratio Percentile Distribution This company did an in-depth simulation analysis the impact of 3 options for growth on the combined ratio and ROE of their company. They were able to make a better-informed decision about the trade-offs presented to them.

46. So what is the point …… • Know more than your expected outcome • A 25% increase in underwriting profit • Know the range around the expected • A 70% decline in underwriting profit to an 50% increase in underwriting profit • Focus on the tail – the “strike zone” • Know the “probability” of the downside • Be aware of the economics underlying the “strike zone” • Think about hedging the unthinkable

47. Evolving Disciplines in Risk Management • Managing for Profitability versus Growth • Advance Risk Metrics • Delaying Claims Payments – Market Consequences

48. Delaying Claims Payment What are the cause for the increase in unsettled claims? • Greater Fear • Greater Pressures on Profitability • Trading Reputation for Short-term Profitability • Willingness to Game Information Asymmetries • Imbalance in Risk Psychology – Fearing Losses More Than Loving Gains • More Litigious Society • More Uncertain World • Simply unclear because the contract was never written with these claims in mind

49. Delaying Claims Payment – Market Consequences and Solutions What might be the market consequences? • Loss of confidence in the insurance markets • Will have downward bias on price What might be a solution? • More disclosure of data • Is this even reasonable? • Does the data even exist? • Re-thinking the economics of contracts • Recognize that incomplete contracts may be optimal • Therefore, how might we design contracts on verifiable losses, given that non-verifiable losses will exist?

50. Summary An A Look Into The Future • Industry Results are Much, Much Better • We might breaking even in 2003 – no longer an economic detractor • Remember, not all lines are producing profits so we have work yet to do • Do we have the discipline to hold rates • Will adverse reserve development continue to be a drag • (Re)emerging exposures—we must keep a watch on these! • Keep an eye on credit quality • Evolving risk management disciplines are key