The Impact of Reinsurance on Primary Company Financials A Case Study

1. The Impact of Reinsurance on Primary Company FinancialsA Case Study Casualty Actuarial Society Loss Reserve Seminar Washington, D.C. September 18 – 19, 2008 Andrew Rippert President, Bunker Hill Insurance Chief Underwriting Officer, Plymouth Rock Corp.

2. Objective • Small, regional, monoline homeowners insurance company needs to produce net underwriting income that will provide at least a minimum acceptable return on capital over a reinsurance price cycle. • Operating constraints include: • Maintain and ultimately improve company rating • Protect insurance entity and holding company parent from catastrophic loss • Manage reinsurance costs to minimize negative impact on net underwriting income and stabilize primary market prices • Deliver maximum capital flexibility • Use homeowners underwriting capacity to complement and support affiliated group companies

3. Context • Competitors are for the most part • Multi-line writers with different underwriting income and return-on-capital objectives for their homeowners line of business [pricing issue] • Mutual property insurers with different return-on-capital requirements [pricing issue] • If primary market rates are to remain reasonably competitive, capital levels required to maintain ratings drive return-on-capital to unacceptably low levels [capital management issue] • Reinsurance price volatility and capacity constraints based on CAT activity and changes to CAT models [pricing and “soft capital” management issues]

4. Context - continued • Post Katrina-Rita-Wilma (KRW) catastrophe models changed the catalog of storms and increased the frequency and severity of storms in Northeast U.S. [risk management, rating agency, RBC, primary and reinsurance pricing issues] • Post-KRW rating agencies increased capital requirements via risk based capital (RBC) models and required the use of CAT model’s higher, near term view estimates [rating and RBC issues] • Holding Company Board of Directors • Risk appetite that is incongruent with rating agency RBC [capital planning and management issues] • Belief that models over-estimate, and reinsurers overcharge, for loss at low CAT excess attachments points [capital planning and management issues]

5. Reinsurance Price Changes • CAT X/S reinsurance price volatility drives volatility of earnings and ROC • Passing price volatility through to policyholder is impractical and will undermine growth, retention and marketing objectives. Additional regulatory and consumer advocacy group issues around primary market price increases The average year-on-year percentage change in the reinsurance price index pre-KRW is approximately 4%. The year-on-year percentage change in the reinsurance price index for the two years post-KRW is 28% and 39%, respectively.

6. BCAR Changes • BCAR Scores at every rating increased significantly post KRW • Higher BCAR scores were driven primarily by a revised capital methodology that imposes two 1:100 storms on an insurer’s portfolio and by CAT model changes (i.e., introduction of the Warm SST/Near Term models) • Meeting return targets on higher capital requirements through price increases is problematic – disruption to retention levels, growth & marketing objectives and distribution channel The average year-on-year percentage change in median BCAR scores pre-KRW is less than 1%. The average year-on-year percentage change in median BCAR scores for the two years post-KRW is 8.5%.

7. Initial Reinsurance Program • Program cost – 19% DWP • Coverage • ratio of net retained-to-gross loss 37% at 0.4% exceedance probability • Entry >90% probability of exceedance • Exit 1.2% probability of exceedance • Description – standard property cat x/s program and quota share that provided cat coverage alongside property cat x/s Pros Easily evaluated within the context of RBC and rating agency models Easy execution Cons High cost and volatile cost Subject to availability of reinsurance capacity Another constraint on execution of market strategy

8. Revised Reinsurance Program • Program cost – 14.5% DWP • Coverage • ratio of net retained-to-gross loss of 31% at 0.4% exceedance probability • Entry >90% probability of exceedance through capital maintenance facility • Entry >81% probability of exceedance through cat x/s • Exit 0.6% probability of exceedance • Description – capital maintenance facility supported with irrevocable letter of credit, standard property cat x/s program and quota share that provided cat coverage alongside property cat x/s Pros Better alignment between risk appetite and retained loss – more protection against extreme events and higher retention of small events Increased capital flexibility & more optimal capital structure Lower dependence on reinsurance markets Easier to execute market strategy Retains profit on most “over” priced layers Cons Does not fit easily within rating agency & RBS models Legal, regulatory, accounting & tax issues Negotiate non-standard documentation and LOC

9. Benefits of Change in Reinsurance Program • Provided savings of 4.5 points of DWP that can be used for a variety of strategic and tactical initiatives • Better able to execute market strategy • Increased level of catastrophic loss protection • Increased flexibility of capital structure • Higher return-on-capital

10. Other Important Considerations • Communication and transparency with rating agency • Triggers and conditions for contingent capital • Portfolio monitoring and guidelines • Holding company has a track record of supporting insurance entity and contributing capital if necessary