Casualty Actuarial Society Spring Meeting May 15 – 18, 2005

1. Casualty Actuarial Society Spring Meeting May 15 – 18, 2005

2. The industry's ability to attract capital given historically low ROEs leads us to question: Is ROE the right measure for the insurance industry's performance? by Joan Lamm-Tennant, PhD

3. Overview • Macro-Economic View of Capital Flows • “Accounting – Based” ROE Trends • If it is not ROE, then what? • Risk-Adjusted Return on Economic Capital • Economic Value Added • Float

4. Macro Market View Basic Laws of Supply and Demand • The demand curve is downward sloping suggesting that price must fall to increase demand for risk transfer • In equilibrium price and demand intersect to determine price • At the appropriate level of capacity, price is the “fair” price Price PV E(L) + Exp S P D Q Quantity

5. S* P* Macro Market View Basic Laws of Supply and Demand • In the short run, net worth may be “shocked” by an extreme event • The “shock” causes a shift (decline) in capacity • Prices increases and new capital may flow in Price PV E(L) + Exp S S Decline in Net Worth P D Quantity Q*

6. D* Macro Market View Basic Laws of Supply and Demand • Behaviors, not only the financials, may change • The “shock” may causes an increase in risk aversion therefore an increase in demand • An increase in demand will exacerbate the price increase Price PV E(L) + Exp S* S* P* S S P P D Quantity Q*

7. Macro Market View Basic Laws of Supply and Demand • Higher prices for risk will eventually restore profitability and replenish capital • Equilibrium is restored at a price of “P” • The cycle continues to repeat itself and, if fact, may become instantaneous • Any interference to offset shocks to capital in the short run could be costly in the long run • Insurance markets are healthy and dynamic!!! Price PV E(L) + Exp S* S* P* S S P P D* D Quantity Q*

8. Quarterly Premium Growth Rates Source: ISO Rate Increases Source: MarketScout

9. Following 9/11 New Capital Entered The Market Raising by Property / Casualty Insurers Since 9/11 Totals $53.2B $25.4 Billion $27.9 Billion 14 Pending 38 Pending 33 Completed 40 Completed *As of September 13, 2002. Source: Morgan Stanley, Insurance Information Institute.

10. 2004 Capital Raising Activity • The US and Bermuda-based property-casualty insurers raised $12.2 billion of capital directly in the capital markets • Of the $12.2 billion raised, 60.2% was traditional debt, 26.4% was equity and the remainder was equity-linked and preferred securities

11. Net Income (AT) 1991 to 2004 *Sources: A.M. Best, ISO, Insurance Information Institute. (amounts in millions)

12. Surplus June 30, 1999 $341 September 30, 2002 $273 September 30, 2004 $369 December 31, 2004 $394 Industry Surplus Q3 2004 Source: A.M. Best and ISO, 2004 Through Third Quarter (amounts in billions)

13. Overview • Macro-Economic View of Capital Flows • “Accounting – Based” ROE Trends • If it is not ROE, then what? • Risk-Adjusted Return on Economic Capital • Economic Value Added • Float

14. Historical Statutory ROE by Decade 10 Year T-Yield Period Combined Ratio P/C ROE 1970s 11.2% 100.3 7,5% 1980s 11.5% 109.2 10.6% 1990s 8.4% 107.8 6.7% 2000 -2004 5.3% 106.3 4.8% Source: A.M. Best Review/Preview

15. 1983 – 2003 2004 Cost of Equity 11.5% Accounting ROE 6.5% Cost of Equity 8.9% Accounting ROE 10.5% Difference 1.6% Return on “Statutory” Equity vs. Cost of Equity U.S. Property / Casualty Industry (1983 to 2004) Return on Equity Cost of Capital Source: A.M. Best; Conning Forecast; CF&S practice; McKinsey

16. Overview • Macro-Economic View of Capital Flows • “Accounting – Based” ROE Trends • If it is not ROE, then what? • Risk-Adjusted Return on Economic Capital • Economic Value Added • Float

17. Risk-Adjusted Performance Metrics • Return on risk-adjusted capital (RORAC) vs. risk-adjusted return on capital (RAROC) • Dividing expected net income by “economic” capital is technically RORAC, nevertheless the industry convention is to call it RAROC • Economic value added (EVA) • Difference between the return on “economic” capital and the cost of capital, where cost of capital is reflective of both capital structure and risk • Float and Cost of Float • Arises because premiums are received before losses are paid • Float may be estimated as • (Total Invested Assets – Capital – Unassigned Surplus) • Since premiums tend not to cover losses, insurers run an underwriting loss which is the cost of float • Cost of float may be negative when the insurer runs an underwriting profit

18. Mean Risk Tolerance Acceptable VaR Perhaps Associated Rating -50% 0% -30% +10% +40% Economic Capital RAROC and EVA Require A Measure of Economic Capital • Economic capital is frequently referred to risk capital • The amount of capital necessary to cover the risk in our business given our risk tolerance Profit

19. Float and Cost of FloatU.S. Property and Casualty Industry Source: AM Best Aggregates and Averages

20. Float and Cost of FloatU.S. Commercial Lines Industry Source: AM Best Aggregates and Averages, Commercial Lines Segment

21. Float and Cost of FloatU.S. Personal Lines Industry Source: AM Best Aggregates and Averages, Personal Lines Segment

22. Industry Comparative Cost of Float Source: AM Best Aggregates and Averages

23. The industry's ability to attract capital given historically low ROEs leads us to question: Is ROE the right measure for the insurance industry's performance? Perhaps consider Risk Adjusted Return on Economic Capital Economic Value Added Float

24. Thank You