Property Casualty Insurance 06 10

Property & Casualty Insurance

June 2010

© 2010 SIA Group – www.s-i-a.ch 1 / 66

AGENDA

Main message: the Property & Casualty Insurance sector offers very good
investment opportunities at current prices. Moreover, it’s likely that those
opportunities will be frequent.

1. Sector Analysis

2. SIA Analytical methodologies

3. Some specific cases

4. Conclusions

5. Q&A


The P&C business is mature, but wide differences in
penetration imply further growth

Market capitalization P&C premiums as a percentage of GDP

Property & Russia
Casualty Brazil
Insurance India
Property & China
Japan
Casualty and
Greece
Multi-line
Spain
Reinsurance Switzerland
Italy
France
Germany
Banking UK
US

0% 5% 10% 15% 20%

(Total Market Cap: USD 50,000,000 mio approx.)

P&C insurance and Reinsurance add up to 2% of total market capitalization

Share of sub-industry in financials services industry has been stable over the last ten years


The industry has its own cycle, uncorrelated with the
economy

• Demand (premium growth rates) in
line with historical GDP growth.

• P&C business cycle is driven by
supply:

• Product and consumers
attitude. Stable price-inelastic
demand.
• Low barriers of entry (and
exit). Capital (and people, IT
and procedures)
• Reserving cycle (COGS not
known initially, margins
uncertain). Calendar year vs
accident year reporting.


The industry is remarkably healthy

With the very special exception of AIG, the industry:

. has received no state aid,
. has issued very few shares,
. pays some of the highest dividend yields in the market,
. and has no solvency/regulatory issues

This is probably due to:

. previous cycle’s mistakes, which have created a generalized conservative outlook
. the nature of the business model, where money is received up-front: insurance
companies are sources of liquidity, while banks have been users of liquidity

All this has been true even through the worst financial crisis of the last 50 years


Apparently, low barriers to entry determine low returns

25%

20%

15%

10%

5%

0%

-5 %
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
In d u s t ry R O E S & P 500

21%

19%

17%
Although returns
look much better in 15%
Europe
13%

11%

9%
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07


But there are important intra-industry differences

US P&C industry ROE. Data based on average 1997-2008

20%
16.0%
16%

12%
9.0% 8.3%
8% 6.6%

4% 2.5%

0%
1 2 3 4 n
Tier Tier Tier Tier M
ea

These differences are due to strategy, economies of scale,
differentiation and the presence of a retail network


Basic strategic choices can make a big difference

U.S. Propert/Casualty – Combined Ratio
Components & Gross Premiums Written
(1997 - 2006)
Good companies are driven by better
underwriting…

U.S. Propert/Casualty – Average Pretax
Return on Revenue & Net Investment Ratios
(1997 - 2006)

1997-2001 soft market, 2002-04 hard, 2005-06 soft (source:
AM best)

…and don’t rely on investment income


Basic strategic choices can make a big difference

U.S. Propert/Casualty – Average Change
In Gross Premiums Written & Average Loss
Development (1997 - 2006)

• Cycle management makes a
difference, even at the expense of
market share

• Loss reserves must be
conservatively managed to succeed


Diversification lowers the need for capital

Less capital for the same amount of business implies a higher ROE

Example. Diversification at Munich Re Example. Diversification at Trygvesta

Munich Re underwrites P&C, Life and Health Trygvesta underwrites general P&C insurance in
reinsurance and primary insurance globally Denmark and the European Nordic countries.
across many different business lines.


Economies of scale also appear in actuarial and modeling
expertise, as well as a business network

Specialty lines. Actuarial and modeling expertise. Economies of scale.

• Example. Euler Hermes: Specialist trade credit insurer. Credit insurance compensates
policyholders when their clients fail to pay for goods or services.

• Economies of scale are obtained due to the costs of the comprehensive business intelligence
associated to underwriting on a global base of customers and related trade counterparties.

• Receivables collecting and credit risk services offered to customers are difficult to replicate.


Reinsurance is clearly subject to economies of scale

The economies of scale lead to concentration. Top 5 reinsurers market share is above 50%


And, for retail business, a network is hard to replicate

• Distribution strategy and sales channels are a competitive advantage in the retail segment.

• Example. Mapfre: multi-line insurer. 3280 branches in Spain (above 5,000 globally). See appendix.

You can find a branch close to your home or office


Conclusion

. Although P&C is a mature business with average profitability (at best), intra-industry
differences indicate the possibility of sustained attractive ROEs in the low to mid-teens.

. The sector, with the notable and special exception of AIG, has received no state aid nor
had liquidity problems. Most companies have paid very high, well covered dividends
through the financial crisis.

. To capture those, investors must be able to discern what the real, sustainable rate is
for each individual company, and buy only when the share price presents a good entry
point.

. Within a portfolio, insurance companies can, if well chose, add good performance with
low volatility, for their business is uncorrelated to the overall economy, depending on
its own cycle, or in random factors (catastrophes).


AGENDA


1. Sector Analysis



4. Conclusions

5. Q&A


Insurance company valuation

• The expected return or IRR of the investment is assessed as an average of the
earnings yield (p/e ratio inverse) and ROE of a benchmark projected year.

• This could be obtained from a dividend discount model with growth given by the
retained capital: (where b is the retention ratio, and g=b x ROE would be the
dividends growth)

• Example. Catlin: 6x p/e ratio and 11% return on equity. IRR=13.8%

• Unfortunately, this simple analysis only holds true if all parameters stay constant. To
check for that sustainability, we must dig further into each company’s accounts and
competitive position


To perform the analysis, we adapt the “Du Pont”
methodology

• Du Pont for P&C


“Du Pont” analysis


Catlin: Valuation


Our due diligence is made up of six steps

1. Excess equity: adequacy and adjustments

2. Reserving: adequacy and adjustments

3. Trend: current operational trends and results

4. Accounting: issues affecting company financials

5. Historical ROE: five years median and variance comparison with industry.

6. Strategy: Management, Operational, Financial, Competitive position and
distribution, Diversification, Other.


Economic capital analysis

• Capital analysis

• Excess capital generation is a measure of value creation.

• Excess capital is a competitive advantage. Capacity.

• Capital management (Risk adjusted return on capital) and risk profile.

• Solvency and rating


Economic capital methodology

• S&P capital model

• Determines a target capital required for each risk and rating.

• Capital requirements correspond to a confidence level in the loss distribution of
that risk.

• Example. An ‘A’ rating capital level corresponds to a 99,4% confidence level
(or capital adequacy) for each individual risk.

• It is a multifactor model with a required capital based on underwriting (and
reserving) related risks (liability risk) and investment and credit risk (asset risk) .

• Includes a diversification credit.


Capital adequacy ratio

• The capital excess/deficit is measured by the Capital Adequacy Ratio: a ratio between
capital available and capital requirements or charges

C1 are investment risk charges
C2 are other assets risk charges
C3 is the underwrtiting risk
C4 is the Reserve risk
C5 are other risks


Catlin: Capital adequacy ratio


Catlin: asset risk charges

• The capital required for asset risk (C1 and C2 risk charges) is calculated by
multiplying S&P factors to the different exposures


Catlin: liability risk charges

• The premium risk (C3) is calculated by multiplying different factors to the premiums of
each line of business


Catlin: liability risk charges

• The reserve risk (C4) is calculated by multiplying different factors to the reserves of
each line of business

• A capital charge for catastrophe risk is also added, using the 1-in-250 years loss
scenario.


Capital adequacy ratio

• Capital Adequacy Ratio at a BBB-rating level:


Reserving analysis

• Reserves analysis

• Reserve adequacy. Redundancy or inadequacy

• Accident Year vs Calendar Year.

• Loss ratio. Prior years loss development.

• Reserving policy. Consistency

• Tail (reserves duration).

• Methodology of analysis: Chain-Ladder and Bornheutter Ferguson


Catlin: Reserving analysis - Chain Ladder

• The basis for reserve estimates on a portfolio basis under the Chain-Ladder method
is a triangular table in which columns represent the years when the claims originated
(underwriting, accident or reporting year) and the rows represent how the claims have
developed over time. The diagonals from the bottom left to the top right give the loss
payments cumulated up to a specific business year


Catlin: Reserving analysis - Chain Ladder

• The Future loss estimates are derived from triangles using the chain ladder method. The
chain ladder method extrapolates future expected claims from claims already paid or
reported using multiplication factors referred to as development factors. These factors
are used to forecast the unknown part of the triangular table and measure the average
increase of cumulated losses from one development year to the next. Losses usually
increase the fastest during the early development years

• The reserves are then the final loss estimates minus the claims already paid as the
reporting period


Catlin: Reserving analysis – Bornheutter Ferguson

• Bornheutter-Ferguson method is based on Loss ratios

• Chain ladder can not be applied when there is little actual claims experience data
(recent accident years). In this case, chain ladder estimates are too much influenced
by recent years.

• Combines prior expectation of losses provided by simple loss ratio estimates with the
actual rate of emergence of claims.



• Initial loss ratio estimate



• Using prices and losses paid for each underwriting year, we estimate a ultimate loss
ratio



• Ultimate loss estimates using loss ratios are compared to corresponding losses paid
and reserves.



• A weighted average of these simple loss ratio estimates and the chain-ladder results
gives the Bornheutter-Ferguson figure


Catlin: Reserving


Catlin: Strategic

• Company strategy analysis

Management
Strategic plan/targets Mostly grow in a diversified fashion
Formal analysis No
Known to management Only to the extent of the simple plan mentioned
Consistent with capabilities Yes
Well comunicated Yes
Operational capability
Expertise Yes
Audit and control Yes
Past performance Acceptable
Stable good management Yes
Organization fits strategy Yes
Financial Good
Targets Yes, 10%+risk free rate
Have been above targets No, but period was bad (KRW)
Conservative accounting Acceptable


Catlin: Strategic

Diversification
Geographic Yes, and growing. But it is new: some dangers of
lack of expertise
Product Not much. Focused on plain P&C, developing
some niche expertise
Distribution
Loyalty Not much (brokers)
Effectiveness Normal
Cost efficient Normal
Market share Not great
Cost advantage Does not show
High share in good markets Weak
Low threat of newcomers Weak
Other

Take-over advantages Wellington was ok, some synergies but mostly
tax and financial; less so operating ones


AGENDA


1. Sector Analysis



4. Conclusions

5. Q&A


PMI: the early warning

• Example. PMI Group Inc: Residential mortgage insurer, providing loss protection to mortgage
lenders and investors in the event of borrower default.


PMI: the early warning


AIG: Underpricing

• Example. AIG Inc. The reserve adequacy of AIG back in 2006 was just enough, and below industry.

2006 AIG Statutory P/C Reserves - $53B

• Other liabilities chain-ladder 2006 estimate
Workers
Comp, 23.7%
All Other,
32.5%

Other Liability,
43.8%

• 2006 Total Redundancies on reserves: (593)MM Other Liability + 797MM WC + 188MM All Other =
$392MM redundancy (0.7% of reserves). Well below large carriers: 8.5% redundancy at ACE,
Hartford and Chubb. Below industry: 2% redundancy.


AIG: Underpricing

• Reserves at the end of 2008 were deficient.


AIG: Underpricing

• Other lines segment includes Financial and Mortgage Guaranty. Premiums: 576mio (2007), 655mio
(2008). Booked Loss ratio: 250%. Loss: 1,6bio


AIG: Underpricing

• Loss ratio booked in 2008 neither looks conservative in the current soft market.


AGENDA


1. Sector Analysis



4. Conclusions

5. Q&A


Conclusions

The P&C insurance sector is stable and with an uncorrelated cycle to the
economy

Average profitability hides wide intra-industry differences

Those differences can be captured ex-ante with the right analytical tools

Addition to P&C insurance and reinsurance companies to a portfolio can
increase its risk-adjusted returns


AGENDA


1. Sector Analysis



4. Conclusions

5. Q&A


Appendices


Appendix: Euler Hermes

• Euler Hermes share price and the credit cycle (2005-09).

Euler Hermes shares, iTraxx CDS main


Appendix: Euler Hermes

• Euler Hermes and the economic cycle (1998-2009)

Combined ratio


Appendix: Scottish Re

• Financial flexibility and liquidity can be a barrier of entry.

• Example. Life insurance/reinsurance can generate funding needs: regulatory reserve
requirements above actuarial estimates for some segments (see US level term), DAC funding.

• P&C and Life businesses show financial synergies and economies of scale both from capital and
funding needs.

• Example. Scottish Re.

• Life reinsurer with an agressive growth strategy until 2006 (3rd US player), when it
suffered a liquidity crisis. They relied in a securitization market funding strategy to do
acquisitions, like the ING Re business bought in 2004. They raised private capital in
December 2006, but in 2007 they experienced losses due to their structured credit
exposures.

• In January 2009, the ING Re business was sold to Hannover Re (a P&C and Life reinsurer)


Appendix: Scottish Re

• Chart from a 2005 Scottish Re presentation


Appendix: ProAssurance

• Claims management can be a competitive advantage.

• Example. ProAssurance Corporation. Specialty medical professional liability insurer in the US.



• ProAssurance Corporation claims management compared to the industry. Claims defence skills is
a differentiation factor.



• ProAssurance Corporation and the Med-mal supply-driven cycle


Appendix: Cap Gemini survey

• Cap Gemini World Insurance Report 2008. Purchase criteria.

• Product and advisory services differentiation is higher in other insurance segments like Life and
Health.


Appendix: Mapfre

• Mapfre operating ratios compared to the sector


Appendix: Mapfre

• Mapfre operating results


Appendix: Life insurance

• The expected return of an investment in a Life business is assessed using the recurrent earnings
and the IRR of the equity shareholder’s cash-flows for a benchmark year. The Embedded Value
report is a good source of this information.

• Example: Allianz

• The profit is measured using the expected business contribution (which is equal to the
unwinding of the embedded value). This was some 2000 mio in 2009.



• Example: Allianz (continued)

• The shareholder’s equity IRR from the existing business in-force can be obtained from the
cash-flow release report. It is the discount rate of the cash-flows that equals the embedded
value (adjusted by adding back to it the TVFOG, CRNHR and FC and subtracting the Free
surplus). Using 2009 data, the IRR is about 6%.



• Some further considerations on the analysis:

• TVOGs: time value of options and guarantees granted to policyholders. Expected earnings
include the release of this cost (incurred in a more risk-neutral world). Similar
considerations for CNRHR, FC items.

• NAV as a percentatge of Embedded Value. A small figure means more value in-force (future
profits) for a given equity investment (NAV).

• New business margin. The in-force IRR can be a misleading guide to future returns if new
business margins differ significantly from in-force.

• Earnings volatility and sensitivities to risk factors. We check the accounts volatility and the
embedded value sensitivities to risk factors.

• Debt leverage at the group level can improve the ROE (and therefore the expected return)
in a diversified mixed insurance company (economy of scale).



• Example: Allianz (continued)



• Example: Mapfre


Property Casualty Insurance 06 10

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