The Global Financial Crisis and Its Impacts on Energy Insurance Markets Trends & Challenges

1. The Global Financial Crisis and Its Impacts on Energy Insurance Markets Trends & Challenges Insurance Information Institute April 2, 2009 Robert P. Hartwig, Ph.D., CPCU, President Insurance Information Institute 110 William Street New York, NY 10038 Tel: (212) 346-5520  bobh@iii.org  www.iii.org

2. Presentation Outline • The Global Economic Storm: What Weakening Economy and the Financial Crisis Mean for the P/C Insurance Industry and Energy Concerns • Recession, Growth & Insurance • Economic Stimulus Package: Worldwide Spending Programs • Impacts & Implications for P/C Insurers and the Energy Sector • Insurer Financial Strength & Ratings • Insurers vs. Banks: A Difference of Approach to Risk Management • Energy Market Review • Capacity, Rating, Exposure, Profitability, Reinsurance, ART • The Financial Crisis: Global Energy Supply, Demand and Investment • Insurance Industry Financial Performance • Capital & Capacity • Regulatory Response to Crisis • Emerging Blueprint for Insurance Regulatory Overhaul

3. THE GLOBAL ECONOMIC STORMWhat Weakening Economies and the Financial Crisis Mean for the Insurance Industry &Energy Concerns

4. Real GDP By Market 2007-2010F(% change from previous year) All major economies except China and Brazil are in recession. Steep declines in GDP will negatively impact exposure growth on a global scale Source: Blue Chip Economic Indicators, 3/10/09 edition.

5. Real GDP for Largest European Economies & Euro Area, 2007-2010F, (% change from prior yr.) All European economies are in recession Source: Blue Chip Economic Indicators, 3/10/09 edition.

6. US Real GDP Growth* Recession began in December 2007. Economic toll of credit crunch, housing slump, labor market contraction is growing The Q4:2008 decline was the steepest since the Q1:1982 drop of 6.4% *Yellow bars are Estimates/Forecasts from Blue Chip Economic Indicators. Source: US Department of Commerce, Blue Economic Indicators 3/09; Insurance Information Institute.

7. Length of US Recessions,1929-Present* Months in Duration Current recession began in Dec. 2007 and is already the longest since 1981. If is now tied for the longest recession since the Great Depression. “We will rebuild. We will recover.” --President Barack Obama addressing a joint session of Congress February 24, 2009 * As of April 2009 Sources: National Bureau of Economic Research; Insurance Information Institute.

8. GDP Growth: Advanced & Emerging Economies vs. World 1970-2010F Emerging economies (led by China) are expected to grow by 3.3% in 2009 The world economy is forecast to grow by 0.5% in 2009, but could shrink for the first time since WW II —by 1% to 2% according to the World Bank. Advanced economies will shrink by 1.9% in 2009, dampening energy demand Source: International Monetary Fund, World Economic Outlook Update, Jan. 28, 2009; Ins. Info. Institute.

9. Global Industrial Production Is in a Tailspin, Reducing Energy Demand Annualized 3-Month Percent Change Industrial demand for energy has been particularly hard hit Global industrial production was down 13% in late 2008, adversely impacting energy demand Source: International Monetary Fund, World Economic Outlook Update, Jan. 28, 2009; Ins. Info. Institute.

10. Auto/Light Truck Sales,1999-2010F (Millions of Units) Weakening economy, credit crunch are hurting auto sales; Gas prices less of a factor now. New auto/light truck sales are expected to experience a net drop of 6.0 million units annually by 2009 compared with 2005, a decline of 35.5% and the lowest level since the late 1960s Impacts of falling auto sales will have a less pronounced effect on auto insurance exposure growth than problems in the housing market will on home insurers Source: US Department of Commerce; Blue Chip Economic Indicators (2/09); Insurance Information Inst.

11. Real GDP Growth vs. Real P/C Premium Growth: Modest Association P/C insurance industry’s growth is influenced modestly by growth in the overall economy Sources: A.M. Best, US Bureau of Economic Analysis, Blue Chip Economic Indicators, 3/09; Insurance Information Inst.

12. Change in Producer Prices for Construction vs. Consumer Prices, 2003 - 2008 Dec. 2008 The inflationary spike of 2008 has been reversed—for now—easing concerns over claims severities Source: Associated General Contractors from BLS (CPI, PPI)

13. Inflation Rates for Largest European Economies & Euro Area, 2007-2010F, (% change from prior yr.) Inflation is down sharply across Europe, reducing claim severity concerns Source: Blue Chip Economic Indicators, 3/10/09 edition.

14. THE $2.75 TRILLION GLOBAL ECONOMIC STIMULUSCountries Trying to Spend Their Way Out of Recession Will Need More Energy & More Insurance

15. Summary of Short-Run Impacts of Global Stimulus Packages on P/C Insurance, Energy Sectors • No Stimulus Provisions Specifically Address P/C Insurance in US and Unaware of Provisions Elsewhere • Spending, Aid and Tax Reductions benefit other industries, state and local governments, as well as individual and some corporate taxpayers • Stimulus Package is Unlikely to Increase US Net Premiums Written by More Than 1% or Approximately $4.5 Bill. in US by 2010 • Little-to-modest impact in Europe and elsewhere • Several Stimulus Countries’ Plans Direct Spending Toward the Energy Sector • Stimulus Plans in US, Europe, China and Japan Have Numerous “Green” Provisions that Could Influence Supply and Demand for Energy Source: Insurance Information Institute

16. Announced Economic Stimulus Packages Worldwide (US$ Bill)* U.S. stimulus comprises a mix of spending, tax relief and aid to states Governments around the world are seeking to soften the economic blow through spending. Deficits as a share of GDP will mushroom leading to a potential inflationary threat and higher interest rates the future. P/C insurers will provide insurance necessary for stimulus projects and will benefit from enhanced economic growth As of March 2009, these countries have approved or proposed at least US$2.3 trillion in stimulus spending *As of March 2009. Sources: Wall Street Journal, January 8, 2009 with updates by I.I.I.; Institute of International Finance and Brookings Institute.

17. Green Energy Spending: An Important Component of Some Stimulus Plans $787B Total European green energy stimulus spending = $54.2B $634.1B Total $586.1B Total $485.9B Total Green energy stimulus spending totals $382B in US, Japan and Europe, or 18.1% of their combined $2.1 trillion in stimulus spending $13.7B Total Source: “Energy Sector Looks for Private, Public Help,” WSJ, 3/9/09, p. A2 from HSBC, New Energy Finance; Ins. Info. Inst.

18. US Economic Stimulus Package: Where the $787B Goes—5% to Energy Projects $ Billions US stimulus package allocates $43B or 5% or total spending to energy programs Source: http://www.recovery.gov/ accessed 2/18/09; Insurance Information Institute.

19. US Economic Stimulus Package: $143.4 in Construction Spending—20% to Energy Projects $ Billions Spending on energy-related construction projects totals nearly $30B or 20% or all stimulus-related construction spending Source: Associated General Contractors at http://www.agc.org/cs/rebuild_americas_future (2/18/09); Insurance Info. Inst..

20. Global Green Energy Spending* ($ Billion) Annual investment needed through 2030 in renewable energy and energy efficiency to keep atmospheric CO2 concentration below 450 parts per million—an amount many scientists claim is necessary to prevent serious consequences from climate change Current investment in green energy falls far short of what some believe is necessary to address climate change issue *Estimated from source below. Source: “Energy Sector Looks for Private, Public Help,” WSJ, 3/9/09, p. A2; New Energy Finance interpretation of International Energy Agency data; Ins. Info. Inst.

21. Stimulus: Reading The Economic Tea Leaves for the Next 4 to 8 Years • Growing Role of Government: 2009 Stimulus Packages and Other Likely Spending Initiatives in US and Elsewhere Guarantee Government Will Play a Much Larger Role Than at Any Other Time in Recent History • Every industry, including insurance, will and must attempt to maximize direct and indirect benefits from this paradigm shift • Obama Administration Priorities: Stimulus Package Acts as “Economic Tea Leaf” on the Administration’s Fiscal Priorities for the Next Several Years • These Include: • Alternative Energy • Environmental Spending • Health Care • Aging/New Infrastructure • Aid to States • Global Financial Services Regulatory Reform • Includes insurance Source: Insurance Information Institute

22. FINANCIAL STRENGTH & RATINGSIndustry Has Weathered the Storms Well

23. US P/C Insurer Impairment Frequency vs. Combined Ratio, 1969-2007 Impairment rates are highly correlated underwriting performance and could reached a record low in 2007 2007 impairment rate was a record low 0.12%, one-seventh the 0.8% average since 1969; Previous record was 0.24% in 1972 Source: A.M. Best; Insurance Information Institute

24. Summary of A.M. Best’s P/C Insurer Ratings Actions in 2008* P/C insurance is by design a resilient in business. The dual threat of financial disasters and catastrophic losses are anticipated in the industry’s risk management strategy. Despite financial market turmoil, high cat losses and a soft market in 2008, 81% of ratings actions by A.M. Best were affirmations; just 3.8% were downgrades and 4.0% upgrades *Through December 19. Source: A.M. Best.

25. Historical Ratings Distribution,US P/C Insurers, 2008 vs. 2005 and 2000 2000 2008 2005 A++/A+ and A/A- gains P/C insurer financial strength has improved since 2005 despite financial crisis Source: A.M. Best: Rating Downgrades Slowed but Outpaced Upgrades for Fourth Consecutive Year, Special Report,November 8, 2004 for 2000; 2006 and 2009 Review & Preview. *Ratings ‘B’ and lower.

26. Reasons for US P/C Insurer Impairments, 1969-2005 2003-2005 1969-2005 Deficient reserves, CAT losses are more important factors in recent years *Includes overstatement of assets. Source: A.M. Best: P/C Impairments Hit Near-Term Lows Despite Surging Hurricane Activity, Special Report,Nov. 2005;

27. Critical Differences Between P/C Insurers and BanksSuperior Risk Management Model & Low Leverage Makea Big Difference

28. Financial Institutions Globally FacingHuge Losses from the Credit Crunch* Billions The IMF estimates total “credit- turmoil-related” losses will eventually amount to $1.4 trillion $205B or 20.8% of estimated total (bank+insurer) losses will be sustained by insurers worldwide *Global losses since the beginning of 2007.Source: IMF Global Financial Stability Report, October 2008, IIF, Bloomberg, cited in a presentation by Thomas Hess (Chief Economist, Swiss Re) October 23, 2008, accessed via Geneva Association web site.

29. How Insurance Industry Stability Has Benefitted Consumers • BOTTOM LINE: • Insurance Markets—Unlike Banking—Are Operating Normally • The Basic Function of Insurance—the Orderly Transfer of Risk from Client to Insurer—Continues Uninterrupted • This Means that Insurers Continue to: • Pay claims (whereas 42 banks have gone under as of 3/13) • The Promise is Being Fulfilled • Renew existing policies (banks are reducing and eliminating lines of credit) • Write new policies (banks are turning away people who want or need to borrow) • Develop new products (banks are scaling back the products they offer) Source: Insurance Information Institute

30. Reasons Why P/C Insurers Have Fewer Problems Than Banks: A Superior Risk Management Model • Emphasis on Underwriting • Matching of risk to price (via experience and modeling) • Limiting of potential loss exposure • Some banks sought to maximize volume and fees and disregarded risk • Strong Relationship Between Underwriting and Risk Bearing • Insurers always maintain a stake in the business they underwrite, keeping “skin in the game” at all times • Banks and investment banks package up and securitize, severing the link between risk underwriting and risk bearing, with (predictably) disastrous consequences—straightforward moral hazard problem from Econ 101 • Low Leverage • Insurers do not rely on borrowed money to underwrite insurance or pay claimsThere is no credit or liquidity crisis in the insurance industry • Conservative Investment Philosophy • High quality portfolio that is relatively less volatile and more liquid • Comprehensive Regulation of Insurance Operations • The business of insurance remained comprehensively regulated whereas a separate banking system had evolved largely outside the auspices and understanding of regulators (e.g., hedge funds, private equity, complex securitized instruments, credit derivatives—CDS’s) • Greater Transparency • Insurance companies are an open book to regulators and the public Source: Insurance Information Institute

31. ENERGY MARKET REVIEW Global Energy Business Is Deeply Impacted by Crisis, but Other Factors Matter Too

32. Key Trends Capacity & Rating Exposure Profitability Reinsurance

33. Global Energy Insurance Markets: Key Trends INSURANCE CAPACITY • Aggregate commercial property/casualty (nonlife) capacity fell sharply in 2008 due to • Reduced Asset Values • Higher Underwriting Losses • Sharply Lower Investment Returns • Surprisingly, overall energy market capacity levels for 2009 have increased, despite start of early stage of market hardening, financial crisis and dislocations of key competitors • Higher capacity and basic laws of supply and demand temper extent of market hardening and limit price gains • Capacity freed up due in part to reduced construction activity and reduced business interruption levels • Fallout from Gulf of Mexico windstorm causes some supply issues for offshore and onshore risks Source: Willis Energy Market Review March 2009

34. Upstream Operating Underwriting Capacities, 2000-08 (Excl. GOM) Source: Willis Energy Market Review: March 2009

35. Downstream Operating Underwriting Capacities, 2000-09 (Excl. GOM) Source: Willis Energy Market Review: March 2009

36. Upstream Capacities and Average Rating Levels, 1993-2009 (Excl. GOM) Source: Willis Energy Market Review: March 2009

37. Onshore Capacities and Average Rating Levels, 1993-2009 (Excl. GOM) Source: Willis Energy Market Review: March 2009

38. Total Theoretical Liability Capacity, 2000-09 Source: Willis Energy Market Review: March 2009

39. Global Energy Insurance Markets: Key Trends INSURED EXPOSURE • Global economic downturn, reduced energy demand and collapse of oil prices hit energy industry project activity and asset values with negative impact on energy insurers’ exposure and therefore premium income levels • Impact is especially acute for industrial energy demand • Credit crisis impacting project viability as well • BOTTOM LINE IN 2009: Crisis will have little impact on long-run demand and supply for energy and energy assets • Global energy demand will begin to rebound in late 2009 • Fuel prices are already beginning to rise • Insurance industry will be able to meet the short, intermediate and long-term demands despite current challenges Source: Willis Energy Market Review March 2009; Insurance Information Institute.

40. Global Energy Insurance Markets: Key Trends PROFITABILITY • Sharp decline in investment returns in 2008, unlikely to turnaround anytime soon • Loss of investment return necessarily increases pressure on (re)insurers to generate underwriting profits • Many insurers will also need to protect capital in 2009 via increased reliance on reinsurance • Higher cost of capital could be a major issue if capital raises are necessary among for insurers and reinsurers • BOTTOM LINE IN 2009: Stable and profitable energy sector (for the most part) particularly for low Nat Cat business • Movement toward disciplined underwriting is necessary Source: Willis Energy Market Review March 2009; Insurance Information Institute.

41. Energy Losses vs. Global Energy Premium Income 1990-2008* *Figures include both insured and uninsured losses Source: Willis Energy Market Review: March 2009

42. Gulf of Mexico Windstorm: Still An Insoluble Problem? • Gulf of Mexico windstorm (GOM) number one underwriting headache in the wake of Hurricane Ike • Long-term sustainability of Gulf wind insurance product in serious question by both the reinsurance and direct markets • Offshore energy losses spike in 2004, 2005 and 2008 due to impact of Big Four (Hurricanes Ivan, Katrina, Rita and Ike) • Lloyd’s Franchise Performance Directorate (LFPD) taking keen interest in individual syndicates’ plans to write GOM wind in 2009. Significant product changes expected. • Market expected to offer 30 percent less capacity than in 2008 • Catastrophe modeling and capital market parametric solutions expected to play a role. Source: Willis Energy Market Review March 2009

43. Reinsurance & Alternative Risk TransferCapacity is Down, Demand is Up

44. Reinsurance Market Trends • Amid global capital markets turmoil and economic downturn global reinsurance industry has faired relatively well (with a small number of exceptions) • Capacity, however, is down due to investment issues • But reinsurers seeking price increases as of 1 January and risk appetite more constrained (e.g., U.S. catastrophe risk) • Primary insurers exploring lower retentions and other reinsurance mechanisms to protect and enhance their capital positions • Increasing syndication of risk as insurers seek to use portfolio diversification to mitigate counterparty exposure • Opportunity for traditional reinsurance market to win back market share as some alternative forms of risk transfer have dried up Source: Willis Energy Market Review March 2009; Insurance Information Institute.

45. Global Reinsurance Capacity Shrank in 2008, Mostly Due to Investments Source of Decline Global Reinsurance Capacity Global reinsurance capacity fell by an estimated 17% in 2008 Source: AonBenfield Reinsurance Market Outlook 2009; Insurance Information Institute.

46. Catastrophe Bond and Sidecar Issuance, 2004-2008 $ Billions The credit crisis and decline in global capital have taken their toll on alternative forms of catastrophe risk transfer Source: AonBenfield Reinsurance Market Outlook 2009; Insurance Information Institute.

47. The Global Financial Crisis Affects Energy Industry Supply and Demand & Insurance Exposure

48. Severe Recession is Depressing US Energy Demand: Change 2009 vs. 2008 Percentage Change in Consumption, 2009 vs. 2008 Industrial consumption of electricity has experienced the most severe declines Sources: Energy Information Administration.

49. World Crude Oil Prices: 1997- March 2009 Dollars per Barrel* PEAK Jul. 2008 $145.29 Crude oil prices peaked at $145.29 in July 2008, then fell 75% to $34.57 in Jan. 2009 but are rising again to more than $47/bbl in mid-March Jan. 1998 $15.21 RECENT 16 Mar. $47.35 TROUGH Jan. 2009 $34.57 *All countries spot market price weighted by estimated export volume. Source: Energy Information Administration; http://tonto.eia.doe.gov/dnav/pet/hist/wtotworldw.htm

50. US Energy Expenditures as a % of GDP Have Been Hurt by Recession Percentage of GDP Recession and 2008 energy price spike sharply decreased energy demand The energy price bubble pushed energy expenditures to 9.9% of GDP in 2008. The bursting of the bubble and recession pushed expenditures down to 7.0% of GDP in 2009. Source: Energy Information Administration, Short-Term Energy Outlook, March 10, 2009; Ins. Info. Inst.