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U.S. Insurance Market within a Global Marketplace

This presentation provides an update on the U.S. insurance market within a global context, covering topics such as market cycles, pricing trends, loss reserves, catastrophe pricing, securitization, capital flight, M&A activity, and more.

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U.S. Insurance Market within a Global Marketplace

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  1. U.S. Insurance Market within a Global Marketplace CAS Annual Meeting, San Francisco November 13, 2006 Todd R. Bault, FCASSenior Analyst Non-Life Insurance

  2. Agenda • Market update: When will the skeptics be right? • Pricing down, but what else is new? • Look at reserves, not pricing • Does the cycle influence loss trend? • Thoughts on the global insurance marketplace • Catastrophe pricing and capital usage: Confusion reigns • Securitization and capital markets: Baby steps • Capital flight to tax-advantaged locales: Lloyd’s goes to Hamilton • M&A: Europe Yea, US Nay • Q&A

  3. Warning • I will not discuss any publicly-traded insurance companies • I’ll blab all day about non-public companies and the industry • Please frame questions generically where possible!

  4. Market update: When will the skeptics be right? • Currently in the midst of a property cycle • Driven by increased US Gulf wind frequency in 2004-05 • ALL peak catastrophe exposures have gone up in price (e.g. Northeast wind, earthquake) • Abnormally low cats this year likely mark the peak of the cycle • All other major lines profitable but softening • This has been happening since 2004—not a new issue • Loss trends cyclically low and helping to sustain profits • Loss reserve adequacy continues to improve • Redundancies on 2003-06 offsetting small deficiencies in late 90s • Corresponds to early 90s behavior—further improvement likely but smaller in magnitude

  5. Market update: When will the skeptics be right? • May be nearing the point where the market becomes generally soft • First need most pricing declining (already there) • Next need loss trends to increase (starting to occur) • Finally need reserve releases (2-3 years from now) • This set of conditions corresponds to 1995-97, prior to late 90s soft market • Current market discipline not unprecedented (e.g. 1989-94) • Until trends and reserves deteriorate, results could remain strong • We call this the “post cycle”: the period after a hard market where growth is low but profits stay strong • Coincident with low pricing, low loss trends, and strengthening loss reserves • Stock performance tends to be good in the post cycle: stocks are cheap but grow their book value (but not premium or earnings)

  6. Pricing down, but what else is new? Estimated price changes for select commercial lines, 1999-2006 • Pricing is down in most lines but Property, and even this may be fading • But this has generally been true since 2004 (circled area) • Ex-catastrophe industry profits are at record levels for 2004-06 • So why the apparent disconnect? Sources: CIAB, Bernstein analysis

  7. Loss trends down even more than pricing Estimated price changes and loss trends, 2000-2006 The disconnect is loss trends, which have been negative since the 2001-03 cycle • Most of this is driven through frequency • This appears to have happened in the past (e.g. early 90s) • Loss trends are much less carefully monitored outside the industry, thus the disconnect Sources: CIAB, ISO, Bernstein analysis

  8. Look at reserves, not pricing Industry reserve adequacy vs. insurance stock outperformance, 1981-2007E • Changes in reserve adequacy a much better leading indicator for cycle • Reserve strengthening coincident with market improvements • Reserve releases leads soft market by 2-3 years • Verified in academic work examining balance sheet accruals and stock performance • Favorable accruals (e.g. reserve releases) signal underperformance Sources: Best’s, ISO, Highline Data via NAIC filings, Bernstein analysis

  9. Does the cycle influence loss trend? Relationship of price increases to future frequency changes, property (left) and liability (right) • Past losses influence future pricing, but does past pricing influence future losses? • It seems to, through claims frequency: frequency declines after price increases (data above 1999-2005) • Theory: Exposure cuts after a hard market (“terms & conditions”) reduces claim counts but is not captured fully in exposure bases • Phenomenon exists in every line we can measure (from personal auto to D&O), and appears global (comment from an Australian CEO) • This result needs more testing, with better data than I have! Sources: CIAB, ISO, Bernstein analysis

  10. Global issues • Catastrophe pricing and capital usage • When US property reinsurance pricing hardened, many predicted Europe to follow • Reasons: 1) inadequate price 2) capital rationing • Argument for 2): reinsurers will deploy capital towards better-priced risks and pull it away from worse-price risks • Capital rationing has not come to pass this cycle • Theory: insurance market doesn’t ration capital, it prices risk • Regulators ration capital, but market is used to this • Capital “allocations” are contingent and notional • No hard money is flowing anywhere, unlike the stock market • Market needs either an event or balance sheet shock to begin rationing capital

  11. Global issues Capital inflows vs. industry premium growth, 1985-2005 • In fact, capital inflows signal price increases in insurance • Chart is total US industry, where premium is a reasonable pricing proxy • This surprises many investors, who assume capital flowing in dampens prices • But insurers only ask for capital in the face of potential pricing strength Sources: ISO, Bernstein analysis

  12. Global issues • Securitization and capital markets: Baby steps • Securitization in insurance still disappointing despite hype • For example, cat bond market on its way to its biggest year ever, yet is still less than 2% of world reinsurance capacity • Compare to credit derivatives (which started about the same time as cat bonds in the mid-90s), which are now many times the size of the global reinsurance market (by limit) • Why the failure? Basis risk is shunned by capital markets • No way to hedge except with true reinsurance • Parametric bonds simply push basis risk onto end user • Contingent capital may be the better way forward • Design products to provide lump of dollars when most needed • ILWs do this, as do sidecars (private reinsurers)—these and other product may replace the traditional retro market

  13. Global issues • Capital flight to tax-advantaged locales: Lloyd’s goes to Hamilton • Despite vast improvement in Lloyd’s underwriting, syndicates continue to move to tax-advantaged locales • Function of the global marketplace more than Lloyd’s • Prediction: Bermuda will lose future influence simply because other regions will offer comparable advantages • For example, Lloyd’s lobbying FSA for tax exemption • M&A: Europe Yea, US Nay • Discussions of insurance M&A all over Europe, but with no follow-through in the US • Seems driven by standard arguments of scale economies, etc. • Ignores US state regulation, which conspires to keep industry fragmented • Need Federal regulation or a much softer market for US M&A

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