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Industry Reserve Adequacy and Other Hot Topics: Financial Analyst’s Perspectives

Industry Reserve Adequacy and Other Hot Topics: Financial Analyst’s Perspectives. 1999 Casualty Loss Reserve Seminar. Scottsdale, Arizona. Presenters. Sarah Hibler - Vice President & Senior Analyst, Moody’s Investors Service Jay Votta - Principal, Deloitte & Touche LLP

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Industry Reserve Adequacy and Other Hot Topics: Financial Analyst’s Perspectives

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  1. Industry Reserve Adequacy and Other Hot Topics: Financial Analyst’s Perspectives 1999 Casualty Loss Reserve Seminar Scottsdale, Arizona

  2. Presenters • Sarah Hibler - Vice President & Senior Analyst, Moody’s Investors Service • Jay Votta - Principal, Deloitte & Touche LLP • Bill Wilt - Vice President & Senior Analyst, Moody’s Investors Service Industry Reserve Adequacy - Financial Analyst's Perspectives

  3. Discussion Topics • Overview of Reserve Adequacy • Results of Moody’s Top 50 Analysis • Use of Reserves in Credit and Equity Analysis • Reserves play critical role in gauging financial health • Reserving Issues in Mergers & Acquisitions • Reserves key consideration in structuring deals Industry Reserve Adequacy - Financial Analyst's Perspectives

  4. Goals of Session • Discuss macro-level trends in loss reserves • Provide insight into how ‘outsiders’ analyze loss reserves • Demonstrate importance of reserves in different contexts: • Credit Analysis • Equity Analysis • M&A Activity Industry Reserve Adequacy - Financial Analyst's Perspectives

  5. Top 50 Analysis • Moody’s Analyzed Top 50 P/C Groups • Approx. 2/3 industry reserves and surplus • Used annual statement data and internal reserve model • Excluded A&E, reinsurance, miscellaneous lines • Tested results against independent analyses where available • Despite limitations, A/S data can provide credible starting point Industry Reserve Adequacy - Financial Analyst's Perspectives

  6. Top 50 Analysis Benefits of Analysis • Critical component of capital adequacy and credit analysis • Provides greater insight in discussions with companies • Independent verification of results • Insight into developing trends: quality of earnings, current rate adequacy • Separate supportable facts from unsubstantiated rumors in market Industry Reserve Adequacy - Financial Analyst's Perspectives

  7. Top 50 Analysis Conclusions • Industrywide $12.6 B redundancy at 12/98 • Represents abut 4% of Reserves and 4.5% of Surplus • PPA, WC provide redundancies; CMP, OL show deficiencies • Trends in Reserve Margins are Major Story • Margins thinning quickly • Differences Between Personal and Commercial Insurers • Whoever heard of a negative loss trend? Industry Reserve Adequacy - Financial Analyst's Perspectives

  8. Top 50 Analysis - Personal Lines Writer’s Current Position Industry Reserve Adequacy - Financial Analyst's Perspectives

  9. Top 50 Analysis - Retrospective View of PPA Industry Reserve Adequacy - Financial Analyst's Perspectives

  10. Top 50 Analysis • Findings - Personal Insurers • All showed reserve redundancies • The story then? • Favorable loss trends early-to-mid 1990s • Actuaries/management slow to recognize in rates • The story now? • Most carriers reducing rates, dividends • Loss cost trends ticking upward again Industry Reserve Adequacy - Financial Analyst's Perspectives

  11. Top 50 Analysis - Commercial Writer’s Current Position Industry Reserve Adequacy - Financial Analyst's Perspectives

  12. Top 50 Analysis - Retrospective View of Reviewed Commercial Lines Industry Reserve Adequacy - Financial Analyst's Perspectives

  13. Top 50 Analysis • Findings - Commercial Insurers • More even mix of deficiencies and redundancies • WC similarities to PPA • legislation and rate reform benefits coupled with loss trends • Competition intensifying, loss ratio climbing steadily • Significant rate pressures all other commercial lines • Most commercial lines show uniformly increasing loss ratio • Diversified Insurers • Redundancies outweigh deficiencies • Favorable PPA and WC experience outweighs other lines Industry Reserve Adequacy - Financial Analyst's Perspectives

  14. Top 50 Analysis Conclusions • Industry adequately reserved -- for now • How actuaries can help: • Expand statement of opinion • Include detailed footnotes in Schedule P • Expand content of actuarial reports and distribution of reports • Reserves Used in Variety of Ways by Many Constituencies…Think Beyond Statement of Opinion Industry Reserve Adequacy - Financial Analyst's Perspectives

  15. Industry Reserve Adequacy -- Beyond the Statement of Opinion • Moody’s Approach to Insurance Analysis • Credit vs. Equity Analysis Industry Reserve Adequacy - Financial Analyst's Perspectives

  16. Moody’s Approach to Insurance Analysis Industry Reserve Adequacy - Financial Analyst's Perspectives

  17. Moody’s Approach to Insurance Analysis Industry Reserve Adequacy - Financial Analyst's Perspectives

  18. Moody’s Approach to Insurance Analysis Analytical Approach - Benchmark • The lowest “Secure” rating has the annual default probability of a “500 Year” event Industry Reserve Adequacy - Financial Analyst's Perspectives

  19. Moody’s Approach to Insurance Analysis • Traditional Financial Indicators • Financial Leverage (Debt/Total Capital) • Double Leverage (Inv in Subs+Goodwill)/Equity • Fixed Charge Coverage and Cash Flow Coverage • In Context of Underlying Business Volatility • In Context of Business Cycle • Does Legal/Regulatory Structure Inhibit Cash/Capital Flows Across the Group? Industry Reserve Adequacy - Financial Analyst's Perspectives

  20. Moody’s Approach to Insurance AnalysisA Practical Reserve Example • Your typical property/casualty insurer Industry Reserve Adequacy - Financial Analyst's Perspectives

  21. Moody’s Approach to Insurance AnalysisA Practical Reserve Example Industry Reserve Adequacy - Financial Analyst's Perspectives

  22. Credit vs. Equity AnalysisWhat Creditors/Policyholders Want • Absolute Repayment • Minimize likelihood of loss of principal; benchmark is risk-free rate • Which translates into: • Conservative corporate governance • Prudent capital and financial management • Capital cushion • Strong earnings and cash flows Industry Reserve Adequacy - Financial Analyst's Perspectives

  23. Credit vs. Equity Analysis What Shareholders Want • Relative Return • Maximize total return, with acceptable level of risk; benchmark is a market index. • Which translates into: • Assertive corporate governance • High capital efficiency, as measured by ROE • Active capital and financial management • Growth in top and bottom lines • Strong earnings and cash flows Industry Reserve Adequacy - Financial Analyst's Perspectives

  24. Credit vs. Equity Analysis Contrasting Analytical Styles • Basic Motivations • Equity and credit analysts both want to be right • Credit analysts have pressure from issuers to be more liberal and investors to be more conservative • Equity analysts can face substantial implied pressure from issuers • Inherent Bias • Credit analysts tend to focus on the downside risk • Equity analysts tend to focus on the upside opportunity Industry Reserve Adequacy - Financial Analyst's Perspectives

  25. Credit vs. Equity Analysis Contrasting Analytical Styles - Example • Trustworthy’s creditors/policyholders have NO upside Industry Reserve Adequacy - Financial Analyst's Perspectives

  26. Industry Reserve Adequacy - Beyond The Statement of Opinion • Reserving Issues in Mergers and Acquisitions • Actuarial Due Diligence Process • Sampling of Solutions to Reserve Uncertainty Industry Reserve Adequacy - Financial Analyst's Perspectives

  27. Reserving Issues in M&AActuarial Due Diligence Process • Reserve Position • Restatement of Reported Results • GAAP Adjustments • Pro Forma Analysis • Appraisal Value Industry Reserve Adequacy - Financial Analyst's Perspectives

  28. Actuarial Due Diligence ProcessReserve Position • “Windshield” Analysis • Limited Review • Business Units • Access • Time • Comprehensive Analysis Industry Reserve Adequacy - Financial Analyst's Perspectives

  29. Actuarial Due Diligence ProcessRestatement of Reported Results Source: Consolidated Industry Loss Ratios Industry Reserve Adequacy - Financial Analyst's Perspectives

  30. Actuarial Due Diligence ProcessGAAP Adjustments • Assets • DAC • Premium Deficiencies • Policyholder Dividends • Contingent Commissions • Salvage & Subrogation • Federal Income Taxes • Other • Present Value of Future Profits (PVFP) Industry Reserve Adequacy - Financial Analyst's Perspectives

  31. Actuarial Due Diligence ProcessPro Forma Analysis Assumptions: • Premium Growth • Earnings Pattern • Loss Ratio • Expense Ratio • Payout Patterns • Investment Portfolio Mix • Investment Yield • Risk Adjusted Discount Rate • Time Horizon Industry Reserve Adequacy - Financial Analyst's Perspectives

  32. Actuarial Due Diligence ProcessPro Forma Analysis Output: • Income • Dividends • Surplus • Cash Flow From Operations • “Value” • Key Ratios, e.g. RBC Industry Reserve Adequacy - Financial Analyst's Perspectives

  33. Reserving Issues in M&A Sampling of Solutions to Reserve Uncertainty

  34. Sampling of Solutions • Purchase Accounting • Retrospective Adjustments • Reinsurance • Carve Outs • Other Industry Reserve Adequacy - Financial Analyst's Perspectives

  35. Purchase Accounting • Reserves are increased by seller prior to transaction date • Purchase accounting does not allow acquirer to book additional reserves • Advantages • fattens the pig before it goes to market • Disadvantages • depresses surplus Industry Reserve Adequacy - Financial Analyst's Perspectives

  36. Retrospective Adjustments • Future adjustment of sales price based on retrospective reserve estimates • Cash settlements • Portion of sales price held as a note payable • Contingent interest dividend paid to stockholders • Advantages • Low transaction cost • Disadvantages • Uncertainty Industry Reserve Adequacy - Financial Analyst's Perspectives

  37. Reinsurance • Stop loss cover provides protection against adverse reserve development • Purchased by seller • internal • external • Purchased by acquirer • Advantages • alleviates uncertainty associated with reserve development • Disadvantages • cost Industry Reserve Adequacy - Financial Analyst's Perspectives

  38. Carve Outs • Segregation of “undesirable” business segments and exclusion from transaction • Prior to transaction • Post transaction • Strategic motives • Advantages • may be only way to attract buyers • Disadvantages • seller may retain unwanted business • Regulatory scrutiny Industry Reserve Adequacy - Financial Analyst's Perspectives

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