Casualty Actuaries in Reinsurance

1. Casualty Actuaries in Reinsurance Terrorism Seminar — Alternative Solutions Session Charles Wolstein September 13, 2004 This document is incomplete without the accompanying discussion; it is confidential and intended solely for the information and benefit of the immediate recipient hereof.

2. Discussion outline • Study background/context • Study objectives and structure • Pool objectives • Overview of prototype pool design • Key issues and conclusions • Areas of analysis • Current status WC Terrorism Reinsurance Pool Feasibility Study The Insurability of Terrorism Risk • 9/11 context/perspective • Key characteristics of terrorism risk

3. BACKGROUND/CONTEXT The study was an effort by WCwriters to explore potential “privatemarket solutions” to managing terrorism exposure • In the aftermath of the September 11, 2001 attacks, insurers came to realize the enormous magnitude of their terrorism exposure • Exposure particularly acute for WC writers because of the statutory nature of the coverage • Terrorism Risk Insurance Act (TRIA) created temporary federal reinsurance backstop; sunsets December 31, 2005 • 14 insurers got together to explore the feasibility of a voluntary WC terrorism reinsurance pool • Tillinghast and Reinsurance businesses were jointly engaged to conduct the feasibility study

4. The breadth and diversity of the sponsor group illustrates the universality of the concern SPONSOR GROUP Project Participants • Represent ~40% of WC DWP • National and regional • Small and large • Private entities and state funds • Multi-line and mono-line Project Sponsors • ACE USA • AIG • CNA • Guard Insurance • The Hartford • Kentucky Employers’ Mutual Insurance Company • Liberty Mutual • Missouri Employers Mutual Insurance Company • The PMA Group • Royal & Sunalliance • The St. Paul Companies • Texas Mutual Insurance Company • Travelers • Zurich North America Other Participants • AIA • NCCI • PCI (formerly AAI and NAII) • Risk Management Solutions (RMS)

5. STUDY OBJECTIVES Solicit industry perspectives to establish a set of common objectives Develop an approach for measuring relative terrorism exposure Develop a specific prototype pool design Model potential pool liabilities, capital requirements and risk-sharing efficacy Assess preliminary interest The insurance industry sought toaddress the unique challenges thethreat of terrorism poses for WC writers • The objective of the study was to assess the feasibility of a Workers' Compensation terrorism reinsurance pool: an effective, equitable, voluntary WC terrorism risk-sharing mechanism

6. POOL OBJECTIVES The sponsors agreed on thestrategic objectives of the pool as well asa number of more specific tactical design objectives Strategic Objectives Design Objectives/Considerations Industry-based Solution • Provide a cost-effective, equitable and competitively neutral mechanism • Mutualize the risk across the insurance industry; maximize the effective use of industrywide capacity; minimize risk of insolvency • Create a mechanism that can serve as a “window” to any proposed ongoing federal backstop program • Provide a tangible measure of terrorism cost, facilitating inclusion of terrorism load in approved primary WC loss costs • Provide a tax-efficient mechanism to build up a fund to pay for these losses • Retain incentives for individual companies to manage risk • Establish a solution quickly • Keep the data requirements and administrative aspects of the program simple

7. OVERVIEW OF PROTOTYPE POOL DESIGN The pool would be an aggregateexcess reinsurer funded primarilythrough accumulated premiums paid by members 4 The premiums are placed in a captive reinsurer owned by the members. The captive is initially funded by paid-in capital, then increasingly by accumulated surplus. As the captive’s capacity grows, the pre-funded layer will be expanded. Government Backstop 3 As a transitional measure until sufficient funds are accumulated, a second pool layer is “post-funded” through a group retrospective rating mechanism Small, aggregate post-fundedlayer, excess above pre-fundedlayer $XX million aggregate pre-funded layer,excess over per-companyattachment 2 The first pool layer is “pre-funded” via exposure-based premiums; losses (subject to a 10% co-participation) are paid from this layer until it is exhausted Co-participation Industry Captive Member Attachment Points 1 Companies choose from three levels of retention based on individual risk appetite; companies can reduce their retention with commercial reinsurance Reinsurance/Capital Markets Commercialreinsurance Captive may, in turn, access reinsurance or capital markets to securitize risk 5 Individual companyretained losses

8. KEY ISSUES/CONCLUSIONS The feasibility studyfocused on several key issues Issue Key Conclusion Capacity • Voluntary pool cannot accumulate enough capacity to meaningfully help insurers absorb mega-terrorism events, even over many years and under favorable assumptions • Pool does provide risk diversification benefit to participants and could help individual insurers withstand moderate terrorism events • Capacity limitations mean pool can’t provide industry-level solution Measuring terrorism exposure • Employee headcount by location is the appropriate exposure base • Since 9/11 many insurers have been collecting this type of exposure data • The data appear sufficient to be used by the pool to measure participants’ exposure, coupled with appropriate data validation protocols Achieving equity • Developing a pricing formula to ensure equity for participants is theoretically possible • Could use commercial terrorism risk models and/or a “proxy” measure of exposure • Models differ in their underlying assumptions and their results • For pool pricing, only relative risk matters • Agreeing on a formula for pricing would ultimately be a “negotiation” among founding pool members; sponsors did not reach consensus on pricing formula

9. AREAS OF ANALYSIS There were four mainareas of analysis during the study ILLUSTRATIVE Terrorism Exposure Modeling —RMS and “Proxy” Pool Funding (Structure, Level and Basis) Comparison of RMS Model Results and Proxy Measure of Exposure Terrorism Share Divided by Headcount Share Pre-funded Pool Capacity Accumulation Years to Achieving Target Capacity (2006) Pre-Funded Capacity RMS/Proxy Blend Accumulation ofDeposited Premiums ($M) Years 1-in-1,000 1-in-500 1-in-250 Capacity needed tofund 1-in-500 loss Minimum Retention Option (All Members) Maximum Retention Option (All Members) Years Pre-funding Level Company Risk Diversification Benefits Distribution of Aggregate Losses Pool Members’ Loss Distribution Compared to Share of Pool Loss Distribution Pool Members' Aggregate Terrorism Losses* ($ Billions) Risk Reduction Risk Reduction Stochastic Modelingof Pool Performance Reduction in 1 Reduction in 1-in-500 loss 90% 90% For very small WC writers, low exposure coupled with a $5 million retention causes the risk diversification benefit to be beyond 1-in-500 80% 80% 70% 70% • Pool composition • Event size, concentration and timing • Pool design/funding • Impact of TRIA 60% 60% 50% 50% 40% 40% 30% 30% Roughly 70% of the market would achieve at least a 50% risk reduction 20% 20% achieve at least a 50% risk reduction 10% 10% 0% 0% 10% 10% 20% 20% 30% 30% 40% 40% 50% 50% 60% 60% 70% 70% 80% 80% 90% 90% 100% 100% 0% 0% Cumulative WC Pool Market Share (WC DWP)

10. CURRENT STATUS The sponsor group decidednot to pursue the detailed designand implementation of a pool at this time • Two main reasons: • The pool would not offer enough capacity to help the industry absorb losses from catastrophic terrorism events • While not considered a viable industry solution, some participants remain quite interested • Uncertainty about the future of federal backstop protection was an important consideration • This outcome reflected a variety of factors: • Findings and conclusions of the study (i.e., capacity) • Political considerations and the uncertainty of external political environment • Diversity of sponsor group The sponsors agreed that the effort provided important insights into the key philosophical, conceptual and practical issues associated with creating a pool — and laid the foundation for future work on a pool, if and when appropriate

11. Study background/context • Study objectives and structure • Pool objectives • Overview of prototype pool design • Key issues and conclusions • Areas of analysis • Current status WC Terrorism Reinsurance Pool Feasibility Study The Insurability of Terrorism Risk • 9/11 context/perspective • Key characteristics of terrorism risk

12. Although terrorism is by no means a new phenomenon, the September 2001 attack was a watershed event Estimated Insured Losses — Select Cat EventsCurrent Loss Equivalents ($ Billions) WTC (2001)* $44 $24.5 Hurricane Andrew (1992) Hurricane Betsy (1965) $11.5 Hurricane 1938-B (1938) $10.8 $8.2 Hurricane Hazel (1954) Estimate in event-year dollars/values Hurricane Carol (1954) $6.3 Adjustment to reflect current exposures, values, dollars $5.5 Hurricane Hugo (1989) Note: Hurricane losses adjusted to reflect current demographic/habitation patterns, property values and inflation. * Represents midpoint of Tillinghast’s estimated range of losses. Source: Florida Department of Insurance (Andrew, original), Property Claims Services (original losses for hurricane losses other than Andrew); Tillinghast estimates (A Macro Validation Data Set for U.S. Hurricane Models).

13. Average annual claims (industry) +12% Workers' Comp 9/11 claims +458% Aviation +75% Comm Property, BI +9% Life, AD&D +14% Liability Other 0 10 20 30 40 50 60 Billions For additional perspective, 9/11 losses had a significant impact on overall industry claims Impact of 9/11 on Industry Annual Claims • As bad as it was, the devastation could have been much worse, particularly the human toll (and WC losses) (e.g., time of day, point of impact, time between impacts/collapse) • It is easy to imagine substantially higher fatalities…with WC losses increasing from ~$3 billion to as much as $6 billion – $12 billion Source: Tillinghast estimates.

14. The key question: What makes terrorism risk different? Inability to Price Potential Magnitude

15. Can terrorism risk be priced? • Requirements for pricing risk: • Frequency • Severity • Three credible commercial terrorism loss modelers… • …three different theories of terrorism • …three different loss profiles Reasons You May Not Be Able to Price Terrorism Exposure • Primary difficulty is estimating frequency • Net effect of “offense” and “defense” • Supposed to be highly secret • How can experts know? • Terrorism risk is intrinsically dynamic • Contrast with essentially static nature of other risks Even if these risks could be priced, there are significant practical/ political constraints to realizing true risk-based premiums

16. Exchange uncertainty for certainty [Reasonably] stable insurance costs Underlying risk can change dramatically over short periods of time Policy duration (one year) too long Potential for extreme fluctuations in premium The dynamic nature of the riskcreates fundamental conflict between the expectations/requirements of insureds and insurers Insured Insurer • Contrast with natural catastrophe pricing • Historical costs • Adjust for changes in the environment (i.e., exposure), not for changes in the underlying risk

17. A mega-event exceeds the industry’s capacity to absorb or willingness to assume • Estimated losses: $32B – $56B; could have been $10B – $20B higher Tillinghast Estimates of Industry Capital (2002) • Primary (commercial) insurers: $125 billion • Global reinsurers: $110 billion Risk Management “Rule of Thumb” • Limit net exposure to 2% – 3% of capital for any single event • Aggressive posture may go as high as 10% (statutory limit in some states) • Sabotage of Indian Point Nuclear Power Plant • Large release of radioactive material; southerly wind • Potential losses: $218B • Large weaponized aerosol anthrax release in downtown NYC; weekday 2pm • Estimated 173,000 deaths • Potential losses: $244B The industry won’t and shouldn’t expose this much of its capital base to a single terrorist event Source: Risk Management Solutions, Inc. (nuclear and biological attack scenarios) estimates; Tillinghast estimates.

18. A few final thoughts ... • “Alternative ‘solutions’” — no such thing, at least foreseeably • In long term, may be possible; would require fundamental changes to current regulatory and accounting practices • Some form of ongoing federal reinsurance program is necessary to protect the insurance system — analogous to Federal Reserve protecting the banking system • Especially true for Workers’ Compensation • Failure to extend federal backstop creates potential for major economic disruption and dislocation • “Partial solutions” could be effective in concert with a federal backstop — includes a pool, and possibly others • “Stay tuned for 200X…same bat time, same bat channel” — if it is extended, what will be different when the extension expires?

19. Are there any questions? Q&A