Casualty Actuarial SocietySpring Meeting

May 15 – 18, 2005

The industry's ability to attract The industry's ability to attract capital given historically low capital given historically low ROEs leads us to question: ROEs leads us to question:

Is ROE the right measure for Is ROE the right measure for the insurance industry's the insurance industry's

performance?performance?

by Joan Lamm-Tennant, PhD

Overview

• Macro-Economic View of Capital Flows

• “Accounting – Based” ROE Trends

• If it is not ROE, then what?

• Risk-Adjusted Return on Economic Capital

• Economic Value Added

• Float

Macro Market View

• The demand curve is downward sloping suggesting that price must fall to increase demand for risk transfer

• In equilibrium price and demand intersect to determine price

• At the appropriate level of capacity, price is the “fair” price

PricePV E(L) + Exp

QuantityQ

S

D

P

Basic Laws of Supply and Demand

Macro Market View

• In the short run, net worth may be “shocked” by an extreme event

• The “shock” causes a shift (decline) in capacity

• Prices increases and new capital may flow in

PricePV E(L) + Exp

Quantity

S

P

D

Q*

S

P* Decline inNet Worth

S*

Basic Laws of Supply and Demand

Macro Market View

• Behaviors, not only the financials, may change

• The “shock” may causes an increase in risk aversion therefore an increase in demand

• An increase in demand will exacerbate the price increase

PricePV E(L) + Exp

Quantity

S

P

D

Q*

S

P

S*

Basic Laws of Supply and Demand

S*

D*

P*

Macro Market View

• Higher prices for risk will eventually restore profitability and replenish capital

• Equilibrium is restored at a price of “P”

• The cycle continues to repeat itself and, if fact, may become instantaneous

• Any interference to offset shocks to capital in the short run could be costly in the long run

• Insurance markets are healthy and dynamic!!!

PricePV E(L) + Exp

Quantity

S

P

D

Q*

S

P

S*

Basic Laws of Supply and Demand

S*

D*

P*

6.2%

10.2%

14.2%16.6% 15.6%

12.8%

9.3% 8.4% 8.9%

4.5% 3.9%4.7%

0%

5%

10%

15%

20%

Q4 2001 Q1 2002 Q2 2002 Q3 2002 Q4 2002 Q1 2003 Q2 2003 Q3 2003 Q4 2003 Q1 2004 Q2 2004 Q3 2004

Quarterly Premium Growth Rates

14%

11%13%

16%

19%

22%

25%

31%31%

28%30%

32%33%

28%29%30%32%

30%

27%25%

28%

22%

18%18%17%16%

12%12%10%

12%11%9% 9% 9%

7% 7%5% 4% 4%

2% 2% 2% 1%

0%

10%

20%

30%

40%

Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul - 04 Oct-04 Jan-05

Source: ISO

Source: MarketScout

Rate Increases

$20,492$11,442

$16,437$4,872

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

2001 2002*

Completed Pending

$25.4 Billion $27.9 Billion

*As of September 13, 2002.

Source: Morgan Stanley, Insurance Information Institute.

14 Pending 38 Pending

40 Completed 33 Completed

Following 9/11 New Capital Entered The Market

Raising by Property / Casualty Insurers Since 9/11 Totals $53.2B

2004 Capital Raising Activity

• The US and Bermuda-based property-casualty insurers raised $12.2 billion of capital directly in the capital markets

• Of the $12.2 billion raised, 60.2% was traditional debt, 26.4% was equity and the remainder was equity-linked and preferred securities

Net Income (AT)

$14,178

$5,840

$19,316

$10,870

$20,598

$24,404

$36,819

$30,773

$21,865$20,559

-$6,970

$9,200

$31,200

38,700

-$10,000

$0

$10,000

$20,000

$30,000

$40,000

$50,000

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

*Sources: A.M. Best, ISO, Insurance Information Institute.(amounts in millions)

1991 to 2004

$0

$50

$100

$150

$200

$250

$300

$350

$400

1975 1978 1981 1984 1987 1990 1993 1996 1999 2002

Industry Surplus

(amounts in billions)Source: A.M. Best and ISO, 2004 Through Third Quarter

Q3 2004

Surplus

June 30, 1999 $341

September 30, 2002 $273

September 30, 2004 $369

December 31, 2004 $394

Overview

• Macro-Economic View of Capital Flows

• “Accounting – Based” ROE Trends

• If it is not ROE, then what?

• Risk-Adjusted Return on Economic Capital

• Economic Value Added

• Float

Period

Historical Statutory ROE by Decade

106.3

107.8

109.2

100.3

Combined Ratio

4.8%5.3%2000 -2004

6.7%8.4%1990s

10.6% 11.5%1980s

7,5% 11.2% 1970s

10 Year T-YieldP/C ROE

Source: A.M. Best Review/Preview

-5%

0%

5%

10%

15%

20%

1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Return on “Statutory” Equity vs. Cost of Equity

U.S. Property / Casualty Industry (1983 to 2004)

Source: A.M. Best; Conning Forecast; CF&S practice; McKinsey

1983 – 2003

Cost of Equity 11.5%

Accounting ROE 6.5%

2004

Cost of Equity 8.9%

Accounting ROE 10.5%

Difference 1.6%

Return on Equity Cost of Capital

Overview

• Macro-Economic View of Capital Flows

• “Accounting – Based” ROE Trends

• If it is not ROE, then what?

• Risk-Adjusted Return on Economic Capital

• Economic Value Added

• Float

Risk-Adjusted Performance Metrics

• Return on risk-adjusted capital (RORAC) vs. risk-adjusted return on capital (RAROC)

– Dividing expected net income by “economic” capital is technically RORAC, nevertheless the industry convention is to call it RAROC

• Economic value added (EVA)

– Difference between the return on “economic” capital and the cost of capital, where cost of capital is reflective of both capital structure and risk

• Float and Cost of Float

– Arises because premiums are received before losses are paid

– Float may be estimated as

• (Total Invested Assets – Capital – Unassigned Surplus)

– Since premiums tend not to cover losses, insurers run an underwriting loss which is the cost of float

• Cost of float may be negative when the insurer runs an underwriting profit

Profit

Mean

+10% +40%

Risk Tolerance

Acceptable VaR Perhaps

Associated Rating

0%-30%-50%

Economic Capital

RAROC and EVA Require A Measure of Economic Capital

• Economic capital is frequently referred to risk capital

– The amount of capital necessary to cover the risk in our business given our risk tolerance

Float and Cost of FloatU.S. Property and Casualty Industry

3.7%

4.9%5.6%

0.8%

6.5%

10.3%

$200,000

$250,000

$300,000

$350,000

$400,000

$450,000

$500,000

$550,000

$600,000

$650,000

1998 1999 2000 2001 2002 2003

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

Float

Cost of Float

Source: AM Best Aggregates and Averages

Float and Cost of FloatU.S. Commercial Lines Industry

1.8%

3.6%4.3%

4.9%

8.2%

4.2%

$200,000

$220,000

$240,000

$260,000

$280,000

$300,000

$320,000

$340,000

$360,000

1998 1999 2000 2001 2002 2003

-4%

-2%

0%

2%

4%

6%

8%

10%

Float

Cost of Float

Source: AM Best Aggregates and Averages, Commercial Lines Segment

Float and Cost of FloatU.S. Personal Lines Industry

-0.7%

4.1%

5.4%5.8%

11.9%

9.4%

$50,000

$75,000

$100,000

$125,000

$150,000

$175,000

$200,000

$225,000

$250,000

1998 1999 2000 2001 2002 2003

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

Float

Cost of Float

Source: AM Best Aggregates and Averages, Personal Lines Segment

Industry Comparative Cost of Float

-2%

0%

2%

4%

6%

8%

10%

12%

14%

1998 1999 2000 2001 2002 2003

U.S. Property / Casualty Industry

Commercial Lines

Personal Lines

Source: AM Best Aggregates and Averages

The industry's ability to attract capital The industry's ability to attract capital given historically low ROEs leads us to given historically low ROEs leads us to

question: question:

Is ROE the right measure for the insurance Is ROE the right measure for the insurance industry's performance?industry's performance?

Perhaps consider Perhaps consider Risk Adjusted Return on Economic CapitalRisk Adjusted Return on Economic CapitalEconomic Value AddedEconomic Value AddedFloatFloat

Thank You