Mergers and Acquisitions in the (Re)Insurance Industry

Casualty Actuaries in Reinsurance SeminarBoston, MassachusettsJune 16, 2000

Presentation Overview

Valuation Overview Critical Assumptions Example

Balance Sheet Income StatementTotal Value

Merger consequences Overview and Critical Assumptions Example

M&A market dynamics Statistics Conclusions

Questions?

Valuation

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Valuation

Overview

The valuation is the sum of :

The “true value” of the balance sheet (old business) The “true value” of the current and future business

on an “as is” basis

Marginal value to the buyer of intended use

Are there other sources of value? Option value Intangibles

Market Value

Economic Value

Price

Valuation

Critical Assumptions

Balance Sheet Reserves

Adequacy Run-off pattern Capitalization Taxes

Assets Yields Market values Liquidity

Income Statement Revenue (premium) Loss experience Expenses

Expected expense savings Integration costs

Cash flows Capitalization Taxes

Cost of Capital Target ROE WACC

Valuation

Balance Sheet

Assets (GAAP): Economic Assets: Invested Assets: 1,800.0 Invested Assets: 1,800.0

Cash: 100.0 Cash: 100.0 Premium Receivables: 500.0 Premiums Receivables: 500.0

DAC: 100.0 Reinsurance Recoverables: 400.0 Prepaid Reinsurance Prem: 100.0

Accrued Inv. Income: 200.0 Accrued Inv. Income: 200.0 Deferred Income Tax: 50.0

Goodwill 50.0 Other Assets: 200.0 Other Assets: 200.0

Total Assets: 3,500.0 Total Assets: 2,800.0

Liabilities (GAAP): Economic Liabilities:Gross L&LAE Reserves: 1,600.0 Net Loss Reserves: 1,098.7

Gross Unearned Premium: 400.0 Net L&LAE in UEPR: 212.9 Other Liabilities: 600.0 Other Liabilities: 600.0

Total Liabilities: 2,600.0 Total Liabilities: 1,911.6

GAAP Equity 900.0 Total Adjusted Equity: 888.4

Valuation

Income statement

2000 2001 2002 2003 2004 2005 …

Written Premium 450.0 475.0 525.0 575.0 625.0 650.0 % Change 5.6% 10.5% 9.5% 8.7% 4.0%Earned Premium 490.0 455.0 485.0 535.0 585.0 630.0 Incurred Loss 367.5 332.2 349.2 379.9 409.5 441.0 Expense 146.3 142.5 157.5 172.5 187.5 195.0 Underwriting Result (23.8) (19.7) (21.7) (17.4) (12.0) (6.0)

Loss Ratio 75.0% 73.0% 72.0% 71.0% 70.0% 70.0%Expense Ratio 32.5% 30.0% 30.0% 30.0% 30.0% 30.0%Combined Ratio 107.5% 103.0% 102.0% 101.0% 100.0% 100.0%

Return on Equity 10.5% 16.2% 17.4% 18.7% 19.9% 19.9%

Economic Value:

NPV

Value of Future Earnings 72.5 Integration Expenses (15.3) Economic Value 57.1

Valuation

Total Value

Value of the Balance Sheet $890Value of the Income Statement $60Other sources of value $50 Total value $1,000Per Share (1) $20

Ratios:Value/Market Price (2) 111%Value/Book (3) 111%Value/Earnings (4) 18.0

(1): Based on 50 million shares outstanding(2): Current share price of $18(3): Book value is $900 million(4): Pro-forma 2000 earnings are $56 million ($1.12/share)

Merger Consequences

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Merger Consequences

Overview and Critical Assumptions

Pro forma income statements and balance sheets of the buyer and the target combined, appropriately reflecting the deal structure

Key considerations Transaction financing Restructuring the balance sheet

Preferred stock Outstanding options Impaired assets Transition costs Conforming accounting

Impact on operating results EPS ROE

Constraints RBC Debt/Capital

Merger Consequences

Sample Analysis

2000 2001 2002 2003 2004

Operating Results:

Statutory UW Result (24) (20) (22) (17) (12) GAAP Adjustment (7) 3 7 7 7 GAAP UW Result (30) (16) (15) (11) (5)

Investment Income and Other 101 102 105 110 118 Pre-Tax Operating Earnings 70 86 90 99 112

Income Tax (10) (15) (16) (19) (22) Operating Income 61 71 74 80 90

Transaction Impact: Goodwill (5) (5) (5) (5) (5) Transition Costs (25) - - - - Lost Investment Income (28) (30) (31) (33) (35) Interest on Debt Issued (38) (38) (38) (38) (38) Income Tax Benefit 28 20 20 20 21

Adjusted Earnings (7) 18 20 25 33

Per Share (0.03)$ 0.09$ 0.10$ 0.13$ 0.17$

Debt/Capital Ratio: Before 16.5% After 20.4%

M&A Market Dynamics

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Chart 1: Number of Deals vs. Statutory Surplus

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1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

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$300,000

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$400,000

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Number of Deals Stat Surplus

Source: Conning & Company

Chart 2: Number of Deals vs. P&C Index

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1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

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Number of Deals Year-End Close

Source: Conning & Company

Chart 3: Aggregate Deal Size vs. P&C Index

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

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Deal Values Year-End Close

Source: Conning & Company

Chart 4: Average Deal Size vs. P&C Index

$0

$100

$200

$300

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$500

$600

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

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Average Deal Size Year-End Close

Source: Conning & Company

Deal Pricing vs. P&C Index

Not only is the quantity and size of deals impacted by relative stock prices, but evidence (albeit limited) shows that the price companies pay in a deal is also impacted by relative stock price…

Over the past three years, the price paid in a transaction versus earnings has followed the P&C index both up in 1998 and down in 1999.

Likewise, the price to book value has also followed the trend in the P&C index.

GAAP P/E vs. P&C Stock Index

01020

304050

1997 1998 1999

GA

AP

P/E

75.085.095.0

105.0115.0125.0

P&

C In

de

x C

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e

GAAP Price to Earnings Year-End Close

GAAP P/B vs. P&C Stock Index

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2

3

1997 1998 1999

GA

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P/B

75.085.095.0

105.0115.0125.0

P&

C In

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x C

los

e

GAAP Price to Book Year-End Close

Source: Conning & Company

Key Conclusions

Our discussion of St. Paul’s valuation and merger consequences approaches, combined with our review of P&C merger and acquisition activity suggests the following…

When market valuations are low: sellers feel they are undervalued buyers stock is generally of low value future earnings are poor premiums to market decline fewer deals get done

When market valuations are high sellers feel the market has more appropriately valued their enterprise buyers have additional currency in the form of stock future earnings are better premiums to market increase more deals get done

Said another way, when market valuation decline, insurers are not necessarily the bargains they appear to be.

Questions?

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