Valuations -- Actual v. Expected CAS Limited Attendance Valuation Seminar St. Louis, Missouri April 10-11, 2000

What can go wrong? Obvious candidates include… 4Reserve adequacy 4Latent claims 4Revenue enhancements 4Expense savings Less obvious candidates include… 4Dilution of existing efforts 4Gross v. net - expenses despite no exposure

Three Stories...

Story 1 “We’re going to 1) re-underwrite the book of business, keeping only the most profitable half, and 2) We’ll reduce fixed expenses by even more to reduce the marginal expense ratio “ 4The valuation is based in large part on the value of expected future earnings in excess of a hurdle rate 4Expected earnings are a function of planned post- merger activity

Story 1 (continued) Expected value of the Loss Ratio = 85% Expense ratio = 35% Combined ratio = 120% Baseline view of the business after thorough due diligence

Story 1 (continued) E[ Loss Ratio| Loss Ratio < 73%] = 50% With expense savings the resultant Expense Ratio = 30% Marginal Combined Ratio = 80% Plan is to eliminate half of the business -- only the bad half, of course. A marginal combined ratio of 80% underlies the valuation.

Story 1 (continued) Expected value of the Loss Ratio between 25th and 75th percentile = 75% Expense savings realized, but denominator is smaller. Expense Ratio = 34% Marginal Combined Ratio = 109% After one year, you are successful at eliminating the worst 25% of the business. Competition has stolen the best 25%. You retain the middle in an effort to prop up volume.

Story 2 “We’re going to integrate the two claims units. Our intention is to create an organization that is the best of both worlds…” 4Culture, like the weather, is something everyone talks about but nobody does anything about. 4Cultural changes and their impact are difficult to predict

Story 2 (continued) Pre-merger average case reserves differ between the two companies. Is it a mix issue? Is it claims philosophy?

Story 2 (continued) Resource is dedicated to integration. Target company is in shock. Average case reserves drop 10%.

Story 2 (continued) Integration is complete. Buyer’s culture confirmed. Observed inflation is 11% in acquired book.

Story 3 “We don’t know what that segment is worth. Let’s just use a market multiple and apply it to book value.” 4Actual will likely depart from expected if you didn’t expect anything! 4Valuation has to be based on the drivers of value and your strategic intent 4Derivative benefits to ratings sensitive business when the acquired business is picked up by a higher rated business (can work the other way)

Story 3 (continued) Flat book of business grows 15%in first year post merger. Higher ratings allowed new product introductions and new distribution channels

Actual v. Expected