The Actuary’s Role in Due Diligence The Actuary’s Role in Due Diligence CAS Annual Meeting November 2000

Overview What is Due Diligence? Traditional Steps in a Public Offering: –Pre-Due Diligence, including Valuation Actuarial Training v. Buyer’s Perspective –Due Diligence Data Room & Site Interviews –Post-Due Diligence & Sale Actuary’s Roles (Buyer’s & Seller’s sides) Financial Community’s Needs from Actuaries

What is Due Diligence?

Dictionary Definition Due diligence (noun) -- first appeared 1903: The care that a reasonable person exercises under the circumstances to avoid harm to other persons or their property.

Merger & Acquisition Process in a Public Offering  Seller Announces Public Offering of Target & Marketplace considers its interest in Target  Prospective Buyers contact Seller for more data in order to perform Valuation of Target  Buyers make Conditional Bids for Target Due Diligence  Qualified Buyers perform Due Diligence  Remaining Buyers make Binding Offers

Mergers & Acquisitions Process: Pre-Due Diligence Activities  Market Considers Target: Using public information and general knowledge of Target, Buyer considers if Target might represent a good fit. Factors include (among others):  Size / Lines of Business / Geographic Mix { (x) Distribution Channel(s)  Historic Profitability, including Cost Structure ™ Market Perception / Target’s Reputation & Brand  Technology / Competitive Advantages

value added  Valuation : Interested Buyers approach Seller for non- public information about Target. In addition to Target’s intrinsic value, Buyers look for potential enhancements, synergies, +/or diversification to existing operations to estimate value added upon acquiring Target.  Product  Distribution  Production  Service Mergers & Acquisitions Process: Pre-Due Diligence Activities

 Conditional Bid: Buyer offers Seller a price based upon its own Valuation of Target. Due Diligence Having estimated its own economic “Value in Use” of the Target, Buyer submits to Seller a conditional offer to purchase, pending a Due Diligence audit to validate the assumptions underlying its Valuation. Mergers & Acquisitions Process: Pre-Due Diligence Activities

Requirement for Sale to Occur Seller’s Value of Target < Sale Price Buyer’s Value of Target > Sale Price where Value = owner’s “Value in Use”, and Buyer’s intended Use of Target may differ from Seller’s

What is the Value of an Insurer? Market Value = current value of o/s common shares Book Value = “as at” date shareholder equity Comparative Value = comparable price ratios for recent acquisitions Dilution Value = price above which buyer impairs earnings per share or ROE Economic Value = Book Value + present value of future earnings EVA Economic Earnings - Cost of CapitalEVA = Economic Earnings - Cost of Capital

Traditional Actuarial Valuation $Value = Book Value + p.v. of Future Earnings =Book Value, adjusted for accounting considerations +Investment income from reserve runoff +U/W & investment income from UPR +U/W & investment income from renewals +U/W & investment income from new business All values are estimated future NET cash flows, including taxes

 Valuation  Economic Value Added $Value Added = P.V. of Future Earnings net of expected gains if capital were otherwise deployed: +Investment income from reserve runoff +U/W & investment income from UPR +U/W & investment income from renewals +U/W & investment income from new business –(Capital Base) * (wtd. average Capital Charge) All values are estimated future NET cash flows, including taxes

Valuation in Mergers & Acquisitions: Actuarial v. Buyer’s Perspective There are important differences in perspective between actuarial valuation training and the buyer’s assessment of a potential acquisition.  Actuarial training focuses on assessing the value of the insurance operation to be acquired.  Prospective buyers must consider the acquisition in conjunction with other existing and potential future operations or investments.

Buyer’s Valuation Activities Evaluate Balance Sheet –Adjust for potentially over-/under-stated items –Review asset concentration/diversification Assess Operational Processes –Identify inefficiencies and overlaps –Look for possible synergies Evaluate Income Statements & Cash Flows –Review company’s historic profitability –Project future cash flows, including benefits of operational changes due to synergies, etc.

So, what is left for Due Diligence?  Due Diligence: A process of examination by the prospective buyers to validate the assumptions underlying their conditional bids.  Business strategies and operating models  Historic results  Perceived competitive advantages  Cash Flow Projections  Look for overstatements and sugar coatings

 Have “Data Room” readied with typical information Prospective Buyers will need to validate their business strategies and examine existing operating models, financial results, and projections.  Avoid temptation to overstate or sugarcoat.  Cooperation is important, but business units are not to be put on display, nor are associates to be exposed. Buyers are assessing processes not people.  Competitive advantages, business plans and strategies are subject to complete disclosure; confidentiality statements are a requirement and will have been secured. Seller’s Role in Due Diligence

What goes into the Data Room? General Overview of Operations: Corporate = structure; Board minutes; Sr. Mgmt. bios Insurance = LOB results/strategies/marketing; Claims Field = organization & sites; authorities; monitors Support = IT; Finance/Reporting; Actuarial; HR Investments = strategies; Schedule D details; leases Legal & = non-claim litigation; recent examination Regulatoryreports; audits; fines & penalties Tax = returns; audits/settlements; open years; NOLs Runoff = details of discontinued operations Benefits = Retirement Plans; Pension Fund Valuations; Group Insurance Plans; severance deals

Post-Due Diligence Process in Insurance Mergers & Acquisitions  Final Bids: Buyer refines conditional bid with information gathered in Due Diligence.  Final Bid reflects changes to assumptions underlying Future Cash Flow estimates  Bid may still include conditions that must be agreed to and met by Seller  Seller selects winning bid and begins negotiations with Buyer to finalize deal