1. Industry Reserve Adequacy and Other Hot Topics: Financial Analyst’s Perspectives 1999 Casualty Loss Reserve Seminar Scottsdale, Arizona

2. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives2 Presenters n Sarah Hibler - Vice President & Senior Analyst, Moody’s Investors Service n Jay Votta - Principal, Deloitte & Touche LLP n Bill Wilt - Vice President & Senior Analyst, Moody’s Investors Service

3. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives3 Discussion Topics n Overview of Reserve Adequacy –Results of Moody’s Top 50 Analysis n Use of Reserves in Credit and Equity Analysis –Reserves play critical role in gauging financial health n Reserving Issues in Mergers & Acquisitions –Reserves key consideration in structuring deals

4. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives4 Goals of Session n Discuss macro-level trends in loss reserves n Provide insight into how ‘outsiders’ analyze loss reserves n Demonstrate importance of reserves in different contexts: –Credit Analysis –Equity Analysis –M&A Activity

5. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives5 Top 50 Analysis n Moody’s Analyzed Top 50 P/C Groups –Approx. 2/3 industry reserves and surplus n Used annual statement data and internal reserve model –Excluded A&E, reinsurance, miscellaneous lines n Tested results against independent analyses where available –Despite limitations, A/S data can provide credible starting point

6. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives6 Top 50 Analysis Benefits of Analysis –Critical component of capital adequacy and credit analysis –Provides greater insight in discussions with companies –Independent verification of results –Insight into developing trends: quality of earnings, current rate adequacy –Separate supportable facts from unsubstantiated rumors in market

7. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives7 Top 50 Analysis Conclusions –Industrywide $12.6 B redundancy at 12/98 »Represents abut 4% of Reserves and 4.5% of Surplus n PPA, WC provide redundancies; CMP, OL show deficiencies –Trends in Reserve Margins are Major Story »Margins thinning quickly –Differences Between Personal and Commercial Insurers »Whoever heard of a negative loss trend?

8. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives8 Top 50 Analysis - Personal Lines Writer’s Current Position

9. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives9 Top 50 Analysis - Retrospective View of PPA

10. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives10 Top 50 Analysis n Findings - Personal Insurers –All showed reserve redundancies –The story then? »Favorable loss trends early-to-mid 1990s »Actuaries/management slow to recognize in rates –The story now? »Most carriers reducing rates, dividends »Loss cost trends ticking upward again

11. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives11 Top 50 Analysis - Commercial Writer’s Current Position

12. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives12 Top 50 Analysis - Retrospective View of Reviewed Commercial Lines

13. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives13 Top 50 Analysis n Findings - Commercial Insurers –More even mix of deficiencies and redundancies »WC similarities to PPA »legislation and rate reform benefits coupled with loss trends »Competition intensifying, loss ratio climbing steadily –Significant rate pressures all other commercial lines »Most commercial lines show uniformly increasing loss ratio n Diversified Insurers –Redundancies outweigh deficiencies »Favorable PPA and WC experience outweighs other lines

14. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives14 Top 50 Analysis Conclusions –Industry adequately reserved -- for now –How actuaries can help: »Expand statement of opinion »Include detailed footnotes in Schedule P »Expand content of actuarial reports and distribution of reports n Reserves Used in Variety of Ways by Many Constituencies…Think Beyond Statement of Opinion

15. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives15 Industry Reserve Adequacy -- Beyond the Statement of Opinion n Moody’s Approach to Insurance Analysis n Credit vs. Equity Analysis

16. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives16 Moody’s Approach to Insurance Analysis

17. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives17 Moody’s Approach to Insurance Analysis

18. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives18 Moody’s Approach to Insurance Analysis Analytical Approach - Benchmark n The lowest “Secure” rating has the annual default probability of a “500 Year” event

19. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives19 Moody’s Approach to Insurance Analysis n Traditional Financial Indicators –Financial Leverage (Debt/Total Capital) –Double Leverage (Inv in Subs+Goodwill)/Equity –Fixed Charge Coverage and Cash Flow Coverage n In Context of Underlying Business Volatility n In Context of Business Cycle n Does Legal/Regulatory Structure Inhibit Cash/Capital Flows Across the Group?

20. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives20 Moody’s Approach to Insurance Analysis A Practical Reserve Example n Your typical property/casualty insurer

21. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives21 Moody’s Approach to Insurance Analysis A Practical Reserve Example

22. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives22 Credit vs. Equity Analysis What Creditors/Policyholders Want n Absolute Repayment n Minimize likelihood of loss of principal; benchmark is risk-free rate n Which translates into: –Conservative corporate governance –Prudent capital and financial management –Capital cushion –Strong earnings and cash flows

23. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives23 Credit vs. Equity Analysis What Shareholders Want n Relative Return n Maximize total return, with acceptable level of risk; benchmark is a market index. n Which translates into: –Assertive corporate governance –High capital efficiency, as measured by ROE –Active capital and financial management –Growth in top and bottom lines –Strong earnings and cash flows

24. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives24 Credit vs. Equity Analysis Contrasting Analytical Styles n Basic Motivations –Equity and credit analysts both want to be right –Credit analysts have pressure from issuers to be more liberal and investors to be more conservative –Equity analysts can face substantial implied pressure from issuers n Inherent Bias –Credit analysts tend to focus on the downside risk –Equity analysts tend to focus on the upside opportunity

25. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives25 Credit vs. Equity Analysis Contrasting Analytical Styles - Example n Trustworthy’s creditors/policyholders have NO upside

26. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives26 Industry Reserve Adequacy - Beyond The Statement of Opinion n Reserving Issues in Mergers and Acquisitions –Actuarial Due Diligence Process –Sampling of Solutions to Reserve Uncertainty

27. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives27 Reserving Issues in M&A Actuarial Due Diligence Process n Reserve Position n Restatement of Reported Results n GAAP Adjustments n Pro Forma Analysis n Appraisal Value

28. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives28 Actuarial Due Diligence Process Reserve Position n “Windshield” Analysis n Limited Review –Business Units –Access –Time n Comprehensive Analysis

29. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives29 Actuarial Due Diligence Process Restatement of Reported Results Source: Consolidated Industry Loss Ratios

30. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives30 Actuarial Due Diligence Process GAAP Adjustments n Assets n DAC n Premium Deficiencies n Policyholder Dividends n Contingent Commissions n Salvage & Subrogation n Federal Income Taxes n Other n Present Value of Future Profits (PVFP)

31. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives31 Actuarial Due Diligence Process Pro Forma Analysis Assumptions: –Premium Growth –Earnings Pattern –Loss Ratio –Expense Ratio –Payout Patterns –Investment Portfolio Mix –Investment Yield –Risk Adjusted Discount Rate –Time Horizon

32. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives32 Actuarial Due Diligence Process Pro Forma Analysis Output: –Income –Dividends –Surplus –Cash Flow From Operations –“Value” –Key Ratios, e.g. RBC

33. Reserving Issues in M&A Sampling of Solutions to Reserve Uncertainty

34. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives34 Sampling of Solutions n Purchase Accounting n Retrospective Adjustments n Reinsurance n Carve Outs n Other

35. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives35 Purchase Accounting n Reserves are increased by seller prior to transaction date –Purchase accounting does not allow acquirer to book additional reserves –Advantages »fattens the pig before it goes to market –Disadvantages »depresses surplus

36. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives36 Retrospective Adjustments n Future adjustment of sales price based on retrospective reserve estimates –Cash settlements –Portion of sales price held as a note payable –Contingent interest dividend paid to stockholders –Advantages »Low transaction cost –Disadvantages »Uncertainty

37. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives37 Reinsurance n Stop loss cover provides protection against adverse reserve development –Purchased by seller »internal »external –Purchased by acquirer –Advantages »alleviates uncertainty associated with reserve development –Disadvantages »cost

38. 1999 CLRSIndustry Reserve Adequacy - Financial Analyst's Perspectives38 Carve Outs n Segregation of “undesirable” business segments and exclusion from transaction –Prior to transaction –Post transaction –Strategic motives –Advantages »may be only way to attract buyers –Disadvantages »seller may retain unwanted business »Regulatory scrutiny