1. Casualty Actuarial Society Spring Meeting May 15 – 18, 2005

2. The industry's ability to attract capital given historically low ROEs leads us to question: Is ROE the right measure for the insurance industry's performance? by Joan Lamm-Tennant, PhD

3. 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

4. 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 Price PV E(L) + Exp Quantity Q S D P Basic Laws of Supply and Demand

5. 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 Price PV E(L) + Exp Quantity S P D Q* S P* Decline in Net Worth S* Basic Laws of Supply and Demand

6. 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 Price PV E(L) + Exp Quantity S P D Q* S P S* Basic Laws of Supply and Demand S* D* P*

7. 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!!! Price PV E(L) + Exp Quantity S P D Q* S P S* Basic Laws of Supply and Demand S* D* P*

8. Quarterly Premium Growth Rates Source: ISO Source: MarketScout Rate Increases

9. $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

10. 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

11. Net Income (AT) *Sources: A.M. Best, ISO, Insurance Information Institute. (amounts in millions) 1991 to 2004

12. 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

13. 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

14. 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-Yield P/C ROE Source: A.M. Best Review/Preview

15. 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 ROE6.5% 2004 Cost of Equity 8.9% Accounting ROE10.5% Difference1.6% Return on Equity Cost of Capital

16. 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

17. 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

18. Profit 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

19. Float and Cost of Float U.S. Property and Casualty Industry Source: AM Best Aggregates and Averages

20. Float and Cost of Float U.S. Commercial Lines Industry Source: AM Best Aggregates and Averages, Commercial Lines Segment

21. Float and Cost of Float U.S. Personal Lines Industry Source: AM Best Aggregates and Averages, Personal Lines Segment

22. Industry Comparative Cost of Float Source: AM Best Aggregates and Averages

23. The industry's ability to attract capital given historically low ROEs leads us to question: Is ROE the right measure for the insurance industry's performance? Perhaps consider Risk Adjusted Return on Economic Capital Economic Value Added Float

24. Thank You