1. 1 RISK AND RETURN: ACTUARIAL CONSIDERATIONS (FIN - 10) FINANCIAL MODELS and RATE OF RETURN PERSPECTIVES Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services Seminar on Ratemaking Las Vegas, NV March 11-13, 2001

2. 2 Contents l “Building Blocks”: The Fundamentals l Reported Financials and Economic Value Concepts l Rate of Return l Important Model Attributes l Parameter Consistency l Return Measures and Their Equivalency l The Fundamental Insurance Total Return Model l Underwriting, Investment & Leverage Components l Aspects of Insurance Total Return l Exhibits: Balance Sheet, Income, Cash Flow & Returns l Standalone single policy/accident year l Calendar year results from ongoing business l Conceptual Commentary

3. 3 “Building Blocks”: The Fundamentals l Balance Sheet, Income and Cash Flow Statements l Accounting Valuation: Conventional (statutory or GAAP) and Economic (present value) l Development “Triangles” of Marketing / Policy / Accident Period into Calendar Period

4. 4 Policy (or Accident) / Calendar Period Development Triangles Balance Sheet, Income, Cash Flow Calendar Period Policy HistoricalFuture Total Period 19971998199920002001 Ultimate Prior X X X X X …... --> Sum 1997 X X X X X …... --> Sum 1998 X X X X …... --> Sum 1999 X X X …... --> Sum 2000 X X …... --> Sum 2001 X …... --> Sum ==== ================ Reported Sum Sum Sum Sum Sum Calendar Rates are set across the policy period “row” but regulatory review is often based on the calendar “column” sum.

5. 5 Shortcomings of Reported Financials l Missing key elements of total return - absence of market value basis omits important information necessary to more fully judge performance l Assets and Liabilities (fully adequate reserves and time value discount) l “Below the line” surplus adjustments, such as unrealized gains, do not flow through “income”. l Lacks more relevant current (i.e. policy / accident period) performance focus l Biased against longer tail and higher combined ratio business which conceals profitability of commercial to a greater degree than personal lines

6. 6 Economic Value Concepts l Economic valuation presents a financial view in which all assets and liabilities are market valued (cash equivalent) l Considers the estimated magnitude and timing of future cash flows l Focus on performance related to current actions (i.e. policy or accident period) rather than performance related to when reported (i.e. calendar period) l Economic income is the change in economic value over a period in time l “comprehensive income” perspective (FASB 130) l tight balance sheet, income and cash flow linkage l no “below the line” adjustments

7. 7 Rate of Return Models: Important Attributes l Focus on Cash Flow l Inclusion of surplus with flow controlled by risk-based rules l Operating (i.e. policyholder) cash flows maintained separately l Economic value with after-tax discounting l NPV income formulation (with and without risk adjustment) l Development of NPV balance sheet liabilities l Policyholder and shareholder rate of return calculations

8. 8 Rate of Return: Parameter Consistency l Dealing with Risk l IRR cost of capital based total return l NPV risk-adjusted total return equal to risk-free rate l NPV total return (without risk-adjustment) equal to cost of capital l Beta of Equity versus Beta of Liabilities l Surplus Flows l Controlling required amount and timing –Liability / surplus relationship –Multi-period aspect l Surplus flow components –Surplus contribution and its release –Investment income on contributed surplus –Release of operating earnings

9. 9 Rate of Return Measures l Income on Investment l Conventional Calendar ROE: Income / Average Equity, including Retained Earnings l Nominal Ultimate ROE (“steady state” calendar equivalent) l Discounted Ultimate ROE (net present value rate of return) l Risk-adjusted Ultimate ROE (risk-adjusted NPV rate of return) l “ROE like” Underwriting and Operating returns also l Cash Flow Internal Rate of Return Basis l Shareholder IRR (also Underwriting IRR and Operating IRR) l Shareholder (i.e. Investor Perspective) l Shareholder Cash Dividend Yield Realized l Shareholder Total Return: dividend plus stock price appreciation (sorry can’t provide formula for this one)

10. 10 Equivalency in Rates of Return For Single Policy - Exhibit 1 l (1) IRR l (2) Net present value ROE l (3) Total policy ultimate nominal ROE l (4) Shareholder annual dividend yield realized For Multiple Policy Ongoing (steady state, no growth) - Exhibit 2 l (5) IRR l (6) Annual nominal ROE while at steady state (income / beginning contributed surplus) l (7) Shareholder annual dividend yield realized

11. 11 The Fundamental Insurance Total Return Model (1) Total Return = Operating Return X Operating Leverage + Investment Rate of Return on Surplus + Investment Rate of Return on Surplus Operating Return = Underwriting Rate of Return Operating Return = Underwriting Rate of Return + Investment Rate of Return on + Investment Rate of Return on Policyholder Liability “Float” Policyholder Liability “Float” OR OR (2) Total Return = Underwriting Return X Operating Leverage + Investment Return X Asset Leverage + Investment Return X Asset Leverage Operating Leverage = Net Liabilities / Surplus Operating Leverage = Net Liabilities / Surplus Asset Leverage = Invested Assets / Surplus Asset Leverage = Invested Assets / Surplus Insurance Consists of Underwriting, Investment & Financial Leverage

12. 12 The Components of Insurance Total Return - Underwriting, Investment & Leverage l Underwriting Return is the price for the transfer of risk to the company associated with the policyholder related cash flows. When positive the company is being paid for the transfer of risk. When negative the company is incurring a cost to acquire the funds from the policyholder and must depend on the investment spread to generate a profit. l Investment Return represents the yield on invested assets (from both policyholder supplied funds and surplus). The spread between the Investment Return applicable to policyholder supplied funds and the Underwriting Return must be positive if the company is to generate a net operating profit from underwriting. l Operating Return is the sum of underwriting return and investment return. This is the risk charge paid by the policyholder. l Leverage (based on surplus requirements needed to meet specified underwriting, investment and financial risk tolerances) creates a magnifying effect on both return and volatility. l Total Return reflects the shareholder oriented return, comprised of levered operating return plus the investment return on surplus.

13. 13 Aspects of Insurance Total Return l The Total Rate of Return, as well as the Underwriting and Investment Rates of Return, can be determined on either l a cash flow basis, via the Internal Rate of Return (IRR) or l as a Return on Equity formed by the ratio of Income to Equity in which the financials are in EITHER Nominal or Present Valued terms l The present value rate of return using a risk-adjusted discount rate will equal the risk-free rate, since by definition risk has been eliminated. l Leverage is controlled by specifying rules governing the flow of surplus and dividend (distribution of earnings) to maintain a uniform risk profile over the life of the policy l Contributed surplus governed by constant liability / surplus ratio l Investment income on surplus dividended as earned l Operating earnings distributed in proportion to per period liability exposure

14. 14 Total Return Model Example Total Return = Oper Return X Oper Levg + Invest Rate of Return on Surplus Total Return = Oper Return X Oper Levg + Invest Rate of Return on Surplus 14.9% = 3.7% X 3.0 + 3.9% not risk-adjusted 14.9% = 3.7% X 3.0 + 3.9% not risk-adjusted 6.0% = 0.7% X 3.0 + 3.9% risk-adjusted basis 6.0% = 0.7% X 3.0 + 3.9% risk-adjusted basis Oper Return = Und Rate of Return + Invest Rate of Return on PH “Float” Oper Return = Und Rate of Return + Invest Rate of Return on PH “Float” 3.7% = -0.2% + 3.9% not risk-adjusted 3.7% = -0.2% + 3.9% not risk-adjusted 0.7% = -0.2% + 3.9% - 3.0% risk-adjusted basis 0.7% = -0.2% + 3.9% - 3.0% risk-adjusted basis CAPM Reference Data: CAPM Reference Data: Risk-Free interest rate6.0%3.9% after-tax Risk-Free interest rate6.0%3.9% after-tax Risk Premium8.9% Risk Premium8.9% Equity Beta1.00 Equity Beta1.00 Indicated cost of capital14.9% Indicated cost of capital14.9% Liability Beta-0.52 Liability Beta-0.52 Indicated risk adjustment4.6%3.0% after-tax Indicated risk adjustment4.6%3.0% after-tax Indicated risk-adjusted discount rate1.4%0.9% after-tax Indicated risk-adjusted discount rate1.4%0.9% after-tax

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17. 17 Simplified Ratemaking Spreadsheet

18. 18 Conceptual Commentary l Reported income and returns (and other financials as well) follow conventional accounting rules which govern the timing of income recognition and are potentially a misleading basis for rating, regulation & financial analysis. Economic rules produce different results. l Retained earnings are largely irrelevant to economic accounting. l Unearned premium reserve is not cash, and thus not economic. l Non risk-based leverage levels involve concessions to the rating agencies and create non-economic based constraints. l Economic value is realized either by converting assets and liabilities to market via sale, or over time to “earn” the discount value. l ROE calculation - change the formula (income / beginning period contributed surplus). Do not include retained earnings and do not average the equity.