2. The Financial Crisis and Its Effect on the P/C Insurance Industry 48 th Annual Insurance All-Industry Day Illinois State University Bloomington, IL November 12, 2009 Steven N. Weisbart, Ph.D., CLU, Senior Vice President & Chief Economist Insurance Information Institute  110 William Street  New York, NY 10038 Office Tel: (212) 346-5540  Cell: (917) 494-5945  stevenw@iii.org  www.iii.org

3. The Economy What It Means for the Industry’s Exposure Base, Growth, and Investments

4. Based on Recent History, the Recovery Is Likely to Last 5 Years, or Even More Current contraction assumed to continue through September 2009 Sources: National Bureau of Economic Research; Insurance Information Institute. Duration (Months) Month Recession Started

5. Real Quarterly GDP Changes (annualized), 2005:Q3-2010:Q4F Sources: US Department of Commerce, Bureau of Economic Analysis (actual) at http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm Blue Chip Economic Indicators 10/09 issue (forecasts). http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm Spike due almost entirely to the weak dollar (growing exports and slowing imports) Red bars are actual; Yellow bars are forecasts/estimates The Q1:2009 decline was the steepest since the Q1:1982 drop of 6.4%

6. Total Industrial Production, monthly Mar 2001-Sept 2009 (Index 2002=100)* Source: http://www.federalreserve.gov/releases/g17/ipdisk/ip_sa.txt. *seasonally adjustedhttp://www.federalreserve.gov/releases/g17/ipdisk/ip_sa.txt 5 Recession began December 2007 A bottom? Index Hurricane Katrina March 2001- November 2001 recession

7. Near-Term Forecasts for Quarterly Industrial Production: A Wide Range Source: Blue Chip Economic Indicators (10/09)

8. 7 State Economic Growth Varied Tremendously in 2008 Lowest growth quintile

9. 8 New Private Housing Starts, 1990-2010F (Millions of Units) Exposure growth due to home construction forecast for HO insurers is dim for 2009 with some improvement in 2010. Impacts also for comml. insurers with construction risk exposure New home starts plunged 34% from 2005-2007; Drop through 2009 is 72% (est.)—a net annual decline of 1.49 million units, lowest since record began in 1959 I.I.I. estimates that each incremental 100,000 decline in housing starts costs home insurers $87.5 million in new exposure (gross premium). The net exposure loss in 2009 vs. 2005 is estimated at about $1.3 billion. Source: US Department of Commerce; Blue Chip Economic Indicators (10/09); Insurance Information Inst.

10. 9 Low auto sales will have a less pronounced effect on auto insurance exposure growth than problems in the housing market will on home insurers Auto/Light Truck Sales, 1999-2010F (Millions of Units) Source: US Department of Commerce; Blue Chip Economic Indicators (10/09); Insurance Information Inst.

11. Labor Market Trends Massive Job Losses Sap the Economy & Personal & Commercial Lines Exposure

12. January 2000 through September 2009, seasonally adjusted U-6 went from 9.2% in April 2008 to 17.0% in Sept. 2009 Source: US Bureau of Labor Statistics; Insurance Information Institute. 9.8% Sept. 2009 unemployment rate (U-3) was the highest monthly rate since 1983. Peak rate in the last 30 years: 10.8% in Nov-Dec 1982. Unemployment and Underemployment Rates: Rocketing Up in 2008-9 Percent

13. U.S. Unemployment Rate Forecasts Quarterly, 2009:Q3 to 2010:Q4 Sources: Blue Chip Economic Indicators (10/09); Insurance Info. Inst. Unemployment is expected to peak in late 2009:Q4 or 2010:Q2. Rising unemployment will erode payrolls and workers comp’s exposure base.

14. Unemployment Rates* by State, September 2009: 15 Highest States *Seasonally adjusted. Sources: US Bureau of Labor Statistics at www.bls.gov/web/laumstrk.htm Insurance Information Institute.www.bls.gov/web/laumstrk.htm The US average was 9.8%

15. 14 % Change in Employment by Industry: All But Government/Health/Education Down Overall, private employment dropped by 5.4% from Sept 2008 to Sept 2009; total nonfarm employment dropped 4.5% in that span Source: US Bureau of Labor Statistics http://www.bls.gov/news.release/empsit.t14.htm; Ins. Info. Institute.http://www.bls.gov/news.release/empsit.t14.htm Percent Change Change: Sept 2009 vs. Sept 2008

16. Inflation Trends Pressures Claim Cost Severities via Medical and Tort Channels

17. After Recent Recessions, the Annual Inflation Rate Dropped Sources: US Bureau of Labor Statistics (actual, blue bars); Blue Chip Economic Indicators, 10/09 issue, (forecasts, yellow bars) Average inflation rate, 1992-2007: 2.67% Post- Recession

18. 17 Insurers 5 Top Concerns/Risks if Inflation is Reignited Rising Claim Severities  Cost of claims settlement rises across the board (property and liability) Rate Inadequacy  Rates inadequate due to low trend assumptions arising from use of historical data Reserve Inadequacy  Reserves may develop adversely and become inadequate (deficient) Burn Through on Retentions  Retentions, deductibles burned through more quickly Reinsurance Penetration/Exhaustion  Higher costs  risks burn through their retentions more quickly, tapping into re-insurance more quickly and potential exhausting their reinsurance more quickly

19. P/C Premium Growth Primarily Driven by the Industry’s Underwriting Cycle, Not the Economy

20. 19 Sources: A.M. Best (historical and forecast), ISO, Insurance Information Institute Strength of Recent Hard Markets by NWP Growth 1975-781984-872000-03 19 Net written premiums fell 1.0% in 2007 (first decline since 1943) by 1.4% in 2008, and 4.2% in H1 2009, the first 3- year decline since 1930-33 Shaded areas denote “hard market” periods

21. Underwriting Trends The Economy Doesn’t Directly Affect Underwriting Performance: Cycle, Catastrophes Are Main Drivers

22. 21 P/C Insurance Industry Combined Ratio, 2001-2009:H1* *Excludes Mortgage & Financial Guaranty insurers in 2008. Including M&FG, 2008=105.1, 2009=100.9 Sources: A.M. Best, ISO. Best combined ratio since 1949 (87.6) As recently as 2001, insurers paid out nearly $1.16 for every $1 in earned premiums Relatively low CAT losses, reserve releases Cyclical Deterioration 21 2005 ratio benefited from heavy use of reinsurance which lowered net losses

23. Catastrophic Loss Catastrophe Loss Trends Are Getting Worse

24. Catastrophic Losses*: Was 2005 an Outlier or a Harbinger? *Excludes $4B-$6b offshore energy losses from Hurricanes Katrina & Rita. **2009:1H Note: 2001 figure includes $20.3B for 9/11 losses reported through 12/31/01. Includes only business and personal property claims, business interruption and auto claims. Non-prop/BI losses = $12.2B. Source: Property Claims Service/ISO; Insurance Information Institute $ Billions 23 Is $25 billion the new level of expected yearly CAT losses? Before 2001, CAT losses averaged about $8-10 billion per year.

25. Source: http://edr.state.fl.us/conferences/population/demographic.htmhttp://edr.state.fl.us/conferences/population/demographic.htm Data are from Feb. 18, 2009 Florida Demographic Estimating conference A Million More Florida Resident Households in the Next Decade? Millions of Households The State of Florida now (Feb 09) forecasts nearly 1 million more households by 2019 (up almost 13%). There will be more businesses, too. Hurricane Andrew Hurricane Wilma

26. Major (Category 3, 4, 5) Hurricanes Striking the US by Decade *Figure for 2000s is extrapolated based on data for 2000-2008 (7 major storms: Charley, Ivan, Jeanne (2004), Katrina, Rita, Wilma (2005), Ike (2008)). Sources: Tillinghast from National Hurricane Center: http://www.nhc.noaa.gov/pastint.shtm.; I.I.I. http://www.nhc.noaa.gov/pastint.shtm Mid 1920s – mid-1960s: AMO Warm Phase Mid-1990s – 2030s? AMO Warm Phase Colorado State team forecasts 3 more intense hurricanes in 2009

27. 26 Inflation-Adjusted U.S. Insured Catastrophe Losses By Cause of Loss, 1989-2008¹ Source: Insurance Services Office (ISO).. 1 Catastrophes are all events causing direct insured losses to property of $25 million or more in 2007 dollars. Catastrophe threshold changed from $5 million to $25 million beginning in 1997. Adjusted for inflation by the III. 2 Excludes snow. 3 Includes hurricanes and tropical storms. 4 Includes other geologic events such as volcanic eruptions and other earth movement. 5 Does not include flood damage covered by the federally administered National Flood Insurance Program. 6 Includes wildland fires.

28. Top 10 Major Disaster Declaration Totals By State: 1953-2009* Total Number *Through November 2, 2009. Source: Federal Emergency Management Agency (FEMA) at www.fema.gov/news/disaster_totals_annual.femawww.fema.gov/news/disaster_totals_annual.fema Illinois had almost as many disaster declarations as Louisiana or Alabama*

29. Government Aid After Major Disasters (Billions)* *Adjusted to 2008 dollars by the Insurance Information Institute. Source: United States Senate Budget Committee, Insurance Information Institute as of 12/31/05; Houston Chronicle, 09/24/08 for Ike. The federal government poured an estimated $22.8B into areas affected by Hurricane Ike Does post-disaster government aid create moral hazard?

30. P/C Insurance Financial Performance A Resilient Industry in Challenging Times

31. 30 P/C Net Income After Taxes 1991-2009:H1 ($ Millions)* *ROE figures are GAAP; 1 Return on avg. surplus. Excluding Mortgage & Financial Guaranty insurers yields an 4.5% ROAS for 2008 and 2.2%. 2009:Q1 net income was $10.0 billion excl. M&FG. Sources: A.M. Best, ISO, Insurance Information Inst.  2005 ROE= 9.4%  2006 ROE = 12.2%  2007 ROAS 1 = 12.4%  2008 ROAS = 0.5%*  2009:H1 ROAS = 2.5%* Insurer profits peaked in 2006 and 2007, but fell 96.2% during the economic crisis in 2008 30

32. 31 1975: 2.4% 1977:19.0%1987:17.3% 1997:11.6% 2006:12.2% 1984: 1.8% 1992: 4.5% 2001: -1.2% 10 Years 9 Years Note: 2008 result excluding Mortgage & Financial Guarantee insurers is 4.2% and 4.5% in H1 2009. Sources: ISO; A.M. Best; Insurance Information Institute. 2008: 0.5% P/C Insurance Industry ROEs, 1975 – 2009:H1* 09:H1: 2.5% 31

33. Investment Performance Investments are the Main Source of Lower Profits

34. Distribution of P/C Insurance Industry’s Investment Portfolio Portfolio Facts Invested assets totaled $1.2 trillion as of 12/31/08, down from $1.3 trillion as of 12/31/07 Insurers are generally conservatively invested, with 2/3+ of assets invested in bonds as of 12/31/08 Only about 15% of assets were invested in common stock as of 12/31/08, down from 18% one year earlier Even the most conservative of portfolios were hit hard in 2008 Source: NAIC; Insurance Information Institute research;. As of December 31, 2008 33

35. 34 Property/Casualty Insurance Industry Investment Gain:1994- 2009:H1 1 1 Investment gains consist primarily of interest, stock dividends and realized capital gains and losses. 2006 figure consists of $52.3B net investment income and $3.4B realized investment gain. *2005 figure includes special one-time dividend of $3.2B. Sources: ISO; Insurance Information Institute. Investment gains fell by 51% in 2008 due to lower yields, poor equity market conditions. Falling again in 2009. 34

36. 35 P/C Insurer Net Realized Capital Gains, 1990-2009:1H Sources: A.M. Best, ISO, Insurance Information Institute. Realized capital losses hit a record $19.8 billion in 2008 due to financial market turmoil, a $27.7 billion swing from 2007, followed by an $11.2B drop in H1 2009. This is a primary cause of 2008/2009’s large drop in profits and ROE. $ Billions 35

37. Financial Strength/ Capacity Industry Has Weathered the Storms Well

38. 37 U.S. Policyholder Surplus: 1975-2009:H1* Source: A.M. Best, ISO, Insurance Information Institute. *As of 6/30/09 $ Billions “Surplus” is a measure of underwriting capacity. It is analogous to “Owners Equity” or “Net Worth” in non-insurance organizations Actual capacity as of 6/30/09 was $463.0B, up from $437.1B as of 3/31/09 Recent peak was $521.8 as of 9/30/07. Surplus as of 6/30/09 is 11.2% below 2007 peak; Crisis trough was as of 3/31/09  16.2% below 2007 peak The premium-to-surplus ratio stood at $0.92:$1 as of 6/30/09, up from near record low of $0.85:$1 at year-end 2007 37

39. 38 Policyholder Surplus, 2006:Q4 – 2009:H1 Source: ISO, AM Best. Declines Since 2007:Q3 Peak 08:Q2: -$16.6B (-3.2%) 08:Q3: -$43.3B (-8.3%) 08:Q4: -$66.2B (-12.9%) 09:Q1: -$84.7B (-16.2%) 09:Q2: -$58.8B (-11.2%) Capacity peaked at $521.8 as of 9/30/07 38

40. 39 Premium-to-Surplus Ratios Before Major Capital Events* *Ratio is for end of quarter immediately prior to event. Date shown is end of quarter prior to event. **Ratio at point of maximum capital erosion; ***Latest available Source: PCS; Insurance Information Institute. P/C insurance industry was better capitalized going into the financial crisis than before any “capital event” in recent history

41. U.S. P/C Industry Premiums-to- Surplus Ratio: 1985-2009:1H Sources: A.M. Best, ISO, Insurance Information Institute. 1998 0.85:1–the lowest (strongest) P:S ratio in recent history. Premiums are a rough measure of risk accepted; surplus is funds beyond reserves to pay unexpected losses. The larger surplus is in relation to premiums—the lower the ratio of premiums to surplus—the greater the industry’s capacity to handle the risk it has accepted. $0.92:1 as of 6/30/09 Ratio at year-end

42. 41 Ratio of Insured Loss to Surplus for Largest Capital Events Since 1989* *Ratio is for end-of-quarter surplus immediately prior to event. Date shown is end of quarter prior to event. **Date of maximum capital erosion; As of 6/30/09 (latest available) ratio = 11.2%. Source: PCS; Insurance Information Institute. The financial crisis now ranks as the largest “capital event” over the past 20+ years

43. 42 P/C Insurer Impairment Frequency vs. Combined Ratio, 1969-2008 Impairment rates are highly correlated with underwriting performance and reached record lows in 2007/08 Source: A.M. Best; Insurance Information Institute 2008 impairment rate was a record low 0.23%, second only to the 0.17% record low in 2007 and barely one-fourth the 0.82% average since 1969

44. Number of Impairments by State, Top 10 States, 1969-2008 Catastrophe risk plays a big role. Other factors influencing impairments include the political environment and business mix Source: A.M. Best; Insurance Information Institute

45. Frequency of Impairments by State, 1969-2008 WY, LA, FL have the highest impairment rates in the country (Impairments per 100 Insurers Domiciled in State) Source: A.M. Best; Insurance Information Institute IL (0.78%) was slightly under the national average 0.82%

46. In 2008, A.M. Best Affirmed or Upgraded 88% of P/C Insurers* *Through December 19. Source: A.M. Best. 45 In 2008, despite financial market turmoil, high cat losses and a soft market, A.M. Best lowered ratings on just 3.9% of P-C insurers. It placed another 4.4% under review

47. 46 Reasons for US P/C Insurer Impairments, 1969-2008 Source: A.M. Best: 1969-2008 Impairment Review, Special Report, Apr. 6, 2008 Deficient loss reserves and inadequate pricing are the leading cause of insurer impairments, underscoring the importance of discipline. Investment catastrophe losses play a much smaller role.

48. Critical Differences Between P/C Insurers and Banks Superior Risk Management Model & Low Leverage Make a Big Difference

49. 48 How Insurance Industry Stability Has Benefitted Consumers BOTTOM LINE: Insurance Markets—Unlike Banking—Are Operating Normally The Basic Function of Insurance—the Orderly Transfer of Risk from Client to Insurer—Continues Uninterrupted This Means that Insurers Continue to:  Pay claims (whereas 120 banks have gone under as of 9/25/09)  The Promise is Being Fulfilled  Renew existing policies (banks are reducing and eliminating lines of credit)  Write new policies (banks are turning away people and businesses who want or need to borrow)  Develop new products (banks are scaling back the products they offer)  Compete Intensively (banks are consolidating, reducing consumer choice) Source: Insurance Information Institute 48

50. 49 Emphasis on Underwriting  Matching of risk to price (via experience and modeling)  Limiting of potential loss exposure  Some banks sought to maximize volume and fees and disregarded risk Strong Relationship Between Underwriting and Risk Bearing  Insurers always maintain a stake in the business they underwrite, keeping “skin in the game” at all times  Banks and investment banks package up and securitize, severing the link between risk underwriting and risk bearing, with (predictably) disastrous consequences—straightforward moral hazard problem from Econ 101 Low Leverage  Insurers do not rely on borrowed money to underwrite insurance or pay claims  There is no credit or liquidity crisis in the insurance industry 49 Why P/C Insurers Have Fewer Problems Than Banks

51. 50 Conservative Investment Philosophy  High quality portfolio that is relatively less volatile and more liquid Comprehensive Regulation of Insurance Operations  The business of insurance remained comprehensively regulated whereas a separate banking system had evolved largely outside the auspices and understanding of regulators (e.g., hedge funds, private equity, complex securitized instruments, credit derivatives—CDS’s) Greater Transparency  Insurance companies are an open book to regulators and the public 50 Why P/C Insurers Have Fewer Problems Than Banks (cont’d)

52. 5 Challenges for Insurers in the Next 5 Years

53. 52 1. Further Erosion of, and “Reloading” of Capital Capital losses were the largest in a generation (a “Black Swan”?). It will take years to return to the 2007 peak. P/C insurers have come to expect that large amounts of capital can be raised quickly and cheaply after major events (9/11, Katrina). This assumption might be incorrect in the current environment The cost of capital is much higher today, reflecting both scarcity and risk Possible consequences of a failure to “reload”: insolvencies, forced mergers, calls for government aid, etc. Implication: P/C (re)insurers need to protect capital and develop detailed contingency plans both to raise fresh capital and generate it internally.

54. 53 2. Long-Term, Low Investment Earnings Low interest rates, risk aversion toward equities and many categories of fixed income securities lock in a multi-year trajectory toward ever lower investment gains Fed actions in Treasury markets will keep yields low Implication 1: Industry must be prepared to operate in environment with investment earnings accounting for a smaller fraction of profits Implication 2: Implies underwriting discipline of a magnitude not witnessed in this industry in more than 30 years. Yet to manifest itself. Lessons from the period 1920-1975 need to be relearned

55. CAT risk and WC is, on net, now being socialized via state-run insurance and reinsurance mechanisms or via elaborate subsidy schemes involving assessments, premium tax credits, etc. Some (life) insurers sought/received TARP money Efforts to expand flood program to include wind Health insurance may be substantively socialized Terrorism risk—already a major federal role backed by insurers Eventual takeover of other lines such as personal auto Ownership stakes in some insurers via bailouts States like FL will lean heavily on Washington in the event of a mega-cat that threatens state finance 3. Socialization/Nationalization of Insurance

56. 55 P/C insurers might get swept into vast federal regulatory overhaul and subjected to duplicative and costly regulation Will some P/C insurers be considered systemically important (i.e., “too big to fail”)? Will personal lines insurance policies be regulated by a new Consumer Financial Protection Agency? What effect will repeal of McCarran-Ferguson have on P/C insurers? Will a new “Office of National Insurance” in the Treasury Department speed adoption of new international regulatory rules? 4. Major New Layers/Types of Regulation

57. 56  Attacks on underwriting criteria such as credit, education, occupation, territory increasing  View that these criteria are discriminatory and create an adverse impact on certain populations  Impact will be to degrade the accuracy of rating systems to increase subsidies  Predictive modeling also at risk  Danger that bans could be codified at federal level during regulatory overhaul  Bottom Line: Industry must be prepared to defend existing and new criteria indefinitely 5. New Restrictions on Underwriting

58. 57 Insurance Information Institute On-Line THANK YOU FOR YOUR TIME AND YOUR ATTENTION! 57