1. ©Towers Perrin Loss Reserve Adequacy and the Underwriting Cycle Casualty Actuarial Society General Meeting Montreal, Canada November 16, 2004 Michael E. Angelina, ACAS, MAAA

2. ©Towers Perrin 2 Agenda 2004 Observations Reserve Adequacy Charges, drivers, management estimates Underwriting Cycle Causes, observations Correlation vs. Observations Reserve Adequacy revisited External influences Other Thoughts

3. ©Towers Perrin 3 Industry Observations - 2004

4. ©Towers Perrin 4 2004 at a Glance Early forecasts continued premium growth Combined ratio below 100% Record results through 2Q Despite reserve increases by several companies Worst hurricane season in 50 years Continued medical malpractice crisis Spitzer allegations turn the industry on its head Source: A.M. Best, ISO.

5. ©Towers Perrin 5 Net income (1991-2004*) Source: A.M. Best, Insurance Information Institute. * First six months of 2004 $ Billions

6. Reserve Adequacy

7. ©Towers Perrin 7 Calendar year reserve hits (U.S. Property/Casualty industry) $ in BillionsTotal All Lines Year-end 2001 $12 B 2002 $22 B 2003 $14 B Context: Industry total reserves = $ 350 B = $ 400 B = $ 300 B About half due to asbestos Industry total premium Industry total surplus

8. ©Towers Perrin 8 A “few” companies account for much of the adverse development Calendar Year 2002: 30 companies accounted for 80% of the one-year development Calendar Year 2003: 30 companies accounted for 90% of the one-year development Not all the same companies as prior year The 30 companies (each year) held 20 – 25% of the industry’s surplus

9. ©Towers Perrin 9 For the industry composites, the first estimate of ultimate losses over/ underestimates ultimate losses in a cyclical pattern Current Ultimate/Initial Ultimate Source: Composite Schedule P.

10. ©Towers Perrin 10 There are many process related drivers of reserve development External environment Asbestos, pollution, construction defects Runaway juries Shock losses WTC, Enron, Mutual Funds, Vioxx(??) Methodologies Chain-ladder, expected loss estimates Data quality TPA handled claims, poor systems Knowledge of underlying exposure

11. ©Towers Perrin 11 There are also decision-based questions that can influence reserve adequacy When to move off of an expected loss estimate (peg)? Before IBNR is negative How bad can a given year really be? 400% loss ratio is bad, 550% is worse When is noise really an underlying trend ? The “but for” rule What can we afford to take/release? Low end of talked down range  Can you say bias Book the medium since reserves only go up

12. ©Towers Perrin 12 Underwriting Cycle

13. ©Towers Perrin 13 * First six months of 2004 Source: A.M. Best, Insurance Information Institute. $ Billions Underwriting gain/loss (1975-2004*)

14. ©Towers Perrin 14 2004 E based on first six months of 2004; * 2004 is after the impact of the hurricanes Source: A.M. Best, ISO, Reinsurance Association of America, Insurance Information Institute. Combined ratio (1991-2004*)

15. ©Towers Perrin 15 Commercial vs. Personal Lines Combined Ratios Source: A.M. Best; Insurance Information Institute Commercial lines’ combined ratios have historically been worse than personal lines 10-YR AVG COMBINED RATIO Commercial lines - 111.1 Personal lines - 105.2

16. ©Towers Perrin 16 Like reserve adequacy, the underwriting cycle is driven by many process-related factors Prior year(s) loss estimates Anticipated investment returns External environment Loss cost trend, inflation Shock losses Catastrophes Market conditions Terms and conditions Rate changes Underwriting criteria Reinsurance costs

17. Underwriting Cycle - Observations

18. ©Towers Perrin 18 Underwriting Cycle Observations – Measuring the impact of price monitoring

19. ©Towers Perrin 19 Underwriting Cycle Observations – Measuring the impact of price monitoring The a-priori estimate When do we find out the estimate is adequate  Test with diagnostics  Prior and subsequent years What happens when the estimate is too low/high  Feedback mechanism  Control cycle

20. ©Towers Perrin 20 Underwriting Cycle Observations – Measuring the sensitivity of price monitoring

21. ©Towers Perrin 21 Underwriting Cycle Observations – Testing the price monitoring assumptions

22. ©Towers Perrin 22 Underwriting Cycle Observations – Link pricing and reserving Control mechanisms  Challenges assumptions  Reflects trends, stability, newly emerged claims Feedback loop  Understand the “difference column”  Systematic bias  Noise  Unexplained differences

23. ©Towers Perrin 23 Underwriting Cycle Observations – Understanding the Difference Column

24. ©Towers Perrin 24 Reserve Adequacy - Revisited

25. ©Towers Perrin 25 Reserve Adequacy - Revisited External Influences Rating Agencies Regulatory  RBC threshold testing  Triennial reviews  Statutory opinions  Moved from opining on net reserves to include identification of other potential factors  SarbOx

26. ©Towers Perrin 26 Reserve Adequacy - Revisited Regulatory Reporting Requirements (last 10 years) Page 3 and Schedule P Schedule F Disputed Recoverables Note 33 (asbestos and pollution disclosure) Ceded Reinsurance Collateral Discounting Sensitivity (tabular plus non-tabular) Retroactive Reinsurance

27. ©Towers Perrin 27 Reserve Adequacy - Revisited Statutory Opinion Requirements Gross versus Net Material Adverse Deviation Risk Factors Comments on IRIS tests Asbestos and pollution comments Discounting Ranges Reinsurance Data testing

28. ©Towers Perrin 28 Other Thoughts

29. ©Towers Perrin 29 Other Thoughts Reserving Actuary as business partner Part of control mechanism and feedback loop Reserving process and therefore pricing process can incorporate Claims department Reinsurance accounting Pricing and underwriting