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FI Analytics

Binder

2Barry M Frohlinger, Inc COPYRIGHT 1981 - 2015

Insurance

v A purchaser of insurance pays a fixed premium in exchange for a promise of compensation in the event of some specified economic loss. v By pooling such risks, insurance intermediaries convert the uncertainty

of an individual loss into a predictable cost. v There are five groups

v Life Insurancev offer protection against the financial risks of death, disability,

health insurance [illness] and annuities.v P&C

v Property insurance covers damage due to specified causes, Casualty covers damage due to accidents and liability insurance covers legal liabilities caused by the policyholder to a third party

v Personal [auto and homeowners] and commercial [business related]

v Multilinev Reinsurancev Insurance Brokers


Reinsurance

v Despite pooling, life insurance companies may have some residual risk and property-casualty have large risks. v Insurance companies buy insurance called reinsurance.

v The bulk of reinsurance is property-casualty. v The reinsurance market is the wholesale insurance market and represents the

marginal cost of insurance.


Reinsurance is insurance between a ceding company and the reinsurer; the reinsurer pays a share of the claims incurred by the ceding company. The reinsurer is paid a "reinsurance premium" by the ceding company, which issues insurance policies to its own policyholders.There are two basic methods of reinsurance:

Facultative Reinsurance, which is negotiated separately for each insurance policy that is reinsured.

Treaty Reinsurance, where the ceding company and the reinsurer negotiate and execute a reinsurance contract under which the reinsurer covers the specified share of all the insurance policies issued by the ceding company which come within the scope of that contract.

There are two main types of treaty reinsurance, proportional and non-proportional.

Under proportional reinsurance, the reinsurer's share of the risk is defined for each separate policy, while under non-proportional reinsurance the reinsurer's liability is based on the aggregate claims incurred by the ceding office.

In the past 30 years there has been a major shift from proportional to non-proportional reinsurance for P&C.

See AIG page 159

Reinsurance


Reinsurance Risk Factors

v Reinsurance companies generally have limited investment risk. v Most reinsurance holding companies have low financial leverage,

v usually less than 20% debt to total capital.v A reinsurance company cannot have a run on the bank [liquidity]

v ceding companies have no call on the assets of the company.


Reinsurance Risk Factors

v Operating risk is relatively high given:v Cyclical pricingv Exposure to anti-selection

v reinsurance clients can be very sophisticated and may have a better understanding of their risks than the reinsurer.

v “Naive” new capacity that enters the marker at cyclical peaks often gets burned by sophisticated clients

v Exposure to adverse loss development from prior year claimsv Exposure to catastrophe losses in property lines

v Despite the cyclical nature of the industry operating losses due to investment losses are rare, and insolvencies are infrequent,

v for the large well established companies.v Ongoing trends towards stronger better capitalized companies,

v the “flight to quality” will hurt second and third tier players.


Reinsurance Key Success Factors

v Market Position:v Absolute capital size, and reputation.

v Underwriting:

v Critical mass of portfolio to provide diversification

v and avoid over-exposure to an event or a series of events.

v Defined maximum aggregate loss exposure appetite, with controls in place to monitor.

v Underwriting for profit, not market share

v management of rate cycle/willingness to impose changes in policy terms


Reinsurance Key Success Factors

v Capitalization:

v Ability to absorb falls in investment asset values, and any potential underestimation of required claims reserves.

v Investment Management:

v Ability to generate acceptable yields without prejudicing portfolio quality

v Reinsurance Management (Retrocession):

v demonstrable limitation of exposure to quality names.


FSR

v An insurance policy is a promise, the value depends on the insurers ability to deliver. v This depends on the financial strength rating [FSR] of the insurer.

v The financial strength of an insurance company is a function of:v Quality of the assetsv Insurance poolv Capital adequacy v Liquidity in assets and liabilitiesv Profitabilityv Stability in premium growth and v Risk diversification

v See page 143 for AIG


Insurance Industry Analysis

v The key attributes for analysis [CAMELOTS] include:v Product & Business Line profilev Distribution v Reputationv Geographic diversity v Management v Risk Managementv Earnings, Cost Structure and Economies of scale.



v Product & Business Line profilev Is the firm a small insurance company writing one or two high risk products [low rating] or v Is its business concentrated in low risk productsv Also, are growth trends in-line or moderately better than peers? v Does the insurer have a narrow product focus where one product accounts for the majority

of profits?v Do you understand the composition of the portfolio of investments?


Insurance

v Marketing costs are much higher in the insurance industry than banking because many of the products sold are considered discretionary [primarily life]v Insurance is marketed through

v independent agents v exclusive agentsv direct writing and v brokers, who represent the customers.

v KEY FOR FI ANALYTICS, Who performs the marketing? What products are sold? DAC?



v Distribution relationships, diversity and efficiency v Does the insurer rely on one channel [high risk] or

v does the firm have solid distribution capabilities with below average distribution costs

v Image, reputation and brand strengthv Is the image and brand undeveloped [high risk] or is it highly recognizable and

respected?

v Geographic diversity v Geographic reach is key analytic issue for all Fis

v Analysis of Management is also a key issue for all FIs


Industry Analysis

v Risk Managementv An understanding of the company's risk management activities is

necessary both to gauge the potential volatility in earnings and to evaluate the adequacy of control procedures used to manage that volatility.

v Broadly speaking, four areas are evaluated: v pricing and underwriting v asset/liability management v hedging v reinsurance or retrocession.

v See AIG page 151 and comment on the implication


Industry Analysis

v Pricing and underwritingv Pricing is an estimate of amounts necessary to cover costs

v most of which will be incurred and paid in the future. v PRICING

v Pricing in the insurance industry begins with the pure premium, v representing the present value of the expected cost of a claim,

v including the claim and the cost of processing the claim. v When a claim is made, the insurer must determine the extent of the

loss v this is called the loss adjustment.

v PRICING v The actual premium is the pure premium plus administrative

expenses. v Premium smoothing is the practice of charging a fixed premium when

the pure premium is changing.


Insurance

v To price premiums properlyv the insurer needs to know

v the probability of a loss and v the size of the claim. v the timing of the claim.

v Determining the probability of a claim [and size and timing] is much easier in life insurance than liability insurance.

v Premium writing creates the following journal entry

v Dr Cash [Investments-General Account]v Cr Unearned Premiums [Reserves/Retained Earnings]


Insurance Liabilities [float]

v The time gap between the receipt of premiums and payment of claimsv Creates float, consists of four components.

v First, the time interval between the receipt of premium and the occurrence of insured events. v The other three components, which vary in importance across PC lines, relate to the gap between the

occurrence of insured events and the subsequent payments. v Some insured losses are discovered many years after the event (e.g., exposure to asbestos), and in

many cases the claim settlement process extends over several years (e.g., medical malpractice litigation).

v Also, in some cases insurance payments are made over extended periods of time (e.g., workers’ compensation).

v These three components of the float are reflected in the financial statements in the balance of the reserve for losses and loss adjustment expenses, which insurers are required to accrue when insured events occur. Accordingly, the analysis of the float often focuses on unearned premium(first source of float) and, primarily, the loss reserve (other three sources of float).


Life Insurance Products

v To counteract the long-term fundamental life insurance problemsv new products have been developed. v The shift is away from traditional mortality protection to retirement related. v Lifes offer separate accounts that invest in stocks.

v These separate accounts have v specific liabilities financing dedicated assets

v as opposed to the general account, v where the holders of liabilities have essentially equal claims to all

assets.

v Key Analytics Issue: What is the size of the separate accounts on the Balance Sheet? Who is taking the risk?



v An annuity is a unique financial vehicle designed to help people accumulate money for their retirement and/or turn a lump sum of money into a guaranteed stream of income for life.

v A Variable Annuity is a contractual agreement in which payments are made to an insurance company; and investments are subject to market risks and may fluctuate in value. v This product can have a guaranteed death benefit payments, which is

dependent on the claims paying ability of the insurance firm.


Insurance Company Accounting

v Traditional fixed annuity and life insurance contracts:v typically offered through an insurance enterprise's general account

v provide for a fixed rate of interest over some specified periodv the insurance enterprise bears the investment risk associated with the

invested assets.v Traditional variable annuity [VA], by contrast,

v offered through an insurance enterprise’s separate accountv provide that all investment risks associated with the separate account assets are

passed through to the contract holder.


Assets, Find these amounts for AIG at FYE 2016

General Account AssetsReinsurance ReceivablesPremium ReceivablesSeparate Account AssetsCashIntangiblesOtherTotal


Insurance

v ORGANIZATIONv The mutual insurance concept originated in England in 1696.

v Mutual companies exist solely to serve the insurance needs of their policyholders,

v not to provide investment profits to shareholders. v Stock insurance companies are owned by investors who may have

no other connection with the companyv 5% of US lifes are mutuals but

v they control almost 46% of all assets.


Property-Casualty

v Property-casualty [also called general insurance] began with marine [Middle Ages] and fire insurance. v The great fire of London in 1666 led to the creation of the first fire insurance

company in 1680. v In the United States, periodic disasters led to insolvencies.

v Of the 202 insurance firms with exposure to the Chicago fire of 1871, 68 failed, 83 settled only in part and only 51 settled in full.

v Hartford, Connecticut emerged as an insurance center because its companies fared better than those in New York.


LIFE INSURANCE

v The importance of life insurance companies as a financial intermediary peaked in 1950 v insurance companies held 21% of all intermediary assets in 1950; they hold less

than 10% today v The decline is attributable

v to a shift to pension plans as a replacement for life insurance as the principal vehicle for life-cycle savings.

v The shift to retirement savings has created a whole new product mix for life insurance companies.

v Only 70% of American households have life insurance.



v In order to understand insurance, you must understand the productsv Products have traditionally been for

v Protectionv Accumulation



v Term insurance is pure life insurance that a pays a fixed sum in the event of death. v Whole-life insurance combines term insurance with a savings plan.

v Because whole-life insurance was highly illiquid, the industry created policy loans.

v Universal Life insurance is a flexible life insurance policy that combines the benefits of permanent life insurance protection and cash values with the convenience of adjustable premiums and payment schedules.v Within a Universal Life insurance policy, cash value accumulations grow tax-

deferred at competitive interest rates.



Lifes developed other retirement-related savings vehicles: v single-premium deferred annuity [SPDA] and v guaranteed investment contract [GIC].

v The purchaser of the SPDA pays a single premium that accumulates interest

v at maturity can be cashed in. v The GIC guarantees a fixed rate of interest on any deposit for a given

period of time [usually 10 years]. v GIC are often marketed to pension plans.


Insurance [VA]

v Separate accounts contract holders assumes the investment risk v and the insurance enterprise receives a fee for investment management.

v Investments in separate accounts are marked to market. v Unlike a mutual fund, the assets of the separate account are legally owned by the

insurance enterprise. v A separate account is not a separate legal entity but

v Must be recognized legallyv The separate account assets must be insulated from the general account assetsv The insurer must invest the funds as directed by the contract holder.v All investment performance must be passed to the contract holder.

v If all four conditions are not met, separate accounts may be shown in the general account


GMDB

v In their purest form, variable annuity policies place all the risk of investment losses with the individual policyholder

v Encouraged by the spectacular stock-market rallies of the late 1990s, insurers sought to attract new business by adding various types of guarantees v they effectively took back much of the policyholder's riskv This has came back to haunt insurers, following the 2000 - 2002 decline in the S&P 500 and

again in 2008/2009.v The most costly feature has turned out to be payment of a guaranteed minimum death benefit

(GMDB).v The GMDB provides a payment to the beneficiary of the deceased, regardless of how much

the underlying assets are worth at the time.


GMDB

v In the late 1990s, GMDBs changed from mere guarantees that beneficiaries would receive back at least the invested premiumsv to structures that captured the account's highest value at a prior anniversary

(high-water mark). v Insurers were not careful to protect themselves against future downturns either

throughv reinsurance or v by purchasing or selling equity options contracts that

v increase in value when equity markets fall.


GMDB

v Guaranteed minimum death benefit (GMDB)v Guaranteed minimum withdrawal benefit (GMWB)

v gives annuitants the ability to protect their investments by allowing the annuitant the right to withdraw a maximum percentage of their entire investment each year until the initial investment amount has been recouped.

v Guaranteed minimum accumulation benefit (GMAB),v guarantees the minimum amount received by the annuitant after the accumulation

period, protecting the value of the annuity and the annuitant from market fluctuations. v Guaranteed minimum income benefit (GMIB)

v When an annuity has been annuitized, this specific option guarantees that the annuitant will receive a minimum value's worth of payments.

v KEY: Who is assuming the Risk? Is the Insurance Firm hedged?


Fixed Annuities

v Fixed annuities entail a risk [to the insurance firm] that the assets in their own investment portfolios do not support their obligations.

v Fixed annuity business therefore requires insurers to hold more capital to support the risk than they would for an equivalent amount of variable annuity business.

v When that capital can not be recruited through earnings, or when an insurer's resources for borrowing are stretched, ratings are affected.


Fixed Annuities

v Some insurers have compensated by seeking the higher yields of high-yield bonds, which has proven a risky path.

v Alternatively, they have invested in bonds with longer maturitiesv also risky

v Another concern for life insurers is potential repeal of the U.S. estate tax. v Heirs of high-net-worth individuals who want to leave large inheritances face estate taxes

of 55%v But bequestors can purchase life insurance that pays for these taxes. v Repeal could therefore undermine a key market for the industry.v 40% of life insurance is policies over $2 million, up from 5% in 1995.


Property-Casualty

v Underwriting Cyclesv In addition to the volatility of risk, the property-casualty industry goes through a regular

underwriting cycle. v High profits lead to new capacity which pushes down premiums and leads to a soft market. v In the soft market, profits are low. v At some point, a natural disaster[s] leads to unusual losses and the market becomes "hard"

and a new cycle begins.v During 2011, the US P&C industry suffered more than $9 billion dollar events v Globally, P&C damages were $350 billion in 2011

v Insurance and reinsurance shouldered $128 billionv These cycles have given impetus to self-insurance, with some large companies creating

captive insurers to provide coverage. v This alternative market is about 30% of the total. v Key Analytics Issue: Where are we in the underwriting cycle?


Catastrophes

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Weather-relatednaturalcatastrophes Earthquake/tsunami Man-madedisasters Total


Total P&C losses

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2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016


Assets, Find these amounts for AIG at FYE 2016

Fixed Income SecuritiesEquityMortgage LoansPolicy LoansAlternatives OtherTotal


Assets

v Property-Casualty companies differ from life insurance companies in two ways. v First, intermediation is less important than issues of insurance.

v This is because the policy life is much shorter. v Therefore, property-casualty companies have much smaller reserves.

v The second difference is that probabilities of loss are not actuarial and the size of claim is often uncertain.

v Because PC reserves involve greater uncertainty than LH liabilities, PC insurers hold larger equity cushions and generally invest in less risky assets compared to LH insurers.

v They also reinsure significant portions of their exposure, issue insurance-linked securities, and arrange contingent capital facilities.

v In addition, because the timing of PC claim payments is less predictable and generally nearer than that of LH benefit payments, PC insurers invest in more liquid and shorter maturity (and therefore less interest rate sensitive) assets, particularly securities.

v In contrast, LH insurers often invest significant amounts in long term mortgages and risky securities.


Asset Quality

v Asset quality has been a prominent factor in several downgrades on life insurers in the past 20 years.

v Investment losses totaling $500 million contributed to Conseco's default in 2002.v In December of 2008, Standard Life of Indiana was ordered into what’s called

“rehabilitation.” Because annuities are regulated at the state level, not federal, the Indiana Department of Insurance took the lead role in protecting the policy holders of this troubled carrier.

v At the time of the rehabilitation, Standard Life of Indiana had close to 40,000 individuals that owned annuity contracts.

v What got Standard Life of Indiana in trouble was “a high concentration of sub-prime debt” which severely deteriorated during the 2008 crisis.

v Remember, Life insurance companies share the same strength as banks-TIME, but on the other side of the balance sheet.

v KEY FI Analytics Issue: Analysis of Asset Quality


0%

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Non Investment Grade Debt as a % of Fixed Income Securities

AIG Travelers All State Hartford

XL Group Progressive Chubb Limited Metlife


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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Separate Accounts/ Total Assets




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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Non Investment Grade Debt as a % of Owners Equity




DAC

v Another analytical issue for life insurers is the intangible asset known as v deferred acquisition costs (DAC) & deferred sales inducement [DSI].

v For most life insurance products, companies create this asset on their balance sheets to offset recognition of sales costs.

v They expense the costs over several years, during which time the policies are expected to generate profits.

v But on variable annuity businessv where falling equity markets lead to a decline in value of the underlying

assets, profitability shrinks, v meaning the sales costs must be recognized more quickly.

v Only costs that are related directly to the successful acquisition of new or renewal insurance contracts can be capitalized.


DAC

v As you look at the DAC in the insurance world, look for similar assetsv in the bank world [MSR] and v the investment management world [12 b1] fees.

v These costs are capitalized v and then expensed the costs over several years

v during which time the cost is expected to generate profits.v If the actual experience of profit differs materially from the assumptions used, then

the company must "unlock" its deferred acquisition costs to reflect reality. v Key Issue: What is the size of the DAC compared to equity


Written and Earned Premium

v Written and Earned Premiumv Written premium is the actual premium paid by a policyholder for an insurance policy. v Earned premium is the premium allocated to the actual exposure to risk arising during a

particular period. v For example, if an insurance company issues a 12 month policy for a premium of

$500 on January 1, 2013, the written premium for 2013 will be $500, and so will the earned premium.

v But if the same policy is issued on July 1, 2013, the written premium will be $500, but the earned premium will only be $250; the other half of the premium will be allocated to an unearned premium reserve which will be credited to 2014 earned premium.

v This is because half of the premium written will be in respect of the exposure of loss during the first half of 2014.


Gross and Net Premium

v Gross premium is the total amount of premium income of an insurer. v Net premium is the premium retained by the insurer after it pays for its reinsurance

protection. v Similarly, gross claims costs are the total claims costs for which the insurer is

liable under the policies it issues. v Net claims costs take account of reinsurance claims recoveries due to the

insurer from its reinsurers.


Life Insurance Income Statements

v Premiumsv Premium Growth is a key FI Issue

v Net Investment Incomev Gains and Lossesv Loss and loss adjustment expensesv Underwriting expenses

v Acquisition costsv General expenses


Industry Concerns

v Long Tail insurancev Industry overcapacityv Premium growth v Global Litigation

v Medical Malpracticev Professional and Product Liability

v Lead paintv Pharmaceutical products

v Various organizations relating to abuse



v The sale of a life insurance contract initiates a long-term contract whose profitability depends on future persistency, mortality, interest and expense ratio, v the income calculated for the current year depends on estimates of the

future values of these rates. v Two methods of premium revenue and liability recognition for insurance

contract existsv short-duration and v long-duration.



v Premiums for short-duration contracts, such as most property contracts, are intended to cover the expected claim costs during a fixed short term period.

v Premiums are earned as revenue evenly as insurance protection is provided.

v A liability for claims relating to insured events that have occurred but have not yet been reported to the insurer, should be accrued.



v Premiums on long-duration contracts, such as life insurance or workers compensation, are recognized when earned.

v However, as revenue in the early years exceeds expected policy benefits, a liability for costs that are expected to be paid is accrued.

v This liability is the present value of estimated future policy benefits less the future net premiums to be collected.


JE for P&C Contract

v Write the journal entry for the receipt of PC premiumv Dr cash

v Cr unearned premiumv Write the entry for revenue recognition

v Dr unearned premiumv Cr earned premium

v Write the entry for cost matchingv Dr Insurance Loss

v Cr IBNR Loss Reservesv At the time claim is filed

v Dr IBNR reservev Cr Claims reserve

v At time claim is adjustedv Dr Claim reserve

v Cr Claim payablev At time the claim is paid

v Dr Claim payablev Cr cash


Insurance Liabilities

v Difference between reserve and liabilityv Liability

v estimate of amounts incurred and due v Reserve

v estimates of amounts incurred but not yet due


Insurance Liabilities

v Three distinct liabilities exist for insurance companies:v Future Policy Benefits is normally the largest liability for life insurance

companies. v It is comprised of the present value of estimated future payments to

holders of life insurance and annuity products v where the timing and amount of payment depends on policyholder

mortality, surrender or retirement. v Policyholders’ account balances are amounts received as payments for

interest-sensitive contracts and deferred annuities. v Unpaid claims and claim adjustment expenses includes estimates of claims

are believed to have incurred. v Liabilities for the variable annuity guarantees are included in the liability for future policy benefits, as follows:

v GMDB and GMIB liabilities are measured by accruing expected payments under these guarantees, with the related changes in the liabilities included in policyholders’ benefits expense.

v In contrast, GMAB, GMWB and similar guarantees are considered embedded derivatives that require bifurcation under SFAS No. 133 and are recorded at fair value.

v Changes in the fair value of these derivatives, along with any related fees, are recorded in realized investment gains (losses).

v Review the separate account disclosure for Blackrock and comment on the liability.


Insurance Reserves [P&C]

v Incurred losses reported in financial statements are typically broken out into two pieces, v the initial estimate of incurred losses for the most recent exposure period, and v changes in the estimate of incurred losses for prior periods.

v There are also two general approaches to the initial recognition of losses for the current accident year –

v those based on actual claim activity and v those based on accrual of estimated incurred losses based on the level of

earned exposure.


How reserves are set

v Reserves are set by line of business.

v Reserves are established for each individual claim and are adjusted as new information becomes known.

v Lines of business for which loss data (e.g., paid losses and case reserves) emerge (i.e., is reported) overa long period of time are referred to as long-tail lines of business.

v Lines of business for which loss data emerge more quickly are referred to as short-tail lines of business.

v Shortest-tail lines of business are property and auto physical damage.

v Longest tail lines of business include workers’ compensation, general liability, and professional liability.

v For short-tail lines of business, emergence of paid loss and case reserves is credible and likely indicativeof ultimate losses.

v For long-tail lines of business, emergence of paid losses and case reserves is less credible in the earlyperiods and, accordingly, may not be indicative of ultimate losses.


Reserves, claim on cashFind AIG unpaid loss reserves, how it will be paid

Liability for Unpaid Losses


Reserves and Liquidity [pages 170 and 239]

Liability for Unpaid Losses begin balance

74,942

Liability for Unpaid Losses ending balance

77,077


Net Liability

PY Develop

US Work Comp 13,069

US Excess 8,749US Other 8,746US Financial 6,102Europe Casualty 5,587

Property/Special 5,913

Consumer Personal

3,454

Legacy 5,967


Balance Description

Unearned Premium

Future Policy Benefits

Policyholder contract deposits


Liquidity page 139 [2017]

Insurance HoldCo How?InsuranceInvestmentsInterestPrincipal


Insurance Company Risks

v Reinvestment risk v interest rates fall and reinvestment earns less

v if asset duration is less than liability duration, the mismatch will increase [Life Insurance]

v Disintermediation riskv as rates rise

v policy loans increase and surrenders increase


Property Casualty

v PC firms invest in investment grade, fixed maturity securitiesv The firm takes large risk in the liability side of the balance sheet

v The insurer with a long-tailed business can tolerate a higher combined ratio

v Combined ratio measures claims losses and operating expenses against premiums earned.

v WHY?


RBC

v Statutory capital and reserve requirements are prescribed by the applicable insurance regulators.

v Insurance regulators have established regulations that provide minimum capitalizationrequirements based on risk-based capital (RBC) formulas for both life and property and casualtycompanies.

v The RBC formula for life companies establishes capital requirements relating to

v insurance, business, asset and interest rate risks, including equity, interest rate and expenserecovery risks associated with variable annuities that contain death benefits or certain livingbenefits.

v The RBC formula for property and casualty companies relates to

v underwriting, asset, credit and off-balance sheet risks.


Statutory Capital

v List of principal GAAP vs. statutory differences v Deferred Acquisition Costs (DAC)

v non-admitted assetsv Deferred tax asset v Acquisition accounting, including goodwill v Losses & Ceded Reinsurance v AFS [OCI] not included in statutory capitalv The difference between the amortized cost and fair value of fixed maturity and other

investments is recorded under U.S. GAAP, while statutory accounting only records certain securities at fair value, such as equity securities and certain lower rated bonds.


Statutory Capital

Book Equity

Statutory Capital

Min Required StatutoryCapital

Ratio


Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from a sponsor to investors. They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake.

For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then it might wish to pass some of this risk on so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of LIBOR plus a spread, generally (but not always) between 3 and 20%. If no hurricane hit Florida, then the investors would make a positive return on their investment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially contributed by the investors would be transferred to the sponsor to pay its claims to policyholders. The bond would technically be in default and be a loss to investors.[2]Catastrophe bonds emerged from a need by insurance companies to alleviate some of the risks they would face if a major catastrophe occurred, which would incur damages that they could not cover by the premiums, and returns from investments using the premiums, that they received.[citation needed] An insurance company issues bonds through an investment bank, which are then sold to investors. These bonds are inherently risky, generally BB,[1] and usually have maturities less than 3 years. If no catastrophe occurred, the insurance company would pay a coupon to the investors. On the contrary, if a catastrophe did occur, then the principal would be forgiven and the insurance company would use this money to pay their claim-holders. Investors include hedge funds, catastrophe-oriented funds, and asset managers. They are often structured as floating-rate bonds whose principal is lost if specified trigger conditions are met. If triggered the principal is paid to the sponsor. The triggers are linked to major natural catastrophes. Catastrophe bonds are typically used by insurers as an alternative to traditional catastrophe reinsurance.


Balance Sheets, do these investments make sense?

Assets

Securities lent $60 billion

RMBS $470 billion

CMBS $180 billion

Private Placements $805 billion


Growth in Net Written Premium, 2000-2014

-4%-2%0%2%4%6%8%

10%12%14%16%18%

NWP Growth


Revenue-Global

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

underwriting Investment capital gains


MetricsLow Medium High

NWP/Surplus 100%

Change in NWP >3% less than 10% 0% Decline or grow>10%

Underwriting Expense/NWP <20% 30% >40%

Combined Ratio <97% 100% >103%

ROE >12% 7% negative

EBIT coverage >12X 6X 0X

Investment Yield Noticeably Above peers

Liquid Assets/Liquid Lliabilities >4X 1X .5X

High Risk Assets/Equity <25% 100% 300%

Reinsurance Recoverables/Equity <35% 100% 200%

[Goodwill + Intangibles]/Equity <20% 50% 75%

Total Financial Leverage <15% 45% 65%


v Combined Ratio v This figure measures claims losses and operating expenses against premiums

earned. v The lower the figure the better. v The combined ratio is the total of estimated claims expenses for a period plus

overhead expressed as a percentage of earned premiums. v A ratio below 100 percent represents a measure of profitability and the

efficiency of an insurance firms underwriting efficiency. v Ratios above 100 percent denote a failure to earn sufficient premiums to

cover expected claims. High ratios can usually occur either because of underpricing and/or because of unexpected high claims.

v Also remember that the combined ratio will be different for the Life vs. P&C industry.

Key Profitability Ratio


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140Combined Ratio

Combined Ratio

Combined Ratios1970s: 100.31980s: 109.21990s: 107.82000s: 102.9P/C Insurance Combined Ratio, 1970-2013


Industry Analysis

v Insurance Company Liquidity is evaluated in relation to potential demands on the company's liquidity. v The credit and market risk of securities in the portfolio is a key indicator of liquidity. v The insurer's need for portfolio liquidity is evaluated in relation to

v the degree to which implicit options exist in the insurer's liabilities; and v the extent to which an insurer is exposed to catastrophe risk.


Life Insurance Earnings

v Earnings for life insurance companies are driven by four pricing assumptions:v Investment returnsv Mortality and Morbidityv Lapsesv Overhead Costs



v Lapsesv A key issue is persistency, or how business will stay on the booksv The other side of persistency is lapsesv High persistency is good for life insurance



v Mortality and Morbidityv Pure risk is the protection provided by life insurance

v Investment returnsv 25% of income is from investment returns


Insurance Risk Factors

Risk Factorsv Life insurance liabilities, with the exception of surrenders, are generally highly predictable.

v little question of reserve adequacy.v Retirement products are growing in complexity

v increasing need for strong risk management.v Risk focus shifting from

v policyholders “dying too young” to the risk of “living too long”. v Assets generally present the bulk of the risk

v e.g., in the U.S. mortgages and real estate, non investment grade debtv Overall quality of life insurance company assets should be high.v Demand for property and casualty insurance is ongoing

v governments often require auto liability insurance, v lenders require that collateral be insured, v many commercial contracts require liability insurance and bonds.

v Operating risk for P&C is relatively high given:v Cyclical pricing in commercial lines insurancev Exposure to adverse loss development from prior year claims v Political pressures in setting premium rates in personal insurancev Workers compensation insurance suffers from similar pressures to increase benefits, while

limiting premium increases to employersv Exposure to catastrophe losses in property lines


Insurance Risk Factors

v Limited financial leverage v typically about 20% debt-to-capital ratios v Life policies and annuities can be surrendered, but tend to be fairly stable.

v Capitalization: v Ability to absorb fall in investment asset values

v and any potential underestimation of required benefit reserves.v Market Position

v Absolute size v Reputation to attract quality business following market’s flight to quality.

v Distribution:v Exclusive distribution system with sufficient sales productivity to cover fixed costs or

v multiple distribution channels that limit the dependency upon any single distributor or groups of distributors.

v Negative distribution factors can include market conduct issues such as v improper sales practices,


Key Success Factors

v Profitability:v Management of fixed and variable costs

v Investment Management:v Ability to generate competitive yields without prejudicing portfolio quality

v asset allocation v credit quality v liquidity v duration matching

v A property and casualty insurer cannot have a run on the bank v policyholders have no call on the assets of the company.

v Despite the cyclical nature of the industry v operating losses due to investment returns are rare, andv insolvencies are very infrequent especially for large well established

companies.


P&C Insurance – Key Success Factors

v Underwriting:v Critical mass of portfolio to provide diversification

v avoid over-exposure to an event or a series of events. v Defined maximum aggregate loss exposure appetite, with controls in place to monitor. v Underwriting for profit, not market share

v management of the rate cyclev willingness to impose changes in policy terms.

v Reinsurance Management:v demonstrable limitation of exposure to quality names.


Notching

v Notching is a technique designed to rate various debt issues of an issuerv Issues may have a different rating than the issuerv Subordination

v Contractual and Structural subordination may have an impact


Insurance Notching

Holding Company* Senior Debt (3 notches down from operating company FSR)

Operating Company** Insurance operating company financial strength rating (FSR)* Insurance operating company senior debt (one notch down from operating company FSR)

** Notching typically starts with the operating company FSR. Other ratings can be ‘implied’ from here.


-5,000

-2,500

0

2,500

5,000

7,500

10,000

12,500

15,000

17,500

20,000

22,500

201520142013201220112010200920082007200620052004

Net Income (loss) Dividends Treasury Stock Purchases

BAC


JPM

0

5,000

10,000

15,000

20,000

25,000

30,000

201520142013201220112010200920082007200620052004

Net Income (Loss) Common Stock Dividends (total)Treasury Stock purchase


-30,000

-25,000

-20,000

-15,000

-10,000

-5,000

0

5,000

10,000

15,000

20,000

25,000

30,000

201520142013201220112010200920082007200620052004

Net Income (Loss) Common Stock Dividends (total) Treasury Stock purchase

Citi


-1,500

-1,000

-500

0

500

1,000

1,500

2,000

2,500

3,000

3,500

201520142013201220112010200920082007200620052004


BNY


0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

201520142013201220112010200920082007200620052004


MS


0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

201520142013201220112010200920082007200620052004


PNC


-200

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

201520142013201220112010200920082007200620052004


Progressive


-80,000

-60,000

-40,000

-20,000

0

20,000

40,000

201520142013201220112010200920082007200620052004


AIG


-3,000

-2,000

-1,000

0

1,000

2,000

3,000

4,000

201520142013201220112010200920082007200620052004


Hartford


-500

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

201520142013201220112010200920082007200620052004


Capital One


0

5,000

10,000

15,000

20,000

25,000

201520142013201220112010200920082007200620052004


WFC


0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

201520142013201220112010200920082007200620052004


USB


0

2000

4000

6000

8000

10000

12000

14000

16000

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

GS

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