Incorporating the New Domestic Political Paradigm into

Financial ResearchInsurance Focus

Financial Management Association Annual MeetingNew York, NY

October 22, 2010Download at: www.iii.org/presentations

Robert P. Hartwig, Ph.D., CPCU, President & EconomistInsurance Information Institute 110 William Street New York, NY 10038

Tel: 212.346.5520 Cell: 917.453.1885 bobh@iii.org www.iii.org

2

Presentation Outline

Financial Services Reform: Provisions Affecting Insurers

Critical Distinctions Between Banks and Insurers

Financial Strength/Solvency Performance Trends Impairment analysis

Financial Performance Under Crisis Conditions

Public Opinion, Crisis and Perceptions of the Insurance Industry

Insurance Industry Financial Strength During the Crisis Distinctions between insurers and banks

Financial Services Reform Legislation Dodd-Frank & Insurance

Solvency II in the EU

Q&A

3

The New Domestic Political Paradigm: Insurance Industry Research

Education: Getting Public Policy Makers to Understand that Insurance is Not Like Banking

Fundamentally Different Approaches to Risk Management Between Banks and Insurers

Moral Hazard is Well Understood and Avoided

Insurance & Systemic Risk: Unlikely

Regulatory Arbitrage

State/Federal

Solvency Regulation in Europe

Solvency II

AIG: Non-Insurance Operations

Risk management of large, complex organizations

Financial Services Reform

4

Insurers Are Impacted, But Not Significantly

5

Financial Services Reform:What does it mean for insurers?

Systemic Risk and Resolution Authority

Creates the Financial Stability Oversight Council and the Office of Financial Research

Imposes heightened federal regulation on large bank holding companies and “systemically risky” nonbank financial companies, including insurers

Federal Insurance Office (FIO)

Establishes the FIO (while maintaining state regulation of insurance) within the Department of Treasury, headed by a Director appointed by the Secretary of Treasury

FIO will have authority to monitor the insurance industry, identify regulatory gaps that could contribute to systemic crisis

CONCERN: FIO morphs into quasi/shadow or actual regulator with a heavy emphasis on consumer protection issues

Surplus Lines/Reinsurance

Title V of the Dodd-Frank bill includes, as a separate subtitle, the Nonadmitted and Reinsurance Reform Act (NRRA), which eliminates regulatory inefficiencies associated with surplus lines insurance and reinsurance

The Dodd Frank Wall Street Reform and Consumer Protection Act

Source: Insurance Information Institute (I.I.I.) updates and research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP

6

Systemic Risk: Oversight & Resolution Authority

Financial Stability Oversight Council created to oversee systemic risk

of large financial holding companies) [a.k.a. TOO BIG TOO FAIL]

P/C insurers potentially could be determined to present systemic risk to the

financial system and thus be supervised by the Federal Reserve.

Such supervision would subject such insurers to prudential standards, if the

Council determines that financial distress at the company would pose a threat to

the U.S. financial system.

Orderly Liquidation

The legislation provides an “Orderly Liquidation Authority” mechanism whereby

the FDIC would have enhance powers to resolve distress at financial institutions.

Insurance holding companies and any non-insurance subsidiaries of insurers

may be subject to this authority.

Issues Related to Systemic Risk & Resolution Authority

Source: Insurance Information Institute (I.I.I.) updates/research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP

7

Systemic Risk: Oversight & Resolution Authority

Orderly Liquidation (cont.)

Insurers are generally exempt from the liquidation authority, but the FDIC would

have “backup authority” to place an insurer into orderly liquidation under state

law if the state regulator has not done so within 60 days of a systemic risk

determination.

Liquidation Fund Assessments

The liquidation fund would be funded by assessments on large financial

companies, potentially including insurers.

But the insurance industry already has a funding system (state guaranty funds) to

pay for the unwinding of failed companies. Therefore, contributions to these state

guaranty funds must be considered.

Issues Related to Systemic Risk & Resolution Authority

Source: Insurance Information Institute (I.I.I.) updates/research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP

8

Federal Insurance Office (FIO):What Would it Do?

Establishes office within US Treasury headed by a Director appointed

by Treasury Secretary, and charged with:

Monitor the insurance industry to gain expertise (oversight extends to all lines of

insurance except health insurance, long-term care insurance and federal crop

insurance).

Identify regulatory gaps that could contribute to a systemic crisis in the insurance

industry or the U.S. financial system.

Gather information from the insurance industry in order to analyze such data and

issue reports. May require insurers, with exception of small insurers which are

exempt, to submit data and FIO director can issue subpoenas to gain such info.

Deal with international insurance matters.

Monitor the extent to which underserved communities have access to affordable

insurance products.

Duties of the Federal Insurance Office

Source: Insurance Information Institute (I.I.I.) updates/research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP

9

Federal Insurance Office (FIO):What Would It Do? (Cont.)

Establishes office within US Treasury headed by a Director appointed by

Treasury Secretary, and charged with:

Make recommendations to the FSOC on whether an insurer (incl. reinsurers) poses

a systemic risk and should be placed under supervision of the Federal Reserve.

Annual reports to Congress and the President on the insurance industry are

required.

A study on the modernization of insurance regulation in the U.S. is required within

18 months, as is a report on the U.S. and global reinsurance market

Oversee the federal Terrorism Risk Insurance Program.

Insurance will continue to be regulated by the states, but the FIO has limited

preemption authority over state law in cases where it determines that state law is

inconsistent with a negotiated international agreement and treats a non-U.S.

insurer less favorably than a U.S. insurer.

Duties of the Federal Insurance Office

Source: Insurance Information Institute (I.I.I.) updates/research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP

12

Other Matters Impacting Insurance

Derivatives:

The bill would require most standardized derivatives to be routed through

clearinghouses and traded on exchanges.

Two new classes of regulated entities would be created: swap dealers and major

swap participants.

Both would be required to register with the SEC and/or the CFTC and would be

subject to margin, capital, record-keeping and business conduct requirements.

Bureau of Consumer Financial Protection:

The Bill creates a new federal level entity within the Federal Reserve with the

authority to regulate financial products offered to consumers.

Insurance products are specifically exempted from this bureau’s authority.

Derivatives and Bureau of Consumer Financial Protection

Source: Insurance Information Institute (I.I.I.) updates/research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP

New Rulemakings Under The Dodd Frank Wall Street Reform and Consumer Protection Act

24

6156

31

54

2

17

4

95

9

0

10

20

30

40

50

60

70

80

90

100

Bureau ofConsumerFinancialProtection

CFTC FinancialStability

OversightCouncil

FDIC FederalReserve

FTC OCC Office ofFinancialResearch

SEC Treasury

A total of at least 243 new rulemakings are expected under the Dodd-Frank financial reform by Federal Agency*

* Total eliminates double counting for joint rule-makings and this estimate only includes explicit rule-makings in the bill, and thus likely represents a significant underestimate.Source: Wall Street Journal, July 14, 2010; Davis Polk & Wardwell. 13

Source: James Madison Institute, February 2008.

ME

NH

MA

CT

PA

WV

VA

NC

LA

TX

OK

NE

ND

MN

MI

IL

IA

ID

WA

OR

AZ

HI

NJRI C

DE

AL

VT

NY

MD

SC

GA

TN

AL

FL

MS

ARNM

KYMOKS

SDWI

IN

OH

MT

CA

NV

UT

WY

CO

AK

= A= B= C= D= F= NG

Source: Heartland Institute, May 2010

A- A-

A-

B-

B-

B-

B-

B-

B-B-

B-B-

B-

B-

B-

B-

B- C-

C-

C-

C -

C-

D-D-

A

A

A

A

B+

B+

B+

B

B

B

B

B

B

C+

C+

C

D+

D+D+

D

NG

NG

D F

F

2010 Property and Casualty InsuranceState Regulatory Report Card

Not Graded: District of ColumbiaMississippiLouisiana

The Longstanding, Raging Debate Over Federal vs. State Regulation

Could Re-emerge in 2011

15

Consumer Poll: I.I.I. Pulse Survey

Q. Of The Following Industries, Which Do You Think Has Been Hurt Most By The Financial Crisis?

Source: Insurance Information Institute Annual Pulse Survey.

More than Half of Americans Think that Banks Are the Industry that Has Been the Most Affected by the Financial Crisis

15%

7%

11%53%

14%

Mutual fund companies

Don’t know

Banks

Securities firms

Insurance companiesThe concern people

express over their insurers remains small compared to concern over banks, mutual

funds and securities

firms

Critical Differences Between P/C Insurers and Banks

16

Superior Risk Management Model and Low Leverage Make a Big Difference

17

How P/C Insurance Industry Stability Has Benefitted Consumers

Bottom Line:

Insurance markets – unlike banking – operated normally throughout the entirety of the crisis and continue to do so today

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 300 banks have gone under as of 10/15/10)

– 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

18

Reasons Why P/C Insurers Have Fewer Problems Than Banks

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

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

A Superior Risk Management Model

Source: Insurance Information Institute

Financial Strength & Ratings

19

Industry Has Weathered the Storms Well

P/C Insurer Impairments, 1969–20098

15

12

71

19

34

91

31

21

99

16

14

13

36

49

31 3

45

04

85

56

05

84

12

91

61

23

11

8 19

49 50

47

35

18

14 15

7 65

0

10

20

30

40

50

60

70

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

Source: A.M. Best; Insurance Information Institute.

The Number of Impairments Varies Significantly Over the P/C Insurance Cycle, With Peaks Occurring Well into Hard Markets

5 of the 11 are Florida companies (1 of these

5 is a title insurer)

22

Summary of A.M. Best’s P/C Insurer Ratings Actions in 2009

3.8%

2.9%3.2%

2.4%

11.9%75.7%

.Source: A.M. Best.

P/C Insurance is by Design a Resilient Business. The Dual Threat of Financial Disasters and Catastrophic Losses

Are Anticipated in the Industry’s Risk Management Strategy

Despite financial market turmoil and a soft market

in 2009, 76% of ratings actions by A.M. Best were affirmations;

just 2.9% were downgrades and 3.2%

were upgrades

Affirm – 1,375

Downgraded – 53

Upgraded – 59Initial – 44

Under Review – 69

Other – 216

23

Reasons for US P/C Insurer Impairments, 1969–2008

38.1%

14.3%8.1%

7.6%

7.9%

7.0%

9.1%

4.2%

3.7%

Source: A.M. Best: 1969-2008 Impairment Review, Special Report, Apr. 6, 2009

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

Deficient Loss Reserves/Inadequate Pricing

Reinsurance Failure

Rapid GrowthAlleged Fraud

Catastrophe Losses

Affiliate Impairment

Investment Problems

Misc.

Sig. Change in Business

Solvency II

24

Move Toward More Stringent Regulatory Requirements for

Insurers Originating in Europe

25

Solvency II: The EU’s Effort to Modernize Insurance Solvency Regulation

Solvency II: Provides a Comprehensive Framework for Risk Management for Defining Capital Levels and to Implement Procedures to Identify, Measure and Manage Risk Levels Solvency I was primarily a Directive aimed at revising and updating existing EU

solvency regimes, which had been in existence since the 1970s. The emphasis was on solvency margins.

Since deficiencies had been identified over the years, individual EU members adopted various fixes resulting in a patchwork of regulatory requirements inconsistent with the goal of harmonized insurance regulation across the EU. Solvency II addresses this goal of harmonization.

Scheduled to Come into Effect in the EU on Dec. 31, 2012

Consists of 3 Main “Pillars”

Pillar 1: Consists of Quantitative Requirements (e.g., amount of required capital) Establishes qualitative and quantitative requirements for calculation of technical provisions and

Solvency Requirement Ratio (SCR) using either a standard regulator-provided formula or an internal model developed by the (re)insurer itself

Pillar 2: Establishes Requirements for Governance

Pillar 3: Focuses on Disclosure and Transparency Requirements

Source: European Commission; Wikipedia: http:en.wikipedia.org/wiki/Solvency_II; Insurance Information Institute

26

US Non-Life Insurance Industry Performance

Insurer Resilience

P/C Net Income After Taxes1991–2010:H1 ($ Millions)

$1

4,1

78

$5

,84

0

$1

9,3

16

$1

0,8

70

$2

0,5

98

$2

4,4

04 $3

6,8

19

$3

0,7

73

$2

1,8

65

$3

,04

6

$3

0,0

29

$6

2,4

96

$3

,04

3

$1

6,5

31$2

8,3

11

-$6,970

$6

5,7

77

$4

4,1

55

$2

0,5

59

$3

8,5

01

-$10,000

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10:H1

2005 ROE*= 9.6% 2006 ROE = 12.7% 2007 ROE = 10.9% 2008 ROE = 0.3% 2009 ROAS1 = 5.8% 2010:H1 ROAS = 6.3%

* ROE figures are GAAP; 1Return on avg. surplus. Excluding Mortgage & Financial Guaranty insurers yields a 7.5% ROAS for 2010:H1 and 4.6% for 2009. 2009:H1 net income was $19.2 billion and $10.2 billion in 2008:H1 excluding M&FG.Sources: A.M. Best, ISO, Insurance Information Institute

P-C Industry 2010:H1 profits rose $10.6B from $6.0B in 2009:H1, due mainly to $2.2B in realized

capital gains vs. -$11.1B in previous realized capital losses

28

ROE: P/C vs. All Industries1987–2009*

* Excludes Mortgage & Financial Guarantee in 2008 and 2009.Sources: ISO, Fortune; Insurance Information Institute.

-5%

0%

5%

10%

15%

20%

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

US P/C Insurers All US Industries

P/C Profitability IsCyclical and Volatile

Hugo

Andrew

Northridge

Lowest CAT Losses in 15 Years

Sept. 11

Katrina, Rita, Wilma

4 Hurricanes

Financial Crisis*

(Percent)

29

-5%

0%

5%

10%

15%

20%

25%

71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

10F

Soft Market Appears to Persist in 2010 but May Be Easing: Relief in 2011?

(Percent)1975-78 1984-87 2000-03

Shaded areas denote “hard market” periodsSources: A.M. Best (historical and forecast), ISO, Insurance Information Institute.

Net Written Premiums Fell 0.7% in 2007 (First Decline Since 1943) by 2.0% in 2008, and 4.2% in 2009, the First 3-Year Decline Since 1930-33.

NWP was flat with 0.0% growth in 10:H1 vs. -4.4% in 09:H1

30

Policyholder Surplus, 2006:Q4–2010:Q2

Sources: ISO, A.M .Best.

($ Billions)

$487.1$496.6

$512.8$521.8

$478.5

$455.6

$437.1

$463.0

$490.8

$511.5

$540.7$530.5

$505.0$515.6$517.9

$420

$440

$460

$480

$500

$520

$540

$560

06:Q4 07:Q1 07:Q2 07:Q3 07:Q4 08:Q1 08:Q2 08:Q3 08:Q4 09:Q1 09:Q2 09:Q3 09:Q4 10:Q1 10:Q2

2007:Q3Previous Surplus Peak

Quarterly Surplus Changes Since 2009:Q1 Trough

09:Q1: -$84.7B (-16.2%) 09:Q2: -$58.8B (-11.2%)09:Q3: -$31.8B (-5.9%)09:Q4: -$10.3B (-2.0%)

10:Q1: +$18.9B (+3.6%)10:Q2: -$10.2B (-1.9%)

Surplus set a new record in 2010:Q1*

*Includes $22.5B of paid-in capital from a holding company parent for one insurer’s investment in a non-insurance business

31

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 9/30/09 (latest available) ratio = 5.9%Source: PCS; Insurance Information Institute

3.3%

9.6%

6.9%

10.9%

6.2%

13.8%

16.2%

0%

3%

6%

9%

12%

15%

18%

6/30/1989Hurricane

Hugo

6/30/1992HurricaneAndrew

12/31/93NorthridgeEarthquake

6/30/01 Sept.11 Attacks

6/30/04Florida

Hurricanes

6/30/05Hurricane

Katrina

FinancialCrisis as of3/31/09**

The Financial Crisis at its Peak Ranks as the Largest

“Capital Event” Overthe Past 20+ Years

(Percent)

Property/Casualty Insurance Industry Investment Gain: 1994–2010:H11

$35.4

$42.8$47.2

$52.3

$44.4

$36.0

$45.3$48.9

$59.4$55.7

$64.0

$31.7

$39.0

$25.8

$58.0

$51.9$56.9

$0

$10

$20

$30

$40

$50

$60

$70

94 95 96 97 98 99 00 01 02 03 04 05* 06 07 08 09 10:H1In 2008, Investment Gains Fell by 50% Due to Lower Yields and

Nearly $20B of Realized Capital Losses 2009 Saw Smaller Realized Capital Losses But Declining Investment Income

Investment Gains Are Recovering So Far in 20101 Investment gains consist primarily of interest, stock dividends and realized capital gains and losses.* 2005 figure includes special one-time dividend of $3.2B.Sources: ISO; Insurance Information Institute.

($ Billions) 2009:H1 gain was $12.5B

Investment gains in 2010 are on track to be their best since 2007

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