property casualty insurance 06 10

1 / 66© 2010 SIA Group – www.s-i-a.ch

Property & Casualty Insurance

June 2010

Main message: the Property & Casualty Insurance sector offers very good investment opportunities at current prices. Moreover, it’s likely that those opportunities will be frequent.

1. Sector Analysis

AGENDA


2. SIA Analytical methodologies

3. Some specific cases

4. Conclusions

5. Q&A

The P&C business is mature, but wide differences in penetration imply further growth

Market capitalization

Property & Casualty Insurance

Property & Casualty and Multi-line

Reinsurance Italy

Switzerland

Spain

Greece

Japan

China

India

Brazil

Russia

P&C premiums as a percentage of GDP


(Total Market Cap: USD 50,000,000 mio approx.)

P&C insurance and Reinsurance add up to 2% of total market capitalization

Share of sub-industry in financials services industry has been stable over the last ten years

Banking

0% 5% 10% 15% 20%

US

UK

Germany

France

Italy

The industry has its own cycle, uncorrelated with the economy

• Demand (premium growth rates) in line with historical GDP growth.

• P&C business cycle is driven by supply:

• Product and consumers attitude. Stable price-inelastic demand.


demand.

• Low barriers of entry (and exit). Capital (and people, IT and procedures)

• Reserving cycle (COGS not known initially, margins uncertain). Calendar year vs accident year reporting.

The industry is remarkably healthy

With the very special exception of AIG, the industry:

. has received no state aid,

. has issued very few shares,

. pays some of the highest dividend yields in the market,

. and has no solvency/regulatory issues


This is probably due to:

. previous cycle’s mistakes, which have created a generalized conservative outlook

. the nature of the business model, where money is received up-front: insurance companies are sources of liquidity, while banks have been users of liquidity

All this has been true even through the worst financial crisis of the last 50 years

Apparently, low barriers to entry determine low returns

-5%

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25%19

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Indus t ry R O E S & P 500

9%

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Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Although returns look much better in Europe

US P&C industry ROE. Data based on average 1997-2008

16.0%

9.0%

6.6%8.3%

8%

12%

16%

20%

But there are important intra-industry differences


2.5%

0%

4%

Tier 1Tier 2

Tier 3Tier 4

Mean

These differences are due to strategy, economies of scale, differentiation and the presence of a retail network

Good companies are driven by better underwriting…

Basic strategic choices can make a big difference

U.S. Propert/Casualty – Average Pretax

U.S. Propert/Casualty – Combined Ratio

Components & Gross Premiums Written

(1997 - 2006)


1997-2001 soft market, 2002-04 hard, 2005-06 soft (source: AM best)

…and don’t rely on investment income

U.S. Propert/Casualty – Average Pretax

Return on Revenue & Net Investment Ratios

(1997 - 2006)

• Cycle management makes a difference, even at the expense of market share

Basic strategic choices can make a big difference

U.S. Propert/Casualty – Average Change

In Gross Premiums Written & Average Loss

Development (1997 - 2006)


• Loss reserves must be conservatively managed to succeed

Diversification lowers the need for capital

Less capital for the same amount of business implies a higher ROE

Example. Diversification at Munich Re Example. Diversification at Trygvesta

Munich Re underwrites P&C, Life and Healthreinsurance and primary insurance globallyacross many different business lines.

Trygvesta underwrites general P&C insurance in Denmark and the European Nordic countries.


Economies of scale also appear in actuarial and modeling expertise, as well as a business network

Specialty lines. Actuarial and modeling expertise. Economies of scale.

• Example. Euler Hermes: Specialist trade credit insurer. Credit insurance compensates policyholders when their clients fail to pay for goods or services.

• Economies of scale are obtained due to the costs of the comprehensive business intelligence associated to underwriting on a global base of customers and related trade counterparties.


• Receivables collecting and credit risk services offered to customers are difficult to replicate.

The economies of scale lead to concentration. Top 5 reinsurers market share is above 50%

Reinsurance is clearly subject to economies of scale


• Distribution strategy and sales channels are a competitive advantage in the retail segment.

• Example. Mapfre: multi-line insurer. 3280 branches in Spain (above 5,000 globally). See appendix.

And, for retail business, a network is hard to replicate


You can find a branch close to your home or office

Conclusion

. Although P&C is a mature business with average profitability (at best), intra-industry differences indicate the possibility of sustained attractive ROEs in the low to mid-teens.

. The sector, with the notable and special exception of AIG, has received no state aid nor had liquidity problems. Most companies have paid very high, well covered dividends through the financial crisis.

. To capture those, investors must be able to discern what the real, sustainable rate is


. To capture those, investors must be able to discern what the real, sustainable rate is for each individual company, and buy only when the share price presents a good entry point.

. Within a portfolio, insurance companies can, if well chose, add good performance with low volatility, for their business is uncorrelated to the overall economy, depending on its own cycle, or in random factors (catastrophes).


1. Sector Analysis

AGENDA




4. Conclusions

5. Q&A

Insurance company valuation

• The expected return or IRR of the investment is assessed as an average of the earnings yield (p/e ratio inverse) and ROE of a benchmark projected year.

• This could be obtained from a dividend discount model with growth given by the retained capital: (where b is the retention ratio, and g=b x ROE would be the dividends growth)


• Example. Catlin: 6x p/e ratio and 11% return on equity. IRR=13.8%

• Unfortunately, this simple analysis only holds true if all parameters stay constant. To check for that sustainability, we must dig further into each company’s accounts and competitive position

To perform the analysis, we adapt the “Du Pont” methodology

• Du Pont for P&C


“Du Pont” analysis


Catlin: Valuation


Our due diligence is made up of six steps

1. Excess equity: adequacy and adjustments

2. Reserving: adequacy and adjustments

3. Trend: current operational trends and results


4. Accounting: issues affecting company financials

5. Historical ROE: five years median and variance comparison with industry.

6. Strategy: Management, Operational, Financial, Competitive position and distribution, Diversification, Other.

Economic capital analysis

• Capital analysis

• Excess capital generation is a measure of value creation.

• Excess capital is a competitive advantage. Capacity.

• Capital management (Risk adjusted return on capital) and risk profile.


• Solvency and rating

Economic capital methodology

• S&P capital model

• Determines a target capital required for each risk and rating.

• Capital requirements correspond to a confidence level in the loss distribution of that risk.

• Example. An ‘A’ rating capital level corresponds to a 99,4% confidence level (or capital adequacy) for each individual risk.


(or capital adequacy) for each individual risk.

• It is a multifactor model with a required capital based on underwriting (and reserving) related risks (liability risk) and investment and credit risk (asset risk) .

• Includes a diversification credit.

Capital adequacy ratio

• The capital excess/deficit is measured by the Capital Adequacy Ratio: a ratio between capital available and capital requirements or charges


C1 are investment risk charges

C2 are other assets risk charges

C3 is the underwrtiting risk

C4 is the Reserve risk

C5 are other risks

Catlin: Capital adequacy ratio


Catlin: asset risk charges

• The capital required for asset risk (C1 and C2 risk charges) is calculated by multiplying S&P factors to the different exposures


Catlin: liability risk charges

• The premium risk (C3) is calculated by multiplying different factors to the premiums of each line of business


Catlin: liability risk charges

• The reserve risk (C4) is calculated by multiplying different factors to the reserves of each line of business

• A capital charge for catastrophe risk is also added, using the 1-in-250 years loss scenario.


Capital adequacy ratio

• Capital Adequacy Ratio at a BBB-rating level:


Reserving analysis

• Reserves analysis

• Reserve adequacy. Redundancy or inadequacy

• Accident Year vs Calendar Year.

• Loss ratio. Prior years loss development.

• Reserving policy. Consistency


• Tail (reserves duration).

• Methodology of analysis: Chain-Ladder and Bornheutter Ferguson

Catlin: Reserving analysis - Chain Ladder

• The basis for reserve estimates on a portfolio basis under the Chain-Ladder method is a triangular table in which columns represent the years when the claims originated (underwriting, accident or reporting year) and the rows represent how the claims have developed over time. The diagonals from the bottom left to the top right give the loss payments cumulated up to a specific business year


Catlin: Reserving analysis - Chain Ladder

• The Future loss estimates are derived from triangles using the chain ladder method. The chain ladder method extrapolates future expected claims from claims already paid or reported using multiplication factors referred to as development factors. These factors are used to forecast the unknown part of the triangular table and measure the average increase of cumulated losses from one development year to the next. Losses usually increase the fastest during the early development years

• The reserves are then the final loss estimates minus the claims already paid as the reporting period


Catlin: Reserving analysis – Bornheutter Ferguson

• Bornheutter-Ferguson method is based on Loss ratios

• Chain ladder can not be applied when there is little actual claims experience data (recent accident years). In this case, chain ladder estimates are too much influenced by recent years.

• Combines prior expectation of losses provided by simple loss ratio estimates with the actual rate of emergence of claims.



• Initial loss ratio estimate



• Using prices and losses paid for each underwriting year, we estimate a ultimate loss ratio



• Ultimate loss estimates using loss ratios are compared to corresponding losses paid and reserves.



• A weighted average of these simple loss ratio estimates and the chain-ladder results gives the Bornheutter-Ferguson figure


Catlin: Reserving


Catlin: Strategic

Management

Strategic plan/targets Mostly grow in a diversified fashion

Formal analysis No

Known to management Only to the extent of the simple plan mentioned

Consistent with capabilities Yes

Well comunicated Yes

Operational capability

• Company strategy analysis


Operational capability

Expertise Yes

Audit and control Yes

Past performance Acceptable

Stable good management Yes

Organization fits strategy Yes

Financial Good

Targets Yes, 10%+risk free rate

Have been above targets No, but period was bad (KRW)

Conservative accounting Acceptable

Catlin: Strategic

Diversification

Geographic Yes, and growing. But it is new: some dangers of lack of expertise

Product Not much. Focused on plain P&C, developingsome niche expertise

Distribution

Loyalty Not much (brokers)

Effectiveness Normal


Cost efficient Normal

Market share Not great

Cost advantage Does not show

High share in good markets Weak

Low threat of newcomers Weak

Other

Take-over advantages Wellington was ok, some synergies but mostlytax and financial; less so operating ones


1. Sector Analysis

AGENDA




4. Conclusions

5. Q&A

• Example. PMI Group Inc: Residential mortgage insurer, providing loss protection to mortgage lenders and investors in the event of borrower default.

PMI: the early warning


PMI: the early warning


AIG: Underpricing

Workers Comp, 23.7%

All Other, 32.5%

2006 AIG Statutory P/C Reserves - $53B

• Other liabilities chain-ladder 2006 estimate

• Example. AIG Inc. The reserve adequacy of AIG back in 2006 was just enough, and below industry.


Other Liability, 43.8%

• 2006 Total Redundancies on reserves: (593)MM Other Liability + 797MM WC + 188MM All Other = $392MM redundancy (0.7% of reserves). Well below large carriers: 8.5% redundancy at ACE, Hartford and Chubb. Below industry: 2% redundancy.

AIG: Underpricing

• Reserves at the end of 2008 were deficient.


AIG: Underpricing

• Other lines segment includes Financial and Mortgage Guaranty. Premiums: 576mio (2007), 655mio (2008). Booked Loss ratio: 250%. Loss: 1,6bio


AIG: Underpricing

• Loss ratio booked in 2008 neither looks conservative in the current soft market.



1. Sector Analysis

AGENDA




4. Conclusions

5. Q&A

The P&C insurance sector is stable and with an uncorrelated cycle to the economy

Average profitability hides wide intra-industry differences

Those differences can be captured ex-ante with the right analytical tools

Conclusions


Addition to P&C insurance and reinsurance companies to a portfolio can increase its risk-adjusted returns


1. Sector Analysis

AGENDA




4. Conclusions

5. Q&A

Appendices


• Euler Hermes share price and the credit cycle (2005-09).

Appendix: Euler Hermes


Euler Hermes shares, iTraxx CDS main

• Euler Hermes and the economic cycle (1998-2009)

Appendix: Euler Hermes


Combined ratio

• Financial flexibility and liquidity can be a barrier of entry.

• Example. Life insurance/reinsurance can generate funding needs: regulatory reserve requirements above actuarial estimates for some segments (see US level term), DAC funding.

• P&C and Life businesses show financial synergies and economies of scale both from capital and funding needs.

• Example. Scottish Re.

Appendix: Scottish Re


• Life reinsurer with an agressive growth strategy until 2006 (3rd US player), when it suffered a liquidity crisis. They relied in a securitization market funding strategy to do acquisitions, like the ING Re business bought in 2004. They raised private capital in December 2006, but in 2007 they experienced losses due to their structured credit exposures.

• In January 2009, the ING Re business was sold to Hannover Re (a P&C and Life reinsurer)

• Chart from a 2005 Scottish Re presentation

Appendix: Scottish Re


• Claims management can be a competitive advantage.

• Example. ProAssurance Corporation. Specialty medical professional liability insurer in the US.

Appendix: ProAssurance


• ProAssurance Corporation claims management compared to the industry. Claims defence skills is a differentiation factor.



• ProAssurance Corporation and the Med-mal supply-driven cycle



• Cap Gemini World Insurance Report 2008. Purchase criteria.

Appendix: Cap Gemini survey


• Product and advisory services differentiation is higher in other insurance segments like Life and Health.

• Mapfre operating ratios compared to the sector

Appendix: Mapfre


• Mapfre operating results

Appendix: Mapfre


• The expected return of an investment in a Life business is assessed using the recurrent earnings and the IRR of the equity shareholder’s cash-flows for a benchmark year. The Embedded Value report is a good source of this information.

• Example: Allianz

• The profit is measured using the expected business contribution (which is equal to the unwinding of the embedded value). This was some 2000 mio in 2009.

Appendix: Life insurance


• Example: Allianz (continued)

• The shareholder’s equity IRR from the existing business in-force can be obtained from the cash-flow release report. It is the discount rate of the cash-flows that equals the embedded value (adjusted by adding back to it the TVFOG, CRNHR and FC and subtracting the Free surplus). Using 2009 data, the IRR is about 6%.



• Some further considerations on the analysis:

• TVOGs: time value of options and guarantees granted to policyholders. Expected earnings include the release of this cost (incurred in a more risk-neutral world). Similar considerations for CNRHR, FC items.

• NAV as a percentatge of Embedded Value. A small figure means more value in-force (future profits) for a given equity investment (NAV).

• New business margin. The in-force IRR can be a misleading guide to future returns if new business margins differ significantly from in-force.



business margins differ significantly from in-force.

• Earnings volatility and sensitivities to risk factors. We check the accounts volatility and the embedded value sensitivities to risk factors.

• Debt leverage at the group level can improve the ROE (and therefore the expected return) in a diversified mixed insurance company (economy of scale).

• Example: Allianz (continued)



• Example: Mapfre



property casualty insurance 06 10

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