Value Creation: The Model for Success

Presented By Colin Brigstock

2007 Niche Insurers Conference

Today’s business planning mantra:

“We want to achieve profitable growth”

The questions

How much profit?How much growth?

How do you decide between the two?Do you have to?

(Option finder questions)

The Profit Dimension

Based on the EVA notion of economic profit

Value is only created when a company covers…..

all its operating costs AND

the cost of its capital

Establishing Target Returns

0%

5%

10%

15%

20%

25%

30%

ROC

Current Cost of Capital is around 11%

Establishing Target Returns

Under-performing

Meeting expectations

Out-performing

0%

5%

10%

15%

20%

25%

30%

ROC

Destroying value

Current Cost of Capital is around 11%

Share Market Views

The Growth Dimension

How measured Risks covered or revenue?Does not matter really

Baselinemaintaining market share

SharemarketsFavour companies achieving better than system growth (i.e. increasing market share)

Critical planning issueWhat is sustainable over the medium to longer term?

OptionFinder

If vehicle registrations are growing at about 2.5% per annum and you have a reasonably mature book of motor business, what “above market” growth rate (in risks covered) do you think might be sustainable over a three year horizon?

1. No more than 5% per annum2. 5% to 7.5% per annum3. 7.5% to 10% per annum4. More than 10% per annum

Motor: ISA growth rates

Distribution of Annual Growth Rates: 2004 to 2007

0

1

2

3

4

5

6

7

0 to -5% 0 to 5% 5 to 10% 10 to 15%

Annual Rate of Growth in Risk Numbers

No

of In

sure

rs

Supplied Courtesy of ISA

Median Growth Rate: 5%

Profit Vs Growth: The Balancing Act

Intrinsic Value Model

Present value of future shareholder cashflowsEarnings less additional capital required to fund growthDiscounted at cost of capital

Projections assumptions1. Use business plan for next three years2. Long term (10 yr +) assumes reversion to “market

average” performance3. Years 4 to 9 blended between 1 and 2

Illustrate using a monoline motor insurer

Portfolio trends200,000 in force risksGWP $100 millionCapitalised at about $30m (about 2.5 times MCR)Expense rate of about 25% of GWP

Industry trendsRegistered vehicles growing at 2.4% per annumClaims inflation of about 2% per annumAverage premiums also growing at about 2% per annum

Base Scenario: Maintaining market share, just covering cost of capital

Results 2006 2007 2008 2009GWP 100.0 104.4 109.1 113.9

% change 4.4% 4.4% 4.4%Capital at year end 32.1 33.5 35.0 36.6 Profit after tax 3.5 3.7 3.8 4.0 % of GEP

Loss ratio 73% 73% 73% 73%Expenses 25% 25% 25% 25%COR 99% 99% 99% 99%ITR % GWP 2.9% 2.9% 2.9% 2.9%

Return on Capital 11.1% 11.1% 11.1% 11.1%

Intrinsic Value 33.9 34% of GWP106% Capital

9.7 times earnings

Scenario 1:5% growth for 3 years, profit = cost of capital

Results 2006 2007 2008 2009GWP 100.0 107.1 114.7 122.8

% change 7.1% 7.1% 7.1%Capital at year end 32.1 34.0 36.4 39.0 Profit after tax 3.5 3.7 3.9 4.2 % of GEP

Loss ratio 73% 73% 73% 73%Expenses 25% 25% 25% 25%COR 99% 99% 99% 99%ITR % GWP 2.8% 2.8% 2.8% 2.8%

Return on Capital 11.1% 11.1% 11.1% 11.1%

Intrinsic Value 34.3 34% of GWP

Change on Base 0.4 107% Capital9.8 times earnings

Not much change in the value of the business!!

Indeed, adding growth per se appears almost worthless

Movement in Intrinsic Value(When Profit = Cost of Capital)

-

10.0

20.0

30.0

40.0

2.4% 5% 10% 15%

3 Year Growth Rate in Risks

Intri

nsic

Val

ue $

m

Scenario 2:2.4% growth for 3 years, RoC = 18.3%

Results 2006 2007 2008 2009GWP 100.0 104.4 109.1 113.9

% change 4.4% 4.4% 4.4%Capital at year end 30.8 32.1 33.6 35.1 Profit after tax 5.5 5.8 6.0 6.3 % of GEP

Loss ratio 70% 70% 70% 70%Expenses 25% 25% 25% 25%COR 96% 96% 96% 96%ITR % GWP 5.9% 5.9% 5.9% 5.9%

Return on Capital 18.3% 18.3% 18.3% 18.3%

Intrinsic Value 66.5 67% of GWP

Change on Base 32.6 216% Capital12.1 times earnings

… and additional growth now starts to add value

Movement in Intrinsic Value(When Profit = RoC of 18.3%)

0

20

40

60

80

100

120

Base 2.4% 5.0% 10.0% 15.0%

3 Year Growth Rate in Risks

Intri

nsic

Val

ue $

m

… but what is possible?

Distribution of Motor Loss Ratios: Year to June 2007

0

1

2

3

4

5

6

55-6060-6565-7070-7575-8080-85

Loss Ratio

No

of In

sure

rs

Supplied Courtesy of ISA

Median Loss ratio: 67%

Scenario 3:Median 5% Growth + Median 67% Loss Ratio

Results 2006 2007 2008 2009GWP 100.0 107.1 114.7 122.8

% change 7.1% 7.1% 7.1%Capital at year end 29.5 31.2 33.5 35.8 Profit after tax 7.4 7.8 8.3 8.9 % of GEP

Loss ratio 67% 67% 67% 67%Expenses 25% 25% 25% 25%COR 93% 93% 93% 93%ITR % GWP 8.5% 8.5% 8.5% 8.5%

Return on Capital 25.6% 25.6% 25.7% 25.7%

Intrinsic Value 106.7 107% of GWP

Change on Base 72.8 361% Capital14.4 times earnings

… but is median aspirational?

Growth Versus Loss Ratio

R2 = 0.0411

-8%

-4%

0%

4%

8%

12%

16%

55%60%65%70%75%80%85%

Loss Ratio

3 ye

ar G

row

th( %

p.a

.)

… targeting the best

Growth Versus Loss Ratio

R2 = 0.0411

-8%

-4%

0%

4%

8%

12%

16%

55%60%65%70%75%80%85%

Loss Ratio

3 ye

ar G

row

th( %

p.a

.)

COR Growth Value

85% 6% 220

87% 10% 233

90% 10% 185

91% 7% 148

Top 4

Strategies for increasing value

Strategy planning: Starting point

Currently travelling wellROC currently above target range 22%Growing marginally faster than market 3% pa

Results 2006 2007 2008 2009GWP 100.0 105.1 110.4 116.0

% change 5.1% 5.1% 5.1%Capital at year end 30.2 31.6 33.2 34.9 Profit after tax 6.5 6.7 7.1 7.4 % of GEP

Loss ratio 68% 68% 68% 68%Expenses 25% 25% 25% 25%COR 95% 95% 95% 95%ITR % GWP 7.2% 7.2% 7.2% 7.2%

Return on Capital 21.9% 21.9% 21.9% 21.9%

Intrinsic Value 83.4 83% of GWP

Change on Base 49.5 277% Capital12.9 times earnings

Strategy Planning Scene 1

Marketing Manager“We’ve done some market research and found that if we reduced our rates by $10 we would see an increase in sales”“Why don’t we target a lower RoC?”

Familiar?

Giving up margin without a surefiremarketing outcome may be expensive!

Before After % Diff

Avg Prem 500 490 -2%

ITR 7.2% 5.8% -19%

ROC 22% 18% -18%

Movement in Intrinsic Value

-

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

3.0% 5.0% 7.0% 9.0% 11.0%

3 Year Growth Rate in Risks

Intr

insi

c Va

lue

$m

Strategy Planning: Scene 2

CEO“Well, it doesn’t look like a smart move to reduce our rates in that way, does it? Any other ideas?”

Actuary“Well, I think pricing should be part of the equation”“While we’ve been tuning our rates over the years, there are still many opportunities for improving the fit of our rates with our experience”

Distribution of In Force Motor Policies By Modelled COR

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

50% 60% 70% 80% 90% 100% 110% 120% 130% 140%Combined Operating Ratio

% o

f In

Forc

e P

olic

ies

Source: Distribution derived from a number of "well priced" client Motor portfolios rescaled for overall 96% COR

Motor pricing still a big “misfit”

Target COR

12% 24%24% 21%17%

P&L By COR Group

No (000)% of Total GWP

U/W profit ITR Net Profit

Cost of Capital

Econ. profit Amount ROC

<80% 25 12% 19.1 6.1 6.5 4.7 0.4 4.3 3.5 136%

Middle 127 63% 60.5 3.0 4.4 3.9 2.0 1.9 17.9 22%

110%+ 48 24% 20.4 (5.1) (4.7) (2.9) 0.9 (3.8) 8.6 -33%

Total 200 100% 100.0 4.0 6.2 5.7 3.3 2.4 30.0 19%

COR Range

Profit & Loss $mIn Force Policies Capital

There will undoubtedly be valuable segments in the business where sales will respond positively to lower pricing

ANDThere will almost certainly be segments where pricing should be significantly higher (and where it would be still value-creating if the business left because of a price hike)Targeted pricing matched against your best go at estimating technical prices is an important part of your weaponry

Strategy Planning: Scene 3

CEO“Well, now we may be getting somewhere”“but I’m intrigued about how sensitive the value of the business is to the COR we achieve”

“let me try a thought on you”

What if we could cut our costs by a modest $11 per policy?

Current Reduction Outcome % Chg

Repairs 220Total Losses 110Third Party 80Glass 10Other 25

445 -8 437 -1.8%

Salvage Recoveries -25 Excess recoveries -10 Third Party Recoveries -70

-105 -2 -107 1.9%

Net Cost of Claims 340 -10 330 -2.9%

Claims Handling 25Sales And Marketing 50Technology 15Other Administration 45

135 -1.0 134 -0.7%

Total Costs 475 -11 464 -2.3%Underwriting Profit 25 11 36 43.4%Premium 500 500

Margin improvement is by far the quickest route to increased value

Results 2006 2007 2008 2009GWP 100.0 105.1 110.4 116.0

% change 5.1% 5.1% 5.1%Capital at year end 29.3 30.7 32.2 33.8 Profit after tax 7.8 8.2 8.6 9.0 % of GEP

Loss ratio 66% 66% 66% 66%Expenses 25% 25% 25% 25%COR 93% 93% 93% 93%ITR % GWP 9.2% 9.2% 9.2% 9.2%

Return on Capital 27.2% 27.2% 27.3% 27.3%

Intrinsic Value 105.9 106% of GWP

Change on Current 22.5 362% Capital13.6 times earnings

1% margin improvement is worth a lot more than 1% higher growth

Intrinsic Value Curves

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

85%87%89%91%93%95%97%99%

Combined Operating ratio

Gro

wth

Rat

e p.

a.

66 80 100 120 160

Final thoughts (1)

Profit not materially above your cost of capital?

Single-minded focus on improving the margins in your existing business

Cost reduction likely to be the biggest contributor

Targeted pricing also important

Final Thoughts (2)

Achieving a healthy margin above your cost of capital?

Treat it preciously

Giving it up to chase market share is unlikely to be value positive

If you want to aggressively target growth with price as a weapon:

• Find some cost reduction to help pay for it• Use pricing in a very segmented and targeted way

This presentation has been prepared for the Finity Niche Insurer Conference held on 8 November 2007. Finity Consulting Pty Limited (ABN 89 111 470 270) wishes it to be understood that opinions put forward herein are not necessarily those of Finity and Finity is not responsible for those opinions. The information presented at the conference was of a general nature and a reader of this presentation must seek their own independent advice before using it for any purpose.