A Buyer’s Guide to the Risk Finance Bazaar

Moderator:

Pamela Ferrandino

Speakers:

Kevin Kelley

Soubhagya Parija

William Panning

Monday April 28, 2008

3:00pm – 5:00pm

Session Code FIN302

A Buyer’s Guide to the Risk Finance Bazaar

Moderator

Pamela F. Ferrandino

EVP, Casualty Practice Leader

Willis North AmericaMonday April 28, 2008

3:00pm – 5:00pm

Session Code FIN302

Introduction

Sources of risk financing continue to proliferate. During soft market cycles, many insurance buyers are tempted to regard contingent capital as a commodity.

Caveat emptor: all capital is not alike.

5.2%

-0.9

%-7

.4%

-6.5

%-1

.5%

1.8%

4.3%

18.6

% 20.3

%5.

8%0.

3%-1

.6%

-1.0

%-1

.8%

-1.0

%3.

1%1.

1%0.

8%0.

4%0.

6%-0

.4%

-0.3

%1.

6%5.

6%13

.7%

7.7%

1.2%

-2.9

% -0.5

%-2

.9%

-2.7

%

-10%

-5%

0%

5%

10%

15%

20%

25%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 08F

Rea

l NW

P G

row

th

-4%

-2%

0%

2%

4%

6%

8%

Real

GD

P G

row

th

Real NWP Growth Real GDP

Real GDP Growth vs. Real P/C Premium Growth: Modest Association

P/C insurance industry’s growth is influenced modestly by growth in

the overall economy

Sources: A.M. Best, US Bureau of Economic Analysis, Blue Chip Economic Indicators, 2/08; Insurance Information Inst.

Factors that Will Influence the Length and Depth of the Cycle

•

Capacity: Rapid surplus growth in recent years has left the industry with

between $85 billion and $100 billion in excess capital, according to analysts

All else equal, rising capital leads to greater price competition and a liberalization of terms and conditions

•

Reserves: Reserves are in the best shape (in terms of adequacy) in decades, which could extend the depth and length of the cycle

•

Investment Gains: With sharp declines in stock prices and falling interest rates, portfolio yields are certain to fall Contributes to discipline

Source: Insurance Information Institute.

More Factors that Will Influence the Length and Depth of the Cycle

•

Sarbanes-Oxley: Presumably SOX will lead to better and more conservative management of company finances, including rapid recognition of deficient or redundant reserves

•

Ratings Agencies: Focus on Cycle Management; Quicker to downgrade

•

Finite Reinsurance: Less Commonly used

•

Information Systems: Management has more and better tools that allow faster adjustments to price, underwriting and changing market conditions than it had during previous soft markets

•

Analysts/Investors: Less fixated on growth, more on ROE through soft mkt.

Source: Insurance Information Institute.

Advertising Expenditures by P/C Insurance Industry,

1999-2007E

$ Billions

$1.736 $1.737 $1.803 $1.708

$3.695

$4.323

$2.975

$2.111$1.882

$1.5

$2.0

$2.5

$3.0

$3.5

$4.0

$4.5

99 00 01 02 03 04 05 06 07ESource: Insurance Information Institute from consolidated P/C Annual Statement data.

Ad spending by P/C insurers is at a record high, signaling

increased competition

A Capital Providers View

Speaker

Kevin H. Kelley

Chairman and CEO

Lexington Insurance Company

Monday April 28, 2008

3:00pm – 5:00pm

Session Code FIN302

The Golden Age“Whether they realize it or not, property-casualty insurers are experiencing the closest thing to a Golden Age that the first half of the century is likely to offer.

Insurers finished 2007 high atop a pillar of financial strength and a riding a powerful tide of momentum into 2008”

Overall Net Income after taxes: $60 – 65BReturn on Average Surplus: 13%Combined Ratio: 93.8

National Underwriter Property & Casualty January 7, 2008 While

Industry faces big challenges, insurers can master their own destiny by Robert P. Hartwig

2007: All was well

No Mega-catastrophesProfits exceeded expectationsRecord gain on investmentsClaims reserves were in good shapeTort costs were moderate

National Underwriter Property & Casualty January 7, 2008 While

Industry faces big challenges, insurers can master their own destiny by Robert P. Hartwig

2008: What to look out for

Abandoning underwriting discipline to boost premium volumeIncrease in private and public alternative risk transfer mechanismsIncreasing demand for risk securitizationOvercapitalizationHurricanes/Earthquakes

National Underwriter Property & Casualty January 7, 2008 While Industry faces big challenges, insurers can master their own destiny by Robert P. Hartwig

P/C Net Income After Taxes 1991-2007F ($ Millions)*

$63,

500

$63,

695

-$10,000

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,00091 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

07E

*ROE figures are GAAP; 1Return on avg. surplus. 2007E figure is annualized actual 9-month net income of $49.399B **Return on Average Surplus; Actual 9-month 2007 result.Sources: A.M. Best, ISO, Insurance Information Inst.

2001 ROE = -1.2%2002 ROE = 2.2%2003 ROE = 8.9%2004 ROE = 9.4%2005 ROE= 9.6%2006 ROE = 12.2%2007E ROAS1 = 13.1%**

Insurer profits peaked in 2006/7

115.8

107.4

100.198.3

100.7

92.593.8

90

100

110

120

01 02 03 04 05 06 07F

P/C Insurance Combined Ratio, 2001-2007E

Sources: A.M. Best; ISO, III. *Actual 9-month result.

•

2006 produced the best underwriting result since the 87.6 combined ratio in 1949

•

2007 deterioration due primarily to falling rates, but results still strong assuming normal CAT activity

Growth in Net Written Premium, 2000-2007E

*2007 figure based on actual 9-month results.Source: A.M. Best; Forecasts from the Insurance Information Institute.

5.0%

8.4%

15.3%

10.0%

3.9%

0.5%

2.7%

0.0%

2000 2001 2002 2003 2004 2005 2006 2007*

P/C insurers could experience their slowest growth rates since the 1940s…but underwriting

results are expected to remain healthy

$0

$10

$20

$30

$40

$50

$60

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*

Net Investment Income$

Bill

ions Growth History

2002: -1.3%2003: +3.9%2004: +3.4%

2005: +24.4%*2006: +5.2%2007: 0.1%**

Source: A.M. Best, ISO, Insurance Information Institute;*Includes special dividend of $3.2B. Increase is 15.7% excluding dividend. **Based on annualized 9M result of $39.515B.

Investment income posted modest gains in 2006, but

ran flat in 2007

Economic Outlook■

Subprime Issue Will ultimately cost hundreds of billions globally

Problem exacerbated by leveraged bets taken by some financial institutions therefore its reach extends beyond simple defaults

■

Heavy toll on capital base of some large financial institutions worldwide;

Cash infusions necessary; Sovereign Wealth Funds primary source

Source: Insurance Information Institute

Economic Outlook (Cont’d)

■

Most significant economic event in a generation

■

US economy will recover, but will take time

Tests of a ModelDiversity of EarningsBalance SheetNimblenessRisk appetite for Market OpportunityDiversity of Product Offerings: Traditional vs. Alternative RiskClaim TrendsReinsurance Factors

CAT Treaties have seen tremendous Change Higher retentionsHigher premiumsLess Capacity available

Risk Treaties are removing CAT Coverage.Lower occurrence limitsFewer reinstatementsChange from Risk Attaching to Losses Occurring.

Aggregate is finite.Greater balance between model approach and aggregate management.

Reinsurance

Primary Insurance

Changes in reinsurance have left primary carriers more vulnerable

Higher retentionsLess coverageMore non-concurrencies

Rating Agency scrutinyTransparencyIncreased volatility

Distribution of Katrina Losses by Market ($Billions)

Market Percentage Amount

Insurers 47% - 53% $18.8 - $28.9Reinsurers 52% - 44% $20.7 - $24.0

Capital Markets

1% - 3% $0.4 - $1.6

TOTAL 100% $39.9 - $54.6

Source: Hurricane Katrina: Analysis of the Impact on the Insurance Industry, Tillinghast, October 2005.

Share of Losses Paid by Reinsurers, by Disaster*

30%

25%

60%

20%

45%

0%

10%

20%

30%

40%

50%

60%

70%

Hurricane Hugo (1989) Hurricane Andrew (1992) Sept. 11 Terror Attack (2001) 2004 Hurricane Losses 2005 Hurricane Losses

*Excludes losses paid by the Florida Hurricane Catastrophe Fund, a FL-only windstorm reinsurer, which was established in 1994 after Hurricane Andrew. FHCF payments to insurers are estimated at $3.85 billion for 2004 and $4.5 billion for 2005.Sources: Wharton Risk Center, Disaster Insurance Project; Insurance Information Institute.

Reinsurance is playing an increasingly important role in the financing of mega- CATs; Reins. Costs are

skyrocketing

Loss Distribution of 2005 CAT Losses (Worldwide)

KRWInsured

Loss

$56.5 B

OTHER2005 CATInsured

Loss

$30 B

InsuranceIndustry

Loss

$45 B

PrimaryInsuranceCession toReinsurers

(i.e. ReinsurancePurchased)

$41.5 B

Loss Assumed

ByReinsurers

(i.e. ReinsurancePurchased)

$33.5 B

Retrocession$8 B

Retrocession$8 B

Insureds Insurers Re-Insurers Retro-cessionaires

Reinsurers and Retro market absorbed nearly half of 2005 CAT losses

Source: Lane Financial Trade Notes, January 31, 2007.

Reinsurance Markets are Globally Linked

Premiums Ceded

Losses Paid

States like LA, MS paid little into the

global reinsurance pool but got a lot in

return, shrinking global claims

paying resources and pushing up

reinsurance costs for all

Global Reinsurance Market

LA

Insured Loss Estimates: Large CNBR Terrorist Attack ($Billion)

Type of Coverage New York WashingtonSan

FranciscoDes

Moines

Group Life $82.0 $22.5 $21.5 $3.4

General Liability 14.4 2.9 3.2 0.4

Workers Comp 483.7 126.7 87.5 31.4

Residential Prop. 38.7 12.7 22.6 2.6

Commercial Prop. 158.3 31.5 35.5 4.1

Auto 1.0 0.6 0.8 0.4

TOTAL $778.1 $196.8 $171.2 $42.3

Source: American Academy of Actuaries, Response to President’s Working Group, Appendix II, April 26, 2006.

Source: AIR Worldwide

•Insured Losses: $110B

•Economic Losses: $200B+

$70

$30

$5 $4 $1$0

$20

$40

$60

$80

NY NJ PA CT Other

Nightmare Scenario: Insured Property Losses for NJ/NY

Total Insured Property Losses = $110B,

nearly 3 times that of Hurricane Katrina

Distribution of Insured Property Losses by State,

($ Billions)

CAT 3/4 Storm

Non-Catastrophe Large Liability Exposure

Sector Wide Healthcare EventsThese type of events usually fall on a fairly random cross section of healthcare entities but challenge practices that are widespread.

Plaintiffs’ Bar UnionsHealthcare Activists

Institution Specific EventsUnfair Competition or Antitrust Claims brought by competing institutionRegulatory Claims brought by whistleblowers or regulatory authorities themselves

Industry Challenges: 2008 and Near Term

GrowthPotential Catastrophe & Large Liability LossesConsolidationEconomyInflationInterest Rates

A Capital Buyers View

Speaker

Soubhagya Parija

Enterprise Risk Manager

Sterling Jewelers Inc.

Monday April 28, 2008

3:00pm – 5:00pm

Session Code FIN302

Risk and Business are Inseparable

A Risk Profile is an aggregated picture of a variety of risks that an organization is exposed to and is expected to manage as the organization strives to grow shareholder value as well as to maintain and protect the value proposition.

Risk Management

Risk management entails identifying risks and developing mitigation strategies to

Manage certain core risksAvoid some risksTransfer some risks by insuring against them or by putting hedges in place Choosing the right risk financing for those risks

244.832.0 5.0%90.0%5.0%

0

0.001

0.002

0.003

0.004

0.005

0.006

0.007

-100 -50 0 50 100

150

200

250

300

350

400

450

Why Risk Management?

Lower Volatility&

Higher Expected Value

Different Risk Categories■

Risk due to catastrophic events or risks mandated by law for coverage (Workers’

Comp.)

Recommended Mitigation – Buy insurance coverage to protect asset value

■

Risks that the business can manage or create natural hedges within the organization

Recommended Mitigation – Manage internally■

Risks that are non-core such as weather risk

Recommended Mitigation - Identify the cost of risk and decide whether to retain the risk or transfer

■

Risks that are too costly to insure against or to manage internally

Recommended Mitigation – Exit is probably the best option if the level of risk is significant

Tools: Sensitivity AnalysisWith the help of Tornado diagrams, the risk manager assesses the relative impact of different risk factors and determines whether the risk is worth retaining or should be insured against

Totals / Actual Impact (sampled) ($k)Correlation Coefficients (Spearman Rank)

0.04

0.04

0.08

0.08

0.09

0.11

0.12

0.18

0.25

0.26

0.48

0.7

-0.1 0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Business Interruption Due to Weather / Occurs?

Entry of new competitor / Occurs?

Failure of new product launch / Occurs?

Strengthening of $ Xrate / Occurs?

Employee wins law suit / Occurs?

IT system, major failure / Occurs?

Fire in head office / Occurs?

Large customer goes bankrupt owing money / Occurs?

Fraud / Occurs?

Serious illness of a Board member / Occurs?

Confidential data lost / Occurs?

Problem with manufacturing process / Occurs?

Coefficient Value

Decisions

•

Financing the risks retained•

Financing the risk transferred

•

Insurance, Reinsurance or Capital Market•

Expense and Capital

•

Liquidity and Counterparty Risk

Capital Utilization

Speaker

William Panning

Executive Vice President

Willis Re

Monday April 28, 2008

3:00pm – 5:00pm

Session Code FIN302

Linking Risk, Capital, and Value

Goal: to make explicit how risk, capital, and value are inter-related in applied

finance■

What questions should I be asking?

■

How do I get the answers?■

How can I be sure that what I do adds value to my firm?

Questions: Risk1. How much risk, and what kinds of

risk, is my firm taking?

Enterprise Risk Management as an emerging discipline (unfinished)Need for a consistent risk metricIssues in aggregating different risks

Questions: Capital2. How much capital, and what kinds

of capital, does my firm have?

Capital creates the ability to withstand adverse eventsCapital creates the ability to invest in emerging opportunities

Questions: Value3. What changes in risk and capital will

increase the value of my firm?

What is “value”?How specifically can actions increase value?Are there limits to the ability to add value?

ValueValue:

the impairment-adjusted present value of future earnings

Impairment:reduction in the ability of the firm to produce future earnings

ImpairmentCritical drop in credit ratingInability to pay debt interestInability to refund debt when it maturesInability to fund crucial investment opportunitiesInability to obtain credit from key suppliersLoss of key resources or capabilitiesLoss of key customers

Increasing Value■

Make changes in risk or capital that reduce probability or severity of impairment

■ Key: benefit exceeds cost

■ Yes, there are limits: there is an optimum

Risk Management Implications

■ Asking the right questions is imperative

Implementation and execution are critical■

Need for closer integration of risk management, capital management, value management

■ Viewing risk management is just another cost center creates perverse incentives that can reduce value

Risk Management Implications

■ Value management often doesn’t happen

Value is often invisibleEVA is a rear view mirror

■ Getting the right combination of risk and capital maximizes value

Questions for the Panel