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04/09/2012

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© 2012 The Actuarial Profession www.actuaries.org.uk

GIRO Conference and Exhibition 2012 Juggling uncertainty the actuary’s part to play

GIRO Conference and Exhibition 2012

Cyclophilia: an analyst’s view of the pricing cycle

Chris Hitchings

Keefe, Bruyette & Woods Ltd

04/09/2012

2

Please refer to important disclosures and analyst

certification information on pages 24-25

Investors do not like P&C insurance

• P&C insurers have not been a good long-term investment

• Underperformed by 45% over past 25 years

• Periods of out-performance have been short, often associated

with problems elsewhere.

2

45

55

65

75

85

95

105

115

125

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

European Non-life insurers rel. to the equity markets



Why? – one reason is a long-standing profit cycle

3

US P&C industry 1920-2011

-20

-15

-10

-5

0

5

10

1920

1925

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

Underwriting/EP

04/09/2012

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Why? – features of the cycle

• A ‘business cycle’ like any other; but much worse

• Product issues:

– Competing products identical (and perceived to be)

– No substitutes; no utility to additional consumption

• Market issues:

– No capacity constraints – easy of entry/exit

– Capacity can be dependent on financial markets

• Industry issues:

– Margins are uncertain

– Easy for companies to delude themselves that they are profitable

– They discover they are not only after a delay

4



Economics of the cycle - demand

• Supply/demand curves:

• Shows market clearing price determined by intersection

• Increased capacity represented by a shift in the supply curve

• Inelastic demand:

– No substitutes

– No utility to additional consumption

• Generates steeper demand curve

• A given change in supply gives a larger change in price 0

10

0 1 2 3 4 5 6 7 8 9 10

Market demand

Old

market

supply

New market supply

Market

clearing

prices

reduce

more

0

10

0 1 2 3 4 5 6 7 8 9 10

Market demand

Old

market

supply

New market supply

Market

clearing

prices

reduce

5

04/09/2012

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Economics of the cycle - supply

• Competing products identical

• No short-run supply constraint

• Individual competitors perceive a

‘kinked demand curve’

– If price raised, no-one follows so

demand collapses

– If price reduced, all follow so

market demand curve

– Causes extreme price instability

and tends to exacerbate cycle

• Even with some ‘brand loyalty’, still a

demand curve kink (lower chart)

0

5

10

0 1 2 3 4 5 6 7 8 9 10

Market demand Market supply

Indidual competitor demand curve (down-cycle) (up-cycle)

Market clearing price

0

5

10

0 1 2 3 4 5 6 7 8 9 10

Market demand Market supply

Indidual competitor demand curve

Market clearing price

6



Margin uncertainty – US P&C reserve development by year of origin

7 © 2011 The Actuarial Profession www.actuaries.org.uk

Good years get better; bad ones get worse

-10

-5

0

5

10

20102009200820072006200520042003200220012000199919981997

Prf

t/los

s fr

om p

rior

yrs

%

Year of origin

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

04/09/2012

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Margin uncertainty – the drivers of reported results


60

70

80

90

100

110

120

-20

-15

-10

-5

0

5

10

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11E

Reported U'writing/EP Reserve release/EP Price index (RH scale)

Prices fallbut margins rise

because reserves

released

Prices risebut margins lag

because reserves

need bolstering

??



Uncertainty of margin – Why?

• Insurers do not just cut prices in

order to grow

• They target growth in segments

believed as exceptionally profitable

• The target involves tweaks to

cover/criteria to broaden appeal

• Other insurers are pursuing similar

but not identical strategies

• Buyers will go with cheapest quote

• The enlarged sample may have

different characteristics from the

pricing basis

• Insurer A specialises in motor for

over 60s:

– Discovers clients with sports

cars profitable so trims rates

• Insurer B specialises in sports cars:

– Discovers clients in rural areas

very profitable so trims rates

• Insurer A succeeds but client base

is more city oriented so has more

theft/vandalism claims

• Insurer B succeeds but client base

is younger than he assumed

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Theory Practice

04/09/2012

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And market prices, thus, fall faster than renewal price indices suggest …

10

50

60

70

80

90

100

110

2003 2004 2005 2006 2007 2008 2009 2010 2011

ZFS US Commcl CIAB US Commercl



How to recognise a turn in the cycle (1)

• It is not what they say but what

they do!

• Actual price rises suggest insurers

would prefer to lose all market

share rather than keep writing (the

kink in the demand curve)

• Suggests panic as prior year

problems emerge

• Initial estimates of reserve

problem too optimistic since hard

to believe technical pricing could

have got it so wrong

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-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

Jan Mar May Jul Sep Nov Jan Mar May Jul

Market ScoutAverage rate change - US commercial

04/09/2012

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How to recognise a turn in the cycle (2 - actuarial)

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38

40

42

44

46

48

50

20112009200720052003200119991997

Y1 paid/ initial incurred

Y1 paid/ latest incurred

high paid/incurred

suggests optimistic

initial reserving

low paid/incurred suggests

cautious initial reserving

?



External estimates are negative

13

($0.7)($0.9)

($0.3)

$0.8

$2.1

$1.8

$2.3

$0.1

($3.1)($3.3)

($4.0)

($3.0)

($2.0)

($1.0)

$0.0

$1.0

$2.0

$3.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

KBW Estimated Accident Year Redundancy (Deficiency) at Year-End 2009

04/09/2012

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Can the cycle be ameliorated?

• Tendency of P&C industry to ruin

itself every 7-9 years was

unpopular with companies

• Cartels were popular up until 1970s

• UK market was very stable until its

cartels (tariffs) disappeared in 1969

(motor) and mid-80s (fire)

• Since then, highly cyclical

• Governments sometimes regulated

prices (Germany, US)

• Regulation in US peculiar since its

aim was to keep prices low

14

90%

95%

100%

105%

110%

115%

120%

125%

130%

19

61

19

64

19

67

19

70

19

73

19

76

19

79

19

82

19

85

19

88

19

91

19

94

19

97

20

00

20

03

20

06

Motor tariff collapses Fire tariffs abolished

Very bad winter

Mortgage indemnity

UK market COR 1961-2007



How to maximise returns

• P&C is an industry where the good years are good and the bad years are

bad.

• The trick of P&C insurance is to grow in pricing upturns and shrink in

downturns.

15

-2

0

2

4

6

8

10

Average 22 good years

Average 20 bad years

Average equal weighted

50% 100% 150%

Average return on earned premiums for US P&C industry 1970-2011

Average if volumes in good years increased by:

04/09/2012

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Lloyd’s insurers manage it

16

KBW Lloyd’s universe premium growth and US cycle

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

2

-30

-20

-10

0

10

20

30

40

50

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

Lloyd's premium growth US U/w result (RH scale)



And significantly outperform the industry

• Long-term track record of the best

Lloyd’s businesses is better than

anything else in the P&C market

• Second chart shows record of

mainstream insurers (green),

Bermudans (pale blue) and Lloyd’s

(orange)

• Bermudans make better returns in

good years but worse returns in

bad years

• Lloyd’s makes good return in good

years; average in bad

17

80%

90%

100%

110%

Am

lin

Catl

in

His

co

x

Beazle

y

* P

art

ner

Re A

IG

Han

no

ver

RS

A

Ev

ere

st R

e

ZF

S

Sw

iss R

e

Mu

nic

h R

e

70%

80%

90%

100%

110%

120%

130%

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

Avge Amlin, Catlin, Hiscox Avge AIG, RSA, ZFS, Munich Re

Avge Everest, Partner

Average combined ratio 1994-2011

04/09/2012

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The few Lloyd’s businesses which do try to grow in cyclical downturns pay the penalty

18

Amlin

Beazley

BRIT

Catlin

Chaucer

Hardy

Hiscox

Kiln

Novae

Omega

-30

-20

-10

0

10

20

30

-60 -30 0 30 60 90 120

CO

R o

/perf

orm

1998-2

002

Growth 1993-98



But only because specialty and primary insurance market works that way

• Primary insurers like high volumes and low risk

– This can be priced statistically and underwritten mechanically

• Specialty insurers write higher risks, lower volumes

– This requires technical pricing and individual underwriting

• In a cyclical downturn, primary insurers grow by raising their risk appetite

• In a cyclical upturn, they retreat to their ‘core business’

19

Speciality

insurers

Ris

k

Primary

insurers

Volume

04/09/2012

11



Prognosis for this cycle: Reinsurers have behaved more rationally?

20

Reinsurance US Primary

70

80

90

100

110

120

130

140

2004 2005 2006 2007 2008 2009 2010 2011 2012

US PropCat Non-US Cat US Casualty

Katrina

NZ/Japan

50

60

70

80

90

100

110

2004 2005 2006 2007 2008 2009 2010 2011 2012

... collapse of Lehman

... low interest rates

... RMS11

Prices will rise ... post Katrina



They have not been rewarded by it … but perhaps that is why …

• This may reflect that Reinsurers did vary badly in the previous

cycle trough

• They are thus more lowly valued

• They are thus under less pressure to grow

21

0.5

1.0

1.5

2.0

Euro P&C US P&C Lloyd's Euro Reins Berm Reins

Current average price/BV

04/09/2012

12



Could modern technology solve the cycle?

22

1

10

100

1000

10000

-10

-5

0

5

10

15

20

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

US Total Margin % Computer Speed MHz (RH scale)

If so, we might have expected it to have done so already …



Questions or comments?

Expressions of individual views by

members of The Actuarial Profession

and its staff are encouraged.

The views expressed in this presentation

are those of the presenter.


04/09/2012

13



Important Disclosures

24

RESEARCH ANALYST CERTIFICATION: I, Chris Hitchings, hereby certify that the views expressed in this document accurately reflect my personal views about the subject companies and their securities. I

also certify that I have not been, and will not be receiving direct or indirect compensation in exchange for expressing the specific recommendation in this document.

Analysts’ Compensation: The equity research analysts responsible for the preparation of this document receive compensation based upon various factors, including the quality and accuracy of research, client

feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking.

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Important Disclosures, continued...

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