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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