Insurance Trends, Drivers and Issues

Presented by:

Steve CallahanSenior Consultant

Robert E. Nolan Company

MapWorld 2007

Helping Insurers Solve Business Helping Insurers Solve Business Challenges Through Challenges Through

People, Process, and TechnologyPeople, Process, and TechnologyFor Over 30 YearsFor Over 30 Years

Discussion Overview Introduction

Framework

Industry Financials

Key Product Line Issues

Operational Considerations: An Industry Survey

Strategic Issues Facing The Industry

About the Robert E. Nolan Company Since 1973, have helped over 540 companies worldwide achieve results.

We specialize in the insurance industry.

Our core competencies are – assisting clients to improve operational effectiveness, – business process redesign, – strategic alignment and – business and technology integration.

Our consultants average 20 years of industry specific experience.

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P & C Clients - Partial List

Farm Insurance• Colorado Farm Bureau• Kentucky Farm Bureau• Indiana Farm Bureau• Michigan Farm Bureau• Country Companies• Sequoia Insurance• Millers Insurance

Personal Lines• Nationwide Insurance • State Farm Insurance• Farmers Insurance • American Family• American Express (P&C)• West Bend

Specialty Lines• Swiss-Re• Norcal• Washington Casualty• LAMMICO• FM Global

Commercial Insurance• CNA• Zurich• Citizens Insurance• Liberty / Peerless• Liberty Insurance• Liberty / Wausau

Presentation

Framework

Things to Keep In Mind The industry is complex and very dynamic, constantly changing

– Financials, product mixes, consumer demographics and even geography– Globalization of markets, competition and distribution shifts– State and Federal regulatory influence, including taxation changes– Capital availability and deployment– Reinsurance, securitizations, captives and retention

There are a vast assortment of tools available to aid success– Risk based pricing– Investment management – Automated underwriting and rating engines– Claims adjudication systems– Risk Aggregation and book of business analysis– Loss forecasting and response formulation– Operational service speed and resource deployment techniques– Catastrophe modeling and management– Market assessment and segmentation

What are your company’s strengths, and where would it benefit from supplementing its toolset?

P/C Industry

Financials

-10%

-5%

0%

5%

10%

15%

20%

25%

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

F20

07F

Note: Shaded areas denote hard market periods.Source: A.M. Best, Insurance Information Institute

1975-78 1984-87 2001-04Growth in Net Written Premiums 1970-2007F

2% 2%

6%

2%

14%12%

9%

-1%

5%

9%

15%

12%

19%

10% 9%

17%

11%11%

6%

9%10%

-5%

0%

5%

10%

15%

20%

25%

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 07F

08F

P/C Industry Profitability 1975 – 2008F

*2007-08 P/C insurer ROEs are I.I.I. estimates.Source: Insurance Information Institute; ISO, A.M. Best.

10 years 10 years 9 years Down?

?

-55-50-45-40-35-30-25-20-15-10-505

101520253035

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

Underwriting Gain (Loss) 1975-2006

Source: A.M. Best, Insurance Information Institute

$ B

illio

ns

Despite the 2006 underwriting profit, the cumulative underwriting deficit

since 1975 is $419 billion.

Comparison of Total Returns by Line

8.23%.61%Brokers

.97%9.53%Multiline

2.84%10.33%All Insurers

.08%16.57%P/C

-1.44%19.95%Reinsurers

8.16%16.24%Life Insurers

4.66%13.62%S/P 500

YTD4/2007

2006

Source: SNL Securities, Standard & Poor’s, Insurance Information Institute

100.00%100.00%3.50%Reinsurance Failure4.60%Sig. Change in Business9.20%Misc.7.30%Investment Problems

8.60%5.60%Affiliate Problems8.60%6.50%Catastrophe Losses

11.40%8.60%Alleged Fraud8.60%16.50%Rapid Growth

62.80%38.20%Deficient Loss Reserves/In-adequate Pricing

2003 to 2005

1969 to 2005Reason for Impairment

Ultimate Risk: Insurer Impairment

Dramatic shift of Deficient Loss Reserves and Inadequate PricingCounterbalanced by significant reduction in growth driven impairments

P/C Insurance Industry is strongly cyclical, characterized by

– periods of soft market conditions• rates are stable or falling and insurance is readily available• companies compete vigorously to increase market share• profits diminish or vanish completely• the capital needed to underwrite new business is depleted

– periods of hard market conditions• competition is less intense • underwriting standards become more stringent• the supply of insurance is limited due to the depletion of capital• rates rise, coverage more difficult to find and profits increase

– higher profits draws more capital into the marketplace • leads to more competition and the inevitable down phase of the cycle

Three decades, three hard markets, overall net premiums growth• 7.7% (1975-1978), 10.0% (1984 to 1987) and 6.3% (2001 to 2004)

P/C Industry: The Cycle Repeats

Financial Trend Implications Growth in Net Written Premiums may be marginal and on a down trend

– Forecast at under 2% for 2007 and 2008, slowing to rates prevalent in the 90’s– Premium Growth: Approaching a Standstill

Net Income After Taxes at an all time high in 2006 for P/C insurers– 2006 shows a 145% improvement over 2005, continuing 4 year trend up– Profit levels appear to be unsustainably high at this point, likely to turn– Net Income: On the Cusp of a Down Cycle?

Combined ratios at all time low in 2006, forecast increasing 2007 and 2008– Even the 2008 forecast is below 100%, far below the 2001 peak of 116%– Combined Ratios: Passing 100% as Premium Growth Flattens?

Underwriting gain in 2006 was over $30 billion– Still, the cumulative underwriting loss since 1975 is over $400 Billion– Result of lack of CATs, tort system improvements and favorable loss levels– Underwriting Profits: Infrequent and Unsustainable?

P/C Financial Performance Synopsis - 2006, A Cyclical Peak

P/C Industry

Key Product Line Issues

Private Passenger Auto – The Cash Cow

101.7 101.3 101.3 101.099.5

101.1

103.5

109.5107.9

104.2

98.4

94.395.1

93.0

90

95

100

105

110

93 94 95 96 97 98 99 00 01 02 03 04 05 06F

Private Passenger Auto Combined Ratio

Source: A.M. Best; Insurance Information Institute

Private Passenger Auto is Enormous Part of Industry – Driving Profits

All Commercial Lines53.9%

PPA Coll/Comp14.2%

Homeowners11.4%

PPA Liability20.5%

Source: A.M. Best; Insurance Information Institute, 2004 values

$251.6B

$53.2B

$95.8B

$66.4B

= 34.7%Of Market

9%

17%

13%

15%

12%14%

14%

11% 12% 12% 10%

8%

2% 2%

4%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

92 93 94 95 96 97 98 99 00 01 02 03 04 05E 06F

Private Passenger Auto Profitability 1992 - 2006E

Source: NAIC; Insurance Information Institute

Segmentation should help

sustain profitability

Private Passenger Auto Market Competitive marketplaces, safer cars, aggressive fraud-fighting and

innovative underwriting driving down the price of auto insurance.– Savings vary by state based on degree of regulations impact on market– Urban population, traffic density and cost of living also effect rate changes– Other factors include tort liability, labor costs, theft rates and coverage limits

Claims frequency decreased 3% to 5% 2006 vs 2005, impacting rates– Modest increase in claims severity of only 2% to 4%

Other key factors influencing decreases in premium include– Fraud fighting successes decreasing false bodily injury claims– Safer vehicles and roads– Graduated licensing programs for teens– Changing demographics with baby boomers in safest driving years

Underwriting acumen is ultimate determinant of success– Utilize a life-cycle approach to underwriting modeling all possible variables– Incorporate credit scores, driving habits, demographics into rating models

Source: Insurance Information Institute. Auto insurance premium expected to drop in 2007 for first time since 1999. December 2006.

Private Passenger Auto Market Segmenting the Market and Modeling Risk

Increase rating factors creating sophisticated underwriting models– Expand number of price points used in risk assessment and modeling– Integrate with new auto safety features tracking actual travel events

• Teen monitoring program in Wisconsin• “Black box” accessories monitoring where, when, speed, braking, etc

– Integrating with geographic attributes to consumer utilization patterns• Where they travel, areas crossed• Parking locations for work and home and likely recreational choices

Profit Focus: “Predictive Modeling” & “Segmentation”– Create a rating system more accurate and therefore equitable to all– Risk reliably mapped to price across a broad range of circumstances– Optimize profits by effective risk profiling and rating

Product Liability – The Black Box of Unknowns

Product Liability – Uncertainty and RiskExcess liability insurance: Most effective way to protect against potentially catastrophic financial

impact of product liability lawsuits Line of insurance has inherent and potentially extreme uncertainties.

According to one trade publication:“Few insurers have the expertise and financial strength to underwrite complex liability exposure long term. Some fall victim to financial insolvency; others retreat after realizing the complexity and magnitude of the losses.”

Takeaway: There are immeasurable unexpected sources of product liability exposures facing companies today that may or may not be within pricing considerations.

Source: U.S. Chamber of Commerce. Products Liability: Emerging Exposures, Best Practices. April 2006.

Product Liability – Some Emerging IssuesLead paint resurfacing on a large scale and highly publicized state & city gov’ts have advanced a public nuisance cause of action could require manufacturers to pay billions abating existing lead paint conditionsBenzene wide array of products containing trace levels makes potential everywhere large awards already granted on gas refinery exposure and aircraft painterPharmaceuticals large single claimant cases and class actions like Vioxx continue damages typically for actual or anticipated injury and loss cost of defense alone can severely damage a firms balance sheetWelding rods developing area of litigation with over 10,000 claims nationwide based on exposure to manganese fumes, causes neurological damageDiacetyl workers who package butter flavored popcorn suffer alleged exposure four lawsuits with verdicts totaling 53 million, over 60 more filed

Source: U.S. Chamber of Commerce. Products Liability: Emerging Exposures, Best Practices. April 2006.

Inflation Adjusted Tort CostsPer Capita, 1950-2005

$96$199

$340$444

$780$722

$878 $897 $914 $880

$0$100$200$300$400$500$600$700$800$900

$1,000

50 60 70 80 90 00 02 03 04 05

Tort costs per capita have

increased 817%since 1950 even

after adjusting for inflation

Source: Tillinghast-Towers Perrin, 2006 Update on US Tort Cost Trends.

Creates Another Layer of Uncertainty in a Very Difficulty Market– Goal is to Compel Insurers to pay losses for risks not priced for

Courts’ retroactively rewrite of long-standing contract terms & conditions creates an unpredictable and unpriceable risk– Juries awarding of massive punitive damages exacerbates risk

Coverage will become more expensive, less available, more risky and losses increasingly volatile– What role can risk aggregation and concentration analysis play– Can patterns depict fraud or probability

BOTTOM LINE: Unknown and unidentified risks along with courts and juries create nearly impossible environment

Market Impacts of Litigation on Insurable Risk

Catastrophes – The Pendulum of Risk

U.S. Insured Catastrophe Losses*$7

.5$2

.7$4

.7$2

2.9

$5.5 $1

6.9

$8.3

$7.4

$2.6 $1

0.1

$8.3

$4.6

$26.

5$5

.9 $12.

9 $27.

5

$100

.0

$61.

9

$9.2

$0

$20

$40

$60

$80

$100

$120

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 0620

??

Source: Property Claims Service/ISO; Insurance Information Institute

$ Billions$100B CAT Year is comingQuestion is not if, but when

Inflation-Adjusted U.S. Insured Catastrophe Losses By Cause of Loss, 1986-2005¹

Winter Storms7.8%

Earthquakes6.7%

Wind/Hail/Flood2.8% Fire

2.3%

Civil Disorders0.4%

Water Damage0.1%

Tornadoes24.5%

All Tropical Cyclones

47.5%

Terrorism7.7%

Utility Disruption0.1%

Source: Insurance Services Office (ISO)

Tropical Cyclones, Wind/Hail/Flood, and

Earthquakes accounted for 81.5% of CAT losses

from 1986-2005

Pattern analysis and risk profiling helps in

managing exposure

U.S. Catastrophe Losses 2006: States With Largest Losses ($ Millions)

Source: ISO; Insurance Information Institute

$601$688

$873$878

$1,500

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

Indiana Missouri Tennessee Texas Kansas

Catastrophe losses in the following five states totalled $4.5B, half the

total losses for the year.

What is profile of exposure by state?

Total Value of Insured Coastal Exposure (2004, $ Billions)

$1,901.6$740.0

$662.4$505.8

$404.9$209.3

$148.8$129.7$117.2$105.3

$75.9$73.0

$46.4$45.6$44.7$43.8

$12.1

$1,937.3

$0 $500 $1,000 $1,500 $2,000 $2,500

FloridaNew York

TexasMassachusetts

New JerseyConnecticut

LouisianaS. Carolina

VirginiaMaine

North CarolinaAlabamaGeorgia

DelawareNew Hampshire

MississippiRhode Island

Maryland

Source: AIR Worldwide

Florida & New York lead the way for insured coastal property at more than $1.9 trillion each.

Northeast state insured coastal exposure totals $3.73 trillion.

Source: AIR Worldwide

Insured Losses: $110BEconomic 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 CAT 3/4 Storm

Profiling of Risks helps identify

cumulative exposures and risk

clusters

Distribution of Insured Property Losses by State ($ Billions)

Outlook for 2007 Hurricane Season: 85% Worse Than Average

185%

11

5

40

9

85

17

2007FApr 2007

140%

8

3

35

7

70

14

2007FDec 2006

+38%75Intense Hurricane Days

+29%275%100%Net Tropical Cyclone Activity

+66%72.3Intense Hurricanes

+14%47.524.5Hurricane Days

+29%145.9Hurricanes

+21%115.549.1Named Storm Days

+21%289.6Named Storms

4 MonthChg

2005Average*

Source: Philip Klotzbach and Dr. William Gray, Colorado State University, April 3, 2007.

Number of Tornadoes,1985 – 2006p

Over 1000 a Year On Average

1071 12

1694

113

7618

1912

54 1333

1132

1133

856

702

65676

568

4

1297

1173

1082 12

3411

7311

4814

2413

45

0200400600800

1,0001,2001,4001,6001,8002,000

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06p

Source: US Dept. of Commerce, Storm Prediction Center, National Weather Service; Ins. Info. Inst.

Risk of Earthquakes The potential cost of earthquakes has been growing due to

– Increasing urban development in seismically active areas – Vulnerability of older buildings, not upgraded to current building codes

Earthquake insurance showed a 5.5% increase in 2005 vs. 2004– Premiums rose to $1.67 billion in 2005 from $1.6 billion in 2004– Wood structures benefit from lower rates than brick buildings – Regions are graded on a scale of 1 to 5 for likelihood of quakes

There are over 3 million earthquakes worldwide each year– The vast majority of those are a magnitude 3.9 or lower– More than 900 earthquakes measure 5.0 or higher each year

Study of U.S. earthquake risk released by FEMA September 2000– The study estimated losses could average $4.4 billion dollars a year

Earthquakes were responsible for more fatalities in 2006 than any other catastrophe with total insured damages $80 million

Source: Insurance Information Institute. Earthquakes: Risk and Insurance Issues. April 2007.

Modeling Earthquake Risks Science and engineering provides tools used to reduce their damage

– identify where likely to occur and what forces they will generate

FEMA uses earthquake loss estimation tool called Hazards U.S. (HAZUS)– Uses information about building stock, local geology, location and size of

potential earthquakes, economic data, and other information to estimate losses

HAZUS is capable of using two separate geographic information systems (MapInfo® and ArcView®) – to map and display ground shaking, the pattern of building damage and– demographic information about a community.

HAZUS estimates, based on location and size of hypothetical earthquake– the violence of ground shaking, the number of buildings damaged,– the number of casualties, the amount of damage to transportation systems, – disruption to the electrical and water utilities, – the number of people displaced from their homes, and – the estimated cost of repairing projected damage and other effects.

Source: Insurance Information Institute. Earthquakes: Risk and Insurance Issues. April 2007.

Terrorism – Our Debate with Uncle Sam

Terrorism Coverage Take-Up Rate Continues to Rise

Source: Marketwatch: Terrorism Insurance 2006, Marsh, Inc.; Insurance Information Institute

24% 26%33%

44% 46% 44%48% 47%

54%59%

64%

03Q2 03Q3 03Q4 04Q1 04Q2 04Q3 04Q4 05Q1 05Q2 05Q3 05Q4

Insurance Industry Retention Under TRIA ($ Billions)

$10.0$12.5

$15.0

$25.0$27.5

$0

$5

$10

$15

$20

$25

$30

$35

Year 1(2003)

Year 2(2004)

Year 3(2005)

Year 4(2006)

Year 5(2007)

$ B

illio

ns

Source: Insurance Information Institute

Individual company retentions rise:• 17.5% in 2006, • 20% in 2007

Above the retention, federal govt. pays: • 90% in 2006, • 85% in 2007

Extension

Robert E. Nolan Company

P/C Industry

Survey Findings

Overriding priority is stick to the basics and avoid distractions- Conventional underwriting levers are being used to drive improvements- Improved practices through improved data, processes and skills

Top operational priorities in rank order1. Organic growth2. Underwriting and general expense management3. Customer service4. New tool introduction

Other findings of interest include – Surprising lack of emphasis on acquisition of new tools– Focus was on squeezing more out of existing IT investments– Outsourcing not seen as a high priority to achieving expense savings– Relatively low priority was placed on acquisitions by respondents

Top UW Priorities – Survey Findings

Better rate pursuit

Maintaining accurate customer data

Better risk evaluation tools

Improved use of claims data in underwriting process

Upgrading front-line underwriting skills

Better use of existing automation

Acquisition of new tools

UW Near Term Focus – Survey Findings

Top Claims Priorities – Survey Findings Deliver on the promise of fast, fair, and hassle-free claims

– Personal Lines claims best reported directly so process begins immediately– Commercial Lines, particularly WC, lend themselves to Internet reporting– Executives believe these claims should be handled directly with the company

AGREE : 63% DISAGREE : 19% NEUTRAL : 18%– Direct reporting and adjuster assignment can decrease time by two to six days

Top operational priorities in rank order1. Loss Costs Management 2. Loss Adjustment Expense Improvements3. Customer satisfaction (quality and timeliness)4. Severity (Frequency and Degree)5. Reserving Accuracy

Other findings of interest include – the relatively high priority placed on traditional file reviews– the need to better utilize existing technology– having the fastest possible reporting, set-up, and initiation of claim is critical– Customers to have the ability to contact them 24x7 any way customer chooses

Claims Near Term Focus – Survey Findings Tie for top 3 Areas of Improvements

1.Improved processes2.Better hiring and training practices3.Deployment of new technologies

Better file reviews

Full utilization of existing technology

HR changes and processes for finding the right people

Increased use of contact centers

Centralizing / decentralizing personnel

Increased use of outsourcing vendors

Other Survey Findings Capture the synergy of investments in people, process and technology

– Business process management is a high priority for achieving improvements– Leveraging greater value from existing systems and technology investments– Continued deployment of paperless processing

Offshoring and outsourcing lower priorities– 80% surveyed disagreed that contact centers will move offshore– 92% surveyed disagreed with use of offshore processing for UW or issue– General sense is both sourcing options have a way to go before being viable

for UW, insurance contact centers, or Claims

Achieving full results from image-enabled processing realizable with– Invest additional time and resources in redesigning processes first– Increased dependence on rules engines and workflow systems require new

skills and a higher degree of collaboration between business units and IT– Consistent rules, changes in staff roles, and new management processes

Strategic Issues

Facing The Industry

What are the “Big Issues”? Cat loss pricing, preparation and management (including Terrorism)

– Cat modeling and risk based pricing models– Risk concentrations and risk portfolio management– Retention and reinsurance

Successfully Navigating a Soft Market– Underwriting and Claims Discipline (consistency and quality)– Expense management during low growth (continuous improvements)– Investment selection and returns optimization– Leveraging technology and operational efficiency (esp. with low growth)

Shifting Demographics– Customer segmentation and profitability targeting– Differentiation and niche solutions– Streamlined product development / rapid time to market

Changing Distribution Dynamics– Increased competition from alternatives (banks, brokers) and internationally– Attrition rates of proven channels / sustaining channel strength

Questions?

Steve Callahan, ChFC, CLU, FLHC, FLMI/MSenior Consultant

Robert E. Nolan CompanyManagement Consultants

Steve_Callahan@renolan.com877-RENOLAN

www.renolan.com