Capital Punishment:Why Earning a Fair Rate of Return

is Tougher than Ever in the P/C Insurance Business

International Union of Marine InsurersNew York, NY

September 16, 2002

Robert P. Hartwig, Ph.D., CPCU, Senior Vice President & Chief EconomistInsurance Information Institute 110 William Street New York, NY 10038Tel: (212) 346-5520 Fax: (212) 732-1916 bobh@iii.org www.iii.org

Presentation Outline

• Profitability in the P/C insurance industry• Insurer Cost of Capital: A Global Perspective• Supply of Capital in P/C Insurance Industry• Cost of Capital: How is it Computed?• Factors Influencing Cost of Capital

Special factors affecting p/c insurance• Summary

Profitability in the P/C Insurance Industry

P/C Net Income After Taxes1991-2002 ($ Millions)

$14,178

$5,840

$19,316

$10,870

$20,598

$24,404

$36,819

$30,773

$21,865$20,223

-$7,921

$20,420

-$10,000

-$5,000

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

91 92 93 94 95 96 97 98 99 00 01 02*

*I.I.I. estimate based on first quarter 2002 data.Sources: A.M. Best, ISO, Insurance Information Institute.

2001 was the first year ever with a full year net loss

2002 Q1 ROE = 1.7%

95

100

105

110

115

120

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00

02**

P/C Industry Combined Ratio

2001 = 115.7

2002 Forecast* = 108.0

2002 Q1: 102.3

Combined Ratios

1970s: 100.3

1980s: 109.2

1990s: 107.7

2000s: 112.9

Sources: A.M. Best; III

* Based on III 2002 Groundhog Forecast

110.

5

105.

0

113.

6 119.

2

104.

8

100.

8

100.

5

114.

3

107.

2

142.

9

117.

4

108.

8 115.

8

106.

9

108.

5

106.

5

105.

8

101.

6

105.

6

107.

7

110.

1 116.

0

101.

6

126.

5

90

100

110

120

130

140

150

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002*

Reinsurance All Lines Combined Ratio

Combined Ratio: Reinsurance vs. P/C Industry

*First Quarter 2002 for all p/c; first half for reinsurance.

Source: A.M. Best, ISO, Reinsurance Association of America, Insurance Information Institute

2001’s combined ratio was the worst-ever for reinsurers

($60)

($50)

($40)

($30)

($20)

($10)

$0

$101

97

51

97

61

97

71

97

81

97

91

98

01

98

11

98

21

98

31

98

41

98

51

98

61

98

71

98

81

98

91

99

01

99

11

99

21

99

31

99

41

99

51

99

61

99

71

99

81

99

92

00

02

00

12

00

2

Underwriting Gain (Loss)1975-2002*

*Annualized estimate based on first quarter 2002 data.Source: A.M. Best, Insurance Information Institute

$ B

illi

ons

P-C insurers paid $53 billion more in claims & expenses than they collected in premiums

in 2001

-5%

0%

5%

10%

15%

20%

US P/C Insurers All US Industries

ROE: P/C vs. All Industries 1987–2002*

*First QuarterSource: Insurance Information Institute; Fortune

-5%

0%

5%

10%

15%

20%

25%

US P/C Insurers All US Industries LifeDiversified Finl. Comm. Banks

ROE: Financial Services Industry Segments, 1987–2001

Source: Insurance Information Institute; Fortune

20.5%

13.2% 12.8%

10.5%

25.9% 25.1%23.5%

17.5%

11.8%

22.0%

0%

5%

10%

15%

20%

25%

30%

US P/C Insurers All US Industries Inland Marine

ROE: Inland Marine vs. Overall P/C & Fortune 500, 1991–2000

Source: NAIC, Insurance Information Institute; Fortune

Inland marine profitability consistently above P/C & Fortune 500

12% After Tax ROE Requires Underwriting Profit

Source: Dowling & Partners

Accident Year Combined Ratio

P : S 90.0% 92.5 % 95.0 % 97.5 % 100.0 % 102.5 % 105.0 % 107.5 % 110.0 % 112.5 %

100 % 13.0 % 11.5 % 10.1 % 8.6 % 7.1 % 5.6 % 4.1 % 2.6 % 1.1 % -0.4 %

110 % 14.0 % 12.4 % 10.7 % 9.1 % 7.5 % 5.8 % 4.2 % 2..5 % 0.9 % -0.7 %

120 % 15.0 % 13.2 % 11.4 % 9.6 % 7.8 % 6.1 % 4.3 % 2.5 % 0.7 % -1.1 %

130 % 16.0% 14.0 % 12.1 % 10.2 % 8.2 % 6.3 % 4.4 % 2..4 % 0.5 % -1.5 %

140 % 16.9 % 14.9 % 12.8 % 10.7 % 8.6 % 6.5 % 4.4 % 2.4 % 0.3 % -1.8 %

150 % 17.9 % 15.7 % 13.5 % 11.2 % 9.0 % 6.8 % 4.5 % 2.3 % 0.1 % -2.2 %

160 % 18.9 % 16.5 % 14.1 % 11.8 % 9.4 % 7.0 % 4.6 % 2.2 % -0.2 % -2.5 %

170 % 19.9 % 17.3 % 14.8 % 12.3 % 9.8 % 7.2 % 4.7 % 2.2 % -0.4 % -2.9 %

180 % 20.9 % 18.2 % 15.5 % 12.8 % 10.1 % 7.5 % 4.8 % 2.1 % -0.6 % -3.3 %

190 % 21.8 % 19.0 % 16.2 % 13.3 % 10.5 % 7.7 % 4.9 % 2.0 % -0.8 % -3.6 %

200 % 22.8 % 19.8 % 16.9 % 13.9 % 10.9 % 7.9 % 4.9 % 2.0 % -1.0 % -4.0 %

225 % 25.3 % 21.9 % 18.6 % 15.2 % 11.9 % 8.5 % 5.2 % 1.8 % -1.5 % -4.9 %

250 % 27.7 % 24.0 % 20.3 % 16.5 % 12.8 % 9.1 % 5.4 % 1.7 % -2.1 % -5.8 %

Insurer Cost of Capital

A Global Perspective

Cost of Capital: A Definition

• Cost of Capital:Rate of return that can be earned by investors in

industries offering comparable degree of risk Must be sufficient to maintain & attract capital

• Insurance Cost of Capital:Will vary substantially by line

-5%

0%

5%

10%

15%

20%

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

ROE Cost of Capital

ROE vs. Cost of Capital: US Non-Life 1991 – 2002*

Source: The Geneva Association, Insurance Information Institute.

There is an enormous gap between the industry’s cost of capital and its rate of return

14.6

pts

9.5.

pts

US P/C insurers have missed their cost of capital by an

average 6.7 points since 1991

0%

5%

10%

15%

20%

25%

30%

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

UK Switzerland France Germany

Cost of Capital: Non-Life Insurers:1978 – 1998

*

Source: Kielholz, Walter, “The Cost of Capital for Insurance Companies,” The Geneva Papers on Economic Activity, v 25, no. 1, January 2000.

Supply of Capital in the P/C Insurance Industry

How Much is There?

$0

$50

$100

$150

$200

$250

$300

$350

75 77 79 81 83 85 87 89 91 93 95 97 99 01

Policyholder Surplus: 1975-2002*

*As of 1st quarter 2002Source: A.M. Best, Insurance Information Institute

Bil

lion

s

(US

$)

Surplus Peaked at $336.3 Billion in 1999

•Surplus decreased 8.7% in 2001 to $289.6 Billion.

•Surplus rose 1.9% in the 1st quarter of 2002

•Surplus is now lower than at year-end 1997.

“Surplus” is a measure of underwriting capacity. It is analogous to “Owners Equity” or “Net Worth” in non-insurance organizations

0.5

1.3

2.0

2.8

Net Premiums Written to Policyholder Surplus Ratio

Source: A.M. Best, Insurance Information Institute

2000: 0.95

2001: 1.16

2002 (Forecast): 1.33

Capital Raising by P/C Insurers Since September 11, 2001*

$20,492

$11,442

$16,437

$4,872

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

2001 2002*

($ M

illi

on

s)

Completed Pending

$25.4 Billion$27.9 Billion

*As of September 13, 2002.

Source: Morgan Stanley, Insurance Information Institute.

14 Pending 38 Pending

40 Completed 33 Completed

Capital Raising by P/C Insurers Since 9/11 Totals $44.5B

Capital Myth 3: P/C Insurers Have $300 Billion to Pay Terrorism Claims

"Target" Commercial*$100 billion

33%

Other Commercial$50 billion

17%

Personal$150 billion

50%

Total PHS = $298.2 B as of 6/30/01

*”Target” Commercial includes: Comm property, liability and workers comp; Surplus must also back-up on non-terrorist related property/liability and WC claimsSource: Insurance Information Institute

Only 33% of industry surplus backs up “target” lines

Price Increases Needed to Achieve Cost of Capital

Second Quarter 2002

Rate Increases By Line of BusinessRate Increases By Line of Business NoNo

Change Up 1-10% 10-20% 20-30% 30-50% 50%-100% >100%Change Up 1-10% 10-20% 20-30% 30-50% 50%-100% >100%

Comm. Auto 2% 6% 28% 39% 21% 1% 1%

Workers Comp 5% 13% 19% 32% 15% 5% 2%

General Liability 2% 9% 24% 45% 15% 2% 1%

Comm. Umbrella 2% 4% 10% 20% 27% 17% 16%

Comm. Property 3% 4% 16% 30% 31% 13% 1%

Business Interr. 3% 8% 32% 33% 10% 1% 0%

Surety Bonds 10% 13% 16% 14% 6% 0% 1%

Source: Council of Insurance Agents and Brokers

100110

120130

140150

160170

180190

200210

220230

240250

260

89 90 91 92 93 94 95 96 97 98 99 00 01 02*

Rate On Line Index(1989=100)

Source: Guy Carpenter * III Estimate

Prices rising, limits falling: ROL up significantly

Cost of Risk per $1,000 of Revenues: 1990-2002E

$6.10

$6.40

$8.30$7.70

$7.30

$6.49

$5.70$5.25

$5.71

$5.20$4.83

$5.55

$7.22

$4

$5

$6

$7

$8

$9

$10

90 91 92 93 94 95 96 97 98 99 00 01E 02E

Source: 2001 RIMS Benchmark Survey; Insurance Information Institute estimates.

Cost of risk to corporations could rise sharply in 2002; About half of increase due to 9/11

0%

5%

10%

15%

20%

25%

19

70

19

72

19

74

19

76

19

78

19

80

19

82

19

84

19

86

19

88

19

90

19

92

19

94

19

96

19

98

20

00

20

02

*Estimate based on first quarter 2002Source: A.M. Best, Insurance Information Institute

Growth in Net Premiums Written (All P/C Lines)

2000: 5.1%

2001: 8.1%

2002: 10.3%*

The underwriting cycle went AWOL in the 1990s.

It’s Back!

Cost of Capital:

How is it Computed?

Cost of Capital: Methods

• 2 Commonly Used MethodsDiscounted Cash Flow (DCF)

Uses current dividend yield & dividend (or earnings) growth rateCapital Asset Pricing Model (CAPM)

Uses risk-free interest rate, risk premium & measure of relative risk, Beta (• Factors currently affecting costs of capital

Dividend yields very low (1.39% mid-2002), little growth expected; Recent earnings performance poor

Interest rates very low (short-term rates < 1.8% mid-2002)Risk premium shrinking (return on alternatives to risk-free return

are shrinking)Beta (low relative to overall stock market (stock price volatility

slightly less than overall market: • CURRENT P/C COST OF CAPITAL IS: 11% - 12%

Factors Influencing the Cost of Capital

4.4%3.5%

2.5%

5.7%

8.3%

4.8%5.6%

2.2%

1.0%

-0.6%

-1.6%

-0.3%

5.0%

1.1%

2.3%3.2%2.7%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Real GDP Growth

Source: US Department of Commerce, Blue Economic Indicators 9/02, Insurance Information Institute.

Economy is experiencing sluggish growth following the

recession of 2001

(first recession since 1990/91)

Economic Outlook for Major US Trading Partners (Real GDP Growth, %)

1.5

-0.3

2.2 3.

0

1.5

7.3

1.5

3.0

1.9

1.8

5.6

1.2

3.0

7.2

1.5

3.5 3.9

0.9

2.9

5.4

2.7

3.9

7.3

3.1

-0.2

-1.9-0

.5

-2

0

2

4

6

8

Real

GDP

Gro

wth

(%)

2001 2002E 2003F

Source: Blue Chip Economic Indicators, September 2002.

Economies of most major trading partners expected to

improve in 2002/2003

Does US have a trade policy?

0%

2%

4%

6%

8%

10%

12%

14%

16%

3-Month T-Bill 1-Yr. T-Bill 10-Year T-Note

Interest Rates: Lower Than They’ve Been in Decades

*Average for week ending September 6, 2002.Source: Board of Governors, Federal Reserve System; Insurance Information Institute

Interest Rates Low for 2 Reasons

1. Weak Economy (= low inflation, less demand for cap)

2. Perception that federal budget will return to surplus

If either of these changes, interest rates and CoC up

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Yie

ld S

pread

(p

oin

ts)

Risky Business: Yield Spread Rising with Corporate Scandals*

*January 1990 through August 2002Source: Board of Governors, Federal Reserve System; Insurance Information Institute

Risk premium (2.46 points) reached all time high in Oct. 2001 (Enron problem surfaced)

Yield Spread Between Long-Term ‘aaa’ Corporates and 10-Year US Treasury Securities

0%

1%

2%

3%

4%

5%

6%

7%

6-Sep-02 7-Sep-01 10-Sep-99

Treasury Yield Curve: Rates Down Across Every Maturity, esp. Short-Term

*Data are averages for all trading days for the week on the indicated date.Source: Board of Governors, Federal Reserve System; Insurance Information Institute

Yield Curve for the week before September 11 terrorist attack

Yield Curve 2 years before attack

Yield Curve: Most Recent (1st anniversary of 9/11 attack)

$0

$9

$18

$27

$36

$45

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

Net Investment Income

Facts

1997 Peak = $41.5B

2000= $40.7B

2001 = $37.1B

2002E = $35.8B

Source: A.M. Best, Insurance Information Institute

Bil

lion

s

(US

$)

Investment income in 2002 could fall 5% to 6%

Realized capital gains in the 1st quarter of 2002 were

down 89%

-30%

-20%

-10%

0%

10%

20%

30%

40%

19

70

19

72

19

74

19

76

19

78

19

80

19

82

19

84

19

86

19

88

19

90

19

92

19

94

19

96

19

98

20

00

20

02

*

Large Company Stocks*As of September 13, 2002.Source: Ibbotson Associates, Insurance Information Institute

Total Returns for Large Company Stocks: 1970-2002*

Headed for 3rd consecutive year of decline for stocks

Last happened 1939-1941

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

UK Switzerland

Average Betas: Non-Life Insurers:1978 – 1998

Source: Kielholz, Walter, “The Cost of Capital for Insurance Companies,” The Geneva Papers on Economic Activity, v 25, no. 1, January 2000.

0.75

0.85

0.95

1.05

1.15

1.25

1.35

1.45

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

UK France

Average Betas: Non-Life Insurers:1978 – 1998

Source: Kielholz, Walter, “The Cost of Capital for Insurance Companies,” The Geneva Papers on Economic Activity, v 25, no. 1, January 2000.

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

UK Germany

Average Betas: Non-Life Insurers:1978 – 1998

Source: Kielholz, Walter, “The Cost of Capital for Insurance Companies,” The Geneva Papers on Economic Activity, v 25, no. 1, January 2000.

0.75

0.85

0.95

1.05

1.15

1.25

1.35

1.45

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

US UK Switzerland France Germany

Average Betas: Non-Life Insurers:1978 – 1998

Source: Kielholz, Walter, “The Cost of Capital for Insurance Companies,” The Geneva Papers on Economic Activity, v 25, no. 1, January 2000.

World’s Most Dangerous Lines of Insurance(Combined Ratio + 1 Std. Deviation)

135.6135.1

133.9133.3

131.6129.3

121.8119.3

118.7117.1

116.3115.1114.6

112.9111

109.7109.1

107106.6

103.4102.9

101.7101.3

10084.1

80 90 100 110 120 130 140 150

EarthquakeMed Mal

Other LiabilityReinsurance

HomeownersAllied Lines

AircraftComm. Multi PerilComm. Auto Liab.

Workers CompFarm Multi PerilCommercial--All

Ocean MarineFire

All LinesPP Auto Liab

Personal--All LinesComm Auto PD

Boiler & MachineGroup A&HOther A&H

Priv Pass PDInland Marine

FidelityOther

SuretyBurglary & Theft

Source: Insurance Information Institute, calculated from A.M. Best combined ratio data.

407.3

Cost of capital will vary significantly by

line and mix of business, according

to risk assumed

P/C Performance Volatile, but Better than S&P 500 Lately

-25.7%

43.4%

-1.2% -3.7%

21.0%

-9.1% -10.9%

-21.7%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

1999 2000 2001 2002*

P/C S&P 500

*Through September 13, 2002.Source: SNL Securities, Insurance Information Institute

Insurer Stock Price Performance:Before & After 9/11

Source: SNL Securities, Insurance Information Institute

-21.

6

-9.7 -8

.2

-20.

0 -16.

5

-23.

0

-21.

7 -18.

3

-21.

1

-26.

2

-7.6

-10.

9

-10.

2

-25.

5

-11.

2

-3.7 -2.6

-21.

7

-13.

2

-29.

5

1.2

-1.2

-7.0

-15.

9

-35.0

-30.0

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

5.0

All Multi L/H P/C Broker S&P500

Pe

rce

nt

10-Sep-01 21-Sep-0128-Dec-02 1 Jan - 13 Sep '02

Total Return

Special Factors Influencing Insurers’ Cost of Capital

TerroristsTrial Lawyers

TycoonsTempests

Sept. 11 Industry Loss Estimates($ Billions)

Life$2.7 (7%)

Aviation Liability$3.5 (9%)

Other Liability

$10.0 (25%)

Biz Interruption$11.0 (27%)

Property -WTC 1 & 2$3.5 (9%)

Property - Other

$6.0 (15%)

Aviation Hull$0.5 (1%)

Event Cancellation

$1.0 (2%)

Workers Comp

$2.0 (5%)

Insured Losses Estimate: $40.2BSource: Insurance Information Institute, July 2002

Accounting Problems are Getting Many Companies into Trouble

•Enron fallout much worse than anticipated

•Many companies restating earnings

Average Jury Awards1994 vs. 2000

419759

187 333

1,140 1,185

1,744

1,168

1,727

269698

3,482 3,566

6,817

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

Overall BusinessNegligence

VehicularLiability*

PremisesLiability

MedicalMalpractice

WrongfulDeath

ProductsLiability

($00

0)

1994 2000

Source: Jury Verdict Research; Insurance Information Institute.

Who Will Pay for the US Asbestos Mess?

Source: Tillinghast-Towers Perrin; Insurance Information Institute

US Insurers30%Asbestos

Defendants39%

Foreign Insurers

31%

Estimated Total US Settlements & Expenses = $200 billion

$78 billion $60 billion

$62 billion

U.S. InsuredCatastrophe Losses

$7.5

$2.7$4.7

$22.9

$5.5

$16.9

$8.3 $7.3

$2.6

$10.1$8.3

$4.3

$28.1

0

5

10

15

20

25

30

89 90 91 92 93 94 95 96 97 98 99 00 01

* Includes $20.3B for 9/11 losses reported through 12/31/01. Includes only business and personal property claims, business interruption and auto claims.Source: Property Claims Service, Insurance Information Institute

$ BillionsCAT Losses for 2001 Set a Record

•20 events (lowest since 1969)•1.5 million claims

•9/11: $20.3B = 51,000 claims

Insurance Mergers and Acquisitions

7.1 6.9 8.6 5.0 8.5 12.527.0

40.856.2

41.755.7

6.6

41.5

243 246

171 188149

221

349382

433

109

300

295

468

$0

$20

$40

$60

$80

$100

$120

$140

$160

$180

89 90 91 92 93 94 95 96 97 98 99 00 01 02*

Val

ue o

f M

& A

s ($

Bil

lion

s)

0

100

200

300

400

500

600

Num

ber

of M

& A

s

Value of Deals Number of Deals

Source: Compiled from Conning & Company reports.

1998: 565 deals valued at $165.4 B

Number of M&As was down 39.4% during the first half of 2002 vs. first half 2001.

Value of deals was down 80.8%.

None of the top deals were in the P/C sector

Summary

• Industry not even close to earnings its cost of capital

• Hard market must continue for it to be earned• Lots of new capital seeking high rate of return• Not all companies will be able to meet investor

expectations• Shareholders like to be more impatient (have give

p/c stocks benefit of the doubt)• Increase in M&A activity possible to squeeze

excess capacity from industry, but not anytime soon.

Insurance Information Institute On-Line

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