by Joan Lamm-Tennant, PhD

Overview
• Macro-Economic View of Capital Flows
• “Accounting – Based” ROE Trends
• If it is not ROE, then what?
• Risk-Adjusted Return on Economic Capital
• Economic Value Added
• Float

Macro Market View
Basic Laws of Supply and Demand
Price
PV E(L) + Exp
P
Q
S
D
Quantity
• The demand curve is downward sloping suggesting that price must fall to increase demand for risk transfer
• In equilibrium price and demand intersect to determine price
•
At the appropriate level of capacity, price is the “fair” price

Macro Market View
Basic Laws of Supply and Demand
Price
PV E(L) + Exp
S*
P*
P
Decline in
Net Worth
• In the short run, net worth may be
“shocked” by an extreme event
• The “shock” causes a shift (decline) in capacity
• Prices increases and new capital may flow in
Q*
D
Quantity

Macro Market View
Basic Laws of Supply and Demand
Price
PV E(L) + Exp
P*
P
P
Q*
D
D*
Quantity
• Behaviors, not only the financials, may change
• The “shock” may causes an increase in risk aversion therefore an increase in demand
• An increase in demand will exacerbate the price increase

Macro Market View
Basic Laws of Supply and Demand
Price
PV E(L) + Exp
P*
P
P
Q*
D
D*
Quantity
• Higher prices for risk will eventually restore profitability and replenish capital
• Equilibrium is restored at a price of “P”
• The cycle continues to repeat itself and, if fact, may become instantaneous
• Any interference to offset shocks to capital in the short run could be costly in the long run
• Insurance markets are healthy and dynamic!!!

Quarterly Premium Growth Rates
20%
15%
14.2%
16.6%
15.6%
12.8%
10%
5%
6.2%
10.2%
9.3%
8.4%
8.9%
4.5% 4.7%
3.9%
0%
Q4 2001 Q1 2002 Q2 2002 Q3 2002 Q4 2002 Q1 2003 Q2 2003 Q3 2003 Q4 2003 Q1 2004 Q2 2004 Q3 2004
Source: ISO
Rate Increases
40%
30%
20%
10%
14 %
11%
13 %
16 %
19 %
2 2 %
2 5 %
3 1%3 1%
2 8 %
3 0 %
3 2 %
3 3 %
2 8 %
2 9 %
3 0 %
3 2 %
3 0 %
2 7 %
2 5 %
2 8 %
2 2 %
18 %18 %
17 %
16 %
12 %12 %
10 %
12 %
11%
9 % 9 % 9 %
7 % 7 %
5 %
4 % 4 %
2 % 2 % 2 %
1%
0%
Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul - 04 Oct-04 Jan-05
Source: MarketScout

Following 9/11 New Capital Entered The Market
Raising by Property / Casualty Insurers Since 9/11 Totals $53.2B
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
$0
$25.4 Billion
$4,872
$20,492
14 Pending
40 Completed
2001
Completed
*As of September 13, 2002.
Source: Morgan Stanley, Insurance Information Institute.
$27.9 Billion
Pending
$16,437
$11,442
2002*
38 Pending
33 Completed

2004 Capital Raising Activity
• The US and Bermuda-based property-casualty insurers raised $12.2 billion of capital directly in the capital markets
• Of the $12.2 billion raised, 60.2% was traditional debt, 26.4% was equity and the remainder was equity-linked and preferred securities

Net Income (AT)
1991 to 2004
$50,000
$40,000
$30,000
$20,000
$14,178
$10,000
$5,840
$19,316
$10,870
$20,598
$24,404
$36,819
$30,773
$21,865
$20,559
$0
$9,200
$31,200
38,700
-$10,000 -$6,970
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
*Sources: A.M. Best, ISO, Insurance Information Institute.
(amounts in millions)

Industry Surplus
$400
$350
$300
$250
$200
$150
$100
$50
$0
1975 1978 1981
Surplus
June 30, 1999
1984
$341
September 30, 2002 $273
September 30, 2004 $369
December 31, 2004 $394
1987 1990 1993 1996 1999 2002 Q3 2004
Source: A.M. Best and ISO, 2004 Through Third Quarter
(amounts in billions)

Overview
• Macro-Economic View of Capital Flows
• “Accounting – Based” ROE Trends
• If it is not ROE, then what?
• Risk-Adjusted Return on Economic Capital
• Economic Value Added
• Float

Historical Statutory ROE by Decade
Period
1970s
1980s
1990s
2000 -2004
P/C ROE
11.2%
11.5%
8.4%
5.3%
Combined
Ratio
100.3
109.2
107.8
106.3
10 Year
T-Yield
7,5%
10.6%
6.7%
4.8%
Source: A.M. Best Review/Preview

Return on “Statutory” Equity vs. Cost of Equity
U.S. Property / Casualty Industry (1983 to 2004)
20%
1983
– 2003
Cost of Equity 11.5%
Accounting ROE 6.5%
15%
2004
Cost of Equity
Accounting ROE
Difference
8.9%
10.5%
1.6%
10%
5%
Return on Equity
Cost of Capital
0%
-5%
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
Source: A.M. Best; Conning Forecast; CF&S practice; McKinsey

Overview
• Macro-Economic View of Capital Flows
• “Accounting – Based” ROE Trends
• If it is not ROE, then what?
• Risk-Adjusted Return on Economic Capital
• Economic Value Added
• Float

Risk-Adjusted Performance Metrics
• Return on risk-adjusted capital (RORAC) vs. risk-adjusted return on capital
(RAROC)
– Dividing expected net income by “economic” capital is technically RORAC, nevertheless the industry convention is to call it RAROC
• Economic value added (EVA)
– Difference between the return on “economic” capital and the cost of capital, where cost of capital is reflective of both capital structure and risk
• Float and Cost of Float
–
Arises because premiums are received before losses are paid
– Float may be estimated as
• (Total Invested Assets – Capital – Unassigned Surplus)
–
Since premiums tend not to cover losses, insurers run an underwriting loss which is the cost of float
•
Cost of float may be negative when the insurer runs an underwriting profit

RAROC and EVA Require A Measure of
Economic Capital
• Economic capital is frequently referred to risk capital
– The amount of capital necessary to cover the risk in our business given our risk tolerance
Profit
Mean
Risk Tolerance
Acceptable VaR
Perhaps
Associated
Rating
-50%
-30% 0% +10%
Economic Capital
+40%

Float and Cost of Float
U.S. Property and Casualty Industry
$650,000
$600,000
$550,000
$500,000
$450,000
Float
Cost of Float
4.9%
3.7%
$400,000
$350,000
$300,000
$250,000
$200,000
1998 1999
Source: AM Best Aggregates and Averages
6.5%
2000
10.3%
2001
5.6%
2002
0.8%
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
2003

Float and Cost of Float
U.S. Commercial Lines Industry
$360,000
$340,000
$320,000
$300,000
$280,000
3.6%
Float
Cost of Float
4.3% 4.2%
8.2%
$260,000
$240,000
$220,000
$200,000
1998 1999 2000 2001
Source: AM Best Aggregates and Averages, Commercial Lines Segment
4.9%
2002
1.8%
10%
8%
6%
4%
2%
0%
-2%
-4%
2003

Float and Cost of Float
U.S. Personal Lines Industry
$250,000
$225,000
$200,000
$175,000
$150,000 4.1%
Float
Cost of Float
5.4%
9.4%
11.9%
$125,000
$100,000
$75,000
$50,000
1998 1999 2000
Source: AM Best Aggregates and Averages, Personal Lines Segment
2001
5.8%
2002
-0.7%
4%
2%
0%
-2%
-4%
14%
12%
10%
8%
6%
2003

Industry Comparative Cost of Float
14%
12%
10%
8%
U.S. Property / Casualty Industry
Commercial Lines
Personal Lines
6%
4%
2%
0%
-2%
1998 1999
Source: AM Best Aggregates and Averages
2000 2001 2002 2003

The industry's ability to attract capital given historically low ROEs leads us to question:
Is ROE the right measure for the insurance industry's performance?
Perhaps consider
Risk Adjusted Return on Economic Capital
Economic Value Added
Float

Thank You