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1 FI Analytics Binder ALL CONTENT HEREIN IS COPYRIGHT PROTECTED 1

2 Insurance A purchaser of insurance pays a fixed premium in exchange for a promise of compensation in the eent of some specified economic loss. By pooling such risks, insurance intermediaries conert the uncertainty of an indiidual loss into a predictable cost. There are fie groups Life Insurance offer protection against the financial risks of death, disability, health insurance [illness] and annuities. P&C Property insurance coers damage due to specified causes, Casualty coers damage due to accidents and liability insurance coers legal liabilities caused by the policyholder to a third party Personal [auto and homeowners] and commercial [business related] Multiline Reinsurance Insurance Brokers 2

3 Reinsurance Despite pooling, life insurance companies may hae some residual risk and property-casualty hae large risks. Insurance companies buy insurance called reinsurance. The bulk of reinsurance is property-casualty. The reinsurance market is the wholesale insurance market and represents the marginal cost of insurance. 3

4 Reinsurance Reinsurance is insurance between a ceding company and the reinsurer; the reinsurer pays a share of the claims incurred by the ceding company. The reinsurer is paid a "reinsurance premium" by the ceding company, which issues insurance policies to its own policyholders. There are two basic methods of reinsurance: is reinsured. Facultatie Reinsurance, which is negotiated separately for each insurance policy that Treaty Reinsurance, where the ceding company and the reinsurer negotiate and execute a reinsurance contract under which the reinsurer coers the specified share of all the insurance policies issued by the ceding company which come within the scope of that contract. There are two main types of treaty reinsurance, proportional and non-proportional. Under proportional reinsurance, the reinsurer's share of the risk is defined for each separate policy, while under non-proportional reinsurance the reinsurer's liability is based on the aggregate claims incurred by the ceding office. In the past 30 years there has been a major shift from proportional to non-proportional reinsurance for P&C. See AIG page 159 4

5 Reinsurance Risk Factors Reinsurance companies generally hae limited inestment risk. Most reinsurance holding companies hae low financial leerage, usually less than 20% debt to total capital. A reinsurance company cannot hae a run on the bank [liquidity] ceding companies hae no call on the assets of the company. 5

6 Reinsurance Risk Factors Operating risk is relatiely high gien: Cyclical pricing Exposure to anti-selection reinsurance clients can be ery sophisticated and may hae a better understanding of their risks than the reinsurer. Naie new capacity that enters the marker at cyclical peaks often gets burned by sophisticated clients Exposure to aderse loss deelopment from prior year claims Exposure to catastrophe losses in property lines Despite the cyclical nature of the industry operating losses due to inestment losses are rare, and insolencies are infrequent, for the large well established companies. Ongoing trends towards stronger better capitalized companies, the flight to quality will hurt second and third tier players. 6

7 Reinsurance Key Success Factors Market Position: Absolute capital size, and reputation. Underwriting: Critical mass of portfolio to proide diersification and aoid oer-exposure to an eent or a series of eents. Defined maximum aggregate loss exposure appetite, with controls in place to monitor. Underwriting for profit, not market share management of rate cycle/willingness to impose changes in policy terms 7

8 Reinsurance Key Success Factors Capitalization: Ability to absorb falls in inestment asset alues, and any potential underestimation of required claims reseres. Inestment Management: Ability to generate acceptable yields without prejudicing portfolio quality Reinsurance Management (Retrocession): demonstrable limitation of exposure to quality names. 8

9 FSR An insurance policy is a promise, the alue depends on the insurers ability to delier. This depends on the financial strength rating [FSR] of the insurer. The financial strength of an insurance company is a function of: Quality of the assets Insurance pool Capital adequacy Liquidity in assets and liabilities Profitability Stability in premium growth and Risk diersification See page 143 for AIG 9

10 Insurance Industry Analysis The key attributes for analysis [CAMELOTS] include: Product & Business Line profile Distribution Reputation Geographic diersity Management Risk Management Earnings, Cost Structure and Economies of scale. 10

11 Insurance Industry Analysis Product & Business Line profile Is the firm a small insurance company writing one or two high risk products [low rating] or Is its business concentrated in low risk products Also, are growth trends in-line or moderately better than peers? Does the insurer hae a narrow product focus where one product accounts for the majority of profits? Do you understand the composition of the portfolio of inestments? 11

12 Insurance Marketing costs are much higher in the insurance industry than banking because many of the products sold are considered discretionary [primarily life] Insurance is marketed through independent agents exclusie agents direct writing and brokers, who represent the customers. KEY FOR FI ANALYTICS, Who performs the marketing? What products are sold? DAC? 12

13 Insurance Industry Analysis Distribution relationships, diersity and efficiency Does the insurer rely on one channel [high risk] or does the firm hae solid distribution capabilities with below aerage distribution costs Image, reputation and brand strength Is the image and brand undeeloped [high risk] or is it highly recognizable and respected? Geographic diersity Geographic reach is key analytic issue for all Fis Analysis of Management is also a key issue for all FIs 13

14 Industry Analysis Risk Management An understanding of the company's risk management actiities is necessary both to gauge the potential olatility in earnings and to ealuate the adequacy of control procedures used to manage that olatility. Broadly speaking, four areas are ealuated: pricing and underwriting asset/liability management hedging reinsurance or retrocession. See AIG page 151 and comment on the implication 14

15 Industry Analysis Pricing and underwriting Pricing is an estimate of amounts necessary to coer costs PRICING most of which will be incurred and paid in the future. Pricing in the insurance industry begins with the pure premium, representing the present alue of the expected cost of a claim, including the claim and the cost of processing the claim. When a claim is made, the insurer must determine the extent of the loss this is called the loss adjustment. PRICING The actual premium is the pure premium plus administratie expenses. Premium smoothing is the practice of charging a fixed premium when the pure premium is changing. 15

16 Insurance To price premiums properly the insurer needs to know the probability of a loss and the size of the claim. the timing of the claim. Determining the probability of a claim [and size and timing] is much easier in life insurance than liability insurance. Premium writing creates the following journal entry Dr Cash [Inestments-General Account] Cr Unearned Premiums [Reseres/Retained Earnings] 16

17 Insurance Liabilities [float] The time gap between the receipt of premiums and payment of claims Creates float, consists of four components. First, the time interal between the receipt of premium and the occurrence of insured eents. The other three components, which ary in importance across PC lines, relate to the gap between the occurrence of insured eents and the subsequent payments. Some insured losses are discoered many years after the eent (e.g., exposure to asbestos), and in many cases the claim settlement process extends oer seeral years (e.g., medical malpractice litigation). Also, in some cases insurance payments are made oer extended periods of time (e.g., workers compensation). These three components of the float are reflected in the financial statements in the balance of the resere for losses and loss adjustment expenses, which insurers are required to accrue when insured eents occur. Accordingly, the analysis of the float often focuses on unearned premium(first source of float) and, primarily, the loss resere (other three sources of float). 17

18 Life Insurance Products To counteract the long-term fundamental life insurance problems new products hae been deeloped. The shift is away from traditional mortality protection to retirement related. Lifes offer separate accounts that inest in stocks. These separate accounts hae specific liabilities financing dedicated assets as opposed to the general account, where the holders of liabilities hae essentially equal claims to all assets. Key Analytics Issue: What is the size of the separate accounts on the Balance Sheet? Who is taking the risk? 18

19 Life Insurance Products An annuity is a unique financial ehicle designed to help people accumulate money for their retirement and/or turn a lump sum of money into a guaranteed stream of income for life. A Variable Annuity is a contractual agreement in which payments are made to an insurance company; and inestments are subject to market risks and may fluctuate in alue. This product can hae a guaranteed death benefit payments, which is dependent on the claims paying ability of the insurance firm. 19

20 Insurance Company Accounting Traditional fixed annuity and life insurance contracts: typically offered through an insurance enterprise's general account proide for a fixed rate of interest oer some specified period the insurance enterprise bears the inestment risk associated with the inested assets. Traditional ariable annuity [VA], by contrast, offered through an insurance enterprise s separate account proide that all inestment risks associated with the separate account assets are passed through to the contract holder. 20

21 Assets, Find these amounts for AIG at FYE 2016 General Account Assets Reinsurance Receiables Premium Receiables Separate Account Assets Cash Intangibles Other Total 21

22 Insurance ORGANIZATION The mutual insurance concept originated in England in Mutual companies exist solely to sere the insurance needs of their policyholders, not to proide inestment profits to shareholders. Stock insurance companies are owned by inestors who may hae no other connection with the company 5% of US lifes are mutuals but they control almost 46% of all assets. 22

23 Property-Casualty Property-casualty [also called general insurance] began with marine [Middle Ages] and fire insurance. The great fire of London in 1666 led to the creation of the first fire insurance company in In the United States, periodic disasters led to insolencies. Of the 202 insurance firms with exposure to the Chicago fire of 1871, 68 failed, 83 settled only in part and only 51 settled in full. Hartford, Connecticut emerged as an insurance center because its companies fared better than those in New York. 23

24 LIFE INSURANCE The importance of life insurance companies as a financial intermediary peaked in 1950 insurance companies held 21% of all intermediary assets in 1950; they hold less than 10% today The decline is attributable to a shift to pension plans as a replacement for life insurance as the principal ehicle for life-cycle saings. The shift to retirement saings has created a whole new product mix for life insurance companies. Only 70% of American households hae life insurance. 24

25 Life Insurance Products In order to understand insurance, you must understand the products Products hae traditionally been for Protection Accumulation 25

26 Life Insurance Products Term insurance is pure life insurance that a pays a fixed sum in the eent of death. Whole-life insurance combines term insurance with a saings plan. Because whole-life insurance was highly illiquid, the industry created policy loans. Uniersal Life insurance is a flexible life insurance policy that combines the benefits of permanent life insurance protection and cash alues with the conenience of adjustable premiums and payment schedules. Within a Uniersal Life insurance policy, cash alue accumulations grow taxdeferred at competitie interest rates. 26

27 Life Insurance Products Lifes deeloped other retirement-related saings ehicles: single-premium deferred annuity [SPDA] and guaranteed inestment contract [GIC]. The purchaser of the SPDA pays a single premium that accumulates interest at maturity can be cashed in. The GIC guarantees a fixed rate of interest on any deposit for a gien period of time [usually 10 years]. GIC are often marketed to pension plans. 27

28 Insurance [VA] Separate accounts contract holders assumes the inestment risk and the insurance enterprise receies a fee for inestment management. Inestments in separate accounts are marked to market. Unlike a mutual fund, the assets of the separate account are legally owned by the insurance enterprise. A separate account is not a separate legal entity but Must be recognized legally The separate account assets must be insulated from the general account assets The insurer must inest the funds as directed by the contract holder. All inestment performance must be passed to the contract holder. If all four conditions are not met, separate accounts may be shown in the general account 28

29 GMDB In their purest form, ariable annuity policies place all the risk of inestment losses with the indiidual policyholder Encouraged by the spectacular stock-market rallies of the late 1990s, insurers sought to attract new business by adding arious types of guarantees they effectiely took back much of the policyholder's risk This has came back to haunt insurers, following the decline in the S&P 500 and again in 2008/2009. The most costly feature has turned out to be payment of a guaranteed minimum death benefit (GMDB). The GMDB proides a payment to the beneficiary of the deceased, regardless of how much the underlying assets are worth at the time. 29

30 GMDB In the late 1990s, GMDBs changed from mere guarantees that beneficiaries would receie back at least the inested premiums to structures that captured the account's highest alue at a prior anniersary (high-water mark). Insurers were not careful to protect themseles against future downturns either through reinsurance or by purchasing or selling equity options contracts that increase in alue when equity markets fall. 30

31 GMDB Guaranteed minimum death benefit (GMDB) Guaranteed minimum withdrawal benefit (GMWB) gies annuitants the ability to protect their inestments by allowing the annuitant the right to withdraw a maximum percentage of their entire inestment each year until the initial inestment amount has been recouped. Guaranteed minimum accumulation benefit (GMAB), guarantees the minimum amount receied by the annuitant after the accumulation period, protecting the alue of the annuity and the annuitant from market fluctuations. Guaranteed minimum income benefit (GMIB) When an annuity has been annuitized, this specific option guarantees that the annuitant will receie a minimum alue's worth of payments. KEY: Who is assuming the Risk? Is the Insurance Firm hedged? 31

32 Fixed Annuities Fixed annuities entail a risk [to the insurance firm] that the assets in their own inestment portfolios do not support their obligations. Fixed annuity business therefore requires insurers to hold more capital to support the risk than they would for an equialent amount of ariable annuity business. When that capital can not be recruited through earnings, or when an insurer's resources for borrowing are stretched, ratings are affected. 32

33 Fixed Annuities Some insurers hae compensated by seeking the higher yields of high-yield bonds, which has proen a risky path. Alternatiely, they hae inested in bonds with longer maturities also risky Another concern for life insurers is potential repeal of the U.S. estate tax. Heirs of high-net-worth indiiduals who want to leae large inheritances face estate taxes of 55% But bequestors can purchase life insurance that pays for these taxes. Repeal could therefore undermine a key market for the industry. 40% of life insurance is policies oer $2 million, up from 5% in

34 Property-Casualty Underwriting Cycles In addition to the olatility of risk, the property-casualty industry goes through a regular underwriting cycle. High profits lead to new capacity which pushes down premiums and leads to a soft market. In the soft market, profits are low. At some point, a natural disaster[s] leads to unusual losses and the market becomes "hard" and a new cycle begins. During 2011, the US P&C industry suffered more than $9 billion dollar eents Globally, P&C damages were $350 billion in 2011 Insurance and reinsurance shouldered $128 billion These cycles hae gien impetus to self-insurance, with some large companies creating captie insurers to proide coerage. This alternatie market is about 30% of the total. Key Analytics Issue: Where are we in the underwriting cycle? 34

35 Catastrophes Weather-related natural catastrophes Earthquake/ tsunami Man-made disasters Total 35

36 Total P&C losses

37 Assets, Find these amounts for AIG at FYE 2016 Fixed Income Securities Equity Mortgage Loans Policy Loans Alternaties Other Total 37

38 Assets Property-Casualty companies differ from life insurance companies in two ways. First, intermediation is less important than issues of insurance. This is because the policy life is much shorter. Therefore, property-casualty companies hae much smaller reseres. The second difference is that probabilities of loss are not actuarial and the size of claim is often uncertain. Because PC reseres inole greater uncertainty than LH liabilities, PC insurers hold larger equity cushions and generally inest in less risky assets compared to LH insurers. They also reinsure significant portions of their exposure, issue insurance-linked securities, and arrange contingent capital facilities. In addition, because the timing of PC claim payments is less predictable and generally nearer than that of LH benefit payments, PC insurers inest in more liquid and shorter maturity (and therefore less interest rate sensitie) assets, particularly securities. In contrast, LH insurers often inest significant amounts in long term mortgages and risky securities. 38

39 Asset Quality Asset quality has been a prominent factor in seeral downgrades on life insurers in the past 20 years. Inestment losses totaling $500 million contributed to Conseco's default in In December of 2008, Standard Life of Indiana was ordered into what s called rehabilitation. Because annuities are regulated at the state leel, not federal, the Indiana Department of Insurance took the lead role in protecting the policy holders of this troubled carrier. At the time of the rehabilitation, Standard Life of Indiana had close to 40,000 indiiduals that owned annuity contracts. What got Standard Life of Indiana in trouble was a high concentration of sub-prime debt which seerely deteriorated during the 2008 crisis. Remember, Life insurance companies share the same strength as banks-time, but on the other side of the balance sheet. KEY FI Analytics Issue: Analysis of Asset Quality 39

40 20% Non Inestment Grade Debt as a % of Fixed Income Securities 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% AIG Traelers All State Hartford XL Group Progressie Chubb Limited Metlife 40

41 60% Separate Accounts/ Total Assets 50% 40% 30% 20% 10% 0% AIG Traelers All State Hartford XL Group Progressie Chubb Limited Metlife 41

42 Non Inestment Grade Debt as a % of Owners Equity 60% 50% 40% 30% 20% 10% 0% AIG Traelers All State Hartford XL Group Progressie Chubb Limited Metlife 42

43 DAC Another analytical issue for life insurers is the intangible asset known as deferred acquisition costs (DAC) & deferred sales inducement [DSI]. For most life insurance products, companies create this asset on their balance sheets to offset recognition of sales costs. They expense the costs oer seeral years, during which time the policies are expected to generate profits. But on ariable annuity business where falling equity markets lead to a decline in alue of the underlying assets, profitability shrinks, meaning the sales costs must be recognized more quickly. Only costs that are related directly to the successful acquisition of new or renewal insurance contracts can be capitalized. 43

44 DAC As you look at the DAC in the insurance world, look for similar assets in the bank world [MSR] and the inestment management world [12 b1] fees. These costs are capitalized and then expensed the costs oer seeral years during which time the cost is expected to generate profits. If the actual experience of profit differs materially from the assumptions used, then the company must "unlock" its deferred acquisition costs to reflect reality. Key Issue: What is the size of the DAC compared to equity 44

45 Written and Earned Premium Written and Earned Premium Written premium is the actual premium paid by a policyholder for an insurance policy. Earned premium is the premium allocated to the actual exposure to risk arising during a particular period. For example, if an insurance company issues a 12 month policy for a premium of $500 on January 1, 2013, the written premium for 2013 will be $500, and so will the earned premium. But if the same policy is issued on July 1, 2013, the written premium will be $500, but the earned premium will only be $250; the other half of the premium will be allocated to an unearned premium resere which will be credited to 2014 earned premium. This is because half of the premium written will be in respect of the exposure of loss during the first half of

46 Gross and Net Premium Gross premium is the total amount of premium income of an insurer. Net premium is the premium retained by the insurer after it pays for its reinsurance protection. Similarly, gross claims costs are the total claims costs for which the insurer is liable under the policies it issues. Net claims costs take account of reinsurance claims recoeries due to the insurer from its reinsurers. 46

47 Life Insurance Income Statements Premiums Premium Growth is a key FI Issue Net Inestment Income Gains and Losses Loss and loss adjustment expenses Underwriting expenses Acquisition costs General expenses 47

48 Industry Concerns Long Tail insurance Industry oercapacity Premium growth Global Litigation Medical Malpractice Professional and Product Liability Lead paint Pharmaceutical products Various organizations relating to abuse 48

49 Insurance Company Accounting The sale of a life insurance contract initiates a long-term contract whose profitability depends on future persistency, mortality, interest and expense ratio, the income calculated for the current year depends on estimates of the future alues of these rates. Two methods of premium reenue and liability recognition for insurance contract exists short-duration and long-duration. 49

50 Insurance Company Accounting Premiums for short-duration contracts, such as most property contracts, are intended to coer the expected claim costs during a fixed short term period. Premiums are earned as reenue eenly as insurance protection is proided. A liability for claims relating to insured eents that hae occurred but hae not yet been reported to the insurer, should be accrued. 50

51 Insurance Company Accounting Premiums on long-duration contracts, such as life insurance or workers compensation, are recognized when earned. Howeer, as reenue in the early years exceeds expected policy benefits, a liability for costs that are expected to be paid is accrued. This liability is the present alue of estimated future policy benefits less the future net premiums to be collected. 51

52 JE for P&C Contract Write the journal entry for the receipt of PC premium Dr cash Cr unearned premium Write the entry for reenue recognition Dr unearned premium Cr earned premium Write the entry for cost matching Dr Insurance Loss Cr IBNR Loss Reseres At the time claim is filed Dr IBNR resere Cr Claims resere At time claim is adjusted Dr Claim resere Cr Claim payable At time the claim is paid Dr Claim payable Cr cash 52

53 Insurance Liabilities Difference between resere and liability Liability estimate of amounts incurred and due Resere estimates of amounts incurred but not yet due 53

54 Insurance Liabilities Three distinct liabilities exist for insurance companies: Future Policy Benefits is normally the largest liability for life insurance companies. It is comprised of the present alue of estimated future payments to holders of life insurance and annuity products where the timing and amount of payment depends on policyholder mortality, surrender or retirement. Policyholders account balances are amounts receied as payments for interest-sensitie contracts and deferred annuities. Unpaid claims and claim adjustment expenses includes estimates of claims are belieed to hae incurred. Liabilities for the ariable annuity guarantees are included in the liability for future policy benefits, as follows: GMDB and GMIB liabilities are measured by accruing expected payments under these guarantees, with the related changes in the liabilities included in policyholders benefits expense. In contrast, GMAB, GMWB and similar guarantees are considered embedded deriaties that require bifurcation under SFAS No. 133 and are recorded at fair alue. Changes in the fair alue of these deriaties, along with any related fees, are recorded in realized inestment gains (losses). Reiew the separate account disclosure for Blackrock and comment on the liability. 54

55 Insurance Reseres [P&C] Incurred losses reported in financial statements are typically broken out into two pieces, the initial estimate of incurred losses for the most recent exposure period, and changes in the estimate of incurred losses for prior periods. There are also two general approaches to the initial recognition of losses for the current accident year those based on actual claim actiity and those based on accrual of estimated incurred losses based on the leel of earned exposure. 55

56 How reseres are set Reseres are set by line of business. Reseres are established for each indiidual claim and are adjusted as new information becomes known. Lines of business for which loss data (e.g., paid losses and case reseres) emerge (i.e., is reported) oer a long period of time are referred to as long-tail lines of business. Lines of business for which loss data emerge more quickly are referred to as short-tail lines of business. Shortest-tail lines of business are property and auto physical damage. Longest tail lines of business include workers compensation, general liability, and professional liability. For short-tail lines of business, emergence of paid loss and case reseres is credible and likely indicatie of ultimate losses. For long-tail lines of business, emergence of paid losses and case reseres is less credible in the early periods and, accordingly, may not be indicatie of ultimate losses. 56

57 Reseres, claim on cash Find AIG unpaid loss reseres, how it will be paid Liability for Unpaid Losses 57

58 Reseres and Liquidity [pages 170 and 239] Liability for Unpaid Losses begin balance 74,942 Liability for Unpaid Losses ending balance 77,077 58

59 Net Liability US Work Comp 13,069 PY Deelop US Excess 8,749 US Other 8,746 US Financial 6,102 Europe Casualty 5,587 Property/Special 5,913 Consumer Personal 3,454 Legacy 5,967 59

60 Unearned Premium Future Policy Benefits Policyholder contract deposits Balance Description 60

61 Liquidity page 139 [2017] Insurance Inestments Interest Principal Insurance HoldCo How? 61

62 Insurance Company Risks Reinestment risk interest rates fall and reinestment earns less if asset duration is less than liability duration, the mismatch will increase [Life Insurance] Disintermediation risk as rates rise policy loans increase and surrenders increase 62

63 Property Casualty PC firms inest in inestment grade, fixed maturity securities The firm takes large risk in the liability side of the balance sheet The insurer with a long-tailed business can tolerate a higher combined ratio WHY? Combined ratio measures claims losses and operating expenses against premiums earned. 63

64 RBC Statutory capital and resere requirements are prescribed by the applicable insurance regulators. Insurance regulators hae established regulations that proide minimum capitalization requirements based on risk-based capital (RBC) formulas for both life and property and casualty companies. The RBC formula for life companies establishes capital requirements relating to insurance, business, asset and interest rate risks, including equity, interest rate and expense recoery risks associated with ariable annuities that contain death benefits or certain liing benefits. The RBC formula for property and casualty companies relates to underwriting, asset, credit and off-balance sheet risks. 64

65 Statutory Capital List of principal GAAP s. statutory differences Deferred Acquisition Costs (DAC) non-admitted assets Deferred tax asset Acquisition accounting, including goodwill Losses & Ceded Reinsurance AFS [OCI] not included in statutory capital The difference between the amortized cost and fair alue of fixed maturity and other inestments is recorded under U.S. GAAP, while statutory accounting only records certain securities at fair alue, such as equity securities and certain lower rated bonds. 65

66 Statutory Capital Book Equity Statutory Capital Min Required Statutory Capital Ratio 66

67 Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from a sponsor to inestors. They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake. For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then it might wish to pass some of this risk on so that it can remain solent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat bond, which would pass the risk on to inestors. In consultation with an inestment bank, it would create a special purpose entity that would issue the cat bond. Inestors would buy the bond, which might pay them a coupon of LIBOR plus a spread, generally (but not always) between 3 and 20%. If no hurricane hit Florida, then the inestors would make a positie return on their inestment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially contributed by the inestors would be transferred to the sponsor to pay its claims to policyholders. The bond would technically be in default and be a loss to inestors.[2] Catastrophe bonds emerged from a need by insurance companies to alleiate some of the risks they would face if a major catastrophe occurred, which would incur damages that they could not coer by the premiums, and returns from inestments using the premiums, that they receied.[citation needed] An insurance company issues bonds through an inestment bank, which are then sold to inestors. These bonds are inherently risky, generally BB,[1] and usually hae maturities less than 3 years. If no catastrophe occurred, the insurance company would pay a coupon to the inestors. On the contrary, if a catastrophe did occur, then the principal would be forgien and the insurance company would use this money to pay their claim-holders. Inestors include hedge funds, catastrophe-oriented funds, and asset managers. They are often structured as floating-rate bonds whose principal is lost if specified trigger conditions are met. If triggered the principal is paid to the sponsor. The triggers are linked to major natural catastrophes. Catastrophe bonds are typically used by insurers as an alternatie to traditional catastrophe reinsurance. 67

68 Balance Sheets, do these inestments make sense? Assets Securities lent RMBS CMBS Priate Placements $60 billion $470 billion $180 billion $805 billion 68

69 Growth in Net Written Premium, % 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% NWP Growth 69

70 Reenue-Global underwriting Inestment capital gains 70

71 Metrics Low Medium High NWP/Surplus 100% Change in NWP >3% less than 10% 0% Decline or grow>10% Underwriting Expense/NWP <20% 30% >40% Combined Ratio <97% 100% >103% ROE >12% 7% negatie EBIT coerage >12X 6X 0X Inestment Yield Noticeably Aboe peers Liquid Assets/Liquid Lliabilities >4X 1X.5X High Risk Assets/Equity <25% 100% 300% Reinsurance Recoerables/Equity <35% 100% 200% [Goodwill + Intangibles]/Equity <20% 50% 75% Total Financial Leerage <15% 45% 65% 71

72 Key Profitability Ratio Combined Ratio This figure measures claims losses and operating expenses against premiums earned. The lower the figure the better. The combined ratio is the total of estimated claims expenses for a period plus oerhead expressed as a percentage of earned premiums. A ratio below 100 percent represents a measure of profitability and the efficiency of an insurance firms underwriting efficiency. Ratios aboe 100 percent denote a failure to earn sufficient premiums to coer expected claims. High ratios can usually occur either because of underpricing and/or because of unexpected high claims. Also remember that the combined ratio will be different for the Life s. P&C industry. 72

73 P/C Insurance Combined Ratio, Combined Ratios 1970s: s: s: s: Combined Ratio Combined Ratio 73

74 Industry Analysis Insurance Company Liquidity is ealuated in relation to potential demands on the company's liquidity. The credit and market risk of securities in the portfolio is a key indicator of liquidity. The insurer's need for portfolio liquidity is ealuated in relation to the degree to which implicit options exist in the insurer's liabilities; and the extent to which an insurer is exposed to catastrophe risk. 74

75 Life Insurance Earnings Earnings for life insurance companies are drien by four pricing assumptions: Inestment returns Mortality and Morbidity Lapses Oerhead Costs 75

76 Life Insurance Earnings Lapses A key issue is persistency, or how business will stay on the books The other side of persistency is lapses High persistency is good for life insurance 76

77 Life Insurance Earnings Mortality and Morbidity Pure risk is the protection proided by life insurance Inestment returns 25% of income is from inestment returns 77

78 Insurance Risk Factors Risk Factors Life insurance liabilities, with the exception of surrenders, are generally highly predictable. little question of resere adequacy. Retirement products are growing in complexity increasing need for strong risk management. Risk focus shifting from policyholders dying too young to the risk of liing too long. Assets generally present the bulk of the risk e.g., in the U.S. mortgages and real estate, non inestment grade debt Oerall quality of life insurance company assets should be high. Demand for property and casualty insurance is ongoing goernments often require auto liability insurance, lenders require that collateral be insured, many commercial contracts require liability insurance and bonds. Operating risk for P&C is relatiely high gien: Cyclical pricing in commercial lines insurance Exposure to aderse loss deelopment from prior year claims Political pressures in setting premium rates in personal insurance Workers compensation insurance suffers from similar pressures to increase benefits, while limiting premium increases to employers Exposure to catastrophe losses in property lines 78

79 Insurance Risk Factors Limited financial leerage typically about 20% debt-to-capital ratios Life policies and annuities can be surrendered, but tend to be fairly stable. Capitalization: Ability to absorb fall in inestment asset alues Market Position and any potential underestimation of required benefit reseres. Absolute size Reputation to attract quality business following market s flight to quality. Distribution: Exclusie distribution system with sufficient sales productiity to coer fixed costs or multiple distribution channels that limit the dependency upon any single distributor or groups of distributors. Negatie distribution factors can include market conduct issues such as improper sales practices, 79

80 Key Success Factors Profitability: Management of fixed and ariable costs Inestment Management: Ability to generate competitie yields without prejudicing portfolio quality asset allocation credit quality liquidity duration matching A property and casualty insurer cannot hae a run on the bank policyholders hae no call on the assets of the company. Despite the cyclical nature of the industry operating losses due to inestment returns are rare, and insolencies are ery infrequent especially for large well established companies. 80

81 P&C Insurance Key Success Factors Underwriting: Critical mass of portfolio to proide diersification aoid oer-exposure to an eent or a series of eents. Defined maximum aggregate loss exposure appetite, with controls in place to monitor. Underwriting for profit, not market share management of the rate cycle willingness to impose changes in policy terms. Reinsurance Management: demonstrable limitation of exposure to quality names. 81

82 Notching Notching is a technique designed to rate arious debt issues of an issuer Issues may hae a different rating than the issuer Subordination Contractual and Structural subordination may hae an impact 82

83 Insurance Notching Holding Company * Senior Debt (3 notches down from operating company FSR) Operating Company ** Insurance operating company financial strength rating (FSR) * Insurance operating company senior debt (one notch down from operating company FSR) ** Notching typically starts with the operating company FSR. Other ratings can be implied from here. 83

84 BAC 22,500 20,000 17,500 15,000 12,500 10,000 7,500 5,000 2, ,500-5, Net Income (loss) Diidends Treasury Stock Purchases 84

85 JPM 30,000 25,000 20,000 15,000 10,000 5, Net Income (Loss) Treasury Stock purchase Common Stock Diidends (total) 85

86 Citi Net Income (Loss) Common Stock Diidends (total) Treasury Stock purchase 30,000 25,000 20,000 15,000 10,000 5, ,000-10,000-15,000-20,000-25,000-30,

87 BNY 3,500 3,000 2,500 2,000 1,500 1, ,000-1, Net Income (Loss) Treasury Stock purchase Common Stock Diidends (total) 87

88 MS 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, Net Income (Loss) Treasury Stock purchase Common Stock Diidends (total) 88

89 PNC 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, Net Income (Loss) Common Stock Diidends (total) Treasury Stock purchase 89

90 Progressie 1,800 1,600 1,400 1,200 1, Net Income (Loss) Common Stock Diidends (total) Treasury Stock purchase 90

91 AIG 40,000 20, ,000-40,000-60,000-80, Net Income (Loss) Treasury Stock purchase Common Stock Diidends (total) 91

92 Hartford 4,000 3,000 2,000 1, ,000-2,000-3, Net Income (Loss) Treasury Stock purchase Common Stock Diidends (total) 92

93 Capital One 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, Net Income (Loss) Common Stock Diidends (total) Treasury Stock purchase 93

94 WFC 25,000 20,000 15,000 10,000 5, Net Income (Loss) Treasury Stock purchase Common Stock Diidends (total) 94

95 USB 7,000 6,000 5,000 4,000 3,000 2,000 1, Net Income (Loss) Treasury Stock purchase Common Stock Diidends (total) 95

96 GS NI Di Shares 96