B / ISSUE FOURTEEN / SPRING 2008 / BENFIELD RESEARCH

Transcription

1 B / ISSUE FOURTEEN / SPRING 2008 / BENFIELD RESEARCH In this edition of B we take a look at the innovative techniques for the assessment and management of risk exposures provided by EuroTempest and ExposureView. We review underwriters response to falling reinsurance prices which could be described as leaving business on the table. The global credit crisis continues to loom large, but our analysis suggests that, so far, contagion of the reinsurance sector is being contained. Looking ahead, we have reviewed the 4th Quantitative Impact Study (QIS 4) which is currently underway and represents a milestone for the implementation of Solvency II in B14

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3 EuroTempest: Quantitative Weather Impact Analysis The global risk management industry is particularly affected by windstorm events in Europe. Swiss Re figures indicate that between 1970 and 2007 severe windstorms were responsible for 75 80% of all European insured losses from natural or man-made disasters. Separately, a 2005 study by ABN AMRO, which included losses from non-catastrophic weather events, concluded over 30% of total industry production in Denmark and the Netherlands is susceptible to loss from adverse weather. Other high-risk countries, i.e. those where 25 30% of total production is vulnerable to adverse weather included the UK, Spain, Italy, Sweden and Norway On 1 March 2008 Windstorm Emma struck Germany, Austria, the Czech Republic, Poland and Romania, having first caused some minor damage in the UK, Belgium and the Netherlands. It was the most destructive European windstorm of the winter season and led to 13 deaths. The total cost to insurers, could reach EUR1bn or more in claims. Despite its status as the most damaging storm of the season Emma had a relatively low impact when compared against the history of European windstorms, even of recent years. In fact, total insured losses from the European winter windstorms of are not likely to differ greatly from those of a typical season. By contrast, in January 2007, when windstorm Kyrill struck large areas of northern, central and eastern Europe it left 54 people dead or missing and estimated insurance losses for this one storm alone reached over USD6bn. 1 In January 2005, windstorm Erwin, which mainly affected the UK and Scandinavia, left 18 people dead or missing and contributed nearly USD2bn to a total seasonal insurance loss from windstorms of nearly USD3bn. 2 The European winter windstorm season was, as mentioned, relatively benign and the initial months were very quiet. Set against this backdrop the stronger windstorms, notably Emma and Johanna (which affected mainly the UK and northern France on 10 March), generated a great deal of interest both in the media and within the insurance and reinsurance industry. Though the media have been criticised at times this season for being alarmist, particularly with respect to Johanna, it is important that the general public are as informed as possible of the potential risks posed by forecast weather. Likewise, it is critical to businesses that they understand their exposure to expected weather events. However, the information required by businesses from a forecast is very different from that needed to maximise public safety and awareness. Given industry s susceptibility to adverse weather events and the wide range of potential impacts, many businesses require much more detailed and focused information than can be gleaned from a generic weather forecast. The innovative weather risk management service, EuroTempest, is able to provide not only analyses of the anticipated weather but, more importantly, quantitative probabilistic assessments of the potential impact of the weather forecast on a specific business. Throughout the winter windstorm season primary insurers using EuroTempest s services were provided with accurate quantitative forecasts of both the number of claims and the total insured loss that they could expect from each expected windstorm up to five days before the storm struck. Reinsurers using the service had access to alerts warning them of severe winds and, soon after each event, an assessment of Europe wide peak gust wind speeds at 2-digit postcode level based on observations from approximately 1,700 weather observation stations as shown in Figure 2. The high level information provided by EuroTempest enables much more informed decision making across all levels of a business than can be achieved from a generic weather forecast. EuroTempest allows all levels of the claims management process to be more effectively managed, it enhances internal communication and therefore external as well. Shareholder confidence can be boosted, and more active capital management can also be facilitated. Thus EuroTempest can assist in minimising the impact of severe windstorm events on a business, its stakeholders and its customers. EuroTempest works closely with businesses to define and deliver precisely the information that will fit their requirements and integrate seamlessly with their established decision making processes. They can provide both windstorm warnings and assessments of the impact of an event once it has happened. The unique technology developed by EuroTempest is not only applicable to the insurance and reinsurance industries. EuroTempest is also able to provide information to a range of services and businesses that have exposure to wind risk e.g. distribution, emergency services, energy, telecoms, utilities, leisure and retail. Seasonal outlooks for the winter windstorm season will be available in the summer as the climatic indicators for the winter only manifest between May and July. As things stand there is no reason to believe that one average season will be followed by another was extremely quiet only to be followed the next season by windstorm Kyrill the most damaging European windstorm for more than five years. And though there have been a number of notable damaging events since the turn of the millennium it is now nearly ten years since the catastrophic serial events, such as Lothar (USD7bn) and Martin (USD3bn), that characterized the winters of the late 1990s. 3 FIGURE 1 EUROTEMPEST FORECAST FOOTPRINT Peak gust wind speeds for windstorm Johanna March 2008 FIGURE 2 EUROTEMPEST REPRESENTATIVE PEAK GUST SPEEDS Wind speed by 2-digit postcode for windstorm Emma 29 February to 1 March 2008 based on observations from ~1,700 weather stations For more information on EuroTempest s range of services visit or enquiries@eurotempest.com. FRANK ROBERTS EUROTEMPEST 1 Swiss Re, sigma 1/ Swiss Re, sigma, 2/ Ibid.

4 ExposureView: Creating a Clearer Picture for Underwriters A sophisticated exposure management tool which uses geographic information systems to create a physical picture of risks and their accumulations, ExposureView has been in use by US insurers since It is a system which enables them to visualise the potential impact of catastrophe events such as wind, terrorism or wildfire on their portfolios both during and after an event. Originally developed to provide underwriters with real time updates on wildfires, the software has now become a valued underwriting tool and can be used with a wide range of data including personal and commercial property, auto business, workers compensation risks and offshore platforms. Key to ExposureView s success is that it not only enables underwriters to plot and view all individual risks whether by street address or a specific latitude/longitude but also overlays such information with hazard shapes or polygons that outline the boundaries of areas impacted by events. Equally important, from an underwriting perspective, the system also enables insurers both to view specific risks and to see how potential new risks would fit with the overall balance and underwriting limitation of existing portfolios. For instance, where necessary, radius-based exclusion zones can be plotted in conjunction with specific risks, to ensure accumulation limitations are maintained, e.g. when underwriting terrorism risks. The map-based output from the system has also been highly valuable to claims teams for use in deploying adjusters and managing and analysing claims. One of the advantages of ExposureView, in addition to the system s mapping capabilities, is that it enables underwriters, at the touch of a button, to retrieve their data in spreadsheet format. This facility provides instant access to the necessary information to manage, analyse and evaluate claims, enabling underwriters to produce swift exposure evaluations in the wake of a major event. In order to maximise the accuracy of their analysis using ExposureView, underwriters can take a highly selective approach to retrieving data, far beyond class of business. Examples include the ability to isolate information on beachfront properties or those that are of a wooden construction type. The system s current library of information includes a wide range of data including maps of hurricane wind speeds from past events, footprints of past windstorm events, data on various US earthquake zones and also a terrorism target database. In addition, it can also be used to visualise the impact of Lloyd s Realistic Disaster Scenarios. Whilst the system s Benfield-sourced library of hazard shapes is currently mainly focused on US exposures, the system has mapping availability for 63 countries. Users can tailor the system by incorporating their own libraries of hazard shapes. Thus, the system has applications as a base from which insurers can build highly tailored exposure modelling tools, which reflect the particular geographical priorities of their own businesses. Following its success with US underwriters, ExposureView is now being made available to a more international audience. As the first stage in this process, Benfield has established a London-based hub for the product which is working with a number of London Market companies on initiatives to enhance the depth of their US underwriting data. A further development of the system for 2008 is the addition of Tropical Storm Tracker s real-time forecasts out to five days lead on all active tropical cyclone systems worldwide. The addition of Storm Tracker, one of the services of the Benfield-sponsored Tropical Storm Risk Group (TSR), will enable users to assess more accurately the potential threat to their portfolios of tropical cyclones, so better placing them to pre-plan such measures as where to deploy loss adjusters. Founded in 2000, TSR offers a leading resource for forecasting the risk from tropical storms worldwide. 1 The TSR scientific grouping brings together climate physicists, meteorologists and statisticians at University College London and the Met Office. Available within 10 minutes of a public forecast advisory being issued, the TSR forecast polygons to be incorporated into the system include: Surface Wind Probabilities which map the likelihood, over the next 5 days, of being struck by one-minute sustained hurricane (74+mph) or by tropical storm strength (39+mph) winds; Forecast Wind Swathes which give, out to 120 hours lead, the most likely forecast wind swathe; Surface Wind History which maps the regions affected by a tropical cyclone's one-minute sustained hurricane and tropical storm strength winds; and Advanced Surface Wind History which shows the regions affected by one-minute sustained winds of tropical storm, cat 1, cat 2, cat 3, cat 4 and cat 5 strengths and also maps regions affected by gusts, for up to three seconds, of between 40 mph and 190 mph at 10 mph intervals. While catastrophic events by their nature remain unpredictable, greater sophistication in modelling and analysing their impact is a key to ever more effective risk management for the insurance and reinsurance industry. JULIANNE JESSUP BENFIELD RESEARCH 1 The TSR consortium is co-sponsored by Benfield, Royal & Sun Alliance and Crawford & Company. For more information, visit

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7 Subprime: Contagion Contained Casualties of the subprime and credit crisis continue to emerge and the insurance sector has not been immune. While greatest damage has been done to the monoline financial guarantee insurers, a number of reinsurers have reported write-downs on their investments. Claims notifications have increased although, to date, many have been accommodated within existing reserves. As defaults snowball in the US residential mortgage market the securitisation of these loans has highlighted the issue of systemic risk across global financial markets. Insurers and reinsurers have exposure both as investors and as underwriters of professional indemnity and other business lines. Rating agencies have downgraded mortgage-backed and similar securities reflecting the impairment of underlying collateral. In the face of very limited investor appetite, new issuance of mortgage-backed securities has slumped, as shown in Figure 3. The trend has continued in 2008 with a year on year fall of 80% to USD45bn in the first quarter. The uncertainty surrounding banks exposure to subprime debt has created liquidity problems as banks have been reluctant to lend to each other. Credit to corporate borrowers has become more restricted and expensive. Bear Stearns and Northern Rock are the most high profile casualties and a number of hedge funds have also failed. Similarly, the secondary market in such investments has virtually dried up, making it nearly impossible to establish a market value for investment holdings. Banks and others have therefore faced a problem when accounting rules require assets to be marked to market. Prominent write-downs include UBS (USD37bn), Merrill Lynch (USD23bn) and Citigroup (USD20bn). 1 The subprime crisis has prompted the central banks to inject billions of dollars into the money markets to improve liquidity. The US Fed Funds interest rate has almost halved from 5.25% in September 2007 to the current level of 2.25% as shown in Figure 4. The knock-on effect of lower interest rates on investment income will be a feature of 2008 earnings. The commentary below concentrates on the impact described in 2007 earnings statements and can be viewed from the perspective of both the asset and liability side of the balance sheet. ASSETS (Re)insurers have historically adopted a conservative investment strategy, restricting investments to traditional asset classes such as fixed income, equities and property (real estate). US companies mostly hold the vast majority of their investments in fixed income, while European companies have historically had a higher allocation to equities and real estate. In recent years, many companies have increased their investment risk appetite in response to falling interest rates, in order to generate higher yields. Allocations to corporate bonds have been increased and investment classes have been widened to include assets such as private equity and so-called alternative investments, such as hedge funds. Asset-backed securities (ABSs) have also become more commonly held investments. ABSs have included mortgage-backed (both commercial and residential) and collateralised debt obligations (CDOs). For the most part, exposures to subprime on the asset side of the balance sheet of conventional reinsurers are negligible. Figure 5 shows the subprime exposed investments as a percentage of 2007 shareholder funds of selected European and Bermudian (re)insurers. It includes only those groups that have quantified their investments in this asset class. Holdings of asset-backed and mortgage-backed securities are very small and mostly in the AAA or super-senior tranches. XL Capital, which has so far reported the greatest exposure of nearly USD2.1bn or 20.7% of shareholder funds (SHF) and approximately 5% of its total invested assets. Most of this (93%) was fairly equally split between first lien mortgages and Alt-A mortgages, with the balance in second lien mortgages and ABS CDOs. Regarding the latter two classes, CIO Sarah Street commented These holdings have been particularly impacted by deterioration in the underlying collateral and as such we have recognised the unrealised losses in their entirety. 2 As of 31 December 2007, USD233mn or 60% of recognised losses were associated with these two asset classes. 3 Max Capital s exposure of USD54mn to subprime bonds and USD49mn of Alt-A exposed securities represented approximately 6.5% of SHF. The company did not expect any losses from these investments. Axis disclosed exposure of USD211mn or 4.1% of SHF to subprime and Alt-A mortgages through investments but indicated that the majority were rated AAA or had government agency backing. FIGURE 3 US ABS ISSUANCE FIGURE 4 FED FUNDS RATE FIGURE 5 SUB PRIME ASSET EXPOSURE 250% 200% 150% 100% 50% 0% Mar 06 Jun 06 Mar 08 Dec 07 Sep 07 Jun 07 Mar 07 Dec 06 Sep % 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Mar 08 Feb 08 Jan 08 Dec 07 Nov 07 Oct 07 Sep 07 Aug 07 Jul 07 Jun 07 May 07 Apr 07 Mar 07 Feb 07 Jan 07 % of 2007 shareholder funds 25% 20% 15% 10% 5% 0% Swiss Re XL ACE Arch Validus Everest Munich Re SCOR Platinum Hannover Re Axis Beazley Montpelier Amlin Max Capital AWAC Endurance Hiscox Catlin Paris Re Source: Source: Source: Benfield Research ANGELA COAD BENFIELD RESEARCH

8 FIGURE 6 INVESTMENTS IN FINANCIAL GUARANTORS Carrying value as at Writedown/Realised loss 31 December 2007 Company Investment (USDmn) (USDmn) ACE Assured Guaranty PartnerRe Channel Re 98 0 RenaissanceRe Channel Re XL Security Capital Assurance and Primus 770* 0 * Includes an estimate of USD100mn writedown on investment in Primus Guaranty, given disclosure regarding fair value of Primus stock at approximately USD105mn as at 31 December 2007 Source: Benfield Research, company announcements Subprime exposure on the asset side mainly relates to realised or unrealised losses from the decline in market value of these investments. Accounting rules (including US GAAP and IFRS) require investments to be marked to market; value impairments which are deemed other than temporary have to be charged to the income statement. In some cases, companies have been forced to take a conservative approach, where the absence of a liquid market has made it difficult to establish a market value. AIG, which suffered an USD11.1bn pre-tax (USD7.2bn after tax) charge on 2007 results, emphasised the difficulties of this approach. These losses emerged from the net unrealized market valuation loss related to the AIG Financial Products Corp. (AIGFP) super senior credit default swap portfolio but AIG stressed such losses are not indicative of the losses AIGFP may realise over time. The group explained that under the terms of these credit derivatives, losses to AIG would result from the credit impairment of any bonds AIG would acquire in satisfying its swap obligations. Based upon the most current analyses, AIG declared that any credit impairment losses realised over time by AIGFP will not be material to AIG s consolidated financial condition. Moreover, except to the extent of any such realised credit impairment losses, AIG expects AIGFP s unrealised market valuation losses to reverse over the remaining life of the super senior credit default swap portfolio. 4 XL suffered the largest write-downs for investments in affiliated entities which participated in business severely impacted by the subprime fallout. Security Capital Assurance (SCA) was written down to a zero value (as at 31 December 2007) from a value of USD669.8mn (as at 30 September 2007) and Primus Guaranty was also written down to a value of zero. Scenarios of zero had seemed until recently very far-fetched. 5 The extent of distress in the credit markets together with the pace of change has taken many by surprise. XL is potentially exposed to further losses from SCA as it guarantees certain subsidiaries of SCA in particular circumstances. These would occur if first, the underlying guaranteed obligation defaults on payments of interest or principal and secondly, the relevant SCA subsidiary (either XL Capital Assurance or XL Financial Assurance) fails to meet its obligations under the applicable reinsurance or guarantee. The guarantee applies only to business which was written prior to the IPO of SCA (August 2006) and concerns approximately USD75.2bn of net par value outstanding. CEO Brian O Hara commented Given that the large majority of topical exposures are post IPO, and that SCA s claimed resources were nearly USD3.5bn as of September 30th, 2007, we continue to consider the probability of having to make any payments under the guarantee remote. 6 Three class action suits have been filed in the US District Court against XL Insurance Ltd by shareholders who bought SCA shares in a secondary offering of stock (June 2007) and shortly before. The shareholders allege that the plaintiffs failed to reveal that SCA was materially exposed to extreme risky securities relating to subprime real estate mortgages. XL intends to vigorously defend the claims. 7 Partner Re and RenaissanceRe, which owned 20% and 32.7% of Channel Re respectively, both wrote down the value of their investments in the company to zero. They do not provide any guarantees to Channel Re and are therefore limited in exposure to the extent of their written down investments. ACE, which owns approximately 24% of Assured Guaranty, wrote down the value of its investment by USD73mn to USD392mn as at 31 December The write-down represented ACE s share of the USD300mn derivatives mark-to-market losses announced by Assured Guaranty. Similarly to PartnerRe and RenaissanceRe, ACE does not guarantee any of Assured Guaranty s business. LIABILITIES (Re)insurers exposure on the liability side arises from: Financial guarantors facing losses related to impairment of the underlying collateral in mortgage-backed securities; and Liability claims (Directors and Officers (D&O) and Errors and Omissions (E&O)) against investment managers and others, from clients who were inappropriately sold investments with exposure to subprime. The exposure of conventional reinsurers to these risks appears to be minimal. Most are not engaged in financial guarantee reinsurance: losses here are likely to impact only the specialist financial guarantee insurers. XL Capital, as described above, is an exception as it reinsures SCA. Swiss Re has proved another exception because of its activities in credit derivatives, but this seems to be an isolated case as other reinsurers do not appear to be active in this sphere. Swiss Re has taken a CHF1.2bn pre-tax mark to market loss arising from its exposure to two credit default swaps which had been structured to provide protection for portfolios comprised of residential and commercial mortgage-backed securities. Swiss Re said unprecedented ratings downgrades in October and the lack of any truly liquid market for these securities precipitated the write-down. 8 Losses on the liability side of the balance sheet from D&O and E&O may still be incurred. Shareholder class action securities fraud suits filed in the US law courts include 56 related to subprime. 9 Figure 7 summarises the commentary provided in recent 2007 results statements and conferences related to business written in the areas of D&O and E&O, most of it specifically in the Financial Institutions (FI) arena. Most companies have indicated that they anticipate any losses from such business to be contained within existing reserves. 1 UBS, 2007 Annual Report and Investor release, 1 April 2008; Merrill Lynch 2007 Annual Report; Citigroup 2007 Annual Report. 2 XL Capital Earnings conference call, 6 February XL Capital SEC filing 10-K. 4 AIG, press release, 28 February XL Capital Earnings conference call, 24 October XL Capital Earnings conference call, 6 February XL Capital SEC filing 10-K. 8 Swiss Re, press release, 19 November Insurance Information Institute, Catastrophes, the Credit Crisis & Insurance Cycle, Robert P. Hartwig, 26 March Side A provides direct insurance of individual directors and officers, which is triggered if the corporation does not or cannot provide indemnification to its directors and officers.

9 FIGURE 7 SUBPRIME EXPOSURE ACE Arch Aspen AWAC Axis Beazley Brit Catlin Chaucer Endurance Size of total D&O and E&O market premiums estimated at between USD3bn to USD4bn. ACE net premiums of USD143mn with average net limits of USD7.7mn in D&O and USD3.2mn in E&O. Potential losses are reserved in 2007 loss ratios. US FI market estimated at between USD3bn and USD4bn. Arch exposures not significant. D&O exposure reduction began in 2005 and weighted more to reinsurance than insurance. Exposure to top six D&O writers limited to one company. Estimated market share in these lines at between 0.4% and 0.8%. Total insurance FI premium: USD89mn gross, USD46mn net with average limit of USD4.5mn and attachment of USD60mn in 2006, slightly less in Exposure very small. A few contracts in international casualty reinsurance and one in US casualty reinsurance. Total exposure USD35mn in reserves, comprising USD20mn additional reserves above the USD15mn expected level. Established and expected loss reserve ratios are adequate to meet potential claims activity. Satisfied with excess position (i.e. XoL). Average attachment about USD120mn on FI, and a little bit less on the rest of the portfolio. Subprime issues not believed to affect D&O portfolio or other professional liability book adversely. No exposure to large FI business and very limited exposure to primary D&O and E&O writers of Fortune 500 companies loss picks include extra provisions. Exposure manageable in FI area. Participated with money centre banks on a Side A only basis plus high attachments. 10 Group has limited appetite for professional liability risks within the financial institution sector. The number of claims from subprime related cases is in single figures. Exposure remains within reserves and reserving philosophy is not anticipated to change. Industry loss estimated at USD6bn. Received notification from 25 insureds which may or may not turn into actual claims. GBP106.1mn gross reserve (GBP62.5mn net) set up in respect of potential claims gross premium income totalled GBP163mn from the classes of business affected. Not a significant insurer in classes such as US D&O and FI that are particularly exposed to claims. The Group does not believe that it has significant exposure to these types of claims and any losses are expected to be within normal expectations for incurred but not reported losses. Mortgage bankers still viewed as an attractive class with few loss notifications to date. A long-standing general avoidance of D&O exposures and a more specific avoidance of subprime mortgage specialists. General avoidance of the large investment banks and US public D&O business should protect against significant loss. However, potential professional liability losses have begun to surface in response to the related global credit squeeze. Approx USD115mn premium in professional lines, split USD45mn (reinsurance): USD75mn (insurance). Approximately USD37mn of Insurance is FI related and some USD5mn related to complex banks, about USD2-3mn D&O classes. Received a limited number of notices but not sufficiently developed to case reserve for them. Everest Additional USD13mn loss for subprime related exposures. D&O less than 5% of total premium. Reduction of D&O exposures began in Hannover Re Hardy Hiscox Max Capital Montpelier Munich Re Novae PartnerRe Paris Re Platinum RenRe SCOR Swiss Re XL Validus Subprime market loss estimated at USD3bn. Given falling rates in US casualty, especially North American D&O, group has reduced market share to 25% of premium volume generated in hard market. Thus strain of subprime expected to be slight. Conservative reserves of EUR20mn established. Exposure is limited with no D&O and only two US PI risks with smaller limits than the rest of the book thus the group feels relatively well placed. Very limited underwriting exposure which is fully reserved. Significantly reduced D&O insurance and reinsurance exposures in Estimate net loss reserves at USD8mn (insurance) and USD10mn (reinsurance). No additional reserves posted during the year. Any future development will not have a meaningful impact owing to reinsurance and retro protection. Minimal E&O business. No D&O business written. Provision made within Corporate Underwriting/Global Clients Division for whole Group for the D&O and professional indemnity losses that could result from the subprime loan crisis. Subprime claims have been limited as group withdrew from US liability reinsurance in 2002 and cut back direct in Contained in general provision. Speciality division has reserved two claims connected with possible subprime issues. Total US D&O market estimated at USD8.5bn (suggesting PartnerRe has 1.2% market share). Approximately USD105mn US D&O premium (USD145mn three years ago) and approximately USD25mn NPW in Europe, together represent about 3.5% of W/W book. USD2.5mn average limit. USD1.168bn reserves for US specialty casualty business (USD687mn for ). Very comfortable with containment of losses in established loss and unearned premium reserves. Estimate US D&O experience at between USD6bn and USD10bn industry event. No estimate for E&O. No specific liability exposure mentioned. Identified six treaties exposed to FI, all XoL basis with generally quite high attachment points. USD1mn average limit. Maximum exposure to any one insurer estimated at USD6.5mn. Estimates worst case loss scenario to three of four accounting firms underwritten at USD30mn. Comfortable with reserve position. Some casualty clash business, USD60mn event specific IBNR reserve posted in addition to normal IBNR for line. USD60mn represents a significant portion of limit. Less than two dozen accounts. No direct liability risks from monoline companies or subprime. Since 2004 Swiss Re has materially reduced its exposure to D&O, E&O and professional indemnity business. Swiss Re thus has a low exposure to possible liability risks from the subprime and credit crisis. USD12mn average policy limit for public D&O. Side A only component is one third of GPW in 2007 and 45% by policy limit. FI business managed through limited line sizes, higher attachment points, risk adjusted rate levels and greater use of Side-A only. USD270mn of coverage available in USD35 xs USD15mn layer in professional lines R/I structure. 26 D&O claims or potential claims notices (9 primary, 17 excess policies) received by year end 2007 with three more by early February. Total net limits associated approximately USD300mn (of which Side-A USD87mn). Assessment is that the lower level of attrition losses and elevated clash losses are contained in loss ratios. For the period between 6 June 2007 (post secondary offering of shares) and 31 December 2007, XL incurred case losses of USD300mn and USD51mn on a NPV basis for XoL and facultative reinsurance agreements related to subsidiaries of SCA. Some exposure to FI business written by Talbot (USD40mn). Small USD1.4mn D&O portfolio. USD14mn professional indemnity portfolio. E&O portfolio has USD39mn in net limits risk. Portfolio heavily reinsured and carries very high IBNR percentage relative to total limits outstanding.

10 Leaving it on the Table RENEWAL ROUNDUP

11 Hard market softening was one of the more memorable phrases used to describe the 1 January 2008 renewals. Underwriting discipline was again the watchword of the season, and companies characterised prices as still technically adequate. A second year of low catastrophe losses meant the downward drift of reinsurance prices was not in question, a trend which went beyond the Property Catastrophe class. With this the case, reinsurers said they had left large pieces of unattractively priced business on the table resulting in an overall decline in renewed premiums. The six groups with a major European presence (Hannover Re, Munich Re, Paris Re, PartnerRe, SCOR and Swiss Re) echoed several of the main findings highlighted in Benfield s Global Reinsurance Market Review 1 : renewals were often late, amid plentiful capacity leading to premium rate erosion across the board. Common themes which emerged from the companies commentaries were: An adherence to strict underwriting and careful risk selection; A continuing trend away from pro-rata to excess of loss treaties; Higher client retentions contributing to a reduction in premiums ceded; An overall decline in US Property Catastrophe premium volumes for the first time since 2004; and Broadly unchanged terms and conditions at renewal. Swiss Re CEO Jacques Aigrain summed up the mood when he said the reinsurance industry was faced with a softer part of the cycle in Property Casualty business. 2 Where companies did maintain premium volume, they generally did so through portfolio restructuring, or through higher exposure and larger participations. Against this background, Hannover Re and Paris Re bucked the trend, reporting flat renewed premiums. Swiss Re s renewed premiums declined 12%, while Munich Re experienced a 4% fall. The contraction at Paris Re and SCOR was limited to 1%. The six groups renewed an estimated EUR18.9bn of business (based on 1 January 2008 exchange rates) representing over two-thirds of their treaty books as shown in Figure 8. Munich Re and Swiss Re together accounted for 70% of the total, while newcomer Paris Re s presence was just 2%. Financial strength ratings continued to be an important issue for cedants with the most highly rated groups reporting advantageous terms, conditions and participations. Munich Re said some cedants had accepted private terms [and] private conditions to keep Munich Re on board. 3 The outcome of the renewals was an aggregate 5% decrease in premiums as shown in Figure 9. This compares to effectively flat premium growth in 2007, adjusting for the effect of the GE Insurance Solutions acquisition by Swiss Re. 4 CEOs were anxious to distinguish between a soft market and a softening market. Willhelm Zeller of Hannover Re said there was almost no easing of terms and conditions and cited this as evidence that the soft market had not yet arrived, but of a hard market softening as rates declined from a high base. 5 Patrick Thiele of PartnerRe commented that the market was increasingly competitive but still rational, which is characteristic of a market in transition. 6 Swiss Re s Jacques Aigrain expected the P&C market to remain challenging in the near term, but added that margins were generally still satisfactory. The emphasis was on profitability over volume. Munich Re reiterated its less pronounced growth expectations until 2010 and, as at the last renewal, its focus was on profitability. The company said that so far, the down cycle had been more muted than some expected but emphasised it was continuing to decline inadequately priced business. Munich Re said it left over EUR250mn on the table in the US excess of loss market, in some Motor lines, and in Offshore Energy. Figure 10 compares the premium growth reported by each company, based on constant exchange rates. Munich Re and Swiss Re, the largest players by renewal volume, experienced significant falls in premiums. Several factors contributed to Hannover Re s relative outperformance. Although the number of proportional treaties continued to shrink, ceded premiums rose 4%, in contrast to the general trend, driven by growth in German Property and Credit & Surety classes. This offset reductions in the excess of loss book which was down 6% due to falls in Marine and Catastrophe business. Munich Re attributed its lower level of renewed premiums to underwriting discipline and cycle management. Casualty business declined the most, with premiums falling 9% due to reductions in proportional business. In contrast to the general picture, Marine premiums were higher with new business at the Watkins Syndicate at Lloyd s an important contributor. Business was modestly down in other classes with a 5% fall in Aviation attributable to lower fleet rates, and a similar reduction in Credit which was due to the restructuring and cancellation of two major participations. Property premiums eased 2%. Paris Re, newly independent of AXA, found business opportunities with cedants who might previously have been unwilling to reinsure with its predecessor AXA Re. Nevertheless, it applied the same underwriting criteria to business generated by new clients and rejected technically inadequate business. Premium growth was strongest in Life, Accident and Health lines which reflected increased writings in emerging markets including the Middle East. Elsewhere, premiums generally declined. Credit, Marine and Aviation premiums fell by 5%. Property was down 3% and Motor and Liability premiums were stable. 7 According to PartnerRe, premium rates continued to soften across most business lines as was expected, aside from isolated pockets of increased demand and market turmoil such as US agriculture. Consequently, premium income fell for all lines except for Worldwide Specialty, which rose 6% due to strong new business volume. Catastrophe premiums were down 13% due to exposure to lower prices and smaller participations. P&C premiums were lower on diminished new business volume. The effect of these reductions was largely offset by new business gained from the acquisition during 2007 of renewal rights to the international reinsurance book of the Groupe Monceau of France. An important objective of SCOR s renewal was the successful retention of former Converium business. In the event, 80% was renewed. The overall business attrition rate for the enlarged group was some 20%, which was in line with the projections set out in the Dynamic Lift merger plan. Premiums in most lines were flat to down with some notable exceptions. Within the Global P&C division, Proportional Motor premiums rose 7% due to stable or increasing primary rates in countries such as the UK and Italy. In Specialty business, Engineering volume rose 22% due to the recapture of lost shares and to business development in emerging markets. Agriculture premiums rose 12% helped by increasing commodity prices and by WTO liberalisation. Declines included a 9% fall in non proportional Property business, driven by a 10% decrease in non proportional Property Catastrophe rates in the US, and a 5% decrease in Europe. Decennial premiums fell by 22% due, in part, to a less favourable real estate environment in Spain. 8 Swiss Re was the only company to report a reduction on business renewing which was attributed to disciplined underwriting and careful risk selection. It mentioned that because it had declined large amounts of business, its average premium rate reduction of 3% was markedly better than the market as a whole where it noted falls of up to 20% were experienced. Prices achieved in non-proportional lines were said to be above technical reference prices while proportional lines achieved pricing which only just met technical requirements. Non-proportional Property, Accident & Health and Specialty margins were the strongest, while proportional Liability rates faced ongoing pressure. Proportional Property, Liability and Motor rates were either at or slightly below technical reference prices. Reinsurers have yet to report on the outcome of the important Japanese renewals at 1 April The trends of the January renewals set the tone, and both reinsurers and cedants anticipated further price declines. Benfield s analysis revealed that, in general, reductions were more modest than initially expected. Wind excess of loss rates were flat to down 10% on a risk-adjusted basis in most cases, while earthquake rates were off by 5 10%, also on a risk-adjusted basis. Notwithstanding challenging conditions in P&C reinsurance, the companies remain positive on the prospects for Optimism is grounded in active cycle management and the prospect of greater profitability from lower volumes of business, as well as changes in business mix. Some have pointed to the potential for reserve releases which will provide further support for earnings. FIGURE 8 PREMIUMS RENEWED AT 1 JANUARY 2008 FIGURE TREATY RENEWALS FIGURE 10 RENEWAL PREMIUM DEVELOPMENT Gross Premium Written 1 Munich Re 43% 2 Swiss Re 27% 3 Hannover Re 14% 4 Partner Re 7% 5 SCOR 7% 6 Paris Re 2% Total EUR18.9bn 100% 90% 80% 70% 60% 50% 40% Renewable % Cancelled/replaced -17% Renewed 83% Decrease on renewal 0% New business 12% Total portfolio post renewal 95% Hannover Munich Paris Partner SCOR Swiss Renewing 100% 100% 100% 100% 100% 100% Cancelled -23% -14% -18% -15% -12% -20% Renewed 77% 86% 82% 85% 88% 80% Increase on renewal 0% 2% 0% 0% 1% -4% New/restructured 23% 9% 18% 14% 11% 11% Total estimated 100% 96% 100% 99% 99% 88% Source: Company information, Benfield Research Source: Company information, Benfield Research Source: Company information, Benfield Research LEWIS PHILLIPS BENFIELD RESEARCH 1 Benfield Research, Global Reinsurance Market Review, Changing the Game, January Swiss Re conference call, 29 February Munich Re conference call, 30 January figures include Converium as a separate entity and do not include Paris Re. 5 Hannover Re conference call, 5 February PartnerRe, press release, 24 January Paris Re press release, 11 February SCOR Global P&C 2008 renewal results presentation, 13 February 2008.

12 Solvency II: QIS 4 Model Feedback Solvency II represents a fundamental review of the existing Solvency regime in Europe, recasting 14 existing EU insurance directives and aiming to establish a new, harmonised set of capital requirements and risk management standards across Europe. Between April and July 2008, the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) will undertake the 4th Quantitative Impact Study (QIS 4) exercise. This constitutes a key milestone in the Solvency II process, and, with the final implementation date set to be 2012, it will most likely be one of the last quantitative impact studies. Following the publication of the QIS 3 report, CEIOPS has developed QIS 4 technical specifications, focusing on issues that appeared to be of greatest importance. In particular, QIS 4 will test the proposed linear approach for the Minimum Capital Requirement (MCR) and, taking into account QIS 3 feedback, CEIOPS has proposed a new treatment for intra-group participations and geographical diversification. The linear approach proposed for the calculation of MCR in QIS 4 simplifies the modular approach tested in QIS 3, with a renewed emphasis on simplicity. It is based on a percentage of technical provisions, with some reference to volume measures. The number of life and non-life respondents to QIS 3, was 1027, representing an increase of almost 100% from QIS 2. The expectation is that QIS 4 will represent an important checkpoint for EU companies and that the participation will remain on QIS 3 levels or even increase. The following commentary is based on the December 2007 technical specifications. Solvency II requirements are based on an economic total balance sheet approach. This approach relies on an integrated appraisal of insurance and reinsurance balance sheets where assets and liabilities are valued in a consistent manner. The Solvency Capital Requirement (SCR) corresponds to the economic capital an insurance or reinsurance undertaking needs in order to limit the probability of ruin to 0.5% (i.e. ruin would be expected once every 200 years). The SCR is calculated using Value at Risk techniques, either in accordance with a prescribed standard formula, or using a company s internal model. All potential losses, including adverse revaluation of assets and liabilities, over a 12 month period are assessed. The SCR reflects the true risk profile of the undertaking, taking account of all quantifiable risks as well as the net impact of risk mitigation techniques. QIS 4 uses a modular approach (Figure 11) where risks are combined using correlation matrices with defined correlation coefficients. One of the most significant changes in the Draft Directive is the recognition of risk mitigation techniques such as securitisation or financial derivatives. The new counterparty default risk module under QIS 4 now explicitly encompasses securitisation and financial derivatives together with traditional reinsurance arrangements and receivables from intermediaries. However, there are a number of risk mitigation instruments and structures that are not fully captured in QIS 4, for example umbrella reinsurance and multi-line covers cannot be incorporated in the lines of business view within the non-life premium and reserve risk area. QIS 4 HIGHLIGHTS VALUATION OF LIABILITIES The best estimate of liabilities will show the value of the relevant cash-flows gross of reinsurance. The reinsurance asset should then be adjusted to allow for the expected level of counterparty default. The cost of capital method must be used for the risk margin calculations, as set out in the Draft Directive. This calculation has to be made net of reinsurance and by line of business, with no allowance for any benefits of diversification. CATASTROPHES A simple factor method is allowed in those cases where no regional catastrophe scenarios are provided by the regulator. In addition to the scenario based approach (presented in QIS 3), QIS 4 enables companies to propose a personalised catastrophe calibration, based on their own business, and to calculate their personalised catastrophe scenario impacts. The catastrophe personalisation can include partial or full internal model outputs this is clearly an area where internal models could be used very effectively. QIS 4 allows firms to make use of commercial catastrophe models for relevant classes, where such models are available. Assessment of the effect of reinsurance treaties on the non-life catastrophe risk exposure is based on a twelve month period. The SCR calibration with a 99.5% confidence level over this one-year time horizon is likely, for most firms, to include the occurrence of a series of catastrophic events. The impact of separate retentions, reinstatements and associated costs on the non-life catastrophe should be taken into account. DISCOUNTING The revised technical specifications (31 March 2008) prescribe that the risk free rates are derived from swap rates. This is a welcome change from the first draft of the QIS 4 specifications where risk free rates were based on AAA rated government bonds. As the swap curve is the reference curve against which financial institutions commonly value derivatives, the choice of the government curve as a basis for discounting valuations would have introduced a fundamental disconnect. REINSURANCE COUNTERPARTY DEFAULT The counterparty default charge has changed significantly compared to QIS 3; in particular, the concept of loss given default is introduced. Reinsurance arrangements, securitisation and derivatives and receivables from intermediaries are considered separately. Following QIS 3 feedback, a factor of 50% has been included in the formula to allow for the fact that, even in the case of a default, the reinsurer will usually be able to meet a large part of its obligations. The reinsurance counterparty default calculation could be time consuming, in particular in relation to financial derivatives, and the charge is still particularly penal in respect of reinsurance ceded to companies that are unrated or BBB rated, as was the case under QIS 3. PAOLA FONTANA BENFIELD FINANCIAL MODELLING

13

14 FIGURE 11 MODULES OF THE STANDARD SCR FORMULA SCR Adj BSCR SCR op SCR nl SCR mkt SCR health SCR def SCR life NL pr Mkt fx Health lt Life lapse Life mort NL cat Mkt prop Health st Life exp Life long Mkt conc Mkt int Health wc Life dis Life cat Mkt eq Life rev Mkt sp cat catastrophe conc concentration def default dis disability eq equity fx foreign exchange int interest long longevity mkt market mort mortality nl non-life op operational risk pr premium/reserve prop property rev revision risk sp spread adjustment for the risk mitigating effect of future profit sharing

15 FIGURE 12 MODEL USES FIGURE 13 QIS 4 Key metric QIS 4 requirement Internal model Pricing Capital allocation Reserving Reinsurance decisions Capital assessment Risk measure Confidence level Time horizon Key modules Value at Risk (VaR) 99.5% (1 in 200 years risk of insolvency) 1 year Operational risk, market risk, credit risk, underwriting risk (premium and reserves) OPERATIONAL RISK CHARGE QIS 3 feedback called for a more risk-sensitive method. Nevertheless it is still based on a formula approach that uses the greater of percentages of premium income and technical reserves, with a maximum ceiling of 30% of the Basic SCR (BSCR). For unit linked business the charge is now expressed as a loading (25%) on the expenses figure. NON-LIFE UNDERWRITING RISK QIS 4 attempts to address geographical diversification benefits; however the diversification benefit allowed is limited. Companies are allowed to replace standard factors with undertaking specific parameters for both reserve risk and premium risk. This was strongly supported in feedback on QIS 3. Non allowance of expected profit and loss was seen as a backward step by many participants in QIS3 (QIS 2 had included allowance of expected profit and loss) and the exclusion remains for QIS 4. ASSESSMENT OF MCR The linear approach proposed in QIS 4 simplifies the modular approach tested in QIS 3. The new formula is based on a percentage of technical provisions, with some reference to volume measures. In particular, given that some risk categories (e.g. market risk) are not included in the calculation using the linear approach, the MCR will be unchanged regardless of any changes to investment strategy. The proposed testing approach does not represent the final decision on the design of the MCR and options tested previously under QIS 3 are not excluded. SIMPLIFICATIONS According to the proportionality principle, undertakings are allowed to use simplified methods and techniques to calculate insurance liabilities. The use of simplifications is not linked to the size of the undertaking but to the nature, scale and complexity of the risks supported. MARKET RISK No significant changes to the interest risk, equity risk and property risk modules have been made in QIS 4. The correlation matrix to aggregate the sub-models which constitute market risk is unchanged from QIS 3, with a zero correlation assumed between equity risk and interest rate risk. The spread risk module now covers all tranches of structured credit products (e.g. asset backed securities and collateralised debt obligations and credit derivatives) that are not held as part of a risk mitigation policy. A dampener formula is also tested as an alternative for the global market equity risk with the objective of discouraging the selling of shares when markets are falling by reducing the capital charge for equity risk. FOCUS ON INTERNAL MODELS The Draft Directive states that insurance and reinsurance undertakings may calculate the SCR using a full or partial internal model, as approved by the supervisory authorities. Undertakings using an internal model will also need to provide supervisory authorities with an estimate of the SCR determined in accordance with standard formula. This stipulation covers a two year period following receipt of supervisory approval. There are some obvious consequences of using the standard formula. The standard formula parameters attempt to capture the risk profile of an average company; however the insurance and reinsurance undertakings actually using it will be heterogeneous in terms of size, business mix and jurisdiction. There may be situations in which the standard model does not accurately portray the risk of a given company and also the formula may well contain conservative parameters. In addition, the standard formula does not capture the effect of some reinsurance features, such as profit-sharing or umbrella, whole account and multi-line covers that cannot be incorporated in the lines of business view of the non-life premium and reserve risk areas. As a consequence, companies that have developed an internal model to determine their capital requirement could potentially have capital charges lower than those calculated using the standard formula. The QIS 3 report stated that only 13% of the participants in the QIS 3 exercise provided internal model results, possibly due to lack of internal models or to some reluctance to share them. Feedback on this area is sought again in QIS 4, on an optional basis. It is important to note that overall, the internal models of non-life insurance companies produced significantly lower total SCR than the standard formula. The average reduction in total SCR was about 25%, mainly in relation to the non-life underwriting risk capital component. Internal models can be customised to be a true reflection of a given undertaking s specific risk profile, making use of the company s data and capturing the specificity of the underwriting and risk processes in their entirety. Internal models can successfully be used as a tool for internal risk management, providing powerful insight into distributions of outcomes, and forming the basis on which capital allocation decisions are made, and therefore become a significant competitive advantage. Figure 12 illustrates the uses of an internal model. In addition, rating agency requirements increasingly include incorporation of results of a company s internal models. The Draft Directive lays down three tests that an internal model must satisfy: Statistical quality test The statistical test is essentially about the statistical soundness of the modelling methods and assumptions, the completeness and accuracy of input data and the methods of aggregation. It is likely that the regulatory approval process will focus particularly on a firm's governance and controls surrounding the model. Companies will be expected to undertake a regular cycle of model validation that includes monitoring the performance of the model, reviewing the appropriateness of specification, and testing outputs against outcomes. Calibration test The internal model must be calibrated using the risk measure and calibration level defined in the Draft Directive. Use test It is required that the model that generates the regulatory capital number is actively used in the management of the business. The internal model must be firmly embedded and play an integral role in risk management, decision-making and capital allocation processes. APPROVAL PROCESS The process for approval of internal models is challenging. The UK s Financial Services Authority (FSA) anticipates that a significant number of firms will seek model approval (either on a full or partial basis) to allow them to use their own models from the date of Solvency 2 implementation. Therefore, the FSA is starting to consider what implementation might look like in practice. As a next step, the Internal Models Sub-Group of the FSA Insurance Standing Group will carry on the discussion on Level 2 model approval criteria to feed into CEIOPS Internal Model Expert Group. Preparations for the approval process of internal models will involve much further engagement with firms over the next few years. GROUPS The treatment of groups is of major significance. The understanding of group capital, group risks and group controls should be an important additional part of the European supervisory framework going forward given that 50% of European direct insurance is written by the 20 largest groups, and given that they operate in a number of Member States through different subsidiaries. QIS 3 was not overly successful in collating useful information on Groups and CEIOPS felt that further feedback was needed in QIS 4. Groups are required to calculate group capital according to four methods: Standard SCR formula applied to the consolidated group position. Sum of solo SCRs. Sum of solo SCRs of each group entity adjusted for intra-group transactions. Group SCR on the basis of an internal group model where used. LOOKING AHEAD The industry has the opportunity to influence issues through participation in QIS 4. In particular, the supervision and the treatment of groups will most likely be an area where the feedback from QIS 4 is significant. The implementation of a flexible and complete internal model will be the appropriate target for several companies. The approval process for this will most likely be demanding both in respect of time and resources and will most certainly require significant interaction with the regulator. Establishing the data systems and model design at the earliest possible stage will be fundamental to success.