PricewaterhouseCoopers Breakfast Briefing Rendez-Vous, Monte Carlo September 7, 2009

Transcription

1 PricewaterhouseCoopers Breakfast Briefing Rendez-Vous, Monte Carlo September 7, 2009 Brian Duperreault President and Chief Executive Officer, Marsh and McLennan Companies

2 Good morning. And thank you for that introduction. As we ve seen and heard in great abundance the past few days, there are a lot of exciting and interesting things going on in our industry. An issue I would like to address today is one of the most significant along the insurance/reinsurance supply chain and a cause of concern among many parties: that of capital management, and its role in a robust ERM strategy. In the past, carriers focused mostly on the management of discrete risks and lines of business. Recently, however, it s become more evident that the threats are much broader and potentially more severe. Traditional measures used to measure risk and allocate capital are insufficient to identify and manage the systemic risks that can strike both sides of the balance sheet. Today, market leadership requires the development and implementation of a broad capital management plan. Frankly, this is also becoming a case of survival. Insurers and reinsurers need to examine how each risk assumed affects their overall ability to achieve financial targets. Both sides of the balance sheet have to be considered -- equity values, credit spreads and inflation can cause as much damage if not more as traditional insured loss events. Insurance is no longer an exercise in risk transfer. Rather, it requires a holistic approach, in which the entire company s threats and opportunities are examined. The goal is to find the best use of capital in other words, the greatest returns relative to specific risk thresholds. Doing this requires a fundamentally different view of the balance sheet, the business and the economy as a whole. Instead of putting on the blinders, carriers will have to consider the many, varied and interrelated threats to their capital -- and devise comprehensive plans to protect their balance sheets while optimizing the capital they put at risk. 1

3 Simply put: every dollar deployed into the market should generate as much value as possible -- without requiring unnecessary risk to be assumed. The potential rewards for taking this approach are great. Preventing unexpected losses can protect market capitalization should a major loss event occur. A certain amount of loss every year is expected in the insurance and reinsurance industry. But, when results exceed expectations, equity analysts and investors can punish a company, consequently pushing the share price lower. The impact of insured and asset losses on earnings are magnified in market capitalization. Companies that have not taken a total view of risk and capital could find themselves beleaguered, while prudent capital managers will more likely outperform their peers. In fact, this is exactly what we ve seen over the past year. At around this time last September, we were watching Hurricane Ike cross the Atlantic just as a worldwide financial crisis erupted. Shareholder value was destroyed in huge amounts, and risk-bearers panicked about the availability of capital, the cost of capital and their abilities to attain financial targets. Credit markets came to a virtual standstill, and equity values plummeted. Capital was constrained, costing all risk-bearers from original insureds to retrocession writers most of their financial flexibility. The financial crisis triggered the worst recession the world has seen in more than 70 years. Unemployment spiked, as did corporate insolvencies across all industries. Both income statements and balance sheets have shown signs of strain. The effect on the insurance industry has varied. Property-catastrophe reinsurance rate increases were contained: up 8 percent on average around the world this year. In the United States, which also had to contend with the impact of Hurricane Ike, rates increased 10-to-15%. 2

4 As U.S. property-cat rates show, companies with specific exposures experienced the largest price increases. Carriers writing business related to economic developments such as Financial Institutions Professional Indemnity and D&O are sustaining insured losses and coping with higher risk-transfer pricing in both the primary and reinsurance markets. While the liability-side losses we re discussing here in Monte Carlo tend to be specific to insurers and reinsurers, everybody has had to deal with the implications for the asset side of the balance sheet. Declining investment asset values and the inability to source new capital put considerable pressure on businesses around the world. Again, the results were far from uniform some industries were hit harder than others. In general, the insurance and reinsurance industry has persevered. Shareholders equity for the Guy Carpenter Reinsurance Composite, which we use as a proxy for the reinsurance space as a whole, fell 18 percent. Without a doubt, this is a substantial loss. But, most people in our business were talking about how to make excess capital productive at the beginning of last year. Even with dividend payments and share buybacks, most carriers were sufficiently capitalized to absorb the financial shock in September. This is why the losses merely impaired financial performance and did not bring the risk-transfer industry to a halt. Nonetheless, the financial crisis did present a challenge for insurers and reinsurers. The uncertainty that followed the event left many wondering if reinsurance rates would harden, as they did after Hurricane Andrew. Some were concerned about a severe capital shortfall and the ability to transfer risk at any price. Well, as we ve seen, these doomsday scenarios did not unfold 3

5 and the reinsurance rate spikes that many expected never occurred. Though there was a slight increase in demand this year, supply was adequate, as reinsurers capital positions at the beginning of 2008 were sufficient to absorb the financial and property losses that would come later in the year. Not only has the business of risk transfer continued, we ve actually seen the financial markets begin to stabilize with the second quarter showing some signs of recovery. The lessons from last September, however, are clear: to survive and be successful, you must have a robust capital management strategy. The ability to manage capital translates directly to the protection and growth of shareholder value. By evaluating the risks faced by the company as a whole, a carrier can protect capital from unexpected (even unpredictable) loss, and thus outperform its peers. This can lead to a significant competitive advantage, as the carrier will be ready for both loss and gain events. On the other hand, not having a plan for addressing risks to capital, and the opportunities to maximize it can result in the destruction of market capitalization. If another financial catastrophe were to break out -- or, for that matter, any other major loss event -- the prepared will mitigate losses, recover faster and be poised to capture market share as competitors struggle. Capital management involves more than the risk side of the equation. It considers the totality of threats that an insurer or reinsurer faces from storm frequency to a financial and physical convergence, with natural catastrophes striking and financial markets are devastated simultaneously. In taking this broader view of capital, consider the macroeconomic factors that can affect your portfolio. Cedents, for instance, have become increasingly aware of third-party security risks, concerned that centralizing their reinsurance purchases among fewer, seemingly 4

6 well-capitalized markets presents risks of over concentration. As we saw this past year, some well-respected firms suffered from a sudden drain on their capital. Here, diversification, a common approach to managing risk, can offer part of the solution. Cedents benefit from diversifying their reinsurance placements among many reinsurers. The syndication of risk carried out within the broker market, we believe, provides an important reduction of the no recovery potential that could arise from reinsurer defaults. I know Guy Carpenter is exploring new ways to integrate broader economic analysis into insurance and reinsurance decision-making. The use of equity market indicators, credit spreads and volatility measures provides dynamic tools for use between the release of financial statements, which only provide point-in-time insights. As a result, it s possible to develop a near-constant view of such factors as capital availability and counterparty credit risk. These financial market and macroeconomic trends can then be used to make specific risk-transfer decisions. After all, the broad strokes in the global economy do have implications deep into every risk-bearer s portfolio. The Line of Business Specialty practices at Guy Carpenter, for example, use their deep knowledge of the marketplace to gauge the implications of both loss potential and broader market factors, such as regulatory or legislative trends that alter the trajectory of liability losses. With these insights, carriers can appropriately allocate their capital to protect their capital and sustain consistent growth. What emerges is a view of risk that encompasses both sides of the balance sheet: the macro issues address how asset values and the availability of capital in general can affect the strength and prospects of a company. And, the developments within a line of business -- the micro issues -- that occur on the liability side. Put them together, and you have a total view of risk a complete sense of the many factors that can threaten a carrier s capital. Whether original insured, cedent or market, the goal is to find ways to 5

7 tip the scales in its favor. The principles of Enterprise Risk Management address this totality -- beginning with clear, measurable financial objectives and establishing risk profile, appetite and tolerance thresholds. The purpose of ERM is to identify the full spectrum of risks a company faces in order to develop a complete, cohesive plan for protecting capital and attaining financial objectives. While ERM is often associated with models and metrics, the basic building blocks are imagination that informs anticipation. Risk managers need to conceive of the inconceivable, envisioning even the most remote threats to a company s balance sheet. How else would you characterize the combination of Ike and the financial crisis on the same weekend last year? Only a thorough inventory of risks provides the protective layer necessary to foresee the financial catastrophe that hit our industry last year. Miss something, and it could undermine the other measures taken to minimize or transfer risk. After a robust risk identification process, we must quantify what could happen. Data is essential here. The availability and quality of data is improving for both property and casualty perils around the world. Climatologic data for mature and emerging economies is becoming increasingly reliable. And risks for which data was thinner in the past such as workers compensation and casualty clash and catastrophe lines is becoming more robust. Once identified, insurers and reinsurers can assume a diversified set of risks in order to avoid accumulations that could drain balance sheets and, in the extreme, imperil solvency. New technologies enable riskbearers to process vast amounts of information to identify exposures for various lines of business online and in real-time. This exposure data can be used to find accumulations and prevent outsized, unexpected losses. Decision-making becomes faster and based on a fuller set of information, yielding better results. Carriers can diversify their portfolios, thus protecting their capital. 6

8 One shareholder class action lawsuit could result in claims against any number of companies with joint venture, supply chain or trading relationships. A carrier writing professional or product liability, for example, may be exposed to claims against several companies and not realize it leading to catastrophic casualty losses. Guy Carpenter s Casualty Cat model, developed with Arium, uses network theory to identify portfolio exposures that could trigger chain reactions in the event of an insured loss. In this scenario, Casualty Cat identifies risk across companies, across regional boundaries and industries and equips an insurer to take decisive, informed action. Once a risk bearer has a sense of where their exposures are, powerful technology platforms like Guy Carpenter s MetaRisk, the leading economic capital model can help evaluate the options available. It s possible to model countless scenarios with a variety of risk-transfer structures in order to identify likely outcomes as well as those that are remote but could be devastating. Scenario modeling capabilities allow carriers to test different structures and find those that yield the best results. Also, with Solvency II and more stringent ERM requirements coming, models like MetaRisk may be an effective alternative to the standard formula for calculating the Solvency Capital Ratio. Instead of using a one-size-fits-all method for determining capital requirements, the internal model option lets European insurers and reinsurers tailor their capital needs to the specific risks they cover. In some cases, this may free capital for use elsewhere, effectively turning compliance into a competitive advantage. ERM on the whole requires a substantial commitment. Rather than set up a framework to simply check the box, effective ERM requires a thorough assessment of all risks to capital, the benchmarking of measures among peers and a best practice review. The result of effective ERM practices is awareness and discipline in addressing the potential impact of threats to capital, whether they are external to the carrier, or operational. 7

9 For instance, should financial market conditions change, catastrophes strike, losses occur the assumptions made at a renewal may not hold true. For this reason, capital management, informed by ERM, must be active and constant. With effective ERM and capital management strategies in place, carriers can focus on optimizing capital. Part of choosing the optimal use of capital, of course, is determining where to source it. With financial markets opening up relative to a year ago, there are many more alternatives available. Narrowing credit spreads and increasing equity values are having positive effects on the cost of capital and the ability to obtain it. The Guy Carpenter Global Reinsurance Composite puts reinsurers shareholders equity up 8.2 percent from the beginning of the year, though most of this came from earnings and improved investment asset values. A combination of diversification to address accumulations of a particular risk and ERM to protect against systemic risks is crucial not only to protecting capital but to managing earnings volatility, which has a direct effect on shareholder value. Reinsurance, of course, is an important part of any insurer s or reinsurer s capital management strategy. As we saw last year, difficult financial markets generally did not impede the availability of sufficient capacity to meet demand though for some lines capital clearly was constrained. But, carriers have other options, as well. Equity and credit capital more available with the recent thawing of financial markets are likely to be integral to a wave of M&A activity that may occur in the future. A combination of capital availability and growth opportunity will probably drive a considerable amount of consolidation over the next few years as some carriers realize that they will have to acquire or be acquired. 8

10 Also, financial market flexibility has reopened the cat bond market. Issuances are down more than 40 percent from the first half of 2008 to the first half of 2009, but it s still a big difference from the silence of the last quarter of last year. Insurers are again able to transfer insurance risks directly to investors and investors are showing an interest in adding them to their portfolios. With traditional reinsurance, cat bonds and alternative sources of capital and ERM strategies to protect their capital, manage earnings volatility and bolster shareholder value, insurers and reinsurers also have a strong platform from which to address the future. Changing financial conditions and emerging risks continually provide new challenges. Emerging risks such as nanotechnology and cyber-risks will require new forms of protection, but a robust risk identification process will make it easier to manage these threats as they arise. There is opportunity, as well. Emerging markets may become accessible through microinsurance, which will lead to risk-transfer needs to protect capital and manage earnings. There is still a way to go for microinsurance, but Guy Carpenter s recent grant from the Bill and Melinda Gates Foundation to create a micro-reinsurance facility could become a major step in opening both developing economies and the attendant revenue opportunity. In summary: our industry has survived and thrived because of our ability to understand risk, price it effectively and manage it through tried and true risk transfer mechanisms. Today, capital management is the mantra of the day -- understanding the threats to capital, from every corner, and managing the risks to capital so we may optimize our investments for a greater return. We are uniquely adept at managing risk, and capital is more readily available than ever. 9

11 I am bullish on the future as we see the true benefits of what was once called convergence. We have eased the barriers to interested capital from markets outside the traditional carriers, and I believe this will spur greater creativity and product development. In the long run, this will strengthen our industry and provide greater opportunities for growth. Thank you for your attention, and enjoy the rest of your time in Monte Carlo. 10