1. © 2006 Towers Perrin November 2006 Kelleen Arquette California Personal Auto Rating Plans The Good, The Bad and The Ugly

2. © 2006 Towers Perrin 2 Agenda California Private Passenger Automobile Regulations Background – Proposition 103 New Regulations Market Impact —Pumping and Tempering —Market Studies —Industry Comments —Lessons from Other States What Can Companies Do? Other Regulations

3. © 2006 Towers Perrin 3 Background – Proposition 103 Enacted in 1988 Requires premiums based on certain variables in a certain order Three Mandatory Factors —Driving Safety Record —Annual Mileage —Years of Driving Experience Optional Rating Factors —Some can be combined with Years of Driving Experience —Only approved list allowed Mandatory rate decrease Average weight of optional factors below third mandatory factor Requires rating plan factors to be developed using sequential analysis Territorial Restrictions 10 frequency bands and 10 severity bands

4. © 2006 Towers Perrin 4 New Regulations Enacted July 14, 2006 Required each insurer to cap the amount of spread an insurer can use for territorial rating 20 frequency bands and 20 severity bands Although more bands allowed, restriction on weight limits territorial dispersion Required each insurer to file an updated rate level indication Weight of each optional factor below third mandatory factor Two phases First filing within 30 days – move part way towards full compliance, including rate filing Second and subsequent filings – achieve full compliance within two years

5. © 2006 Towers Perrin 5 Implementation – Phase One First filing required to correct for any non-compliance by 15% For any factor with weight above the third mandatory factor, decrease the weight by 15% Initial filings did not accomplish full compliance for factor weights Frequency and severity bands Gender and marital status in some cases

6. © 2006 Towers Perrin 6 Implementation – Phase One (continued) Auto Club (Interinsurance Exchange of the Auto Club) First to file 7.0% decrease Weights for multi-car, gender for a few coverages, frequency bands and severity bands still above third mandatory factor Retained current frequency and severity band definitions

7. © 2006 Towers Perrin 7 Implementation – Phase One (continued) USAA Second to file 5.1% decrease Weight for frequency band factors still above weight of third mandatory factor Retained current frequency and severity band definitions Reduced weight of frequency band factors by lowering the relativities for the highest rated bands and increasing the relativities for lowest rated bands, instead of tempering

8. © 2006 Towers Perrin 8 Implementation – Phase One (Continued) Pending Rate Changes State Farm: -8% Mercury: +4.5% Auto Club: -7% Farmers: 0% Allstate: 0% AIG: -5% California State Auto: -5% Progressive: -2% USAA: -5% GEICO: -5% California Market Share

9. © 2006 Towers Perrin 9 Implementation – Phase Two Full compliance with proposed regulations must be achieved by July 14, 2008 Requires at least one filing – rate and class plan Redefine territory definitions to 20 territories Number of filings will depend on Customer rate impact Customer retention Rate indication Competition

10. © 2006 Towers Perrin 10 Pumping and Tempering Factor weight Weighted average of the absolute difference of the relativities from the mean Measure of dispersion Temper – lessens dispersion, decreases factor weight Pump – increase dispersion, increases factor weight Example Driving Safety Record10 Annual Mileage 9 Years of Driving Experience 8 Frequency Band13 Possible solutions Select different relativities to align weights Temper frequency band relativities Pump years of driving experience, annual mileage and driving safety record

11. © 2006 Towers Perrin 11 Pumping and Tempering (continued) Cross-subsidies Pumping Driving Safety Record – Drivers with accidents and convictions pay too much, high surcharges may create incentive for unreported minor accidents Pumping Annual Mileage – Long annual mileage drivers subsidize short annual mileage drivers, incentive for policyholder to underestimate annual mileage Pumping Years of Driving Experience Higher rates for new drivers increases likelihood of undisclosed drivers Increase uninsured population of new drivers (<9 years driving experience) and experienced drivers (59+ years of driving experience) Temper Cost and Frequency Bands – Urban rates subsidized by suburban and rural rates Temper Gender/Marital Status – Rates for inexperienced single male drivers subsidized by other drivers

12. © 2006 Towers Perrin 12 Pumping and Tempering (continued) 2003 study ranked importance of rating variables Three most important factors connected to loss propensity do not align with California’s Three Mandatory Factors Insurance score is not an optional factor in California Years of driving experience used in California instead of age CoverageFactor 1Factor 2Factor 3 Bodily Injury Liability Age/GenderInsurance ScoreGeography Property Damage Liability Age/GenderInsurance ScoreGeography Medical Payments Insurance ScoreLimitAge/Gender ComprehensiveModel YearAge/GenderInsurance Score CollisionModel YearAge/GenderInsurance Score Source: The Relationship of Credit-Based Insurance Scores to Private Passenger Automobile Insurance Loss Propensity, Michael Miller, FCAS and Richard Smith, FCAS, Epic Actuaries, June 2003

13. © 2006 Towers Perrin 13 Market Studies – Robert Downer Study Study commissioned by Personal Insurance Federation of California (PIFC) and Association of California Insurance Companies (ACIC) Study performed by Robert Downer of ARM Consultants, Inc. Data from four large auto insurers Study focused on rate changes for individual drivers rather than rates relative to indicated costs Study assumed revenue neutral changes Study shows Over 60% of all drivers will receive a rate increase Nearly 75% of drivers with 34 years driving experience (50+ years old) will receive rate increases Over 60% of California Good Drivers will receive rate increases Over 55% of drivers not considered California Good Drivers will receive rate decreases Source: Personal Insurance Federation of California Reference Book, “Impact of petition to modify use of Optional Rating Factors”, Robert Downer

14. © 2006 Towers Perrin 14 Market Studies – Mercer Oliver Wyman Study California Department of Insurance commissioned study by Mercer Oliver Wyman Participation from several companies Three instruction sets completed by participating companies, data provided to Mercer Oliver and Wyman for analysis Study focused on rate changes for individual drivers rather than rates relative to indicated costs Study assumed revenue neutral changes Study shows Rate increases for 52 of 58 counties Approximately 60% of California drivers would receive a rate increase 27% of all drivers will get a rate increase of over 10% Rural drivers subsidize urban drivers Magnitude of cross-subsidies range from $344 million to $742 million Two studies show same results – New regulations will result in rate changes for drivers across the state Rate changes not considered in either study Source: California Farm Bureau Federation Fact Sheet, “Proposed Amendment of Title 10 California Code of Regulations, Section 2632.8 – Optional Automobile Insurance Rating Factors” Californians to Stop Unfair Rate Increases, “Two Different Studies – Same Conclusion, Department of Insurance Proposal Will Result In Higher Auto Insurance Rates for More Drivers?”

15. © 2006 Towers Perrin 15 Industry Comments – 45 Day Comment Period Insurer comments during 45 day comment period prior to passage of new regulations Rates should be cost-based and substantially related to the risk of loss A driver’s location (zip code) should be a critical factor in calculating insurance rates Drivers in rural regions of the state should not be forced to subsidize the rates for drivers in urban regions of the state The proposed regulations will result in arbitrary rates because of the act of pumping and tempering and the resulting cross- subsidies. Pumping and tempering move rate relativities in opposite direction of indicated

16. © 2006 Towers Perrin 16 Lessons from other states - Michigan Michigan Essential Insurance Act Take-all-comers provision Territory restrictions —20 territories —Maximum 10% rate differential between adjacent territories —Restrictions on maximum rate differential between highest and lowest rated territories (lowest rated not less than 45% of highest rated) Market Impact Urban territories subsidized by suburban and rural territories Insurers specialized in urban or rural areas, with rates that reflected their market area Coverage availability problems in Detroit Increase in the involuntary market, especially in Detroit Similarities to California Regulations Territory restrictions that create a subsidy for urban drivers CA insurers must accept all California Good Drivers Source: Mackinac Center for Public Policy, www.mackinac.org, “The Essential Insurance Act”

17. © 2006 Towers Perrin 17 Lessons from other states - Massachusetts State-mandated rates Territories Territory definitions are re-defined every two years Urban territories subsidized by rural territories 27 territories Age, gender and marital status prohibited Mandatory Offer Rule Tempering and capping Exit restrictions Reallocation of premiums across insurers based on loss experience Source: Chapter 2 “Automobile Insurance Regulation: The Massachusetts Experience” Sharon Tennyson, Mary A. Weiss, Laureen Regen

18. © 2006 Towers Perrin 18 Lessons from other states – Massachusetts (continued) Market Impact Cross-subsidies – urban territories subsidized by rural territories, inexperienced drivers subsidized by experienced drivers Massachusetts auto insurance market less profitable than the U.S. auto insurance market overall Increase in residual market Fewer firms in the market compared to other states Shift to Massachusetts-only firms Cross-subsidies distort consumer behavior —Insurance premiums charged do not reflect true cost of providing insurance —Greater relative participation of high risk drivers in the driving and insuring population, increasing average expected costs Companies specialize in urban or rural markets Regulations lead to higher insurance costs Source: Chapter 2 “Automobile Insurance Regulation: The Massachusetts Experience” Sharon Tennyson, Mary A. Weiss, Laureen Regen National Association of Mutual Insurance Companies press release, “Study supports NAMIC Position That Massachusetts Over-Regulation Leads to Higher Insurance Costs”, April 30, 2004

19. © 2006 Towers Perrin 19 Lessons from other states – Massachusetts (continued) Proposed legislation in 2006 to revise auto system. Although not passed, work is ongoing to build support Similarities to California market Territorial restrictions CA insurers must accept all CA Good Drivers Pumping and tempering Complex system of cross-subsidies Difference from the California market No mechanism for reallocation of premium Source: Chapter 2 “Automobile Insurance Regulation: The Massachusetts Experience” Sharon Tennyson, Mary A. Weiss, Laureen Regen National Association of Mutual Insurance Companies press release, “Study supports NAMIC Position That Massachusetts Over-Regulation Leads to Higher Insurance Costs”, April 30, 2004

20. © 2006 Towers Perrin 20 Conclusions Cross-subsidies Reduce incentive for companies to write subsidized drivers Insurance premiums charged do not reflect true cost of providing insurance Greater relative participation of high risk drivers in the driving and insuring population, increasing average expected costs Companies specialize in rural or urban markets Higher insurance costs Auto insurance market less profitable than U.S. auto insurance market Rate increases for rural and suburban drivers Rate changes across the state Consumer shopping

21. © 2006 Towers Perrin 21 What can companies do? Diligent data collection for accurate rating MVR reports – must balance with cost of MVR ($ ) Annual mileage Undisclosed drivers Misclassification lowers factor weights Underestimation of annual miles lowers the factor weight for annual mileage annual mileage

22. © 2006 Towers Perrin 22 What can companies do? (continued) Redefine cost and frequency bands – geographic clustering As major competitors make class plan filings, include competitive review and make adjustments to proposed class plan Maximize use of optional rating factors

23. © 2006 Towers Perrin 23 What can companies do? (continued) Optional Rating Factors Type of vehicle Vehicle performance capabilities (including alterations) Type of use of vehicle (pleasure, business, commute, etc.) Percentage use of the vehicle by the rated driver Multi-vehicle households Academic standing (Good Student Discount) Driver training or defensive driving courses Vehicle characteristics (protective devices, theft deterrent devices) Gender Marital status Persistency (renewal discount) Non-smoker Secondary driver characteristics (safety record, years licensed, gender, marital status, driver training, academic standing for drivers not assigned as primary or secondary drivers on another vehicle) Multi-policy discount Relative claims frequency Relative claims severity Source: California Insurance Regulations, Title 10, Chapter 5, Subchapter 4.7, Section 2632.5

24. © 2006 Towers Perrin 24 What can companies do? (continued) Years of driving experience can be combined with Percent use Academic standing Gender Marital status Driver training Analyze rating factors used by competitors Household Composition Factor (Allstate) Liability Symbol (Allstate) Model year for liability coverages in addition to liability symbol (Auto Club) New Vehicle Discount (USAA) Multiple Policy Discount (State Farm) Garaging location for comprehensive coverage (Auto Club) Persistency Discount (several insurers) Source: California Insurance Regulations, Title 10, Chapter 5, Subchapter 4.7, Section 2632.5

25. © 2006 Towers Perrin 25 What can companies do? (continued) Sequential Analysis Order of optional factor —Driving Safety Record (first), Annual Mileage (second), Years of Driving Experience (third) —Cost and Frequency Bands (last) Multivariate analysis to compare proposed to indicated

26. © 2006 Towers Perrin 26 Other Regulations Regulations on the Horizon Annual Mileage Regulations Prior Approval Regulations

27. © 2006 Towers Perrin 27 Regulations on the horizon – Annual Mileage Proposed regulations Estimated annual mileage (new business or added vehicles) —Based on policyholder estimate —May use reasonable estimate if policyholder’s estimate is not available Calculation —Distance to/from work, number of days driven to work —Difference between estimate and prior 12 months Verification (renewal business) —Odometer reading from insured —Service records (insurer can’t require) —Technological devices provided by insurer —Smog check odometer readings New business – cannot request annual mileage from prior carrier Source: CDI Proposed Regulation Text, Mileage Verification, Section 2632.5

28. © 2006 Towers Perrin 28 Regulations on the horizon – Annual Mileage (continued) Association of California Insurance Companies’ response to proposed annual mileage regulation Insurers should be allowed more flexibility in estimating annual mileage Annual mileage verification should be allowed on new business High potential costs to insurers as regulations may require collection of annual mileage information from current book Source: Statement of the Association of California Insurance Companies on “Proposed Amendments of Section 2632.5”, June 2006

29. © 2006 Towers Perrin 29 Regulations on the horizon – Annual Mileage (continued) “Black Box” rating (telematics) Potentially provides information to car makers (and insurers) through on-board sensors, Global Positioning Units (GPS) units and mobile phone technology GM announced telematics will be standard on all GM vehicles by 2007 (and has been standard for Mercedes-Benz and BMW) If cost and potential legislative barriers are overcome, could provide exact annual mileage Progressive has been piloting a system in Minnesota since 2004 and Texas since 1998

30. © 2006 Towers Perrin 30 Regulations on the horizon – Prior Approval Insurance Regulations Prior Approval Regulations Specifies methodology for developing rate indication —Loss Development – dollar-weighted average of last three link ratios, no tail factor —Trend – company’s latest 12 quarters of calendar year paid claim cost and frequency data, developed using exponential curve of best fit —Efficiency Standard – maximum allowable expense ratio set by insurance commissioner, three-year average expense ratio —Leverage Factors and Surplus – allocation based on loss and unearned premium reserves —Credibility – current rate plus a trend —Catastrophes – historical experience only, no external data Limited scope for variance requests Source: Proposed Regulation Text 2642.4 – 2648.4

31. © 2006 Towers Perrin 31 Regulations on the horizon – Prior Approval Insurance Regulations (continued) Association of California Insurance Companies – “Comments on Proposed California Prior Approval Insurance Regulations”, Michael A. Walters Unprecedented degree of prescription – no ratemaking methodology is appropriate in all cases Removes actuarial judgment —Methodology —Input Result – cause operating losses or inadequate returns for insurers and lines constricted by simplistic rate indication approach Recommendation – proposed procedures guideline for simplistic approach, identify filings that need more attention Source: Michael A. Walters, Tillinghast report to the Association of California Insurance Companies, September 13, 2006

32. © 2006 Towers Perrin 32 Questions?