1. Reinsurance Topics: Impact on Insurance Rates Alabama Affordable Homeowners Insurance Commission November 21, 2011 Bob Fox, ACAS, MAAA Director, Catastrophe Actuarial Aon Benfield

2. 1 History of Homeowners Pricing 20’s-60’s 5% Profit Provision 70’s-80’s Offset for investment income 1990’s Rise of auto specialists Increase in hurricane activity leads to introduction of catastrophe models 2000’s Profit models Reinsurance recovery 2010’s Cost of equity capital held to support catastrophe risk

3. 2 Drivers of Catastrophe Risk Hurricane risk estimated by simulation models (AIR & RMS most common) Tornado/Hail risk usually estimated by company experience Hazard Drives reinsurance purchases and costs Causes companies to hold more capital in safe liquid (low return) investments Concentration Proprietary & Confidential

4. 3 Catastrophe Models in Insurance and Reinsurance AdvantagesDisadvantages Multiple Independent Views Current Exposure Distribution and Risk Characteristics All Known Historical Data Latest scienceModel ChangeModel MissBlack Box Perception Proprietary & Confidential They may not be perfect, but they’re the best tool currently available to assess catastrophe risk

5. 4 Model Miss: April, 2011 Storms Over 10,000 year return period in AL based on models Anecdotally, more likely a 50-year event Proprietary & Confidential  DOI capping at 1:250 years based on countrywide model estimate  Will this hurt availability?  Is tornado/hail risk changing?

6. 5 Model Change: RMS Hurricane  Use of multi-model average cuts expected loss reduction in half, to 20%  Fixed expenses of 20-30% limit required premium reduction to 14-16%  Expected loss from other perils (5-10%) limit required premium reduction to 12-15%  Further reduction to reinsurance and capital costs likely, if included in rates and allocated properly  Premium reductions realized ONLY if rates were fully adequate based on prior model “In both Baldwin and Mississippi’s Jackson counties, expected hurricane losses are projected to be more than 40 percent lower under RMS’ new model. That, in turn, could mean an average 34 percent drop in overall premiums in Baldwin County, RMS found.” AL.com, September 4, 2011

7. 6 Property Cat Excess of Loss Reinsurance More insurers More capacity for each insurer Makes the market work Global Pooling of Risk Especially for diversifying risk Sufficient/flexible capacity Brokers working on behalf of insurers Competitive Market High returns when cat activity is low Potentially large losses in high activity years Reasonable Risk-Adjusted Returns Proprietary & Confidential

8. 7 Reinsurance Premium Fixed Costs Ceded Losses Risk Load Variable Costs Drivers of Reinsurance Premiums

9. 8 Reinsurance Treaty Costs by Region Florida Hurricane High expected loss and volatility Highest margins Global PML driver California Earthquake Low take-up rates Low expected loss Extreme volatility Diversifying risk Midwest Tornado/Hail Lowest severity Lower ceded volatility Diversifying risk Northeast Hurricane Lower expected loss Volatility still high Somewhat diversifying

10. 9 Aon Benfield Reinsurance Pricing Model 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 0.00%10.00%20.00%30.00%40.00%50.00%60.00% Model ROL Actual ROL

11. 10 Reinsurance Costs Within Alabama Upstate Tornado/Hail Lower expected loss Lower ceded volatility Diversifying risk Downstate Hurricane Higher expected loss and volatility Higher margins Still diversifying  A reasonable allocation of reinsurance costs by state will consider not only ceded expected loss, but also volatility and correlation to industry  A reasonable within-state allocation should consider all of these as well  Insurance is designed for risk sharing, not subsidies

12. 11 Diversification of Catastrophe Risk Increased Availability Lower Costs (yes, lower) Fewer Insolvencies Impact of Reinsurance on Insurance Market

13. 12 Reinsurance as an Inexpensive Source of Capital Diversification Benefit: marginal volatility to reinsurer is less than marginal volatility ceded by primary company One measure of capital required to support retained cat risk

14. 13 So Rating Agencies are the Problem? Evaluate the ability of a company to pay claims For example, can the company pay claims resulting from 100-year catastrophe event, net of reinsurance Stressed capital adequacy models evaluate the company following a significant event If either of these is in doubt, the company may be subject to a ratings downgrade A downgrade could jeopardize the ability of a company to continue operating, as mortgage companies require minimum ratings Rating agencies Rating agencies don’t cause capital needs, they just quantify them Most companies still aren’t pricing for the ROE that they claim to be targeting Observations Proprietary & Confidential

15. 14 Aon Benfield Homeowners ROE Study

16. 15 Created to fill gaps in insurance markets Don’t need to answer to stockholders, so poor returns have persisted Still need to grow surplus to remain viable Dominated by mutual companies “Alabama’s -8% average Homeowners ROE over the last 10 years means that if a company had started with $1 billion in net worth 10 years ago, today the company would only have $434 million net worth remaining” “[The DOI] disallowed an expense load for the cost of capital despite such load being a reasonable financial concept” May require more DOI flexibility Why Would Anyone Write Homeowners Insurance?

17. 16 Retained Catastrophe Costs Within Alabama Upstate Tornado/Hail Expected loss higher than previously thought High retained volatility Need to diversify risk Downstate Hurricane May still drive net PML Risk/return insufficient for admitted insurers AIUA, E&S writers filling the gaps

18. 17 Concentrations Drive Reinsurance and Capital Costs People Tend to Live in Concentrated Areas The Problem of Concentrations  The April storms woke Alabama insurers to the risk of concentrations, even away from the coast  If companies can’t price for tail risk, they will try to reduce it by cutting policies  If returns are perceived as adequate, more companies will share the load on the coast and inland  The more the risk is spread among different companies, the lower capital needs will be for each Proprietary & Confidential