Inflation Risk andP C IP-C Insurance:

Overview and OutlookJoint Meeting of the Underwriting, Claims,

and Emerging Issues Committeesand Emerging Issues CommitteesReinsurance Association of America

May 18, 2010 Philadelphia, PASteven N. Weisbart, Ph.D., CLU, Senior Vice President & Chief EconomistInsurance Information Institute ♦ 110 William Street ♦ New York, NY 10038Office: 212.346.5540 ♦ Cell: (917) 494-5945 ♦ stevenw@iii.org ♦ www.iii.org

Presentation Outline

1. What Causes Inflation?2 Inflation’s Past and Future2. Inflation s Past and Future3. Inflation’s Effect on Property-Casualty

Insurance ClaimsInsurance Claims4. P-C Premium Growth and Inflation5 Underwriting and Inflation5. Underwriting and Inflation6. Investments and Inflation7. Inflation, Reserve Adequacy, and Impairment

Q&A

2

What Causes Inflation?What Causes Inflation?

3

What Makes Prices Increase?

An increase in the prices of the components (e.g., materials and labor) of the things we buy, if the sellers of those things pass along their increasedsellers of those things pass along their increased costs to buyers

S it f l i l ti t d d If thScarcity of supply in relation to demand. If there isn’t enough of a good or service to meet demand, the price of that item will tend to rise (and some b ill d t ti l /d dbuyers will drop out, creating a supply/demand equilibrium at a higher price)

Expectations. If sellers expect their costs to rise in the near future, they might raise prices now to avoid being caught. This includes the category of “b bbl ”“bubbles.”

What Makes the Prices of Items orComponents from Overseas Rise?

A drop in the value of the U.S. dollar. The price of any component that we buy from overseas couldany component that we buy from overseas could rise for us if the U.S. dollar’s value drops in relation to the value of the seller’s currency. In effect, it takes more U S money to convert to the sametakes more U.S. money to convert to the same price in foreign currency.

Trade-Index-Weighted US Dollar Exchange Rate*

110

115

January 2000 through April 2010Post-crisis

depreciation of dollar

Dollar appreciates in its role as the global “reserve

c rrenc ” is affirmed d ring

95

100

105

110 currency” is affirmed during the global financial crisis

85

90

95

Depreciation of dollar after

70

75

80of dollar after Tech bubble

and post 9-11

Jan00

Jan01

Jan02

Jan03

Jan04

Jan05

Jan06

Jan07

Jan08

Jan09

Jan10

Except in Times of Global Financial Crisis,The U.S. Dollar Has Weakened vs. Other Currencies

*The broad index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares. Sources: US Federal Reserve, Board of Governors, at http://www.federalreserve.gov/releases/g5/current/ ; Insurance Information Institute.

What Makes the Prices of Items orComponents from Overseas Rise?

New taxes, tariffs, or other charges (e.g., shipping) that increase the effective price of an itemthat increase the effective price of an item.

An increase in the price of the item in the selling countrycountry.

Inflation Rates for Largest European Economies & Euro Area, 2010F-2011F

9% 2010F 2011F

% Change from Prior Year

2010F 2011F

6% Annual inflation is below 2% across

most major European economies

2.6%

1 8%

3%

1.3% 1.1%1.5%

1.1%1.6% 1.5%

1.8% 1.6% 1.5%

0%0%Euro Area Germany UK France Netherlands

Source: Blue Chip Economic Indicators, 5/10/10 edition.

Inflation Rates for MajorEmerging Economies, 2010F-2011F

9 2%10.0% 2010F 2010F

% Change from Prior Year

9.2%

7.2%7.4%7.5%

5.0% 5.0%

6.6%

4.7%5.0%

2.8% 2.9%3.3%

4.2%

3.1%

2 5%

5.0%

Annual inflation is forecast to be above 3% across most

0 0%

2.5% to be above 3% across most major countries from which

we import

0.0%China India Brazil Russia Mexico S. Korea

Source: Blue Chip Economic Indicators, 5/10/10 edition.

“Headline” Inflation Rates,* Emergingvs. Advanced Economies, 2002-2009

10%Advanced Economies Emerging Economies

6%

8%

4%

6%

0%

2%

-2%

%

02 02 03 03 04 04 05 05 06 06 07 07 08 08 09 09

Jan

Jul

Jan

Jul

Jan

Jul

Jan

Jul

Jan

Jul

Jan

Jul

Jan

Jul

Jan

Jul

*12-month change in consumer price index, monthlySource: International Monetary Fund, “World Economic Outlook” update January 2010

This is Odd: “Core” Inflation is Now Higherin Advanced vs. Emerging Economies

5%

12-month change, monthly This spike preceded the

global financial crisis. It

4%

gbegan in early 2008

3%

1%

2%

0%

n 05 l 05

n 06 l 06

n 07 l 07

n 08 l 08

n 09 l 09

Advanced economies

Emerging economies

11

Jan

Jul

Jan

Jul

Jan

Jul

Jan

Jul

Jan

Jul

Note: data are through November 2009Source: International Monetary Fund World Economic Outlook January 2010 update at http://www.imf.org/external/pubs/ft/weo/2010/update/01/data/figure_2.csv

Japan is an Inflation ExceptionAmong Advanced Economies

221

113

115United States, Consumer Prices, All items, SA, Index,USD, 1982-1984=100Euro Zone, Consumer Prices, All Items, Total (ECB),SA, Index, EUR, 2005=100

216

109

111

113United Kingdom, Consumer Prices, By Commodity, Allitems (CPI), Index, GBP, 2005=100Japan, Consumer Prices, Nationwide, All Items,General, SA, Index, JPY, 2005=100

206

211

107

109

201

206

103

105

196

c-06 r-0

7

r-07

n-07 t-0

7

t-07

c-07 r-0

8

r-08

n-08 t-0

8

t-08

c-08 r-0

9

r-09

n-09 t-0

9

t-09

c-09

99

101

Source : Ecowin & SCOR (2010)

déc

févr avr

juin

août oc

t

déc

févr avr

juin

août oc

t

déc

févr avr

juin

août oc

t

déc

Recent Monthly Changesin U.S. Non-Fuel Import Prices

0 4% 0 4% 0 4% 0 4% 0 4%0.5%0.6%

Inflation Rate (%)

Mainly increases in prices for industrial supplies and materials

0.4% 0.4% 0.4%0.3%

0.4% 0.4%

0.1%0.2%0.2%0.2%

0.1%0.2%

0.4%

-0.2%-0.2%

0.0%

-0.6%

-0.4%

0 7%

-0.6%

-0.4%

Overall non-fuel April 2009-to-April 2010 increase was 3.2%. 12-month increase in

industrial supplies and materials was 16.0%-0.7%-0.8%Jan

2009Feb March April May June July AugustSept Oct Nov Dec Jan

2010Feb March April

13Source: http://www.bls.gov/news.release/pdf/ximpim.pdf

Overall Inflation In Some Countries From Which We Buy Is Forecast to Be Modest, But More Severe in Others

Forecasts of 2010-11 Inflation Ratesin Selected Countries

8 3

10

Inflation Rate (%)

8.3

6.47.3 7.4

6

8ChinaIndiaRussiaBrazilSouth Korea

4.4 4.7

2.9 2.9

4.84.0

2.41 8

2.3 2.63.2

2.64

6 South KoreaMexicoEuro ZoneJapanU.K.Australia

1.3 1.6

-0 2

1.8

0

2

-1.0-0.2

-22010 2011

14Source: Blue Chip Economic Indicators Mar. 2010.

Overall Inflation In Some Countries From Which We Buy Is Forecast to Be Modest, But More Severe in Others

Now, Really, What Causes Inflation?

“Too much money chasing too few goods ” When the Federal Reserve andgoods. When the Federal Reserve and the “shadow” banking system provide more money than people need at current y p pprices, prices rise to absorb the extra money.

“Inflation is everywhere and always a monetary phenomenon.” (Milton Friedman)

Inflation and the U.S. Monetary Base Have Roughly Moved Together (1975-2007)

18%CPI-U % change in monetary base

% Change from Start to End of Year

12%

15%The Monetary Base is coins, paper, and bank reserves—

money available for use.

9%

12%

3%

6%

-3%

0%

3%

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Sources: http://www.federalreserve.gov/releases/H3/hist/h3hist4.txt Insurance Information Institute (calculations).

But the U.S. Monetary Base Exploded in 2008 (Monthly, 1990–2010*)

Billions

$2 000

$2,250The subsequent 6-

month increase, from mid-Sept 2009 to mid-March 2010,

$1,750

$2,000to mid March 2010,

was 16.7%.

$1,250

$1,500

The 12-month increase, from mid-Sept 2008 to mid-

$750

$1,000from mid Sept 2008 to mid

Sept 2009, was 108.5%.

$250

$500

'90 '93 '96 '99 '03 '06 '09

17

*As of end of April 2010; seasonally adjustedNote: Recessions indicated by gray shaded columns.Sources: http://www.federalreserve.gov/releases/H3/hist/h3hist4.txt National Bureau of Economic Research (recession dates); Insurance Information Institutes.

90 93 96 99 03 06 09

What Does the Spike in the Monetary Base in 2008-09 Mean for Future Inflation?

110%CPI-U % change in monetary base

80%90%

100%So far, this hasn’t produced

rampant inflation because banks have been reluctant to lend (and businesses reluctant to borrow)

50%60%70% businesses reluctant to borrow).

But this could change at any time.

20%30%40%

-10%0%

10%

10%

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: US Department of Labor, Bureau of Labor Statistics

In 2008, Central Banks in Europe, the UK, andthe US Dramatically Expanded the Money Supply

2500000

3000000

250000

300000US Federal reserve Banks, Total assets or liabilities, dollars

Euro Zone, Eurosystem, Total assets or liabilities, EUR

United Kingdom, Bank of England, assets, GBP

2000000

2500000

uros

200000

250000g g

1500000

oilli

ons

of D

olla

rs o

r E

150000

500000

1000000Mo

50000

100000

0

2006

2006

2006

2007

2007

2007

2007

2008

2008

2008

2008

2009

2009

2009

2009

0

Source : Ecowin

26/0

5/2

26/0

8/2

26/1

1/2

26/0

2/2

26/0

5/2

26/0

8/2

26/1

1/2

26/0

2/2

26/0

5/2

26/0

8/2

26/1

1/2

26/0

2/2

26/0

5/2

26/0

8/2

26/1

1/2

Households and Businesses Are Now “Deleveraging”: Low Inflation Pressure

15%

Percent Change in Debt Held(Quarterly since 2004 at Annualized Rate)

9%

12%

3%

6%

-3%

0%

Home Mortgage Consumer Credit

-6%

3%

4:Q

14:

Q2

4:Q

34:

Q4

5:Q

15:

Q2

5:Q

35:

Q4

6:Q

16:

Q2

6:Q

36:

Q4

7:Q

17:

Q2

7:Q

37:

Q4

8:Q

18:

Q2

8:Q

38:

Q4

9:Q

19:

Q2

9:Q

39:

Q4

Home Mortgage Consumer CreditBusiness Corporate

2004

2004

2004

2004

2005

2005

2005

2005

2006

2006

2006

2006

2007

2007

2007

2007

2008

2008

2008

2008

2009

2009

2009

2009

Source: Federal Reserve Board, at http://www.federalreserve.gov/releases/z1/Current/z1r-2.pdf (latest data as of 5/14/2010)

Conventional Wisdom: Inflation Won’t Threaten Until We’re At Full Capacity

82%

Percent of Manufacturing Capacity

H i

“Full Capacity”

78%

80%Hurricane Katrina

74%

76% Recession began December 2007

70%

72%

hThe closer the economy is

66%

68%

70% March 2001-November 2001

recession

to operating at “full capacity,” the greater the

inflationary pressure

66%

Mar

01

Jun

01

Sep

01

Dec

01

Mar

02

Jun

02

Sep

02

Dec

02

Mar

03

Jun

03

Sep

03

Dec

03

Mar

04

Jun

04

Sep

04

Dec

04

Mar

05

Jun

05

Sep

05

Dec

05

Mar

06

Jun

06

Sep

06

Dec

06

Mar

07

Jun

07

Sep

07

Dec

07

Mar

08

Jun

08

Sep

08

Dec

08

Mar

09

Jun

09

Sep

09

Dec

09

Mar

10

Source: Federal Reserve Board statistical releases at http://www.federalreserve.gov/releases/g17/Current/default.htm 21

But Some Industrial ProductionCapacity Has Vanished

Some unused capacity is gone, and in other industries new capacity is needed, so the economy might be closer to full capacity than the industrial production numbers indicate

Source: Wall Street Journal, Feb. 3, 2009

capacity than the industrial production numbers indicate.If so, this might spur inflation sooner than expected.

Inflation’s Past and FutureInflation s Past and Future

23

Inflation Isn’t Double-Digit Now as It Was in 1974-81

14%

If you started work in the insurance industry 27 years ago, you never experienced

Annual Inflation Rates (%)

10%

12%

g , y pannual inflation as high as 6%

6%

8%

2%

4%

-2%

0%

70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10F

7 7 7 7 7 7 7 7 7 7 8 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 1

Sources: US Department of Labor, Bureau of Labor Statistics; Blue Chip Economic Indicators (5/2010 issue) (2010 forecast)

A Closer Look: Annual Inflation Rates(CPI-U, %), 1990–2014FAnnual Inflation Rates (%)

The recession and the collapse of commodity prices appear to have reduced inflation, at least for nowTwo years after the last

recession ended prices

3 4 3 4 3 23.8

5.4

4.24.0

5.0

6.0 recession ended, prices started up again

2.92.3

1.62.2

3.42.8

1.62.3

2.73.4 3.2

2.8

2.0 1.92.3 2.4 2.4

3.0 3.02.6 2.8

2.0

3.0

-0.41 0

0.0

1.0

-1.0

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10F

11F

12F

13F

14F

The Annual Inflation Rate (CPI-U) Has Been Below 4% Since 1992. The

25Sources: US Bureau of Labor Statistics; Blue Chip Economic Indicators, 3/2010 and 5/2010 issues (forecasts).

The Annual Inflation Rate (CPI U) Has Been Below 4% Since 1992. The Compound Average Growth Rate of Inflation 1992-2009 was about 2.3%.

Forecasts of Yearly U.S. Inflation Rates(CPI-U, %), 2010–2015FAnnual Inflation Rates (%)

Even the pessimistic forecasts don’t see the CPI rising much above 3% in the next 5+ years

2 5

3.23.13.13.12.83

4

Blue Chip AvgPessimistic

Bl Chi

2.0 1.92.3 2.4 2.4 2.5

1.71.5 1.6 1.7 1.8

2.4

2

Blue ChipMedian

Blue Chip AvgOptimistic

1.11

02010 2011 2012 2013 2014 2015

Overall Inflation Is Forecast to Rise Modestly through 2015

26Source: Blue Chip Economic Indicators Mar. 2010 and May 2010 issues.

y gbut Is Not Expected to Become a Major Concern

But Some Economists Say the Fed’s Inflation Target Should be Higher

Headline in Wall Street Journal Monday February 22, 2010:

Low Inflation Always Best? Some Urge a Policy RethinkSome Urge a Policy RethinkHigher inflation brings higher interest rates, giving the g g g g gFederal Reserve “more room” to lower rates when it wants to stimulate the economy.Higher inflation also lessens the debt burden (inflationHigher inflation also lessens the debt burden (inflation pushes incomes up but debt payments are fixed)

P d i fl ti t t 4% (C t t t 2%)Proposed inflation target: 4% (Current target: 2%)

Bernanke’s Recent Views onthe Fed’s 2% Inflation Target

A major inflation driver is expectations regarding the future rate of inflationfuture rate of inflation

Firms will raise prices if they expect their costs to increaseW k ill d d i t ff t t dWorkers will demand pay raises to offset expected higher inflation

Bernanke’s worry: If the Fed changes its target to a y g ghigher inflation level, people might think that the Fed isn’t serious about inflation, and might bid prices up proactivelyproactivelyBernanke: the Fed should maintain its 2% target in order to support current beliefs that the Fed will act to limit inflation to 2%

Source: http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm

So If Inflation Isn’t Threatening Now,Why Are We Worried About It?

Rising Claim SeveritiesCost of claims settlement rises across the board (property and li bilit )liability)

Rate InadequacyRates inadequate due to low trend assumptions arising from use of hi t i l d thistorical data

Reserve InadequacyReserves may develop adversely and become inadequate (d fi i t)(deficient)

Burn Through on RetentionsRetentions, deductibles burned through more quickly

Reinsurance Penetration/ExhaustionHigher costs risks burn through their retentions more quickly, tapping into reinsurance more quickly and potentially exhausting th i i i kl

29

their reinsurance more quickly

Inflation’s Effect on Property-p yCasualty Insurance Claims

P-C Claim Severity Generally Has Risen Faster than the CPI

30

Resurgent Inflation Would Shift ClaimSeverity Upward for any Given Distribution

Loss distribution

Claims before inflation resurgenceClaims after inflation resurgence

)

g

roba

bilit

y (%

)Lo

ss p

r

Source : SCORLoss size ($)

Source: Philippe Trainar, “Inflation risk: a long term Pressure scenario for insurance companies,” presentation at the GenevaAssociation’s Amsterdam Circle of Chief Economists, February 11, 2010.

Major Components of the CPI-U,by Weighting

P-C Insurance Doesn’t Pay for the Major Items in the CPI. It FactorsSlightly in Housing, Transportation; Significantly in Medical Care

3 5%

Other

Recreation

Apparel

6.4%

6.4% 3.7%3.5%

Housing

Education & Communication

42.0%6.5%

gMedical Care

16.7%

14.8%Food & Beverages

Nearly 2/3 of this is the rent homeowners pay to themselves for

living in their own h

32Source: BLS News Release, March. 18, 2010 “Consumer Price Index – February 2010”

Transportationhome

Inside the Jan. & Feb. 2010 CPI:*Components Move Differently

2.8%

2 5%

3.0%Jan-10 Feb-10

Percent changefrom prior month

Weights of Selected CPI Components

1.5%

2.0%

2.5%g

Owners’ Equivalent Rent 25.2%Food and Beverages 14.8%Energy 8.6%Medical Care 6.5%

0.2% 0.2%0.5%

0 0% 0.1% 0 0% 0 0%

0.5%0.5%

1.0%

1.5%

-0.1% -0.1%

0.0% 0.1% 0.0% 0.0%

-0.5%-0.5%

0.0%

Overall CPI "Core" CPI Owners' Food & Medical EnergyOverall CPI Core CPI OwnersEquivalent

Rent

Food &Beverages

MedicalCare

Energy

The “Core” CPI Excludes Price Changes for Food and Energy Which Are Generally

*seasonally adjusted.Source: BLS

The Core CPI Excludes Price Changes for Food and Energy, Which Are Generally Volatile. These Items Are Nearly ¼ of the CPI. The Largest Single CPI Component isan Estimate of What Homeowners Would Pay as Rent to Themselves as Landlords.

33

Inside the Jan. & Feb. 2010 CPI:*Components Move Differently

19.1%18%20%

Percent change fromsame month, prior year

Weights of Selected CPI ComponentsOwners’ Equivalent Rent 25.2%Food and Beverages 14.8%Energy 8.6%

14.4%

12%14%16%

Energy 8.6%Medical Care 6.5%

2 6%3.5% 3.6%4%

6%8%

10%

2.6%1.6%

0.4%

-0.2%

2.1% 1.3%0.3%

-0.1%-2%0%2%4%

Overall CPI "Core" CPI Owners'Equivalent

Rent

Food &Beverages

Medical Care Energy

The “Core” CPI Excludes Price Changes for Food and Energy Which Are Generally

*seasonally adjusted.Source: BLS

The Core CPI Excludes Price Changes for Food and Energy, Which Are Generally Volatile. These Items Are Nearly ¼ of the CPI. The Largest Single CPI Component isan Estimate of What Homeowners Would Pay as Rent to Themselves as Landlords.

34

When Prices for Some Items Drop, Check the Prior-Year Surgeg

10.3% 9.7%10%12%

2008 2009(Percent)

3.8%

6.8%

9.7%

4.8%

4%6%8%

10%

2.3%

-0 40%

1.7%

2%0%2%4%

0.40%

-2.9%-4.6%-6%

-4%-2%

Overall CPI "Core" CPI Heating Structural ResidentialOverall CPI Core CPI HeatingEquipment

StructuralSteel

Products

ResidentialMaint &Repair

Sources: Bureau of Labor Statistics; Insurance Information Institute.

Some Costs Related to Construction Spiked in 2008,Far Above the Overall Inflation Rate (CPI), then Retreated in 2009

35

Price Indexes for Elements ofProperty Claims Monthly, Jan 2008-Feb 2010

210

Price Index

Construction materials prices spiked Up 10 7%

Material and Supply Inputs to Construction Industries

205.

0

206.

1

4

205.

4

1.1

205

through the first half of 2008, returned to pre-spike levels by Spring 2009,

but prices for construction materials are climbing again.

Up 10.7% Jan-July

2008.0

200.

4

194.

3

6 7

201

197.

4

195

200

Up 3.4% Mar 2009-Feb 2010

5.5

186.

6

190.

1

193 1

189.

5

189.

9

187.

4

86.3

86.3 18

7.6 188.

9

187.

9 189.

9

189.

5

188.

8

189.

8

190.

2 192.

619

2.

185

190

Annual price increases,

Feb 2010

185 1 18 18

180

185

08 08 08 08 08 08 08 08 08 08 08 08 09 09 09 09 09 09 09 09 09 09 09 09 10 10

p ,2008 over 2007: +8.2%2009 over 2008: -3.9%

Jan

0

Feb

0M

ar 0

Apr

0M

ay 0

Jun

0Ju

l 0

Aug

0Se

p 0

Oct

0N

ov 0

Dec

0Ja

n 0

Feb

0M

ar 0

Apr

0M

ay 0

Jun

0Ju

l 0

Aug

0Se

p 0

Oct

0N

ov 0

Dec

0Ja

n 1

Feb

1

Sources: Bureau of Labor Statistics; Insurance Information Institute calculations.36

Inflation in Legal and Auto Repair Costs Affects P/C Claims More than the CPI Suggests

4.1%3.8% 3.9%

4%

5%(Percent)

1.8%

2.7%3.0%

2%

3%

4%

0%

1%

2%

-0.4%-1%

0%

Overall CPI "Core" CPI Legal US Tort Motor Motor MotorServices Costs Vehicle

Parts &Equipment

VehicleBody Work

VehicleRepair

Repair Parts/Labor and Legal/Tort Costs

Sources: BLS; Legal services and motor vehicle body work are avg. monthly year-over-year change from BLS;Tort costs is 2009 Towers-Perrin estimate.

Repair Parts/Labor and Legal/Tort CostsAre Major P/C Insurance Cost Drivers.

37

In the UK, the Household Rebuilding CostIndex is Also Higher Than the British CPI

Annual Change in the Household Rebuilding Cost Index and Retail Prices IndexAnnual Change in the Household Rebuilding Cost Index and Retail Prices Index

9,00

10,00 Household Rebuilding Cost Index

7,00

8,00

%)

4,00

5,00

6,00

nnua

l Inc

reas

e (%

2,00

3,00

An

B iti h

0,00

1,00

nv-9

8vr

-98

uil-

98oc

t-98

nv-9

9vr

-99

uil-

99oc

t-99

nv-0

0vr

-00

uil-

00oc

t-00

nv-0

1vr

-01

uil-

01oc

t-01

nv-0

2vr

-02

uil-

02oc

t-02

nv-0

3vr

-03

uil-

03oc

t-03

nv-0

4vr

-04

uil-

04oc

t-04

nv-0

5vr

-05

uil-

05oc

t-05

nv-0

6vr

-06

uil-

06oc

t-06

nv-0

7vr

-07

uil-

07oc

t-07

nv-0

8vr

-08

uil-

08oc

t-08

nv-0

9

British CPI

Source : Association of British Insurers

jan av ju o jan av ju o jan av ju o jan av ju o jan av ju o jan av ju o jan av ju o jan av ju o jan av ju o jan av ju o jan av ju o jan

HRCI RPI

All Segments of French Motor Insurance CostsHave Grown Faster than the CPI for Over 20 Years

Average cost of motor insurance

220Liability for materialsTheft & Fire

180

200

Theft & FireGlass breakageAccidental damagesCPI

160

180

00 =

198

7

140

10

100

120

Source : Fédération Française des Sociétés d’Assurance

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Most segments of French home insurance costs have been growing more rapidly than the CPI for more than 20 years

Average cost of home insurance ("multirisque habitation")

300

FireWi d S H il

250

Wind, Snow, HailTheftWater damagesLiabilityGlass breakageCPI

150

200

100

50

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Source : Fédération Française des Sociétés d’Assurance

Of Course, The Prices of Some ThingsP-C Insurers Pay For Have Dropped

120

Plywood & Engineered WoodIndex Price Change from Prior Year2004 7.0%2005 -1.7%

110

120 2006 -5.3%2007 -5.0%2008 1.3%2009 -5.4%

100

90

80

c 03

c 04

c 05

c 06

c 07

c 08

c 09

Dec

Dec

Dec

Dec

Dec

Dec

Dec

Source: Department of Labor (Bureau of Labor Statistics); not seasonally adjusted

Inflation’s Effect is Unusually Strong y gwith Health Care Costs

This Isn’t Just a U.S. Phenomenon

42

Medical Cost Inflation Has Outpaced Overall Inflation for Many Years

380Since 1982-84, (index =100) the cost of

medical care has more than tripled, while the overall cost of living merely doubled

320

4=10

0

the overall cost of living merely doubled

260

ue (1

982-

84

140

200

Inde

x V

alu

80

140

2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9

All Items Medical Care

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Department of Labor (Bureau of Labor Statistics); not seasonally adjustedhttp://www.bls.gov/news.release/pdf/cpi.pdf

French Health Insurance Tells the Same Story (as Does Many Other Countries)

130

135CPIHealth Insurance CPI

125

130

115

120

100

= 19

98

110

1151

100

105

Source : INSEE

1001998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

P-C Claims Tend to Be for Intense Medical Activities,Whose Costs Grew Faster than Medical Care in General

220

Hospital Services Medical CareIndex

200

220From 1997 to 2009, hospital services costs grew 107% while the cost of medical

care overall grew 60%

160

180care overall grew 60%.

120

140

100

120

97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Department of Labor (Bureau of Labor Statistics); not seasonally adjusted; medical care costs re-indexed to 100 in 1997 by III calculations

In France, since 2001 a growing gap between the growth rateof the cost of severe injuries and inflation/GDP growth rate

Average cost of severe French bodily injuries180

160

170 Average costsInflationGDP at current prices

140

150

ost i

n 20

01

130

140

100

= C

o

110

120

Source : SCOR Global Life (2009)

1002001 2002 2003 2004 2005 2006 2007

The Rising Cost of Medical Care AffectsP/C Claims More than 2009 CPI Implies

5.5%6.2%

6%

7%(Percent) The “core” = the overall CPI after

removing the effect of price changes in food and energy

3.1%

4.3%

3%

4%

5%

1.8%

1%

2%

3%

-0.4%-1%

0%

Overall CPI "Core" CPI Medical Care PP Auto WC Med PP Auto No-Bodily Injury

SeveritySeverity Fault Claim

Severity

Healthcare Costs Are Major P/C Insurance Cost Drivers.

Sources: BLS; medical care changes are avg. monthly year-over-year change from BLS; BI and no-fault figures from ISO Fast Track data for 4 quarters ending 09:Q3. WC figure is I.I.I. estimate based on historical NCCI data.

Healthcare Costs Are Major P/C Insurance Cost Drivers.They Are Expected to Increase Above the Inflation Rate (CPI) Indefinitely

47

Shifting Legal Liability & g g yTort Environment

Tort Costs Might Spike Again; but This Isn’t the Conventional SenseThis Isn’t the Conventional Sense

of Inflation

48

The Frequency of Million-Dollar Verdicts*Was Increasing With Moderate Inflation

100%2001-2003 2004-2005 2006-2007

%

80%

90%2001-2003 2004-2005 2006-2007

Across all liability types, million-dollar-plus awards rose from 13% of all awards from

48%

59%

%

53% 60

%

51% 57

%

65%

50%

60%

70% from 13% of all awards from 2001-2003 to 17% in 2006-07.

29% 37

% 41%

33%

30%

30%

40%

50%

0%

10%

20%

0%Business Negligence Government Negligence Medical Malpractice Products Liability

*Verdicts of $1 million or more.Source: Jury Verdict Research; Insurance Information Institute.

In the 1990s and Since 2003, Tort SystemCost Growth Has Moderated vs. Inflation

15% Rate of Tort System Cost Growth Without these two high-growth years tort cost

Growth Rate

9%

12%CPI

growth years, tort cost growth this decade

would have been close to the CPI

3%

6%

9%

0%

3%

-6%

-3%

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20

Sources: US Bureau of Labor Statistics, Tillinghast-Towers Perrin, 2009 Update on U.S. Tort Costs; Insurance Info. Inst.

So P C Insurance Claim CostsSo P-C Insurance Claim Costs Increase Faster Than Inflation.

But Why?

51

7 Reasons Why P-C Insurance Claims Often Rise Faster than Inflation1. They contain at least an element of moral

hazard, if not also a fraud/abuse dimension that i ’ i i llisn’t present in prices generally.

a. This is reinforced by “bad faith” laws and/or consumer attitudes (surveys show that manyconsumer attitudes (surveys show that many people believe that it’s okay to inflate an insurance claim). So to avoid “bad faith” outcomes insurers

l i th i ht th i h llpay some claims they might otherwise challenge

2. When deductibles apply, they tend to stay fixed pp y, y y(in dollars) over long periods of time, even though the price of the insured item increases (so that a larger percent of the damage is(so that a larger percent of the damage is covered as time goes on)

Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)

3. P-C insurance sometimes pays for open-ended items (e g additional living expenses liabilityitems (e.g., additional living expenses, liability defense costs) which can, through the quantity of the item purchased, inflate the insurer’s l i diclaims spending.

4. For claims that involve health care of severely-yinjured people, the cost of hospital services has far outstripped the CPI

Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)

5. In some cases, competitive price forces don’t operate as strongly on insured goods andoperate as strongly on insured goods and services (vs. non-insured goods and services); for example, they might

a. Be protected from international competitionYou can’t outsource repair of a car or a building to a lower-labor-cost countryff f f &b. Be affected by the changing social value of life &

sufferingThe cost of pain medication for people with chronic pain is far outstripping general inflation

c. Concern services where productivity gains are limited

Examples are defending lawsuits, repairing roofs, clearing debris, etc.

Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)

5. for example, they mightd. Be confident that they car raise prices without fear y p

of a drop in demand for their services If your property is damaged you generally must get it repaired or replacedp p

e. Be affected by shortages of particular skilled labor despite general conditions of high unemployment

If might be difficult to find and keep mechanics with theIf might be difficult to find and keep mechanics with the training and experience to fix today’s complex modern cars

f. Be affected by the cost of acquiring expensivef. Be affected by the cost of acquiring expensive new diagnostic equipment and the “need” to use it (and charge for its use) perhaps more often than necessarynecessary

Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)

6. Demand Surge. In catastrophe (and some other) situations, demand for materials andother) situations, demand for materials and labor is highly concentrated, pushing up prices for scarce resources.

7. Cost-shiftinga The “deep pocket” principle: as long as ana. The deep pocket principle: as long as an

insurer “can afford it,” some Courts will extend their liability (judicial cost inflation)

b. Medical care providers charge higher rates for patients not covered by Medicare or Medicaid

56

P/C Premium Growth and InflationP/C Premium Growth and Inflation

Mainly Driven by the Industry’s Underwriting CycleIndustry s Underwriting Cycle,

Not the Economy

57

P-C NWP Growth Generally Matchesor Exceeds Inflation 1971-2009

25%

CPI-U NPW Growth(Percent)1975-78 1984-87 2000-03

20%

10%

15%

5%

-5%

0%

71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

58

7 7 7 7 7 7 7 7 7 8 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0

Shaded areas denote “hard market” periodsSources: A.M. Best, ISO, Insurance Information Institute

Underwriting and InflationUnderwriting and Inflation

59

Other Underwriting-RelatedEffects of Higher Inflation

Rising Insurable ValuesPremium volume and agent commissions will rise even if rates gare flat

Increased Political Response to Rate Increase RequestsRequests

Regulators might reject rate increase proposals to curry favor with insurance consumers

L P fit D t R St th iLower Profits Due to Reserve StrengtheningBurn Through on Retentions

Retentions, deductibles burned through more quickly, g q y

Reinsurance Penetration/ExhaustionHigher costs risks burn through their retentions more quickly, tapping into reinsurance more quickly and potentially exhausting

60

tapping into reinsurance more quickly and potentially exhausting their reinsurance more quickly

An Inflation Spike Would be More Costly for“Long-tail” than “Short-tail” Insurance Lines

Short tail LoBs (mainly property insurance) can quickly adjust to an increase in the ratecan quickly adjust to an increase in the rate of inflation

–Policy periods generally last six months to aPolicy periods generally last six months to a year, or may be on a reporting form, so they adjust premiums frequently

–Claims tend to be paid soon after they’re reported, so an inflation spike won’t affect th hthem as much

–Their asset durations match their liability structure so investment income maystructure, so investment income may increase rapidly with interest rates

An Inflation Spike Would be More Costly for“Long-tail” than “Short-tail” Insurance Lines

Long tail LoBs have more difficulty with resurgent inflationresurgent inflation

–Claims tend to be paid long after they’re reported, so an inflation spike would magnify p , p g yclaims

–Their asset durations match their liability structure, so investment income may increase gradually, while values of existing assets o ld decline ith an inflation spikeassets would decline with an inflation spike

–Needed reserve strengthening would sap profits making it difficult to earn their equityprofits, making it difficult to earn their equity cost of capital

Investments and InflationInvestments and Inflation

Interest-Based InvestmentsBenefit from Higher Inflationg

63

Distribution of P/C InsuranceIndustry’s Invested Assets

Portfolio Facts As of September 30, 2009

Invested assets totaled $1.245 trillion as of 9/30/09 68.7%

Bonds

Insurers are generally conservatively invested, with more than 2/3 of assets invested in bonds as of 9/30/09

Only about 17% of assets were invested in common and preferred stock as of 9/30/09 7 3%

17.0%5 7%

Other

Even the most conservative of portfolios was hit hard in 2008

7.3%1.2%

5.7%

StockMortgages & Real Estate

Cash and Short-term

Investments

64Sources: NAIC, via SNL Financial; Insurance Information Institute calculations.

Bond Yields Tend to Follow Inflation,but the Relationship is a Loose One

10%CPI-U % Change U.S. Treasury 10-Year Note Yield

8%

10%Forecast

6%

2%

4%

0%

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10F

11F

12F

13F

14F

-2%Sources: US Bureau of Labor Statistics (history); Blue Chip Economic Indicators, 10/09 and 2/10 issues (forecast)

P/C Investment Income* as a % ofInvested Assets Follows 10-Year U.S. T-Note

9%P-C Inv Income/Inv Assets 10-Year Treasury Note

7%

8%The midpoint of the Blue Chip forecasts indicates that T-note

yields might spike in 2012.

5%

6%

7%

4%

5%

P-C investment yield historically tracks

2%

3%

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 0F 1F 2F 3F 4F

P C investment yield historically tracks 10-year Treasury note quite closely

1 1 1 1 1

*Not including realized capital gains/lossesSources: history: Board of Governors, Federal Reserve System; A.M.Best; Insurance Information Institute.forecasts: Blue Chip Economic Indicators, 10/2009 issue

Inflation’s Effect onP C Cl i RP-C Claim Reserves

Will I i t RiWill Impairments RiseIf Reserves Are Deficient?

67

Strengthening and Releasing P/C Reserves Appears Unrelated to Inflation

$23.2

$20

$25

$30

e ($

B

3 0%

3.5%

4.0%Prior Yr. ReserveDevelopment ($B)Inflation

$2.3 $1 0

$11.7 $13.7$9.9

$7.3$5

$10

$15

$

erve

Rel

eas

1 5%

2.0%

2.5%

3.0%

Inflation

-$2.1

-$8.3

-$2.6-$6.6

-$9 9-$9 8

-$4.1

$1.0

-$6.7-$9 5

-$5.0-$10

-$5

$0

rior Y

r. R

ese

0.5%

1.0%

1.5%

(CPI-U

)

-$9.9-$9.8 -$9.5-$14.6-$16.0-$15.0

-$20

-$15

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10F

11F

P r

-0.5%

0.0%

1 1

Reserve Releases Are Expected to Taper Off in 2010 and Drop Significantly in 2011

68

Note: 2005 reserve development excludes a $6 billion loss portfolio transfer between American Re and Munich Re. Including this transaction, total prior year adverse development in 2005 was $7 billion. The data from 2000 and subsequent years excludes development from financial guaranty and mortgage insurance. Sources: Barclay’s Capital; A.M. Best, BLS

Reasons for US P/C Insurer Impairments, 1969–2008

Deficient Loss Reserves and Inadequate Pricing Are the Leading Cause of Insurer Impairments, Underscoring the Importance of Discipline.

Investment Catastrophe Losses Play a Much Smaller Role

3.7%4 2%

Investment Catastrophe Losses Play a Much Smaller Role

Reinsurance Failure

Mi

Sig. Change in Business

4.2%9.1%

7.0% 38.1% Deficient Loss Reserves/Inadequate Pricing

Investment Problems

Misc.

7.9%

38.1% Inadequate Pricing

Affiliate Impairment

7.6%

8.1% 14.3%Catastrophe Losses

69Source: A.M. Best: 1969-2008 Impairment Review, Special Report, Apr. 6, 2008

Rapid GrowthAlleged Fraud

P/C Insurer Impairments, 1969–2009p

60 5860

70 5 of the 11 are Florida companies (1 of these

5 is a title insurer)

649 50 48

55

541

49 5047

40

50

6034

19 6

36

3134

296

3118 19

351820

30

40

815

127

11 9 913 12

19

16 14 13

1 612

1 1 114 15

711

5

0

10

20

0

69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09p

The Number of Impairments Varies Significantly Over the P/C Insurance

Source: A.M. Best; Insurance Information Institute.

p g yCycle, With Peaks Occurring Well into Hard Markets

P/C Insurer Impairment Frequencyvs. Inflation, 1970-2009p

12%

14%

1.8

2.0Inflation P/C Impairment Frequency

8%

10%

CPI

)

1.2

1.4

1.6

Impa

4%

6%

Infla

tion

(

0 6

0.8

1.0

irment R

ate

0%

2%

0.2

0.4

0.6

-2%

70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

0.0

The Highest Impairment Rates Appear Affected by Inflation,

710.36% 2009 impairment rate is III estimate based on preliminary A.M. Best data.Sources: BLS, A.M. Best, Insurance Information Institute

g p pp y ,But the Correlation Isn’t a Strong One

What Can Insurers Do?What Can Insurers Do?

72

Re-Ignited Inflation is An Economic Catastrophe (Like a Major Hurricane?)( j )

Hold more capital to cover the uncertainty of re emergent inflationof re-emergent inflationGo more heavily into inflation-indexed investmentsinvestmentsImprove the quality of data used for reserving

Underlying trends & elasticitiesTailored inflation inde es?Tailored inflation indexes?

Regulators Must Be Part of the Discussion

Insurance Information Institute Online:

www iii orgwww.iii.org

Thank you for your timeThank you for your timeand your attention!