PAMIC – CEO ROUNDTABLES JUNE 3, 2015. WHY ARE WE HERE? ERM for Mutual Insurance Companies The New World Order in Insurance Regulation The Board and Risk.

PAMIC – CEO ROUNDTABLES

JUNE 3, 2015

WHY ARE WE HERE?

• ERM for Mutual Insurance Companies

• The New World Order in Insurance Regulation

• The Board and Risk Oversight

• Boards and Their Focus on Enterprise Risk Management

• Keys to an Effective Board: Education, Selection & Succession

• Emerging Trends and Boards

INDUSTRY TRENDS AND STRATEGIC THOUGHTS

1. The rate of change is accelerating

2. Competition is more evolving – big data is king

3. Regulation is becoming more stringent and complex

4. Demographics are creating new challenges

5. Distribution channels are changing

This is an expensive time to be in the insurance industry and some players will not survive.

WHAT ARE THE RISKS TO YOUR COMPANY?

Why do insurance companies fail?

AM BEST - WHY COMPANIES FAIL*38.1% - Deficient Loss Reserves/Inadequate Pricing14.3% - Rapid Growth9.1% - Misc8.1% - Alleged Fraud7.9% - Affiliate Impairment7.6% - Catastrophe Losses7.0% - Investment Problems4.2% - Significant Change in Business3.7% - Reinsurance Failure

Source: AM Best 1969 – 2008 Impairment Review, April 6, 2008

CHANGE OR DIE8 Fundamental Changes in the Insurance Industry

• The Rate of Change

• Market Segmentation by Competition and Associate IT Expenses to Keep Up

• Changes in the Marketplace

• Potential Change to the Independent Agency System

• Need for Different Workforce and Board Composition

• Changes in the Reinsurance Market

• Need for Sophistication in ERM

• Regulation and Legislation

RATE OF CHANGE1ST FUNDAMENTAL CHANGE

THE RATE OF CHANGE – HISTORY’S TIMELINE• 2-4 Million to 50,000 BC - Old Stone Age

• Fire, spoken language, burial of the dead

• 50,000 - 10,000 BC - Middle Stone Age

• art in caves, more sophisticated stone tools

• 10,000 - 4000 BC - New Stone Age

• agriculture, settled villages, pottery, Stonehenge

• 4000 - 750 BC - Bronze Age

• 750BC - AD43 - Iron Age

• AD43 – 1950 – Middle Ages, Early Modern Period, Industrial Revolution

• 1950 – Today – DATA!!!! Computing Power!!!

TERMS AND TECHNOLOGIES THAT DIDN’T EXIST 20 YEARS AGO

Digital Cameras Blogs

DVDs Google

Mobile Phones Cyberstalking

Texting Staycations

Touch Screens E-Books

Reality TV The Euro

Amazon Wikipedia

Facebook Twitter

iPhones Skype/VOIP

YouTube

LARGE COMPANIES THAT DIDN’T MAKE IT

Blockbuster Lucent Pan American

Xerox Motorola Child World

Boarders Books IBM Orion Pictures

Polaroid Commodore Schwinn Bicycle

Hostess (as in Twinkies) Palm (as in Palm Pilots) Wang Laboratories

Publishing HP Caldor

Nokia Eastern Airlines Fruit of the Loom

ADOPTION RATES

• The rate of adoption of new technologies has increased dramatically. Older technologies such as electricity, automobiles and telephone took 50 years to achieve 50% adoption which newer technologies such as the Internet, PCs, smartphones, tablets, IPods, etc. are being adapted much faster…

WILL YOUR COMPANY ADJUST TO FAST CHANGE?

Or will you be added to the list of companies that don’t exist anymore?

MARKET SEGMENTATION2ND FUNDAMENTAL CHANGE

ADVERSE SELECTION

Original market – price for policy - $100

New entrant observes that loss ratios are worse for younger drivers and introduces two tiered rates - $110 for drivers 16 to 24 and $90 for drivers 25 and over

What happened???

RULES TO REMEMBER• If another carrier has a higher price than you do on a given segment

of business, you are likely the victim of adverse selection (you are writing business at a lower rate than you should be and you will get more of it over time)

• If another carrier has identified a segment that can be priced differently than you do, you are in trouble (They will price this segment so that they can obtain or discourage this business)

• If another carrier identifies a segment which it prices below your rates, you are going to lose VERY profitable business (They will take this profitable business and you will end up with what is perhaps your most unprofitable business with nothing to shore it up)

THE PROBLEM WITH BIG DATA• Companies are now rating based on huge amounts of data.

Progressive found that red cars are more prone to accidents than other colors…a new segment. These segments are teased out of the data by sophisticated actuarial software which requires huge amounts of computer power and data

• Companies are finding new and innovative segments such as census tract data – for example if one census tract has more stay at home Moms, is theft loss lower? It takes a very sophisticated IT system to be able to rate on multiple levels of factors.

• Predictive modeling is on the rise

• The cost of having IT that can do all this is very high – and the smaller the company, the bigger the impact

CHANGES IN THE MARKETPLACE3RD FUNDAMENTAL CHANGE

JUST A FEW MARKETPLACE CHANGES• Internet Sales are on the rise in our industry

• Companies are finding innovative ways to market insurance

• Insurance as part of the price of the vehicle for the first year – loss leader but hope for retention

• Pay at the pump?

• Telematics – Usage-Based Insurance (UBI - yet another new segment)

• Retail grocery changes such as Tesco in the UK and Kroger in the US have implemented the distribution of insurance products via their stores

• Megatrends in Demographics

• Fewer homeowners – more rental insurance?

• Self driving cars – will the days of accidents be over?

• Immigration

• Purchasing Behavior of younger consumers

CHANGES TO THE INDEPENDENT AGENCY SYSTEM4TH FUNDAMENTAL CHANGE

INTERMEDIARIES THAT HAVE CHANGED DUE TO THE INTERNET• On-line Retailing – think Amazon

• On-line Banking

• On-line Music Distribution – think Apple

• Book publishing and distribution

• Car buying

• House buying

• News

Global Online Sales grew from $680 Trillion in 2010 to $1.250 Trillion in 2013

AN EXAMPLE OF CHANGE IN INTERMEDIARIES - TRAVEL AGENTS

• Old Way – One called the travel agent to discuss options for flights, picked up the ticket at the agent’s office and obtained thoughts on hotels, rental cars etc. from the agent

• New Way – Check out Expeida on a smartphone, make a selection, book a seat, check in and flash a boarding pass at the gate. Reserve hotels, rental cars, amusement park tickets and restaurant seating on your tablet or phone

TRAVEL WEEKLY, DECEMBER 2, 2013• According to Shelly Younger, manager of settlement services

for ARC, that number (number of Travel Agencies) has dwindled to 13,000 from a peak of 46,000 in the early 1980s. It began falling in the mid-’90s, when airlines capped and then cut the commissions that had been the foundation of the retail travel model. (ARC is the Airlines Reporting Corp which handles accreditation of travel agencies that issue airline tickets)

• John Pittman, ASTA’s vice president of industry affairs, consumer affairs and research, suggests that the best measure of agent numbers is probably Bureau of Labor Statistics (BLS) data. By that measure, the number of full-time agency employees in the U.S. has fallen from a peak of 124,000 in 2000 to 64,000 in 2012.  (ASTA is an association of travel professionals)

CHANGE HAPPENED VERY QUICKLY• While travel agents are still in use, they are not on every corner,

there was a huge amount of consolidation and travel agents often specialize in niche markets

• Will there be a rapid period of change in our industry? Will your company be able to adapt and survive or will it go the way of Buggie Whip manufacturers?

• Michael Jans – CEO Agency Revolution – Regarding Insurance Agents :

• Local Agents wrote 80% of new PPA in 2003. They only wrote 63% in 2010

• Since 2005 the Independent Channel’s PPA market share decreased from 34% to 31% while the Direct Channel increased from 21% to 28%

• In 2010, 22% more quote requests were bound online than the previous year

THEIR (BIG CARRIERS WHO ADVERTISE) WILLINGNESS TO BYPASS THE LOCAL AGENT IS EVIDENCED BY THE FACT THAT P&C CARRIERS WENT FROM SPENDING $1.7N IN ADVERTISING IN 2002 TO $5.9B IN 2001 MICHAEL JANS – CEO AGENCY REVOLUTION

IMPACT OF ADVERTISING ON BIG SPENDERS

NEED FOR A NEW WORKFORCE AND PERHAPS BOARD COMPOSITION5TH FUNDAMENTAL CHANGE

CHANGES TO OUR INDUSTRY1. Changes to the Way we do business:

The Insurance Industry has moved from:

Armies of clerical workers searching for lost files, coding, rating, performing data entry and participating in typing pools

To:

Imaging, on-line capture, big data, predictive modeling, etc.

2. Insurance training was once conducted by the “big” companies and they turned out underwriters, adjusters, premium auditors and actuaries by the thousands. Now – not so much.

3. Demographics guarantee problems as our skilled employees age and retire

INSURANCE TRAINING, ONCE THE PROVINCE OF THE “BIG CARRIERS” IS NOW DIFFICULT TO FIND

• The profession of claims adjuster is facing its own circumstances. These individuals already face enormous workloads and stressful employment conditions. The expertise that insurers require comes from experience – and that quality is rapidly being depleted and not replaced. Approximately 70 percent of claims adjusters in the United States are now over 40 years of age and similar numbers apply in Europe.

IBM Global Business Services – Insurance 2020

BOSTON GLOBE - DEC 07, 2014

• About half of all insurance workers are older than 45

• According to the Institutes (a Pennsylvania professional development organization for the industry):

• By 2020, insurers will have an estimated 400,000 job openings

• There are about 2.5 million insurance workers in the county; half will retire within the decade

US LABOR FORCE CHANGES

EDUCATION IS CHANGING – QUICKLY ENOUGH?

WHAT DOES THIS MEAN IN TERMS OF EMPLOYEES?

• Insurance carriers increasingly require high levels of technical skills in their employees

• There are fewer trained insurance professionals to be hired

WHAT ABOUT BOARD COMPOSITION?

• Originally boards of mutual insurance companies, like banks, were expected to bring in business from the area and the skills required to be a board member involved general business knowledge and contacts with others in the marketing area

• Today, boards are expected to have a deep understanding of the property casualty business and all aspects of the ever increasingly technical business.

• New regulations will up the ante in this area (look at the new Corporate Governance Annual Disclosure Model Act (CGAD))

A NEW ERA IN MANAGEMENT KNOWLEDGE-CAPTURED BOARDS?

“A recent survey by PwC and a joint survey by Deloitte and the Society of Corporate Secretaries & Governance Professionals found that the most sought after new director attribute is industry expertise.”

Ann C. Mule and Charles M. Elson – Director Evaluation

CHANGES TO THE REINSURANCE MARKET6TH FUNDAMENTAL CHANGE

MCKINSEY & COMPANY, NOV 27, 2015

The influx of third-party capital into reinsurance markets has increased significantly

in recent years. Primary carriers are turning to capital markets instead

of traditional reinsurance companies to provide protection,

particularly for property catastrophe coverage. Pension funds and asset

managers are increasingly investing in this space, along with the dedicated

funds that specialize in this type of investment. These investors are attracted

to the property catastrophe market’s uncorrelated returns and historically

attractive yields, especially in today’s low-rate environment.

PROSFor cedents in both personal and commercial lines the main benefit of third party capital is that it provides another source of reinsurance protection. This, in turn, gives carriers more negotiating leverage in the reinsurance market. Apart from more pricing power, third-party capital offers carriers other benefits relative to traditional reinsurance (Exhibit 3, page 4):

• Reduced counterparty credit risk (particularly when third-party vehicles are backed by collateral)

• Greater diversification, as coverage becomes less concentrated with a few reinsurers that are often interconnected through the retrocessional market

• The ability to lock in rates with multiyear structures, as catastrophe bonds have durations of two to three years or longer. This helps to prevent significant pricing shifts after a large catastrophic event (such as the75 percent rate increase after Hurricane Katrina)

CONSThe main drawback of third-party capital is concern over its long-term availability, as well as its inability to replicate traditional reinsurance structures:

• Third-party capital may not be as permanent as traditional capital. If the provider of third-party capital withdraws (or fails to reissue) due to a large catastrophic event or a more favorable interest rate environment, primary carriers will be compelled to turn back to traditional reinsurers to purchase protection—and they will do so with a weakened negotiating position. Currently, even with softening conditions, these investments remain attractive to capital markets, given the arbitrage between the cost of equity for reinsurers (recently rising) and expected returns required by institutional investors (recently falling in the low-rate environment). However, this attractiveness will diminish with the inevitable rise in rates.

• Alternative third-party vehicles often lack critical provisions included in reinsurance contracts (such as reinstatements), and providers lack the value-added expertise that reinsurers offer.

AND…..

As these new vehicles become more available, cedents will need to develop new internal capabilities to actively manage them.

Before – everyone paid pretty much the same rates for their coverages and bought the same basic programs….

THEREFORE…

Companies that successfully navigate the new realities of the reinsurance market will have a distinct advantage over those who do not adapt

NEED FOR SOPHISTICATION IN ERM7TH FUNDAMENTAL CHANGE

ERM HISTORY

• Initially, ERM was driven by rating agencies• AM Best –Capital Adequacy Ratio - BCAR• S&P – Capital Adequacy Ratio – CAR•Moody’s – Risk Adjusted Capital Model (MRAC)

• As ERM evolved, regulators began to develop new methods of regulating:•NAIC - Risk Based Capital (RBC)• European Union - Solvency I & II• Financial Services Authority - UK

ERM HISTORY

•Politicians added their own touches•Sarbanes Oxley – July 30, 2002 - Public Company Accounting Reform and Investor Protection Act•Enacted as a reaction to corporate and accounting scandals – Enron, Tyco, Adelphia, WorldCom•Set new or enhanced standards for all U.S. public company boards

•New reforms are still being discussed as a result of the 2008 financial meltdown

WHAT DO CARRIERS NEED TO DO?

•As these entities continue to develop their rules, regulations, guidelines, etc., ERM will continue to evolve

•Companies need to remain vigilant to ensure that new developments are appropriately considered and adopted

•Companies will need to develop more sophisticated tools such as internal BCAR, capital and catastrophe models

REGULATION AND LEGISLATION8TH FUNDAMENTAL CHANGE

INSURANCE REGULATION – OUT-REGULATING THE REGULATORS?

• State regulation has been a mainstay of insurance regulation since the inception of the industry

• Post financial crisis movements toward federal regulation have initiated protracted discussion on state vs federal regulation

• The state insurance commissioners dusted off an 1871 entity, the NAIC, and have exuberantly attempted to prove that they are up to the job and don’t need federal help

NEW COMPETITION TO CONSIDER

• As globalization increased, foreign companies and multi-state carriers have raised a warning about the difficulties of dealing with 51 state regulators which they contend have a negative impact on consumer choice and competition.

• After the financial crisis, with AIG’s non-insurance arm causing huge problems in the “too big to fail” category, there have been demands for integrated regulation of the financial services industry – banking, securities and insurance

LEGISLATION

While some states are more or less “pro business” and/or “pro insurance”, inevitably, legislation which affects insurance companies either by creating rules by which carriers operate or by raising fees and taxes end up increasing expenses.

Some states also seem to react to one-off issues by passing legislation which is sometimes subject to the laws of unintended consequences

COST OF REGULATION

Do high levels of insurance regulations benefit consumers?  This ConsumerGram provides new empirical evidence showing that increased state insurance regulation is strongly correlated with higher consumer insurance premiums.  Our statistical analysis finds that the average household pays about $300 more for property and casualty insurance in heavily regulated states, compared to the least regulated states.  This means that, across the U.S., high regulations push up consumer property and casualty insurance premiums by approximately $13.7 billion each year.  In other words, when it comes to excessive state regulations, consumers are the biggest losers.

The American Consumer.Org, March 27, 2008

COST OF REGULATION AND LEGISLATION

While some costs of regulation may be passed on through higher rates, the impact of these rules and regulations is felt differently by various companies and even though smaller companies may have a larger relative cost, competition may dictate that not all expenses end up adequately passed on.

i.e., some companies will have higher impacts on their expense ratios than others.

IN CONCLUSION

The insurance business is a strange one:

•We don’t know the cost of goods sold for many years (if ever)

•When we make changes to our business (rate, product, reserving changes), we are like a barge in a channel

Unless we keep up with change we risk joining a long list of carriers who have disappeared…

What needs to be done?

WHAT TO DO• Develop appropriate strategic plans – have a serious idea of

what change may affect you

• Develop energetic, dynamic ERM programs – know your risks

• Think strategically – don’t be a slow motion train wreck – employ change agents

• Consider innovation reactions to major change – alternate sources of capital, innovative reinsurance programs, affiliations, strategic alliances, etc.

• Attend PAMIC, NAMIC and other educational programs – know what you don’t know

WHAT TO DO• Make certain that your management is thinking strategically and

is willing to do the difficult work of being an agent of change

• Review your governance practices and determine if your current board can support what needs to be done

• Consider your staff – do you have highly skilled and talented technicians in underwriting, claims, finance, statistics, actuarial, IT?

• Make sure someone is watching what is actually changing so that you are not surprised if insurance experiences a “travel agent transition”

THANK YOU!!!!!!!!!!!!!!