®

1999 CARe SEMINAR1999 CARe SEMINAR

JUNE 6-8, 1999JUNE 6-8, 1999

GENERAL SESSIONGENERAL SESSION

®

“Mistakes of the Past,

Lessons Learned, and

Future Prospects of the Reinsurance Industry”

( + “Underwriting Cycle is Dead?”)

®DISCUSSION AGENDA

1. Underwriting Cycle

2. Lessons Learned

3. Mistakes and Dé jà vu

4. The Future

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Is the Underwriting Cycle Dead?

®

It depends on what we mean. . .

®

-20

-10

0

10

20

30

40

50

Bil

lio

ns

of

do

llar

s

6-Year Profit Cycle

-20

-10

0

10

20

30

40

50

Bil

lio

ns

of

do

llar

s

6-Year Profit Cycle

6-YEAR PROFIT CYCLEIllustration Only

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THAT CYCLE IS DEAD!

(Was it ever alive?)

®

-20

-10

0

10

20

30

40

50

Bil

lio

ns

of

do

llar

s

Pre-tax operating income

-20

-10

0

10

20

30

40

50

Bil

lio

ns

of

do

llar

s

Pre-tax operating income

ACTUAL INSURANCE PROFITABILITY STATISTICS(Best’s Aggregates and Averages)

®

But profits do look cyclical

®

PRETAX PROFIT MARGIN(Best’s Aggregates and Averages)

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

% o

f N

EP

Pre-Tax Profit Margin

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

% o

f N

EP

Pre-Tax Profit Margin

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INDUSTRY UNDERWRITING RATIOS(Combined Ratios after Dividends to Policyholders)

Years 1951-1997

®

Rate Cycle?

®

INDUSTRY “BASE RATES” History(1990 = 100)

(ISO & NCCI)

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1990 1991 1992 1993 1994 1995 1996 1997

Pers Auto Liability Physicians, Surgeons, … Hospitals

Comm Auto Liability Prem/Ops Products

Commercial Property Workers Comp Homeowners

®

Mistake # 1

Losing track of what is really

happening to pricing adequacy

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Rates Down (Stagnant at Best),

Profits Up!!

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IT CAN’T LAST

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Cyclical Downturn

in Profits is Coming

®

1997 was peak of

current profit cycle

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Why have profit margins

remained buoyant for so long?

®

Mistake # 2

Relying on calendar year numbers

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Impact of Unexpected Disinflationon Both Claims and Interest Rates

•Lower actual loss costs

•Asset appreciation

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Inertia (Market Momentum)

Leads to Persistency

in Expected Trends

®

Insurance and financial

markets pricing cycles

tend to overshoot

®

Mistake #3

Confusing cyclical phenomena for

permanent trends

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Stock Market

Predicts a Cyclical Downturn in Insurance

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Mistake #4

Overestimating Stock Market’s

Short Term Predictive Power

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Sometimes the stock market

punishes “good” and

rewards “bad” behavior

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Sometimes its signals

are just confusing

®

-100

-50

0

50

100

150

200

250

300

350

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

% Change in Book Value per shareStock Price % Change in Stock Price

SHAREHOLDER VALUE VS. STOCK PRICE FAIRFAX FINANCIAL

®LESSONS LEARNED

To generate superior returns you must be

prepared to buck the conventional wisdom . . .

®LESSONS LEARNED

This requires patient, long term, oriented

investors

®LESSONS LEARNED

Have to be willing to work hard ---

successfully bucking conventional wisdom

is

more difficult than following it

®LESSONS LEARNED

Invest patiently for the long term,

because innovations often have a long

gestation period

®

LESSONS LEARNED - LONG GESTATION

Stochastic Cat Modeling

•Early 1980s research

•1985 CAS paper

•1992 Post-Andrew breakthrough acceptance

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LESSONS LEARNED - LONG GESTATION

Cat Bonds

•Mid 1980s conception

•Mid 1990s first implementation

®DÉ JÀ VU

•Primary Pricing

•Reinsurance Pricing

Early 1980s all over again

®DÉ JÀ VU

Underwriting controls weakening

•Problems with (some) MGAs

•Home-grown problems, too

®DÉ JÀ VU

•Increase in (attempted) reinsurance arbitrage

•Limited (so far) return of “spiral”

•Increase in disputes & collectibility issues

®FUTURE OF INDUSTRY

•Global consolidation will continue (insurance & reinsurance)

•Reinsurers (esp. U.S. based) driven into arms of larger groups

•Convergence of reinsurance and capital/derivatives markets

®FUTURE OF INDUSTRY - CONVERGENCE

•Increasing Acceptability of Imperfect Hedging Methods Because

•Less dependent on cedent specific data

•Less intrusive

•Less administratively costly

•Market data of sufficient quality increasingly available

•Legal & Regulatory R&D advancing rapidly

®SUMMARY

•Cycle is not dead

•Similar mistakes are being made again

•Success depends on steady, long term view (requires patient, smart investors)

•Industry consolidation will continue

•Reinsurance and financial markets solutions will increasingly converge