1 Joseph L. Petrelli, President, Demotech, Inc.Ohio Association of Mutual Insurance Companies 137th Annual Convention Financial and Regulatory Outlook Joseph L. Petrelli, President, Demotech, Inc. June 9, 2016

2 Mission Statement (1985) Demotech, Inc. will become the leading provider of innovative solutions to financial analysis issues by focusing our resources on niches presenting opportunity for corporate growth.

3 Financial and Regulatory OutlookInsurance Statistics Top 6 P&C Insurance Risks Commoditization of Insurance Your Clients Regulatory Scrutiny Enterprise Risk Management Own Risk and Solvency Assessment Transparency Regulators – Rating Agencies or States?

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23 Top 6 P&C Insurer Risks Center for Excellence in Enterprise Risk Management St. John’s University Tobin College of Business January 2015 Event Name Frequency The insurance industry is highly regulated 96% The failure of cyber and other information security systems 91% The P&C industry is highly competitive 90% Actual claims or loss adjustment expense exceeding the loss reserve estimate A downgrade in financial strength ratings of company, subsidiaries, or reinsurer 86% The risk of a natural catastrophic event (i.e. hurricanes, tornadoes, etc.) 75%

24 Here are some of my thoughts on P&C insurer risks:Negative interest rates Commoditization of primary insurance Convergence of capital markets Customer issues – your clients

25 Negative Interest RatesAn act of monetary policy desperation. Europe’s central bank chose to experiment with negative rates. Policy makers in Europe and Japan are trying to prevent a slide into deflation. 

26 Negative Interest RatesInterest rates below zero should reduce borrowing costs for companies and households, driving demand for loans. There’s a risk that the policy may do more harm than good. If more and more central banks use negative rates as a stimulus tool, there’s concern the policy might ultimately lead to a currency war of competitive devaluations.

27 Negative Interest RatesWhenever people or businesses hold cash rather than spend or invest, there is a risk of deflation. When demand is low AND nothing sells, prices continue to fall.

28 Commoditization of Primary InsuranceCommoditization is the process by which goods or products that have economic value and possess unique attributes become viewed as interchangeable and nearly indistinguishable in the eyes of market consumers. Insurance policies are examples of this, as despite inherent differences in coverage, they are often viewed as uniform.

29 Convergence of Capital Markets and InsuranceThis term is utilized to describe the development of alternative sources of securitization and capital outside of the insurance industry.

30 Bad News for Reinsurers“Convergence of capital markets and insurance” is essentially the commoditization of reinsurance. Securitization requires liquidity or cash. Yet reinsurance possesses numerous other attributes including expertise, experience and accretive business acumen.

31 Financial Outlook Should Include the Concerns of Your Customers, Potential Customers and Producers

32 What Concerns Your ClientsCost of health insurance and other employee benefits (rank 2015 #1) Being able to attract customers (#2) The U.S. economy (#8) Rising costs of doing business (#5) Maintaining existing customer base (#3) Source: 2016 SMB Insights – A Market in Transition The Business Journals A Division of ACBT

33 Regulatory Outlook Scrutiny ORSA Enterprise Risk ManagementTransparency Rating Agencies

34 Top 6 Regulatory Risk Disclosures in the P&C Industry Center for Excellence in Enterprise Risk Management St. John’s University Tobin College of Business January 2015 Response Frequency Dodd-Frank Act 72% TRIA (TRIPPA) 57% Solvency II 49% Sovereign Debt (EU) 46% Own Risk and Solvency Assessment 33% Affordable Care Act 32%

35 Dodd-Frank Act The Dodd-Frank Wall Street reform and Consumer Protection Act Nothing like it since the Great Depression (1929) Creates the Financial Stability Oversight Council to monitor financial institutions and identify risks to U.S. financial stability and respond to those emerging threats.

36 Terrorism Risk Insurance Act (TRIA)Extended TRIA for six years through 2020 Triggering event is $100,000,000 at 01/01/2016 Over time industry absorbs greater dollar amount via deductibles or co-payments Aggregate retention initiated at $27.5 B and rises to $37. B in $2B increments Wharton Risk Management and Decision Process Center has concluded that some insurers already have a high ratio of “TRIA deductible” to surplus. (20% of commercial P&C insurance premium)

37 Solvency II As a response to the credit crisis, the Basel Committee published global standards, e.g., Basel III. When this was revised, it was decided to update the Solvency framework. There are three pillars to Solvency II.

38 Pillar 1 Calculations, models and capital requirementsSolvency Capital Requirement is a risk responsive capital estimate designed to achieve a 99.5% probability that insurer can meet its obligations over next year. Minimum Capital Requirement is the de minimus amount needed to cover risk and cannot be below this amount. Internal models and external models can be used if met requirements and test of supervision

39 Pillar 2 Own Risk and Solvency AssessmentProve your Solvency Capital Requirement Provide a 3 to 5 year forward looking perspective and analysis Evidence and documentation are necessary

40 Pillar 3 Supervisory purposes, disclosure, transparency including service provider agreements

41 Own Risk and Solvency AssessmentOwn Risk and Solvency Assessment (ORSA) requires insurers of a certain size or greater to identify and discuss their own judgment about risk management and the relative financial position of the carrier(s). What are the reasonable and foreseeable material events that might adversely affect an insurer’s ability to respond to its stakeholders?

42 ORSA should include dialogue on the risks of underwriting, credit, market, operations, liquidity risk, etc. Your self assessment is reduced to a report format.

43 Affordable Care Act U.S. citizens and legal residents must have qualifying health coverage or incur a tax penalty Of an employer of 50 or more full-time employees, there are penalties if you do not offer coverage Employers with more than 200 employees should automatically enroll employees into health care plans. Employee can opt out. Subsidized costs for some Provide dependent coverage for children up to age 26. Numerous other provisions too lengthy to reference

44 Enterprise Risk ManagementAvoid silos within an entity – communicate internally and prove to regulators that you have communicated internally. Move to evaluating risk rather than evaluating the balance sheet and income statement. What might have happened versus what occurred.

45 Contemporary TerminologyRisk Appetite Risk Tolerance Diversification Extreme Scenarios Emerging Risks

46 Identify Risks Measure Risks Project Risks Protocols to Limit Impact of Adverse Risks Manage Downside of Risk

47 Rating Agencies or Regulators

48 “Rating agencies are more important than regulators”Catrin Shi, SNL Financial, Conference Chatter, ‘Rating Agencies are more important than regulators’ says insurance exec, Nov. 3, 2014.

49 Insurer rating agencies are importantHowever, the antitrust exemption granted to the “business of insurance” is founded on state regulation. Public, not private, regulation of insurance.

50  In discussions surrounding the development of the McCarran-Ferguson Act, Senator Joseph C. O’Mahoney, a principal architect of the legislation, observed:

51 “There are three forms of regulation.There is State regulation… There is Federal regulation as a legal possibility…

52 The third, and this has been harmful to the public interest, is regulation by private combination and groups; a type of regulation which has been enforced by private combinations and groups …”

53 “Nothing in the proposed law would authorize a State to try to regulate for other States, or authorize any private group or association to regulate in the field of interstate commerce…” and concluded that the regulatory framework should consist of “public regulations written by public authority.”

54 When Congress passed the McCarran-Ferguson Act, it specifically declared “that the continued regulation and taxation by the several States of the business of insurance is in the public interest, and that silence on the part of Congress shall not be construed to impose any barrier to the regulation or taxation of such business by the several States.”

55 The regulation of the business of insurance is a public duty – the duty of the states. Rating agencies are not regulators and must be accountable to the public through the competitive process. Based upon the definition of the “business of insurance”, antitrust laws are applicable to rating agencies.

56 Some recent perspectives on rating agencies versus state regulation

57 “There is no requirement that insurance companies be rated, and that among those that are, companies make choices about rating organizations based on management’s evaluation of the perceived strengths of each organization as it relates to their markets and business models.” -Charles M. Chamness, President, National Association of Mutual Insurance Companies Letter to the Editor of the Missouri Lawyers Weekly, June 1, 2015

58 “The test of such ratings is whether in the long run the companies perform as expected…”- Charles M. Chamness, President, National Association of Mutual Insurance Companies Letter to the Editor of the Missouri Lawyers Weekly, June 1, 2015

59 One insurer rating agency or several insurer rating agencies?

60 Utilizing a single rating undermines the nature of rating opinions by foreclosing the marketplace of ideas, improperly excluding reliable participants and valuable, competing ideas, as well as adversely impacting opportunities at duly licensed insurers and their producers.

61 Consumers deserve a competitive effort with regard to insurer ratings, including the opportunity to avail themselves of the duly licensed carrier of their choice.

62 A “one size fits all” rating requirement restricts competition by artificially defining acceptable ratings, minimizing the number of acceptable insurers, while restricting agent and consumer access to the valuable options offered by competing insurers.

63 “In order to support an information-efficient capital market, rating agencies should compete vigorously on the basis of the reliability and usefulness of differing and independently formed opinions.” - Raymond W. McDaniel, President, Moody’s Investors Service to Jonathan G. Katz, Secretary U.S. Securities and Exchange Commission (July 28, 2003) (emphasis added).

64 A single rating agency should not be in a position to regulate the business of insurance, as the regulatory regime for insurance never envisioned nor does it sanction “private regulation.”

65 Regulators versus Rating AgenciesConsistency Objectivity Transparency

66 Financial reporting changesOwn Risk and Solvency Assessment Sarbanes Oxley Enterprise Risk Management

67 What might A.M. Best think of competition in ratings?

68 “For the great enemy of the truth is very often not the lie – deliberate, contrived and dishonest, but the myth, persistent, persuasive, and unrealistic. We enjoy the comfort of opinion without the discomfort of thought.” - John F. Kennedy, Jr. President United States of America

69 “Insanity: doing the same thing over and over again and expecting different results.” - Albert Einstein

70 A.M. Best, wrote to the Securities and Exchange Commission, reminding the Commission that the “market demands a regulatory approach that fosters genuine competition…” . Letter from David Brey, Vice President, A.M. Best Company, to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission (May 10, 2013)

71 In Regis Ins. Co. v. A. M. Best Co. , IncIn Regis Ins. Co. v. A.M. Best Co., Inc., Best stated that its ratings are opinions, not statements of fact and not capable of being proven true or false. Memorandum in Support of Summary Judgment for A.M. Best, at 2, Regis Ins. Co. v. A.M. Best Co., Inc., No. 10-cv-03171(E.D.Pa. filed May 18, 2012)

72 “A.M. Best’s rating…constitutes A.M. Best’s opinion…” “The rating…represents the opinion of A.M. Best and not a statement of fact…” “A.M. Best’s rating…constitutes A.M. Best’s opinion…” “It is well-established that credit ratings are ‘opinions’ that inherently are not capable of being proven true or false.” Memorandum in Support of Summary Judgment for A.M. Best, at 2, Regis Ins. Co. v. A.M. Best Co., Inc., No. 10-cv-03171(E.D.Pa. filed May 18, 2012)

73 Similarly, in A. M. Best Co. , Inc. vSimilarly, in A.M. Best Co., Inc. v. SNL Financial LC, Best has repeatedly stated that its ratings are not facts but rather are “original, creative, expressive works…” In a brief to the court, Best affirmed that its ratings “are not facts that exist in the world like stock prices, bond yields, exchange rates, or mortgage market interest rates… rather, FSRs reflect A.M. Best’s original, creative authorship.” Memorandum in Opposition to Motion to Dismiss for A.M. Best at 3, A.M. Best Co., Inc. v. SNL Financial LC No (D.N.J. filed July 18, 2011). Please note, A.M. Best’s abbreviation of its financial strength ratings as FSRs should not be confused with Demotech’s abbreviation of Financial Stability Ratings® as FSRs.

74 Best states that the “competition of other ideas” is critical as its rating opinions are “not facts that exist in this world,” are “creative authorship,” and are neither true nor false.

75 Long standing principle“The main purpose of Best is not to predict insolvencies.” “We don’t have a rating that says this company or that company will go broke in two years.” Paul Wish Vice President, A.M. Best Company Professional Agent, May 1989, Page 22

76 First company to review and rate independent regional and specialty insurance companies was Demotech, Inc. (1989)

77 Demotech respects niche carriers as well as those that have geographic and product line diversification. We focus on balance sheet fundamentals as manifested over representative historical operating periods, as influenced by the execution of business models, quality and quantity of reinsurance purchased and other tactical plans including enterprise risk management.

78 One recurring discussion topic about A. MOne recurring discussion topic about A.M. Best’s rating is that large companies get favorable treatment. Smaller entities, particularly mutuals, appear to many to be under-rated from a financial perspective.

79 “The rating reflects the company’s ability to pay claims“The rating reflects the company’s ability to pay claims. A big company has a number of strengths a small company does not: depth of management, spread of risk and it can more easily tap into money markets. I don’t think that’s preferential treatment, but just good, economic sense.” C. Burton Kellogg (Officer, Board Member & Shareholder) A.M. Best Company Professional Agent, May 1989, Page 22

80 “I would put more faith in a company that has 1,000 employees and writes in 50 states than a company with one secretary and a president that writes in Warren County, New Jersey. Insurance is based on spread of risk.” C. Burton Kellogg A.M. Best Company Professional Agent, May 1989, Page 22

81 A recent analysis of 2,676 insurers reporting data to the NAIC indicated that only 57 insurers (2.1%) were licensed in and also wrote at least $1,000,000 of direct written premium in each state or jurisdiction. Let’s call this group the “diversified” group.

82 State Specialists, Coverage Specialists and Risk Retention GroupsAccounted for 1,365 of the 2,676 insurers reporting financial information to the NAIC.

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84 With only 2% of the industry diversified and 51% of the industry focused on a niche, the composition of the industry supports our position and conclusion as does the perspective of business icons.

85 "Diversification is protection against ignorance"Diversification is protection against ignorance. It makes little sense if you know what you are doing.“ Warren Buffett

86 One of the eight themes within Tom Peters' In Search of Excellence was stick to the knitting.Companies that are in search of excellence stay with the business they know and understand.

87 Financial Models Objective or Not-So-Objective?

88 Quantitative CriteriaIn deterministic models, the output of the model is fully determined by the parameter values and the initial conditions and inputs. Stochastic models possess some inherent randomness. The same set of parameter values and initial conditions can lead to different outputs, based upon the assumptions that were the inputs.

89 Quantitative CriteriaA stochastic model is a tool for estimating probability distributions of potential outcomes by allowing for random variation in one or more inputs over time.

90 Does a model that treats catastrophe exposure as a capital charge ignore the fact that virtually all states permit reinsurance costs to be reflected in pricing models? If your premium includes a charge for the cost of reinsurance and you by reinsurance, does size matter?

91 Demotech believes that differences in ratings should be correlated withthe quantitative differences in the objective underlying financial condition of insurers and the impact on the carrier’s ability to implement its business model.

92 Consistency Objectivity Transparency

93 Formulas and economic models may be intended to measure financial stability.However; the models may wind up measuring the fact that entities are “different” as opposed to “better or worse.”

94 Larger carriers are not necessarily better than regional carriersLarger carriers are not necessarily better than regional carriers. Certainly, they are different. Regional and specialty insurers are different from larger companies. A one size economic model or a single rating agency philosophy does not address all circumstances.

95 "Beware of geeks bearing formulas."As a final thought on economic models, I defer to the Oracle of Omaha, Warren Buffett: "Beware of geeks bearing formulas."

96 Memo Angeles/Shutterstock.comSubjective Criteria Memo Angeles/Shutterstock.com

97 VIDEO

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99 Experience and Expertise of the Reviewers of Insurers

100 The Great Recession The Great Recession was a period of general economic decline observed in world markets, lasting 19 months, from December 2007 through June 2009.

101 The value of experienced, professional analysts who understand the business of insurance, whether at the front lines, supervisory or management level, cannot be overstated.

102 If the processes at any rating agency or government regulator involves an analytical hierarchy that relies on inexperienced front line information gatherers to meet the needs of an internal committee or group of managerial personnel, then the value of insurer interaction with an inexperienced front line analyst is limited.

103 It is important for everyone involved in the process, including consumers, to recognize and acknowledge that the assignment of insurer ratings is a complex and multi-faceted process. Although concepts such as diversification and economic modeling may sound quantitative, they may be utilized to enforce subjective, qualitative biases rather than objective evaluation criteria.

104 Where do we go from here on regulators versus rating agency as regulator?

105 “We cannot solve our problems with the same thinking we used when we created them.” - Albert Einstein

106 National Conference of Insurance Legislators (NCOIL) Resolution in Support of the States’ Authority as the Primary Regulator of Insurance Companies (Excerpt) Adopted by the NCOIL Financial Services & Investment Products Committee on November 12, 2015, and by the Executive Committee on November 15, Sponsored by Rep. Bob Hackett (OH), Del. Harry Keith White (WV), and Rep. Lana Theis (MI)

107 National Conference of Insurance Legislators (NCOIL) Resolution in Support of the States’ Authority as the Primary Regulator of Insurance Companies (Excerpt) WHEREAS, there is no requirement that duly licensed insurance companies be rated and that among those that are, companies make choices about ratings organizations based on management’s evaluation of the perceived strengths of each rating organization as it relates to their markets and business models; and

108 National Conference of Insurance Legislators (NCOIL) Resolution in Support of the States’ Authority as the Primary Regulator of Insurance Companies (Excerpt) WHEREAS, the test of insurer ratings is whether in the long run the companies perform as expected, and in that regard each of these rating organizations on the whole has a consistent record of accurately gauging the ability of the companies to pay claims and service their customers; and

109 National Conference of Insurance Legislators (NCOIL) Resolution in Support of the States’ Authority as the Primary Regulator of Insurance Companies (Excerpt) WHEREAS, an unintended yet direct consequence of designating a single, exclusive insurer rating requirement in laws, statutes, bulletins or other public materials is the diminution of “public regulation by public authority” and an implication of private regulation of insurance;

110 National Conference of Insurance Legislators (NCOIL) Resolution in Support of the States’ Authority as the Primary Regulator of Insurance Companies (Excerpt) NOW, THEREFORE, be it resolved that the National Conference of Insurance Legislators urges each state to foster competition in insurer ratings to benefit consumers, duly licensed insurance companies, producers, and other third-party stakeholders by promulgating and embracing insurer rating requirements in laws and regulations that incorporate the enumeration of multiple, competent insurer rating organizations.

111 CONCLUSION Global regulatory efforts will undoubtedly impact domestic state and federal regulation of insurance. We are seeing this in: TRIA Flood Multi-state efforts or wind catastrophe exposure

112 With regulatory efforts focused on managerial transparency, i. eWith regulatory efforts focused on managerial transparency, i.e., ORSA, and ERM, we are moving toward an “essay evaluation” rather than a “tick and tie, true or false” evaluation process.

113 The National Conference of Insurance Legislators (NCOIL) has recognized the need for the states to assert themselves as the primary regulator of insurance companies.

114 The antitrust exemption for the “business of insurance” is dependent upon state regulation. If a single, dominant, private sector, for profit rating agency usurps the powers and authority granted to the states, the antitrust exemption for the business of insurance may not exist as we have known it to be.

115 “We cannot solve our problems with the same thinking we used when we created them.” - Albert Einstein

116 Most financial and regulatory issues can be explicitly addressedMost financial and regulatory issues can be explicitly addressed. ‘Rating agency as regulator’ cannot be easily addressed. The antitrust exemption of the business of insurance may be at risk if the issue is not resolved on the side of state regulation. The financial and regulatory issues impacting the P&C insurance industry will likely be focused on carriers of all sized and uniformly applied to those carriers regardless of the size of the carrier.

117 Questions?