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Year End 2010 P&C Industry Review (March 16, 2011)

Surplus for the ALIRT P&C Composite1 rose marginally in 2010 as somewhat weaker underwriting
and operating income was offset by substantial shareholder dividends paid to parent companies.
Accident year underwriting results continued to underperform reported results though the gap
between the two underwriting profitability measures narrowed as prior year reserve redundancies
shrank. Direct and net premiums written were flat as soft market conditions persist in the face of
weak economic conditions and abundant capital.

State of the Underwriting Cycle: ALIRT Capacity Quadrant

In recent months we have been asked more often about when commercial pricing might harden
and/or what kind of capital hit could “move the market.” As we enter the 7th year of the current soft
market cycle, these questions are only natural.

We reiterate first the important distinction between capital and capacity, as they are not the same
thing. Capital (or “surplus” in the statutory reporting world) is technically the difference between
assets and liabilities and represents the financial cushion available to insurers to absorb operating
losses (among other things). Capacity reflects this financial capability (capital/surplus) to write
business, but also the willingness to do so. It is the removal of this willingness to write business
which will ultimately lead to a market turn. This is a very human element and involves the daily
decisions of thousands of market participants, from insurance management, underwriters, and
actuaries to insurance producers to end insureds. This is also the element that makes predicting a
market turn so difficult.

Below we provide a visual – The ALIRT Capacity Quadrant - which charts the interaction of capital
and willingness to write business and how this dynamic impacts capacity and ultimately the price of
property & casualty insurance.

ALIRT Capacity Quadrant As both capital and the willingness to write business rise,
prices tend to get soft (upper right hand quadrant). This
is where the market resides currently. As both capital
Hig he r and willingness to write business decline, the market
Hardening Soft tends to get hard (bottom left hand quadrant). The
Market Market thatched area represents a condition of market
equilibrium, where rates should be relatively stable.
Capital There are several directions we could go from here:
Hard Softening 1. Both capital and willingness to underwrite remain
Market Market
relatively high as profitability/capital positions do
Lo w e r not deteriorate. Pricing remains soft. An alternative
to this is that the market moves into the thatched
area = prices are flat for an extended period of time.
Lo w e r Willingness Hig he r

1
The ALIRT P&C Composite is comprised of 50 large U.S. P&C insurers, representing about 53% of total industry net written premium.
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ALIRT Insurance Research Page 1 March 16, 2011
2. Capital levels remain high but willingness to write business starts to flounder as soft market
exhaustion sets in, in which case we would move into the upper left hand quadrant. In this
scenario, prices would harden but perhaps not appreciably and/or swiftly;

3. A large catastrophe loss and/or rapidly deteriorating underwriting results lead to deteriorating
capital and the willingness to write business is sharply reduced. This would push the market
into the lower left hand quadrant = rapidly hardening prices = hard market.

Brian Dupperault, CEO of Marsh, recently remarked that market psychology is very important at
this stage of the pricing cycle. In a presentation to an industry gathering, he stated that underwriters
are “tired” and that one “can’t underestimate the importance of market psyche.” Although capital
remains plentiful, insurers could latch on to a near term excuse to begin firming pricing. If this is
true, it may be an important factor impacting future willingness to write business.

Insured losses from the tragic events in Japan are currently estimated at between $15-$35 billion,
with these preliminary figures taking into account only the earthquake damage. While these insured
losses will be disproportionately absorbed by the Japanese insurance market, global reinsurers will
also suffer losses. These losses, combined with other large global catastrophes thus far in the first
quarter, could serve to tighten reinsurance pricing in the U.S. come mid-year renewals. Some are
beginning to ask whether this potential tightening of reinsurance rates could act as a catalyst to push
primary rates up somewhat in the U.S. – or at least halt their decline.

Executive Summary: ALIRT P&C Composite Results

Below we provide 2010 financial highlights for the ALIRT P&C Composite, based on insurers’
statutory financial statements.

• ALIRT Composite surplus rose 2.5% in 2010, as operating earnings of $18.8 billion and
capital gains of $8.6 billion were offset by sizeable shareholder dividends of $21.5 billion and
other one-time changes of almost $2.0 billion.

• The ALIRT Composite reported a 2010 combined ratio of 102.6%, a 2.4 percentage point
deterioration from the 2009 result. Reported underwriting results were aided by $2.4 billion
of prior year reserve releases. These redundancies were well below the $7.8 billion of net
prior year reserve releases as of 9/30/2010, as a number of Chartis Commercial Lines
subsidiaries strengthened reserves substantially in the 4th quarter.

• The composite accident year combined ratio (which excludes the impact of prior year reserve
development), rose 1.8 percentage points to 103.7% in 2010 on the continuation of soft
market pricing. The accident year results have underperformed reported results for
nineteen consecutive quarters, a reflection of reserve releases into earnings and an
indication of a soft market.

• Pretax operating income of $21.1 billion in 2010 was 11.6% lower than in the prior year
period, reflecting weaker underwriting results as prior year reserve redundancies eased.
Composite pretax ROE declined 150 basis points to 7.3% (annualized) when compared to the
2009 ROE of 8.8%.

• In 2010, net investment yield rose 38 basis points to 4.44% from 4.06% in 2009, helped by
large one-time dividends paid to a composite insurer. Total return declined 11 basis points to
5.87% in 2010 despite continued strong equity market performance in the fourth quarter.

• Direct and net premiums were flat year over year (0.0% and 0.3%, respectively). This
represents an improvement vs. prior figures, which were negative, though it continued a weak
trend reaching back to 2008.
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ALIRT Insurance Research Page 2 March 16, 2011
• Gross and net underwriting leverage ratios were also flat when compared to 2009 results and
remain historically low at 1.17 times (gross) and 0.75 times (net) as of 12/31/2010. The low
net underwriting leverage is an expression of the relatively abundant capital in the current
P&C market.

Company Highlights

• In February 2011, AIG announced that its Chartis commercial lines pool strengthened its
reserves substantially, which resulted in a 4th quarter GAAP net charge of $4.1 billion. To
help offset this loss, AIG entered into an agreement with the U.S. Treasury to retain $2 billion
of funds from the recently closed sale of overseas business. Chartis reported that the reserve
strengthening was for four classes of long-tail liability business, with the majority coming
from accident years 2005 and prior.

• Liberty Mutual Insurance Company (LMIC) took $2.4 billion in shareholder dividends from
four of its regional P&C subsidiaries (Liberty Mutual Agency Corp. = LMAC) in 2010,
which resulted in sharp surplus declines for General Ins. Co. of America, Ohio Casualty,
Peerless Ins. Co., and Safeco Ins. Co. of America. These dividends boosted net investment
income considerably for LMIC (and hence for the composite).

In September, Liberty Mutual postponed its previously announced IPO of LMAC, which
management stated was due to an “unfavorable environment for receiving appropriate
value for the business.” Management has announced that it may re-attempt this IPO in
the “not too distant future.”

• In February 2010, Motors Insurance Corporation (MIC) completed the sale of its U.S.
personal lines P&C business to a joint venture backed by American Capital Acquisition
Corporation and AmTrust Financial. The transaction included the sale of ten pool
subsidiaries which resulted in a sharp decline in MIC’s net premium written.

• In the third quarter 2010, OneBeacon Insurance Group sold its traditional personal lines
business to Tower Group, Inc. This necessitated the termination of an intercompany
reinsurance agreement between One Beacon Insurance Company (OBIC) and two
subsidiaries sold to Tower Group, as well as the cession of additional personal lines business
written by other One Beacon subsidiaries. This reduced net premiums written at OBIC, the
lead member of the One Beacon Pool.

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ALIRT Insurance Research Page 3 March 16, 2011
Capital and Surplus

Surplus for the ALIRT P&C Composite rose 2.5% in 2010, a much lower increase than the 11.5%
reported in 2009, which largely offset the reduction in surplus in 2008. Thus, surplus is only up
1% from year end 2007 levels (the previous high level mark), which indicates a substantial
slowing of capital growth looking over the period since 2003.

As can be seen in the graph below, the decline in surplus growth is due to both: 1) diminishing
operating earnings, and 2) substantially higher shareholder dividends paid in 2010. The large
dividend payments are likely an expression of a perceived lack of opportunity to put excess
capital funds to profitable use, as we enter the 7th year of a protracted soft market. On balance,
this is a positive sign for a potential market turn as capital is stripped away from the industry,
putting potential support under pricing.

We do note, however, that net premium leverage (net premium to surplus) fell to a cyclically low
of 0.75 times in 2010. This shows that even with the industry’s low capital growth, the amount of
premium being written against that base remains at conservative levels. This reflects the
continued impact of weak exposure bases due to economic struggles and weak pricing, the latter
expressing an elevated willingness to write business.

Surplus Development: ALIRT P&C Composite


(Data in $ Millions) 2003 2004 2005 2006 2007 2008 2009 2010

Surplus Beginning of Period 151,644 184,882 208,276 226,664 268,200 290,216 256,779 286,003

Operating Earnings 12,070 17,235 17,278 31,532 32,018 20,298 20,315 18,764

Net Capital Gains or (Losses) 20,037 14,634 6,899 19,781 10,628 (40,405) 11,268 8,559

5,008 4,741 4,539 769 590 5,312 2,161 3,232


Surplus Paid-In
Shareholder Dividends (6,904) (9,184) (9,247) (9,706) (18,891) (17,410) (9,062) (21,489)

All Other Changes to Surplus 3,027 (1,254) (1,081) (840) (2,330) (1,232) 4,542 (2,008)

Surplus End of Period 184,882 208,276 226,664 268,200 290,216 256,779 286,003 293,061

Change in Surplus 21.9% 12.6% 8.8% 18.1% 8.2% -11.5% 11.5% 2.5%

Individual Company Results

Thirty-four composite companies reported an increase in surplus during 2010, led by Employers
Insurance Co. of Wausau (22%), American Home Assurance (14%, aided by a $1.9 billion capital
infusion in the fourth quarter), Factory Mutual Ins. Co. (12%), Erie Insurance Exchange (12%),
Nationwide Mutual Ins. Co. (12%), Liberty Mutual Ins. Co. (10%, helped by a $500 million
capital infusion), and Chubb subsidiary Pacific Indemnity Company (10%).

Twelve composite companies incurred surplus declines exceeding 10% in 2010, all of which paid
substantial shareholder dividends to their parent companies. Of these, four are the
aforementioned Liberty Mutual subsidiaries within the Liberty Mutual Agency Corp.
intercompany pool. These include Safeco Insurance Company of America (-26%), Peerless
Insurance Company (-26%), General Insurance Company of America (-25%), and Ohio Casualty
Insurance Company (-16%). Also reporting hefty surplus declines were Onebeacon Insurance
Company (-32%, $513 million in dividends), Commerce & Industry (-31%), Motors Insurance
Corporation (-26%, $850 million dividend), and Travelers subsidiaries Travelers Indemnity
Company (-15%, $2.3 billion dividend) and Travelers Casualty and Surety Company (-12%, $2.0
billion dividend).
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ALIRT Insurance Research Page 4 March 16, 2011
Underwriting Profitability

The ALIRT P&C Composite reported a combined ratio of 102.6% in 2010, a 240 basis point
deterioration from 2009 results. As we will discuss later, this deterioration was due in part to
substantial reserve strengthening on the part of several Chartis commercial lines subsidiaries.
The operating ratio, which takes into account both underwriting and investment earnings,
deteriorated by 70 basis points vs. the prior year’s result. This reflects considerable net
investment income growth, though investment income was distorted somewhat by large dividends
paid to Liberty Mutual Insurance Company from a number of its regional subsidiaries.

The accident year combined ratio of 103.7% was appreciably higher than the prior year’s results,
likely reflecting the impact of weaker current pricing as 2010 as estimated catastrophe losses
appear to be in-line with the prior year result (see chart on page 8). As shown below, excluding
the larger catastrophe-impacted years 2005 and 2008, accident year profitability has deteriorated
sequentially since 2004.

Underwriting Results: ALIRT P&C Industry Composite


Change
from 9/09
2004 2005 2006 2007 2008 2009 2010 (points)
Loss/LAE Ratio 73.4% 77.0% 66.7% 68.5% 75.7% 73.4% 75.4% +2.0
Expense Ratio 23.9% 23.8% 25.0% 25.5% 25.9% 26.3% 26.6% +0.3
Combined Ratio 97.8% 101.2% 92.7% 94.5% 102.0% 100.2% 102.6% +2.4
AY Comb. Ratio* 95.4% 99.2% 94.0% 96.0% 104.5% 101.8% 103.7% +1.9
Operating Ratio 88.0% 90.1% 81.4% 82.2% 90.1% 89.6% 90.1% +0.7
* Accident year combined ratios remove the impact of prior year reserve adjustments, thereby reflecting the profitability of business
written only in the current year.

Individual Company Results

Only two composite companies reported combined ratios below 90% in 2010, both of which were
aided by substantial prior year reserve releases: Factory Mutual (78.4%) and Great American
Insurance Company (86.0%). The next strongest combined ratios were reported by Ace
American Insurance Company (90.4%, 8 points of reserve release), and two lead Chubb
subsidiaries Pacific Indemnity and Federal Insurance Company (91.0% and 91.3%, respectively,
5 points of reserve release). All five of these top performing companies are commercial lines
predominant, although of the 20 companies with the strongest underwriting performance, 15 are
either personal lines predominant or multi-line carriers (such as Travelers, Chubb, and Hartford),
indicating the relative strength of the personal lines segment at present.

Twenty-seven companies reported combined ratios that exceeded 100% in 2010, with seven
reporting ratios in excess of 110%, including lead Chartis commercial lines pool subsidiaries
Commerce & Industry (142%), National Union Fire (138%), and American Home Assurance
(138%), due to substantial 4th quarter 2010 reserve increases which added approximately 38
points to the reported combined ratio (on which, see more below). Also reporting weak
underwriting profitability were lead Crum & Forster pool member United States Fire (114%),
Continental Casualty Company (113%), and New Jersey Manufacturers (112%).

Again, we note that the poorest underwriting results were concentrated among commercial lines
predominant carriers, reflecting the longer tail/greater volatility in those lines of business.

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ALIRT Insurance Research Page 5 March 16, 2011
Loss Reserve Adequacy

The table below tracks prior year loss reserve development for the ALIRT P&C Composite over
the past 10 years. As the far right hand column illustrates, aggregate reserve releases as of
12/31/2010 were the largest for accident year 2004 (= $12.9 billion) and trailed off sequentially
for accident years 2005-2009. Total reserve releases fell to $2.4 billion for calendar year 2010,
substantially below the $7.8 billion reported in 2009. This is largely due to the substantial
strengthening of prior year reserves in the Chartis commercial lines pool in the 4th quarter 2010,
as National Union Fire and American Home Assurance Company together boosted prior year
reserves by almost $4 billion.

PRIOR YEAR RESERVE DEVELOPMENT


ALIRT P&C COMPOSITE (2001 – 2010) – Data in $Millions
CY CY CY CY CY CY CY CY CY CY
Acc. Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total
Prior Yrs.* 4,618 7,946 9,696 8,420 8,626 3,808 3,339 1,906 3,176 3,260 54,795
2001 -- -369 602 1,371 1,803 406 435 123 325 190 4,886
2002 -- -- -2,909 795 1,835 475 127 159 -52 98 528
2003 -- -- -- -5,609 -1,129 -200 -165 38 -232 -1 -7,298
2004 -- -- -- -- -7,377 -2,290 -1,417 -1,109 -518 -237 -12,948
2005 -- -- -- -- -- -5,553 -2,081 -1,755 -947 -633 -10,969
2006 -- -- -- -- -- -- -3,815 -2,550 -1,335 -874 -8,574
2007 -- -- -- -- -- -- -- -2,658 -2,095 -637 -5,390
2008 -1,992 -939 -2,931
2009 -2,590 -2,590
Total Dev. 4,618 7,577 7,389 4,977 3,758 -3,354 -3,577 -5,846 -3,670 -2,363 9,509

Due to the outsized impact of the Chartis commercial lines pool prior year reserve strengthening,
we take a look at the size and character of this action. Below we detail the total charges taken by
each of the six participating pool members. As shown, the lines disproportionally impacted by
the reserve charges were Workers Compensation and Other Liability – Occurrence, where the
bulk of Asbestos & Environmental (A&E) liabilities reside. These two lines together comprised
90% of the total $5.2 billion of net statutory reserve strengthening.

Chartis Commercial Lines Pool


Prior Year Reserve Strengthening – 2010
By Major Line of Business
(Data in $MM) Total Prior Other
Yr. Reserve Workers Liability
Company Additions Comp. Occurrence
American Home Assur. 1,904 651 995
Chartis P&C Co. 261 91 138
Commerce & Industry 575 199 304
Insurance Co. in State of PA 261 91 138
National Union Fire 1,986 688 1,051
New Hampshire Ins. Co. 261 91 138
Chartis Comm’l Lines Pool 5,248 1,811 2,764
% of Total Reserve Addition 100% 35% 53%

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ALIRT Insurance Research Page 6 March 16, 2011
The chart below shows the accident years in which the majority of the reserve strengthening
occurred. Of the $5.2 billion reserve action, 45% occurred in accident years prior to 2001, which
would reflect the bulk – if not all – of the A&E charges. While AIG, in its initial release
regarding these reserve charges, indicated that the majority of charges were for “older accident
years,” we note that 28% of the total actually came in accident years 2007-2009.

There was some concern during the credit crisis that AIG subsidiaries were aggressively pricing
business to protect their renewal base. While this reserve action is not conclusive one way or the
other, it is interesting to note that the composite released reserves for accident years 2008-2009
and that not one of Chartis’ commercial lines peers reported comparable strengthening in either of
those years (only Continental Casualty and Firemans Fund among national lines peers reported
strengthening in both 2008 and 2009).

It could also be argued that Chartis is a proverbial “canary in the coal mine,” taking necessary
action to strengthen near-term accident years before most of its peers. If this is so, we might
expect to see deteriorating reserve quality for these accident years over the coming reporting
periods for other insurers, perhaps marking the beginning of a “pain” cycle which could move
pricing higher.

Chartis Commercial Lines Pool


Prior Year Reserve Strengthening – 2010
By Accident Year
Other
% of Workers % of Liability % of
Acc. Year Total Total Comp Total Occur. Total
Prior Yrs. 2,371 45% 826 46% 1,217 44%
2001 271 5% 99 5% 179 6%
2002 259 5% 92 5% 130 5%
2003 247 5% 43 2% 92 3%
2004 198 4% 23 1% 108 4%
2005 154 3% 39 2% -10 0%
2006 282 5% 80 4% 131 5%
2007 668 13% 135 7% 407 15%
2008 478 9% 301 17% 288 10%
2009 321 6% 173 10% 224 8%
Total Dev. 5,248 100% 1,811 100% 2,766 100%

Individual Company Results

Companies reporting the largest prior year reserve releases in 2010 were State Farm Mutual Auto
($849 million), lead GEICO subsidiary Government Employees Ins. Co. ($499 million),
Nationwide Mutual Ins. Co. ($453 million), Continental Casualty Company
($431 million), and Federal Insurance Co. ($319 million). Of the 10 companies with the largest
releases, 8 were personal lines predominant or multi-line carriers. Only two – Continental
Casualty and Factory Mutual – were commercial lines specialists.

Only five insurers strengthened reserves in 2010, of which the top three are the lead Chartis
commercial pool carriers discussed above. Additionally, Fireman’s Fund boosted prior year
reserves by $209 million in 2010, largely reflecting the strengthening of legacy A&E liabilities in
the 2nd quarter, while Allstate Insurance Company boosted reserves by $16 million, with
strengthening of $306 million for accident years prior to 2001 largely offset by releases in recent
accident years.

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ALIRT Insurance Research Page 7 March 16, 2011
Operating Earnings

Pretax and after-tax operating earnings4 and returns in 2010 declined slightly when compared to
results over the last two years. Had 2005 and 2008 not been disproportionately impacted by
catastrophe losses, we would see a smoother rise and fall in earnings metrics since 2001 -
expected given the cyclical nature of P&C pricing. Underwriting profitability over the last two
years has been helped by the relative lack of major catastrophes (see catastrophe loss table
below), as well as by continued prior year reserve redundancies, which appear however to be
drying up.

ALIRT P&C Composite Return on Equity ALIRT P&C Composite Return on Earned Premium
20.0% 20.0%

15.0% 15.0%

10.0% 10.0%

5.0% 5.0%

0.0% 0.0%

-5.0% -5.0%

-10.0% -10.0%
'96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10
15 Year Average Pretax ROE PT ROE AT ROE 15 Year Average Pretax ROR PT ROR AT ROR

As for how this gradual decline in operating earnings could affect industry pricing, we note the
much weaker profitability in the period 1998-2000 before the last hard market turn. With capital
positions strong and industry profitability just beginning to fall below 15 year averages (see black
lines in graphs above), willingness to write business is probably unlikely to fall away rapidly –
barring an extremely large catastrophe or capital market shock.

Net Cat Losses for P&C Industry (Data in $Billions) Individual Company Results
Full
Ye ar 1Q 2Q 3Q 4Q Year Fifteen companies reported annualized pretax
1999 1.9 3.5 2.72 0.27 8.36
returns on earned premium (ROP) exceeding 20%
2000 1.2 1.5 0.3 0.8 3.8
in 2010. The top five companies include national
2001 0.7 6.2 19.1 0.5 26.5
multi-line insurers Travelers Indemnity and
2002 0.6 2.8 0.7 1.7 5.8
2003 1.5 5.1 3.7 2.6 12.9
Travelers Casualty & Surety (38.7% and 33.8%,
2004 1 2.3 23.7 0.5 27.5 respectively), Liberty Mutual Ins. Co. (35.2%,
2005 2.1 0.9 48.4 10.8 62.2 large dividends received from subsidiaries),
2006 1.5 5 1.3 1.5 9.3 Federal Insurance Company (35.0%), and Ace
2007 1.3 2.2 1.1 1.7 6.3 American Ins. Co. (34.0%).
2008 3.4 6 13.3 2.5 25.2
2009 3.5 5.2 2.6 0.2 11.5 Also reporting strong results were OneBeacon Ins.
2010 2.7 5.6 1.9 ?? 9.2* Co. (33.4%) and Motors Insurance Corporation
Source: ISO Property Claim Service quarterly estimates
Net Loss and Loss Adj. Expenses (after reinsurance)
(31.1%), both helped by sizeable transactions,
* 4th quarter 2010 cat losses not yet available from ISO along with specialty insurers Great American Ins.
Co. (29.3%) and Factory Mutual Ins. Co. (28.3%).

Only seven composite companies reported operating losses in 2010, including the three Chartis
subsidiaries discussed at length above, American Home (-21.5%), Commerce & Industry (-21.4%), and
National Union Fire (-13.3%). The remaining four insurers with 2010 operating losses were Farmers
Insurance Exchange (-6.6%), United States Fire (-2.5%), New Jersey Manufacturers (-0.3%), and State
Farm Fire & Casualty (-0.2%).

4
Excludes the impact of net capital gains/losses.
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ALIRT Insurance Research Page 8 March 16, 2011
Premium Income

Direct and net premiums for the ALIRT P&C Composite were essentially flat in 2010 versus the
prior year period. Premiums are a function of both pure rate and the amount of insurance written
(exposure units & any changes in deductibles/limits). Somewhat more difficult to measure are
changes in terms and conditions which may result in more/less coverage for a static level of
premium. Such policy changes could result in higher/lower future losses.

As the chart below shows, this is the first time since year end 2007 that annual net written
premium growth was positive, if only by less than half a percentage point. This may reflect a
gradual increase in economic activity in 2010, which would expand exposure units even if
underlying pricing remains soft (as indicated in the second graph below). Additionally – and
likely - companies may be keeping more net business, even with weak pricing, as a way to utilize
“excess” surplus.

5.6%
Composite Net Written Premium Change by Quarter
300 6%
3.5%
2.5% 2.8%
250
3%

YOY Change in NWP


0.4%
NWP - $ in Billions

0.3%
200 -0.4% -0.1%
-1.4% -1.3% -1.4% 0%
-1.8%
150 -2.5%
-3.1%
-4.0% -3.8%
-4.5% -3%
100

-6%
50
$232 $58 $117 $178 $233 $57 $115 $175 $227 $55 $110 $168 $220 $54 $110 $168 $221
0 -9%
YE06 3/07 6/07 9/07 YE07 3/08 6/08 9/08 YE08 3/09 6/09 9/09 YE09 3/10 6/10 9/10 YE10
NWP $ in Billions YOY % Chng.

The graph below depicts the quarterly average of three, largely commercial lines pricing surveys6.
The last soft market commenced in the third quarter of 2004 and has followed a wavelike pattern
over the last six years. Since mid 2008, broad price decreases have moderated and appear to have
leveled off starting in mid-2009. We point out that as pricing becomes ever weaker, large year-
over-year declines become less likely. The fact that price decreases have remained steady argues
for the tenacity of the current soft market cycle, exacerbated by weak macro economic conditions.

P&C Industry Commercial Lines Rate Changes (per Market Surveys*)


(* Weighted Average of CIAB, CLIPS [Q2:05 & subsequent] and MarketScout Surveys)
12%
8.2%
Weighted Avg. Rate Change

9%
6%
3% 4.4% 1.4%
0%
-2.6% -3.1% -2.8% -3.0% -3.5% -3.1%
-3% -3.5%
-1.7% -4.9% -5.5%
-6.5%
-6% -4.0% -4.2% -4.0% -3.0% -3.2% -3.0%
-5.3% -5.2% -9.5% -9.3%
-9% -10.1%
-7.9% -8.0%
-12% -10.1% -10.5%
-15%
Q4:03

Q1:04

Q2:04

Q3:04

Q4:04

Q1:05

Q2:05

Q3:05

Q4:05

Q1:06

Q2:06

Q3:06

Q4:06

Q1:07

Q2:07

Q3:07

Q4:07

Q1:08

Q2:08

Q3:08

Q4:08

Q1:09

Q2:09

Q3:09

Q4:09

Q1:10

Q2:10

Q3:10

Q4:10

6
The CLIPs survey is estimated based on average prior quarters’ results as the 4Q report will likely not be released until April.
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ALIRT Insurance Research Page 9 March 16, 2011
Individual Company Results

Seven composite companies reported net premium growth exceeding 10% in 2010, led by
Farmers subsidiaries Farmers Insurance Exchange and Mid-Century Insurance Company (31.3%,
due in part to an amendment of a quota share reinsurance agreement in 2Q). Other companies
with strong net premium growth include Hanover Insurance Company (19.5%), Lexington
Insurance Company (19.5%; Chartis Surplus Lines Pool expanded with the inclusion of Chartis
Specialty Insurance Company), Liberty Mutual subsidiary Employers Insurance of Wausau
(16.8%, due to revisions to its intercompany pool at 1/1/2010), Ace American Insurance
Company (15.2%), and Progressive Direct (10.9%).

In contrast, seven companies reported net premium declines in excess of 10%, with the largest
declines reported by Motors Insurance Corporation (-76.2%; sale of personal lines business in
1Q). Other companies with large net premium declines include Onebeacon Insurance Company
(-40.1%, sale of traditional personal lines business), the three Chartis pool members, in part on
changes to intercompany pooling arrangements: Commerce & Industry (-18.0%,), National Union
Fire (-18.0%), and American Home Assurance (-14.3%), as well as Fireman’s Fund Insurance
Company (-15.2%) and Geico Indemnity Company (-11.6%).

Investment Mix

Invested assets for the ALIRT Composite rose 2.6% in 2010, as net premium flow was flat but
net investment income was up 14%, in part on large one-time dividends paid to Liberty Mutual
Insurance Company in anticipation of an IPO which was subsequently put on hold (see
introductory comments).

Distribution of Invested Assets


ALIRT P&C Composite
Chng.
12/31/05 12/31/06 12/31/07 12/31/08 12/31/09 12/31/10
in 2010
Bonds 58.8% 57.5% 57.1% 58.7% 59.6% 59.3% -0.3%
Unaffiliated Stocks 14.7% 15.6% 15.2% 10.6% 11.6% 11.4% -0.2%
Affiliated Stocks 16.6% 16.6% 17.3% 18.8% 18.2% 18.1% -0.1%
Mortgage Loans & Real Estate 1.4% 1.4% 1.6% 1.7% 1.5% 1.4% -0.1%
Cash & Short-Term 4.2% 4.5% 3.8% 4.1% 3.4% 3.3% -0.1%
Schedule BA 3.6% 3.9% 4.9% 5.6% 5.4% 5.9% +0.5%
Other 0.7% 0.5% 0.2% 0.5% 0.3% 0.6% +0.3%

Change in Inv. Assets 8.1% 11.1% 4.9% -7.4% 5.6% 1.9% N/M

As shown above, the mix of invested assets stayed relatively steady in 2010 after some sizeable
changes in 2008 and 2009. Since year end 2007, the mix of bonds has risen by over 2 percentage
points while unaffiliated stocks have declined by almost 4 percentage points, likely due to
continued depressed market values as equity markets remain well below year end 2007 levels.
The mix of cash & short-term investments holdings also continues to trend lower, likely
reflecting growing comfort with capital market recovery, while the holding of Schedule BA assets
(= hedge funds, private equity, REITs, and other alternative type investments) increased, perhaps
an expression of insurers trying to boost investment returns.

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ALIRT Insurance Research Page 10 March 16, 2011
In recent months, analysts Meredith Whitney and Nouriel Roubini created a media stir by
estimating that municipal bond losses could range from between $100 billion (Roubini) to
“hundreds of billions” (Whitney). Other prominent asset managers have since disputed this thesis
and the discussions continue.

Whatever the merits of the various arguments, it remains true that P&C insurers are large
investors in municipal bonds and that some of these bonds could come under pressure given
lower tax and other fee revenues in some cities and states, as well as sizeable challenges
associated with current and future budget deficits. As shown below, just under half of the
composite’s year end 2010 bond portfolio was invested in these securities. The exposure to this
class of bonds, however, declined by almost 8 percentage points over the last two years, offset by
holdings of U.S. federal and corporate bonds.

P&C Composite - Bond Portfolio Composition Comparison


100% 1.9% 2.1% 1.9% 1.9%
2.3% 2.0% 0.6% 0.5% Affil. Securities
90%
80% 31.5% 31.6% 34.0% 36.0%
Other
70%
% of Portfolio

60% Corporate Bonds


50%
40% Municipal Bonds
54.6% 55.3% 51.4% 47.6%
30%
Foreign Gov.
20%
10% 2.7% 3.7%
3.6% 2.1% U.S. Bonds
6.1% 6.9% 9.5% 10.3%
0%
2007 2008 2009 2010

In a recent release, Moody’s estimated potential municipal bond related losses of $500 million for
the industry under current credit conditions, though this figure could rise to $3 billion, under
stress test scenarios, if there is further deterioration in the market. P&C insurers could likely
absorb such losses – even in the higher range of these estimates – with little trouble. Of course,
individual insurers might face disproportionate losses, though a look at the holdings of the
composite carriers does not indicate a large number of outliers (see Appendix A).

Investment Results

Net Investment Yield

Net investment yield for the Composite rose 38 basis points to 4.44% in 2010 vs. 4.06% in 2009.
These results, however, were distorted to the upside by a large one-time gain in net investment
income at Liberty Mutual Insurance Company (LMIC) as a number of subsidiaries upstreamed
large dividend payments. LMIC’s yield jumped to 12.29% in 2010 from just 2.27% in 2009 on
net investment income of $3.4 billion in 2010. Also receiving extraordinary large dividend
payments was OneBeacon Insurance Company, likely tied in part to the sale of a number of
subsidiaries to Tower Insurance Group in mid year 2010.

Net Investment Yield and Total Return - 50 Company Composite


7.00% 18.00%
15.05%
6.50%
14.00%
6.00% 5.68% 10.32%
5.50%
9.60%
Total Return

7.97% 7.52% 8.26% 10.00%


5.50%
Net Yield

5.07% 5.92% 6.49%


9.44% 5.90% 5.87%
5.00% 4.62% 6.00%
5.07% 5.23% 4.55%
4.98%
4.50% 4.59% 4.59% 4.67%
3.64% 4.51% 2.00%
4.44%
4.00% Net Yield 1.75% 4.29%
0.76% 4.06% -2.00%
3.50% Total Return
-2.18%
3.00% -6.00%
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

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ALIRT Insurance Research Page 11 March 16, 2011
Although improved, net yield for the composite remains at a near 15 year low as the Federal
Reserve currently targets its Federal Funds rate at near 0% and both government (including
municipal bonds) and investment grade corporate bonds offer relatively low yields, especially in
the shorter maturity issues that P&C insurers favor. These historically weak investment yields
place additional focus on underwriting results, as carriers cannot depend on investment income to
help offset poor underwriting decisions, as has happened in the past. All things equal, these weak
investment yields could help support a market turn when it comes.

Total Investment Return

Total Return of 5.87% for 2010 was in line with 2009 results of 5.90%, despite the fact that
equity markets reported another strong year of growth (see graph below). This was due, in part,
to lower composite net capital gains (-23% in 2010), as several large companies reported much
lower gains (or net capital losses) year over year, including Federal Insurance Company,
Government Employees, Liberty Mutual and State Farm Auto.

Equity markets have been extremely volatile thus far in the 1st quarter 2011, up only slightly in
aggregate (after sizeable gains in earlier months), in part due to uncertainty regarding the
durability of the global economic recovery, the impact of political unrest in the Middle East, and
the recent catastrophic events in Japan.

2004 2005 2006 2007 2008 2009 2010 1Q11*


DJIA +3.1% -0.6% +16.3% +6.4% -33.8% +17.9% +11.0% +0.8%
S&P 500 +9.0% +3.0% +13.6% +3.5% -38.5% +21.3% +12.8% +0.4%
NASDAQ +8.6% +1.4% +9.5% +9.8% -40.5% +36.0% +16.9% -0.8%
Avg. % Change +6.9% +1.3% +13.1% +6.6% -37.6% +25.1% +13.6% +0.1%
* First quarter equity index results are through midday March 16, 2011.

Conclusion

Financial results for the ALIRT P&C Composite are beginning to show signs of wear and tear as
we enter the 7th year of the current soft market cycle. Surplus rose only slightly as insurers made
sizeable shareholder dividend payments to parent organizations, while both reported and accident
year combined ratios deteriorated and prior year reserve releases slowed. Premium growth, on
both a direct and net basis, remains flat.

As discussed earlier, capacity is a product of the interaction between insurer capital levels and the
willingness to place business. At some point, especially if industry financial deterioration
continues, some catalyst could move carriers to dial back their appetite to place business. This
would lead to harder pricing and a market turn.

Examples of catalysts could include large catastrophe losses impacting reinsurance capacity (the
string of global catastrophe events thus far in the first quarter?), additional dramatic increases in
prior year reserves (a la AIG/Chartis in the 4th quarter), or a marked deterioration in economic
conditions/global capital markets. Even continued sideways investment results might be enough
to push insurers to the brink of psychological exhaustion.

Lastly, ALIRT notes the regulatory action taken against three insurers over the last month (two
were placed in liquidation). While these insurers are small, the companies’ ALIRT trends
identified them as laggards up to several years before. As we continue to sift through and analyze
the financials of many property & casualty insurers every quarter, we are likely to turn up other
carriers to watch closely, especially after such a long stretch of soft market pricing.

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ALIRT Insurance Research Page 12 March 16, 2011
APPENDIX A – COMPOSITE MUNI BOND HOLDINGS
(Sorted High to Low By % of YE2010 Surplus)
(Data in $MM)
MUNI BONDS
States & % Tot. Political % Tot. Special % Tot. % YE2010 % YE2010
COMPANY GROUP Territory Munis Subdivision Munis Revenue Munis Total Bonds Surplus
Commerce & Industry Insurance Co AIG 751 19% 746 19% 2,363 61% 3,859 69% 205%
Lexington Insurance Company AIG 1,929 18% 2,441 23% 6,158 58% 10,528 69% 190%
General Insurance Co of America Liberty Mutual 25 3% 81 11% 628 86% 734 48% 179%
American Home Assurance Company AIG 2,097 19% 2,809 25% 6,239 56% 11,145 63% 167%
Pacific Indemnity Company Chubb Corp. 608 15% 484 12% 2,862 72% 3,954 80% 163%
State Farm Fire and Casualty Co State Farm Mutual 1,567 12% 5,343 41% 6,249 47% 13,160 67% 150%
Metropolitan Property & Cas Ins Co MetLife Inc. 27 1% 110 5% 2,295 94% 2,432 90% 132%
Travelers Casualty & Surety Company Travelers Cos. 1,300 19% 2,359 34% 3,255 47% 6,913 75% 127%
Berkley Regional Insurance Company WR Berkley 80 9% 70 8% 724 83% 874 58% 127%
Safeco Insurance Co of America Liberty Mutual 94 9% 80 8% 863 83% 1,037 43% 123%
Ohio Casualty Insurance Co Liberty Mutual 152 11% 155 11% 1,049 77% 1,355 42% 121%
Travelers Indemnity Company Travelers Cos. 1,414 17% 2,874 34% 4,086 49% 8,374 64% 118%
Berkley Ins Co WR Berkley 275 9% 144 5% 2,603 86% 3,021 62% 115%
Peerless Insurance Company Liberty Mutual 283 15% 230 12% 1,375 73% 1,887 47% 106%
Ace American Ins Co ACE Ltd. 156 8% 145 7% 1,750 85% 2,051 34% 104%
Country Mutual Insurance Co Country Mutual 139 8% 649 38% 914 54% 1,703 74% 104%
St Paul Fire & Marine Insurance Co Travelers Cos. 1,200 20% 2,672 44% 2,146 36% 6,018 55% 103%
Mid-Century Insurance Co Zurich Financial 98 12% 125 15% 627 74% 850 33% 102%
Continental Casualty Co C.N.A. 582 6% 1,330 14% 7,371 79% 9,282 32% 95%
New Jersey Manufacturers Ins Co New Jersey Manuf. 1,153 54% 997 46% 0 0% 2,150 50% 90%
Employers Ins of Wausau Liberty Mutual 154 13% 131 11% 895 76% 1,180 50% 90%
Federated Mutual Insurance Co Federated Mutual 84 4% 776 41% 1,010 54% 1,870 66% 85%
Hartford Accident & Indemnity Co Hartford Financial 292 12% 340 13% 1,888 75% 2,519 30% 79%
Firemans Fund Insurance Co Allianz 246 11% 317 15% 1,580 74% 2,143 39% 79%
Farmers Insurance Exchange Zurich Financial 316 11% 417 15% 2,118 74% 2,851 39% 77%
Federal Insurance Company Chubb Corp. 1,614 15% 1,328 12% 7,731 72% 10,673 71% 75%
Cincinnati Insurance Co Cincinnati Fin'l 3 0% 1,587 62% 952 37% 2,543 52% 67%
USAA Casualty Insurance Co USAA 137 6% 0 0% 2,325 94% 2,462 44% 67%
Nationwide Mutual Fire Insurance Co Nationwide Mutual 202 14% 400 27% 890 60% 1,491 48% 67%
Great American Insurance Co American Fin'l Corp. 147 15% 123 13% 713 73% 983 36% 67%
Allstate Insurance Company Allstate Corp. 183 2% 1,527 15% 8,166 83% 9,876 44% 64%
United States Fire Ins Co Fairfax Financial 79 14% 0 0% 491 86% 570 63% 63%
National Union Fire Ins Co of Pitts AIG 1,297 19% 1,706 25% 3,856 56% 6,859 44% 54%
Hanover Insurance Company Hanover Ins. Grp. 53 6% 133 15% 708 79% 893 31% 51%
Zurich American Ins Co Zurich Financial 0 0% 0 0% 3,558 100% 3,559 19% 48%
Liberty Mutual Insurance Co Liberty Mutual 779 13% 686 12% 4,402 75% 5,867 42% 43%
Amica Mutual Insurance Company Amica Mutual 248 25% 194 20% 550 55% 992 53% 42%
State Farm Mutual Auto Ins Co State Farm Mutual 3,307 13% 10,739 42% 11,503 45% 25,549 64% 42%
Sentry Insurance A Mutual Co Sentry Ins. Group 8 1% 401 33% 818 67% 1,227 56% 36%
Government Employees Insurance Co Berkshire Hathaway 0 0% 5 0% 2,153 100% 2,158 24% 33%
Nationwide Mutual Insurance Co Nationwide Mutual 389 12% 631 19% 2,280 69% 3,299 33% 31%
Progressive Direct Ins Co Progressive Corp. 69 21% 5 1% 262 78% 337 13% 28%
Erie Insurance Exchange Erie Indemnity Co. 195 14% 301 21% 919 65% 1,415 29% 28%
Factory Mut Ins Co FM Global 235 13% 148 8% 1,494 80% 1,877 56% 27%
Onebeacon Ins Co White Mountains 1 0% 0 0% 246 100% 247 23% 27%
Motors Insurance Corp GMAC Inc. 0 0% 0 0% 316 100% 316 12% 22%
Progressive Casualty Insurance Co Progressive Corp. 2 1% 0 0% 172 99% 173 13% 13%
Hartford Fire Insurance Co Hartford Financial 202 11% 211 12% 1,372 77% 1,785 13% 13%
Usaa USAA 62 7% 0 0% 808 93% 871 16% 5%
GEICO Indemnity Company Berkshire Hathaway 0 0% 0 0% 24 100% 24 1% 1%

50 Company Composite 24,233 13% 45,947 24% 117,759 63% 187,939 48% 64%

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ALIRT Insurance Research Page 13 March 16, 2011
We note above that 64% of composite municipal bond holdings at 12/31/2010 were held in Special
Revenue/Special Assessment Obligations, which derive their interest and principal payments from
special revenue streams and do not depend on a municipality’s ability to levy taxes and/or control
general operating expenses. These types of bonds represent by far the largest holding of muni-
related securities for both property & casualty as well as life/annuity insurers.

Three of the four composite insurers with the highest surplus exposures to municipal bonds are
AIG subsidiaries: Commerce & Industry (205%), Lexington Ins. Co. (190%), and American
Home Assurance Company (167%), while several Liberty Mutual and WR Berkley subsidiaries
also report higher than composite average surplus exposure to municipal bonds

Only New Jersey Manufacturers and Cincinnati Insurance Company had well above composite
average municipal bond exposure to States & Territory/Political Subdivision holdings (see in
yellow), though neither insurer had an overall outsized surplus exposure to municipal bonds.

This review is prepared by ALIRT Insurance Research, an independent insurance industry financial analysis firm. ALIRT provides its ALIRT (AnaLysis of Insurer Risk Trends) Services to institutional
clients responsible for monitoring exposures to insurance company financial deterioration. This review is for the specific internal use of our clients, and may not be redistributed without the express written
permission of ALIRT Insurance Research.

While this review is prepared for your personal use, it is not a substitute for an impartial and thorough investigation of insurance company relative financial strength, and does not satisfy federal and state
mandated fiduciary due diligence. Financial information contained in this review is obtained from public sources we consider reliable, but we cannot guarantee as accurate. This review should not be
considered complete, includes expressions of our opinion, and must be accepted without responsibility to ALIRT.

ALIRT Insurance Research, LLC - 200 Day Hill Road, Ste. 220, Windsor, CT 06095
Phone: (860) 683-2070 Fax: (860) 683-4020
Email: info@alirtresearch.com Website: www.alirtresearch.com

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ALIRT Insurance Research Page 14 March 16, 2011