Implications ofDynamic Financial Analysis (DFA)

on Demutualization

by Jan Lommele andKevin Bingham

Guest Speaker: Stephen List, CFOThe National Atlantic Companies

DFA Case Study

Plymouth/Royale

3:30 p.m. - 5:00 p.m.

Actuarial Standards and DFA

• Parallel’s Between ASB#19 and DFA– DFA is a Tool For an Actuarial Appraisal– Concepts in ASB#19 are Directly Applicable

• Distribute Earnings

• Risk Adjusted Rates of Return

• Value of Existing (v.s. Future) Business

• Lapsation of Contracts

• Operational Assumptions

• Economic Assumptions

• Sensitivity Analysis (Stochastic Analysis)

The National Atlantic Companies

• Company Background• Unique Agent Partnership Strategy• Use of DFA in Acquisitions

– Identify Target (Mutual or Non-Mutual Company)

– Discuss Insurance Department Requirements

– Benefits of Demutualized Company

• Immediate Access to Market

• Name Brand Recognition

• Reduces Time and Cost of Licensing New Company

– Demutualize Company and Implement Strategy

Introduction

• Approaches to Demutualization

• Why Demutualization

• Actuarial Valuation Considerations

• Actuarial Valuation Methodology

• Deterministic Base Case

• Stochastic Simulation

• Model Results and Communication

• Afterthoughts

Approaches to Demutualization

• Full Demutualization– Focus of This Paper

• Mutual Holding Company– NAIC White Paper Draft on “Mutual Insurance

Holding Company Reorganizations”

Why Demutualize?“ A C C E S S T O C A P I T A L ”

• Key Drivers for Accessing Capital– Entering New Lines of Business

– Expansion Into Different Geographic Areas

– Investment in Technology and New Products

– Increased Competition

– Acquisitions

• Current Options for Accessing Capital– Retention of Net Profits

– Issuance of Surplus Notes

– Offer Shares of Stock in Downstream Subsidiary

– Merger

Actuarial Valuation Considerationsfor Demutualization

• Parties Involved– Insurance Department

– Policyholders

– Lawyers

– News Media

– Investment Bankers

– Tax Specialists

• Actuarial Valuation Considerations– Use of DFA

– Readability of Analysis

– Comfort With Actuarial Assumptions

– Conceptualization of Actuarial Valuation Methodology

– Comfort With Final Appraisal Range of Value

Actuarial Valuation Methodology

• Key Assumptions– Leverage Ratio

– Renewal Retention Ratio

– Opportunity Cost of Capital

• Model Set-up– Losses and Reinsurance

– Invested Assets

– Non-Invested Assets• Uncollected Premiums

– Other Liabilities• Unpaid Expenses

– Benefit Accruals (Deferred Compensation and Post-Retirement Health)

– Other Income

– Taxes

Actuarial Valuation Methodology

• Actuarial Appraisal Range of Value – Implied Dividends or Capital Contributions

• Net Liability To Surplus Ratio < Selected Ratio Dividend to Policyholders (DIV)

• Net Liability To Surplus Ratio > Selected Ratio Capital Contribution (CC)

– Discount DIV/CC and Ending Surplus Stream Using Opportunity Cost of Capital (OCC)

– Adjustments

• Reserve Inadequacy/Redundancy

• Adjustment of Assets to Fair Market Value

– Appraisal Value Factor = Simulated Company ValueActual December 31st Surplus

Deterministic Base Case

XYZ CASUALTY MUTUAL COMPANYDIVIDEND OR CONTRIBUTION ESTIMATION

Simulation Years1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

(1) Net Loss & Loss Adjustment Expense Reserves (Balance Sheet)10,142,481 9,792,645 9,001,649 8,128,737 7,228,352 6,380,369 5,607,362 4,913,878 4,299,643 3,762,189

(2) January 1st Surplus (Income Statement)4,298,679 5,071,241 4,896,322 4,500,825 4,064,368 3,614,176 3,190,185 2,803,681 2,456,939 2,149,822

(3) Net Income After Tax (Income Statement)671,592 768,095 747,839 688,182 622,675 554,620 490,083 431,112 377,979 330,728

(4) Simulated December 31st Surplus Prior to Dividend or Capital Contribution = (2) + (3)4,970,271 5,839,336 5,644,161 5,189,007 4,687,043 4,168,796 3,680,267 3,234,793 2,834,918 2,480,549

(5) Net Liability to Surplus Ratio Prior to Dividend or Capital Contribution = (4) / (1)2.04 1.68 1.59 1.57 1.54 1.53 1.52 1.52 1.52 1.52

(6) Capital Contribution (+) / Dividend To Policyholder (-) (Income Statement)100,970 (943,013) (1,143,337) (1,124,639) (1,072,867) (978,611) (876,587) (777,854) (685,097) (599,455)

(7) December 31st Surplus = (2) + (3) + (6)5,071,241 4,896,322 4,500,825 4,064,368 3,614,176 3,190,185 2,803,681 2,456,939 2,149,822 1,881,094

(8) Liability to Surplus Ratio = (7) / (1)2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00

NOTE: SELECTED NET LIABILITY TO SURPLUS RATIO = 2.000

XYZ CASUALTY MUTUAL COMPANYAPPRAISAL VALUE FACTOR

Simulation Years1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

(1) Capital Contribution (-) / Dividend To Policyholder (+) - POLICYHOLDER PERSPECTIVE(100,970) 943,013 1,143,337 1,124,639 1,072,867 978,611 876,587 777,854 685,097 599,455

(2) December 31st Surplus5,071,241 4,896,322 4,500,825 4,064,368 3,614,176 3,190,185 2,803,681 2,456,939 2,149,822 1,881,094

(3) Discount Factor Using Opportunity Cost of Capital of 12.5%88.9% 79.0% 70.2% 62.4% 55.5% 49.3% 43.8% 39.0% 34.6% 30.8%

(4) Estimated Value = (1) x (3) + (2) December 31, 2008 x (3)

(89,751) 745,097 803,002 702,106 595,365 482,720 384,350 303,164 237,345 184,600 - - - - - - - - - 579,276

(89,751) 745,097 803,002 702,106 595,365 482,720 384,350 303,164 237,345 763,876

4,927,274

(5) XYZ Casualty Mutual Company December 31, 1998 Balance Sheet Surplus

4,298,679

(6) Appraisal Value Factor = (4) / (5)

1.146

XYZ CASUALTY MUTUAL COMPANYINTERNAL RATE OF RETURN (IRR)

Simulation Years1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

(1) Initial Investment for IRR Calculation

(4,298,679) = - XYZ Casualty Mutual Company December 31, 1998 Balance Sheet Surplus

(2) Cash Flows for IRR Calculation = ( Dividend or Contribution + Return of December 31, 2008 Surplus )(100,970) 943,013 1,143,337 1,124,639 1,072,867 978,611 876,587 777,854 685,097 599,455

- - - - - - - - - 1,881,094 # (100,970) 943,013 1,143,337 1,124,639 1,072,867 978,611 876,587 777,854 685,097 2,480,549

(4) IRR15.3%

(5) Opportunity Cost of Capital (OCC)

12.5% IRR > OCC, Appraisal Value Factor > 1.000

(6) Appraisal Value Factor

1.146

Stochastic Simulation

• Losses• Premiums• Expenses• Asset Returns• Timing of Cash Flows

– Variability of Payout Pattern (% Unpaid)

– Premium Collection Lag

– Expense Payment Lag

XYZ CASUALTY MUTUAL COMPANY XYZ CASUALTY MUTUAL COMPANYDISTRIBUTION OF ESTIMATED COMPANY VALUE TO 12/31/98 STATUTORY SURPLUS DISTRIBUTION OF ESTIMATED COMPANY VALUE TO 12/31/98 STATUTORY SURPLUS

ASSUMING SURPLUS RETURNED AT END OF YEAR 2008 ASSUMING SURPLUS RETURNED AT END OF YEAR 20083/1/99 11:10

0

10

20

30

40

50

60

70

80

Ratio of Estimated Value to Surplus

Fre

qu

en

cy

OCC =12.5%

80.0% C.I.

Model Results and Communication

• Management Discussion– Model Coverage

• Name Brand Recognition

• Agency Distribution Network

• Value of Licenses

– Result Overview and Appraisal Value Factors

• Commissioner of Insurance - Public Hearing– Hearing Goal; “Fair and Equitable”

• Final Distribution– Stock

– Cash• Distributed based upon the ratio of the policyholder’s net-earned premium paid in a

timely manner during the three years immediately preceding the adoption of the Conversion Plan to the total net earned premiums received by the Company from all policyholders

Afterthoughts

• Goal of DFA Analysis– Demutualization

• Appraisal Value Factors• External Focus (Insurance Department and Policyholders)

– State Fund• Profitability• Market Share (Premium)• Impact on Equity

– SFAS 115

– SFAS 130 - “Other Comprehensive Income”

• Internal Focus (Primarily Board of Directors)

– IRS Section 42 - Affordable Housing Funds• Model Risk Factors Facing LIHTC Projects• Estimate Reinsurance Costs For Client• GAAP Projections

Afterthoughts

• Internet Documentation– NAIC Research Library

• http://www.naic.org/ - Lists a number of articles and documents discussing demutualization and mutual holding companies.

– Glenndaily.com Information Services• http://glenndaily.com/ - Web Site provides the reorganization status of

mutual life insurance companies.

– Demutualization.org• http://www.demutualization.org/ - Policyholder focused web-site listing a

number of articles, documents and answers to typical policyholder questions.