Catlin Re RELEASE – Nr.1/2012

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1/2012 — Bulletin of Catlin Re Switzerland

Assume Inflation Why inflation risk needs to be taken seriously

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Editorial Dear Reader I am pleased to present to you our first 2012 edition of RELEASE. On 31 December 2011 Catlin Re Switzerland completed its first full year of underwriting, providing the opportunity to review the impact of our 2011 activities on a year-to-year basis. In highlighting our accomplishments we hope to demonstrate that the launch of Catlin Re Switzerland has been met with some quite ‘healthy’ appetite from cedants. Generating over USD 140m gross premiums in its first year of existence, Catlin Re Switzerland also reached its profitability targets in 2011 which added significantly to the diversification of the Group’s underwriting portfolio.

In case you have not had the opportunity to read our 2011 financial results, they are available in full on www.catlin.com.

In line with our previous editions, we would like to take the opportunity to highlight a reinsurance topic that merits special attention. Currently, the risk of inflation receives little attention from economic experts. However, Daniel Gantner, Underwriting Director Casualty at Catlin Re argues that, although currently a remote possibility, a resurgence of inflation in the midterm could have potentially ‘pernicious effects on non-life long-tail insurers’.

Finally, we would like to continue introducing our expert teams. This time RELEASE takes a look at our Iberian market team in Madrid. Headed by Julio Sáez the team is on its way to prove that reinsurance in Spain and Portugal is first and foremost about knowing your cedants and their markets from own experience.

Yours sincerely

Peter Schmidt Chief Executive Officer

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Managing inflation risk – The value of reinsurance Ultra-lose monetary policies and surging levels of public debt suggest that inflation is a scenario to be reckoned with. How are insurers affected? How can they respond and what is the role of reinsurance in addressing the challenge?

Why inflation risk needs to be taken seriously Monetary inflation, defined as the rate of change of the general Consumer Price Index (CPI), seems to be a remote scenario. Economic growth in the advanced economies remains sluggish and highly vulnerable to adverse developments such as further deterioration of the Euro zone sovereign debt crisis, destabilization of the banking system and fiscal austerity measures.

However, insurers should not ignore a medium-term scenario of surging inflation: Central banks have pushed policy rates to record-low levels, close to zero. In addition, they have adopted unconventional and unprecedented measures such as quantitative easing, the purchase of (government) bonds through newly created money. It cannot be ruled out that these measures have inflicted a lasting damage to central banks’ reputation as the guardians of monetary stability – the consequences of which could prove painful as soon as economies recover and inflation picks up again. A further reason to be wary of inflation is government debt. Unfunded pension and health care liabilities are set to blow huge holes into public budgets in the not too distant future. Inflation may be one of the options for governments to alleviate the real burden of their debt.

Inflation drives up future claims costs …

In the past, inflation has had pernicious effects on non-life long-tail insurers in particular. Those carriers, especially casualty writers, have to deal with a significant time lag between the receipt of premium payments, loss occurrence and claims settlement and payment. Claims develop over years and are therefore exposed to a major degree of uncertainty. Factor in monetary inflation and claims may grow dramatically faster than premiums, potentially resulting in a dangerous depletion of loss reserves and severe solvency problems. This happened, for example, in the US in the late 1970s and early 1980s. CPI inflation surged to double-digit levels. At the same time, the

“Inflation may be one of the options for governments to alleviate the real burden of their debt.”

escalation of the tort system heralded a fullblown liability insurance crisis. The effects of this double-whammy, i.e. monetary inflation combined with what is called ‘superimposed’ inflation were dramatic: Claims costs skyrocketed, reserves developed adversely and the insurability of liability exposures was called into question as a number of players went out of business and rates shot up.

Historically, ‘superimposed’ inflation has been even more damaging to insurers than monetary inflation.

Claims have risen faster as a result of legal changes, court decisions, rising standards of living as well as demographic and technological trends – as compared with effects from increases in retail prices, wages or salaries.

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… and could weaken balance sheets However, the effects of inflation on insurers go far beyond the level of future claims costs. For example, it is a challenge to adjust pricing and reserving methods based on historical values for spikes in inflation. Sharp and erratic changes of the CPI can severely impair product pricing and reserving and the resultant uncertainty on part of the insurers may be passed on to policyholders through higher risk loadings.

And, last but not least, inflation can have a major impact on an insurer’s balance sheet.

Let us assume that interest rates rise in tandem with inflation. Under most relevant accounting standards, assets are marked-to-market. Higher interest rates, therefore, immediately translate into lower asset valuations. Liabilities, however, are not discounted under US-GAAP and IFRS accounting standards. This mismatch could erode shareholders’ funds depending on the proportions of the inflationary shock.

“Insurers can address inflation risk by shortening the duration of claims liabilities and indexing contract clauses to overall inflation.”

How insurers can mitigate inflation risk Insurers can address inflation risk by shortening the duration of claims liabilities and indexing contract clauses to overall inflation.

For example, ‘claims-made’ policies effectively mitigate latency risk. Under such a clause, the policy only covers claims which are reported during the policy term. Claims that occur at a later stage are not covered. Such clauses are instrumental in maintaining the insurability of long latent exposures such as pharmaceutical liability.

‘Claims-made’ clauses are less effective though in dealing with claims which occur fast (such as motor bodily injury) but take a long time to be settled. For such exposures, index clauses are a more suitable risk mitigation strategy for insurers. The core elements of an insurance policy, i.e. premiums, limits and deductibles are linked to an inflation index such as the CPI. Therefore, the originally agreed ‘economics’

of an insurance policy are (somewhat) protected from inflation risk. The degree of protection depends on the specific characteristics of the index clause. Policy features may be fully adjusted with the index (‘Full Index Clause’), as from a certain level of accumulated inflation only (‘Franchise Index’) or as from a certain level of accumulated inflation but only in excess of this threshold (‘Severe Inflation Clause’).

Index clauses are used in reinsurance and commercial insurance to equitably share the burden arising from unexpected claims inflation between the reinsurer and cedant or the insurer and commercial policyholder, respectively.

The promise of reinsurance Through ‘sharing the fortune’ of their clients reinsurers traditionally provide protection against claims inflation, for example in proportional treaties where the reinsurer shares the adverse effects of inflation on the cedant’s claims costs.

The picture is more complex under non-proportional reinsurance treaties. Unless contract limits are adjusted, the reinsurer bears any downside arising from claims inflation as soon as the cedant’s self-retention is exceeded. The introduction of index clauses as described above provides a variable degree of inflation risk sharing between the reinsurer and the ceding company. However, even under the most

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restrictive index clause, the reinsurer assumes from the client all claims escalation risk associated with superimposed inflation. The full transfer assumption of this basis risk, i.e. the usually positive difference between claims inflation and general (CPI) inflation, is a powerful value proposition of long-tail reinsurance solutions.

In summary, in times of heightened monetary and social inflation risk, reinsurers’ fundamental role of sharing their clients’ exposures takes on even more prominence. Based on the reinsurance industry’s global diversification power and risk expertise there is plenty of scope for mutually beneficial contract schemes designed at mitigating inflation risk.

Daniel Gantner, Ph.D., Underwriting Director

“Historically, ‘superimposed’ inflation has been even more damaging to insurers than monetary inflation.”

How Catlin Re Switzerland aims to mitigate inflation risk Catlin Re Switzerland pursues an integrated risk management approach to reflect inflation risk in all key business processes, including underwriting, pricing, reserving and capital and investment management: • We apply contract terms (e.g. loss indexation clauses) to allow for a fair sharing of the burden of inflation between our clients and us.

• We closely monitor monetary inflation trends as well as legal and social developments to anticipate superimposed inflation risk. We also regularly analyse the loss history in respect of superimposed inflation.

• Our pricing and reserving strategy aims to reflect the uncertainties associated with long-tail business. For example, we apply loadings to take into account inflation expectations and make robust assumptions on monetary and superimposed inflation when pricing our business.

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Bringing in our first yield In 2011 Catlin Re pursued a single overarching goal – to lay the foundation on which to build a multiline reinsurance company devoted to long-term relationships with clients in Continental Europe. This positioning of Catlin Re Switzerland struck a chord with cedants.

Obviously, for Catlin Re Switzerland a year-on-year comparison of the 2011/ 2 012 renewals has limited merit since we only received our reinsurance license in mid December 2010, when last year’s January renewals were already in full swing. However, as of April 2012 we look after 250 client relationships with over 500 programmes. In 2012 we were invited to review more than 750 programmes, an increase of 70 percent over the prior year.

“In the current market environment in Continental Europe pricing remains competitive with rate adequacies sometimes still ranging above 100 percent.”

Today we write business across property, credit, casualty and specialty. As measured by premiums, close to 80 percent of our business originates from Continental Europe – bearing in mind that Catlin Re Switzerland writes Credit & Surety on a global basis.

When we started with Catlin Re last year, our Italian team under the lead of Antonio Fiengo was already with the Group. Today, our Italian market still accounts for 30 percent of premiums. However, our presence across Continental Europe – including a sizeable footprint in the Americas and Asia Pacific, due to Credit & Surety – is the accomplishment of our work in the 2011 renewals.

Product split of gross written premiums, April 2012.

Casualty 7% Specialty 11%

Catlin Re Switzerland pursues a conservative underwriting approach. In our market expansion, we achieve a positive underwriting contribution by focusing on our clients and diversifying into lines and risks with good terms and conditions.

We continue to tread cautiously. As mentioned in the 2012 renewal reports issued by brokers and reinsurers, and in accordance with our own experience, the reinsurance market is quite diverse. Programmes with loss experience in 2011 saw some large price increases. However, those focused on Continental Europe were largely unaffected by the claims in Asia Pacific and the US, and so prices remained flat.

In our non-proportional Property book we realized price increases of about 5 percent, primarily by diversifying away from European windstorm. For proportional Property, our marketing efforts started to pay off as we continue to build our presence in Germany, Austria, Scandinavia, Iberia, Turkey and Israel. In Casualty, we are beginning to penetrate in lines such as Accident & Health, Motor, Casualty XL and quota share reinsurance across all Continental Europe. In Specialty, we focus on cedants with local construction portfolios rather than global portfolios. Finally, our Credit & Surety portfolio benefits from further market penetration, as we broadened our client base and were able to win new accounts with clients in Continental and Eastern Europe.

Going forward we will continue to pursue our strategy of complementing geographical penetration with underwriting additional lines and products, securing new accounts, expanding shares on existing programmes and finally targeting programmes that benefit from price increases or improvements in terms and conditions.

Credit 47% Property 35%

For further information, please visit www.catlinreswitzerland.com

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Trust and proximity prevail A solid understanding of our clients’ markets is part of our value proposition. Right from the start, we pursued the approach of building a presence in Continental Europe.

Inspired by the success of our Italian office, we announced in June 2011 the opening of our Iberian office in Madrid.

The Madrid office, targeting the Spanish and Portuguese markets, was announced as part of the appointment of Julio Sáez, an experienced insurance and reinsurance veteran who previously had served as Head of Engineering and Senior Underwriter at Swiss Re in charge of Iberia and Latin America.

Shortly thereafter he was followed by a former colleague, Andrés Esteban, who joined us as Senior Underwriter. In the meantime, the team has been strengthened further with the addition of Julio S. Vicente as Operations Assistant.

“We have just started to write our first treaties,” says Julio Sáez. “Given that we only opened in October 2011, we are very satisfied with how well our entry to the market has been received,” he said.

“Reinsurance in Spain is foremost about trust and relationships,” said Sáez. “Cedants want the confidence that they can bank on their reinsurer. They expect solid solutions, a partner with sufficient financial clout to weather the market’s challenges and the stamina to stay and not walk away when the first claims roll in,” he said.

“In entering the Iberian market we benefit from the reputation of the Catlin brand. We are known to pursue a conservative and cautious underwriting approach, are interested in expanding our relationships over time, and to only underwrite risks which we fully understand,” said Sáez Although Julio Sáez and his team had a good start, they follow the market with some concern. Engineering and liability showed the impact of the financial crisis in Europe, and have both seen falling premiums of 11.5% and 6% respectively. Motor slightly declined by 2.3%, while property and health both increased by around 3%. In general, personal lines tended to be rather stable due to a benign loss experience and a lack of competition, with the exception of Motor, which remained under pressure due to over-supply of capacity.

The order: (f. l. t. r.) Andrés Esteban, Deputy Branch Manager / Julio Sáez, Branch Manager / Julio S. Vicente, Operations Assistant

Cedants are facing a further challenge from Spain’s two-notch sovereign debt ratings downgrade. As a consequence, their ratings have been lowered, and in addition, the security of their asset portfolio is impaired. Potentially this will increase their capital requirements, and thus, they could seek additional reinsurance protection as a proxy for capital.

“We follow the fortunes of our clients and do not opportunistically allocate our capacity where we expect the most immediate return.”

For 2012, Julio Sáez and his team aim to strengthen their presence in the market. They are planning to host two client-events in Madrid and Barcelona respectively, both in May. In addition, they intend to visit every insurance company in the Spanish and Portuguese market, proving to them that nothing matters more than a trusted relationship.

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Your Contacts Catlin Re Switzerland Feldeggstrasse 4 8008 Zurich Switzerland Tel. +41 43 268 34 00 Peter Schmidt

Christophe Chandler

Jérôme Domenichini

Chief Executive Officer

Underwriting Director Zurich

Senior Underwriter Zurich

Tel: +41 43 268 84 30 peter.schmidt@catlin.com

Tel: +41 43 268 84 31 christophe.chandler@catlin.com

Tel: +41 43 268 34 57 jerome.domenichini@catlin.com

Andrés Esteban

Markus A. Eugster

Antonio Fiengo

Deputy Branch Manager Madrid

Underwriting Director Zurich

Branch Manager Rome

Tel: +34 67 365 64 09 andres.esteban@catlin.com

Tel: +41 43 268 23 75 markus.eugster@catlin.com

Tel: +39 0632 898 751 antonio.fiengo@catlin.com

Daniel Gantner

Martin Hochstrasser

Stefanie Koch

Underwriting Director Zurich

Underwriting Director Zurich

Underwriter Zurich

Tel: +41 43 268 34 28 daniel.gantner@catlin.com

Tel: +41 43 268 23 76 martin.hochstrasser@catlin.com

Tel: +41 43 268 34 29 stefanie.koch@catlin.com

Ortwin Kroeninger

Jean-Pierre Portmann

Maria Elena Saccotelli

Senior Underwriter Cologne

Underwriting Director Zurich

Deputy Branch Manager Rome

Tel: +49 221 1688 7378 ortwin.kroeninger@catlin.com

Tel: +41 43 268 84 33 jean-pierre.portmann@catlin.com

Tel: +39 0632 898 752 mariaelena.saccotelli@catlin.com

Julio Sáez

Dorothee Therstappen

Toni Vukadinovic

Branch Manager Madrid

Underwriter Cologne

Underwriting Director Zurich

Tel: +34 67 073 99 02 julio.saez@catlin.com

Tel: +49 221 1688 7360 dorothee.therstappen@catlin.com

Tel: +41 43 268 34 53 toni.vukadinovic@catlin.com

Impressum: Published by Catlin Re Switzerland / Concept & Design by agor ag, Zurich / Edited by Dr. Schanz, Alms & Company, Zurich