Valuations --

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Valuations -- Actual v. Expected CAS Limited
Attendance Valuation Seminar St. Louis,
Missouri April 10-11, 2000
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What can go wrong?

• Obvious candidates include
• Reserve adequacy
• Latent claims
• Revenue enhancements
• Expense savings
• Less obvious candidates include
• Dilution of existing efforts
• Gross v. net - expenses despite no exposure

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Three Stories...
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Story 1

• Were going to
• 1) re-underwrite the book of business, keeping
  only the most profitable half, and
• 2) Well reduce fixed expenses by even more to
  reduce the marginal expense ratio
• The valuation is based in large part on the value
  of expected future earnings in excess of a hurdle
  rate
• Expected earnings are a function of planned
  post-merger activity

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Story 1 (continued)
Baseline view of the business after thorough due
diligence
Expected value of the Loss Ratio 85 Expense
ratio 35 Combined ratio 120
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Story 1 (continued)
E Loss Ratio Loss Ratio lt 73 50 With
expense savings the resultant Expense Ratio
30 Marginal Combined Ratio 80
Plan is to eliminate half of the business -- only
the bad half, of course. A marginal combined
ratio of 80 underlies the valuation.
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Story 1 (continued)
After one year, you are successful at eliminating
the worst 25 of the business. Competition has
stolen the best 25. You retain the middle in an
effort to prop up volume.
Expected value of the Loss Ratio between 25th
and 75th percentile 75 Expense savings
realized, but denominator is smaller. Expense
Ratio 34 Marginal Combined Ratio 109
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Story 2

• Were going to integrate the two claims units.
  Our intention is to create an organization that
  is the best of both worlds
• Culture, like the weather, is something everyone
  talks about but nobody does anything about.
• Cultural changes and their impact are difficult
  to predict

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Story 2 (continued)
Pre-merger average case reserves differ between
the two companies. Is it a mix issue? Is it
claims philosophy?
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Story 2 (continued)
Resource is dedicated to integration.
Target company is in shock. Average case
reserves drop 10.
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Story 2 (continued)
Integration is complete. Buyers culture
confirmed. Observed inflation is 11 in acquired
book.
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Story 3

• We dont know what that segment is worth. Lets
  just use a market multiple and apply it to book
  value.
• Actual will likely depart from expected if you
  didnt expect anything!
• Valuation has to be based on the drivers of value
  and your strategic intent
• Derivative benefits to ratings sensitive business
  when the acquired business is picked up by a
  higher rated business (can work the other way)

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Story 3 (continued)
Flat book of business grows 15in first year post
merger. Higher ratings allowed new product
introductions and new distribution channels
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Actual v. Expected