The Correlation between Actuarial Valuations and Insurance Company Market Valuations Steven W. Fickes, F.S.A.

I. INTRODUCTION The purchase price of a Target Insurance Company is typically determined through an actuarial valuation. In a very simplistic form, an actuarial valuation is defined as the discounted value of the projected future cash flows from operations of the Target Insurance Company, plus its adjusted net worth. Cash flows are basically defined as the projected distributable earnings, which are typically assumed to equal the projected net after tax earnings of the Target Insurance Company, determined under statutory accounting practices (SAP). When an Insurance Company goes public in an initial public offering (IPO), Investment Bankers determine the public company valuation price by reference to comparable price to earnings (P/E) and price to book value (P/BV) ratios. Both ratios are calculated using earnings and book values determined according to generally accepted accounting principles (GAAP). After an IPO is completed, the common stock price of the Insurance Company is perceived as being largely driven by GAAP financial results. For most investors, the only financial statements readily available in a useful form are the GAAP financial statements. Often times, even the senior management teams of insurance companies come to view their companies as two separate entities - the Statutory Companies and the GAAP Companies. When properly applied, both accounting standards are inter-related; and, therefore, both should support consistent valuations. The purpose of this paper is to demonstrate that there is a strong correlation between actuarial valuations and the day-to-day trading price of the equity securities of publicly traded U.S. Insurance Companies. Furthermore, it appears that investors in the public markets are attempting to find accurate values through trial and error using various proxies. Properly constructed actuarial valuations provide a better and more stable determination of the value of insurance companies than the valuation proxies currently being employed in the public markets. II. VALUATION PROXIES One of the first issues to consider is: how, if public markets are investing based on GAAP financial information, can such public market valuations correlate to actuarial valuations, which are entirely driven by statutory accounting? The answer is that most proxies are derived from fact and not fantasy. A common problem is that oftentimes the user of a valuation proxy relies entirely on the proxy and therefore loses sight of the fact that the proxy is merely an approximation. For example, there was a time in which portfolio managers traded fixed income securities relying upon the rule of fives. The rule represented the approximate change in the price of a bond for every five basis point change in yield. That was in the days of pre-computer and pre-calculator, which surprisingly were not that long ago. P/E ratios implicitly assume a pattern of future earnings and a discount rate. If an investor demands an after-tax rate of return of 15%, the appropriate multiple is 6.67 times earnings assuming no growth in earnings and 11.5 times earnings, assuming earnings growth of 5% per year. The derivation of both of these multiples can be shown mathematically.

if: EV0 = Equity Value of an enterprise at time 0 CFt = Cash Flows, or earnings, in year t CFt+1 = CFt * (1+g), where g represents the annual growth in earnings v = 1/(1 + i), where i represents the required rate of return then: EV0 = v * CF1 + v2 * CF2 + v3 * CF3 + . . . EV0 = v * (1 + g) * CF0 + v2 * (1 + g)2 * CF0 + v3 * (1 + g)3 + . . . EV0 = CF0 * (1 + g) / (i-g) In estimating the equity values of insurance companies, the use of GAAP earnings in place of statutory earnings (cash flows) multiplied by a P/E ratio is convenient because GAAP can act to smooth earnings. Offsetting the advantage of potentially smoother earnings is the disadvantage of opaque financial statements at best, and too often, completely non-transparency. Using a multiple of GAAP book values is also a commonly used approximation or proxy for equity valuations. For Property & Casualty (P&C) insurance companies, the book value is expressed relative to the amount of premiums which can be written, which in turn drives profitability. With Life insurance companies, the deferred acquisition assets (DAC) and value of business acquired (VOBA) represent a portion of the companys embedded value. Based upon historical observations, typically, the DAC and VOBA assets, both of which are GAAP assets, tend to be in the 40% to 60% range of a companys embedded value. The use of a multiple of GAAP book value, therefore, approximates all of the components of an actuarial valuation. While using GAAP financials as the basis for estimating the equity value of an insurance group maybe convenient, GAAP valuations can be flawed because GAAP financial results can vary significantly for two identical companies, depending on the objectiveness of management in establishing assumptions and depending on the timing and circumstances under which such assumptions were established. While investors and analysts attempt to adjust for such factors, the introduction of such adjustments moves the valuations towards art and away from science. Therefore, if one is to conclude that P/E and P/BV ratios are simplified attempts to arrive at a valuation using as a basis GAAP financials, why not use actuarial valuations which rely on the more transparent and less subjective statutory financials? III. ACTUARIAL VALUATIONS BARRIERS TO USE A.) Organization Structure Anyone who has ever been involved in the development of a traditional actuarial valuation knows that it generally involves teams of actuaries and can take weeks or months to complete. Added to the already inherent level of complexity is the common practice of Insurers to operate through multiple regulated insurance entities, referred to herein as (Regulated Insurance Companies). For example, Chart 1 below shows a portion of the corporate organization structure of Progressive Corporation. While most stock market investors would regard Progressive as one insurance company, in reality, it is comprised of approximately sixty (60) subsidiaries, of which over half are Regulated Insurance Companies.

Chart 1

Corporate Structure for Progressive Corporation (partial)

as of December 31, 2008 NAIC GROUP TIER 1 TIER 2 TIER 3 TIER 4 TIER 5

155
Progressive Cas Ins Co PROGRESSIVE GULF INS CO-PGR SUB Progressive Gulf Ins Co Progressive Direct Ins Co Progressive Specialty Ins Co United Fncl Cas Co PROGRESSIVE COMMERCIAL CASUALTY CO Progressive Northwestern Ins Co Progressive Northern Ins Co Progressive Preferred Ins Co Progressive MI Ins Co Progressive American Ins Co Progressive Express Ins Co Progressive Classic Ins Co Progressive Marathon Ins Co Progressive Select Ins Co Progressive Max Ins Co Progressive Northeastern Ins Co Progressive Mountain Ins Co National Continental Ins Co Progressive Choice Ins Co Progressive Advanced Ins Co Progressive Universal Ins Co Progressive West Ins Co Progressive Southeastern Ins Co Mountain Laurel Assur Co Progressive Bayside Ins Co Progressive Security Ins Co Progressive HI Ins Corp Progressive Premier Ins Co Of IL Drive NJ Ins Co Progressive Paloverde Ins Co Artisan & Truckers Cas Co Progressive Freedom Ins Co Progressive Garden State Ins Co Progressive Cnty Mut Ins Co

Progressive Corporation (PGR)

24260 37286 42412 16322 32786 11770 12879 42919 38628 37834 10187 24252 10193 42994 37605 10192 24279 10042 35190 10243 44288 11851 21727 27804 38784 44180 17350 10050 10067 21735 11410 44695 10194 12302 14800 29203

The organizational chart, shown above, highlights companies both by tier and type of company within the organization structure. A Tier 1 Subsidiary, for example, is a subsidiary held directly by the holding corporation. Tier 2 Companies have a single intermediate parent between the Tier 2 Company and the ultimate holding company. This layering of companies within an organizational structure allows companies reporting under statutory accounting principles to, at times, double count statutory capital and surplus. This is referred to as stacking. The occurrence of stacking obscures statutory accounting principles financial statements and, thereby, makes any actuarial analyses more difficult.

In the U.S., organizational charts are included in Schedule Y of statutory statements filed by regulated insurance companies. All regulated insurance companies file statutory financial statements with the National Association of Insurance Commissioners, (NAIC), and the state insurance department, where they are licensed. The organizational structure shown above is abbreviated in that it does not include all the companies within Progressive Corporations organization structure. The Companies highlighted in yellow represent the regulated P&C Insurance Companies within Progressive Corporation. It should also be noted that Progressive Corporation was not singled out because it operates through so many regulated insurance companies. In fact, for its size, Progressive has one of the simpler organization structures compared to other publicly insurance groups. For example, American International Groups organizational structure, before it started its divestitures, filled six type written pages in single line format. It is easy to understand therefore, if the actuarial valuation of a single regulated Insurance Company requires teams of actuaries working weeks or months to complete, valuations for multiple Regulated Insurance Companies, within any actionable time frame, would be virtually impossible. In order to create actuarial valuations for publicly traded insurance groups, which will be discussed later herein, it was necessary to created consolidated financial statements for all of the regulated P&C Insurance Companies within every insurance group combined, and when applicable, consolidated financial statements for all regulated Life Insurance Companies within each insurance group. The process of creating the consolidated financials for the Regulated Insurance Companies involves the elimination for each individual Regulated Insurance Company within the consolidation, all affiliated common equity and the income from affiliated common equity investments. Through the elimination of all affiliated common holdings in consolidating the Regulated Insurance Companies, the number of valuations required for each insurance group can be reduced to at most two: a valuation for the regulated P&C Insurance Companies and a valuation for the regulated Life Insurance Companies. B.) Valuation of the Holding Company and Other Operations Another difficulty that arises when attempting to apply the methodology of an actuarial valuation to a publicly traded insurance group is the Valuation of the Holding Company and Other Operations. The information required to value the Holding Company and Other Operations is not available through statutory filings of the Regulated Insurance Companies. Such information can, however, be obtained from a Companys annual 10-K filings with the Securities and Exchange Commission. The most significant components in the valuation of the Holding Companies and Other Operations are discussed below. Cash and Invested Assets: Holding Company Cash and Invested Assets, other than investments in subsidiaries, are reported in the condensed financial statements for the parent company in the annual 10-K filing. Holding Company Debt: Unaffiliated debt is reported in the consolidated balance sheets of the parent company, including both long-term and short-term debt. Affiliated Debt: Affiliated Net Receivable/Payable to Parents, Subsidiaries, and Affiliates is reported in the consolidated financial statements for the parent company in the annual 10-K filing. Since these amounts are also included in the adjusted net worth of the Regulated Insurance Companies, to avoid double counting, they must be removed from the valuation. Value of Other Operations: There is no simple method of valuing Other Operations. This can only be done through research such as determining the original purchase price or carrying values if the Other Operations are held as investments by any of the Regulated Insurance Companies.

For most publicly traded U.S. Insurance Groups, the value of Other Operations is not significant. A good method by which to gauge the significance of Other Operations is to compare the consolidated statutory assets of the Regulated Insurance Companies, not including affiliated equity and debt, to the parent companys consolidated assets shown on a GAAP basis in the annual 10-K filing. Below, Exhibit 1 demonstrates such a comparison, again using Progressive Corporation for illustrative purposes. Exhibit 1, shown below, illustrates that the consolidated statutory assets of Progressive Corporations regulated insurance companies represent approximately 95% of Progressive Corporations consolidated GAAP assets. Goodwill, Deferred Acquisition Assets (DAC) and Value of Business Acquired (VOBA), all items applicable only to GAAP, represent 2% of the GAAP assets. Reinsurance recoveries and other GAAP asset represent the remaining 3% of GAAP assets. In Progressives case, at least, on an asset basis, the statutory balance sheets capture almost the entire company. For insurance groups with operations outside of the regulated insures, such operations can manually be adjusted if it is deemed to be material to the overall valuation. Exhibit 1

GAAPversusStatutoryAssetAnalysis December31,2008

US Statutory Insurance Assets

-1% 2% 2%

DAC and VOBA Assets GAAP Reinsurance Receivable All Other Assets

95%

Source: Raedel Financial Solutions

C.) Access to Available Information Once the holding company and other operations have been valued, the remaining value of the enterprise is the actuarial value of the regulated insurance companies within a group. This is an obstacle in that U.S. companies, at least, do not annually create such valuations; and, when they are created, are seldom made public. To independently create a traditional actuarial valuation would require access to inside information and management. Fortunately, however, the statutory financials provide an abundance of financial information from which non-traditional actuarial valuations can be built.

IV. NON-TRADITIONAL ACTUARIAL VALUATIONS Non-traditional actuarial valuations or economic valuations can be performed using only publicly available financial data, primarily from the statutory filings the regulated insurance companies provide to the NAIC. This information serves as the basis for the assumptions necessary to create projections. However, by using assumptions derived solely from public data, the assumptions become somewhat sterile

in that they only reflect historical performance and not managements outlook, insights, pessimism, or optimism. On the other hand, using only public financial data may be beneficial in that all assumptions can be derived more consistently, mechanically and objectively, thereby removing some of the actuarial art and managerial bias, which may be present in a traditional actuarial valuation. The non-traditional actuarial valuation, which relies on assumptions derived from public information, mimics the form of a traditional actuarial valuation, the components of which are discussed below. Adjusted Net Worth: The combined total adjusted statutory net worth of all of the combined U.S. Regulated Insurance Companies within a group can be obtained from the statutory statements filed by each company. All affiliated common equity investments must be excluded from reported Capital and Surplus. Included in the adjusted statutory net worth is the consolidated capital and surplus, adjusted for affiliated investments, and for Life Insurance Companies, the interest maintenance reserve and the asset valuation reserve. Cost of Capital: The cost of capital is an imputed charge made in order to reflect the fact that at least a portion of a Regulated Insurance Companys adjusted net worth is not immediately available to shareholders. The capital must remain in the company to support its business and ratings. The cost of capital each year is assumed to equal the difference between: 1) the after-tax rate of return required by shareholders, and 2) the after-tax investment yield the company could reasonably earn on investments, applied to the minimum capital that the companies must maintain each year. The projected annual cost of capital is then discounted back to the valuation date using selected discount rates. Value of Existing and New Business: The value of the existing and new business is calculated as of the valuation date based on the discounted present values of projected statutory income for fifty (50) calendar years following the valuation date. For new business, it is assumed that ten years of new business is written. The projected statutory income amounts are developed based on assumptions derived from the historical statutory financial statements of the Regulated Insurance Companies within an insurance group. The projected statutory income amounts are determined based on unit expense assumptions developed by line of business based on industry results, or the insurance companys actual unit expenses, if lower. For lines of business where the insurance companys unit expenses exceed the industry unit expenses, the difference is calculated and assumed to be an expense over-run. Policyholder Dividend Obligations: This represents an adjustment for the estimated present value of future policyholder dividend obligations, after tax. Expense Over-runs: An additional expense amount, for each line of business, is calculated by comparing a companys reported expense ratios to the industry expense ratios. If the companys expense ratios exceed the industry expense ratios, the excess is considered to be an expense overrun and is projected assuming a run-off at a rate of 10% per year. The present value of the projected expense over-runs is calculated and represents a potential offset against the overall valuation of the company. If a company is managing its business below industry expense ratios, 100% credit is given in all future projection years for such expense efficiency. Estimate Loss Reserve Deficiency: The estimated value of a P&C Insurance Companys operation must also include an estimate of the loss reserve deficiency, if any. The loss reserve deficiency can be estimated using several different methods together with the information provided in the Schedule P of the statutory annual statements. Other Adjustments: Insurance Companies at times assume reinsurance from other companies and cede reinsurance to other companies. Because non-traditional actuarial valuation projections are based on

an analysis of direct business, an estimate must be made for the present value of the projected net cost of reinsurance, after tax. Actuarial Value (non-traditional) after tax: The estimated non-traditional actuarial value, after tax, is calculated as follows: 1) Adjusted Net Worth, less the Cost of Capital, plus 2) Net Existing and New Business Values, less 3) Adjustments for projected Expenses Over-runs and Policyholder Dividend Obligations, plus 4) Other Adjustments, including outstanding debt. Assumptions: The assumptions used to project future statutory earnings should be based on historical results of the company, the industry and peer companies. However, most importantly, the formulas and methods used should be consistently applied to all companies. If this is done, some of the subjectivity, which at times can be introduced into traditional actuarial valuations, is removed. V. NON-TRADITIONAL ACTUARIAL VALUATIONS - CASE STUDY At this point, an actual case study may be useful. The MONY Group, Inc. and AXA Financial, Inc. announced that they had agreed to a transaction under which AXA Financial would acquire 100% of MONY in a cash transaction valued at approximately $1.5 billion. The corporate organization structure of the MONY Group as of the prior year-end is shown below in Chart 2. The companies highlighted in blue represent the regulated Life Insurance Companies; the MONY Group had no U.S. P&C insurance operations. Chart 2 The MONY Group, Inc Organizational Structure prior to acquisition

Using the methods and processes previously discussed, an economic value range for the MONY Group, Inc. of from $1.215 billion to $1.558 billion was established using a non-traditional actuarial valuation based entirely on publicly available financial information. The components of the valuation are discussed below.

VALUATION SUMMARY The MONY Group A.) Holding Company and Other Operations Cash and Invested Assets: Holding Company Cash and Invested Assets, other than investments in subsidiaries, of $221.1 million were reported in the condensed financials for the parent company. Holding Company Debt: The unaffiliated debt of $883.3 million was reported in the consolidated balance sheets of the company. This amount included long-term debt of $876.3 million, and $7.0 million of short-term debt. Affiliated Debt: Affiliated Net Receivable/Payable to Parents, Subsidiaries, and Affiliates in the amount of a $3.1 million payable was reported in the financial statements of the consolidated U.S. Insurance operations along with $1.3 million of affiliated invested assets. Since these amounts were included in the net worth of the U.S. Insurance operations, they were removed from the consolidated valuation to avoid double counting. Value of Other Operations: The estimated value assigned to the Other Operations of the MONY Group was $471.1 million. This was determined using $162.9 million for the value of the non-insurance investments held by the Regulated Insurance Companies, their respective statutory book value and $308.2 million for the Advest Group Inc, its original purchase price. B.) Valuation of U.S. Life Insurance Operations Value of Business: The estimated future statutory earnings for the MONY Life Insurance Operations existing business were projected and then discounted at 8%, 10%, and 12%, producing aftertax values ranging from $1.785 billion to $2.252 billion. The values of statutory new business were developed by projecting the anticipated statutory profits from ten years of new business. The projected statutory profits were then discounted using rates of 10%, 12%, and 14% to produce an after-tax value range of from $375 million to $637 million. Cost of Capital: The Cost of Capital is normally the difference between Required Capital and the lesser of discounted cash flows from interest earned after taxes at 6.5% on the Required Capital. For the MONY Group, however, the Cost of Capital adjustment was limited to 50% of the Required Capital. Policyholder Dividend Obligations: Future policyholder dividends were projected then present valued using discount rates of 8%, 10%, and 12%. The present values of the policyholder dividend obligations for the MONY Group were significant, ranging from $959 million to $1.281 billion. Expense Over-runs: An additional expense amount for each line of business was calculated by comparing the companys reported expense ratios to the industry expense ratios. The expense over-run was then projected assuming a run off at a rate of 10% per year. The present value of the projected expense over-runs was offset against the overall valuation of the company. The MONY Group had significant expense over-runs, which on a present value basis, even assuming a 10% reduction per year, exceeded $500 million. Other Adjustments: No Other Adjustments were made to the valuation of the U.S. Life Insurance Operations. Tax Rate: An effective tax rate of 35% was applied to all estimated future statutory earnings. C.) Valuation of US Property Casualty Operations: No US Property Casualty operations were owned.

In Table 1, which is shown below, the various components of value are summarized: Table 1 The MONY Group Inc. Non-Traditional Actuarial Valuation Range
Value Range Estimated Value of Holding Company and other Operations Holding Company Cash & Investments Holding Company Debt and Preferreds Less Affiliated Assets on Ins. Company books Less Net Intercompany Receivable/Payable Estimated Value of Non Insurance Operations Estimated Value of Debt and other Operations US Life Operations Adjusted Net Worth Less Cost of Capital Existing Business after tax New Business after tax Less Policyholders Dividends Less Additional Expenses Other Adjustments Net Present Value of US Life operations US P&C Operations Capital & Surplus Less Cost of Capital Present Value of Business After Taxes Less Additional Expenses Estimated Loss Reserve Deficiency Other Adjustments - Primarily Reinsurance Net Present Value of P&C Operations Estimated Value of US Insurance Operations Estimated Total Value incl. Other Operations 1 High $221.1 ($883.3) ($1.3) $3.1 $471.1 ($189.3) Medium $221.1 ($883.3) ($1.3) $3.1 $471.1 ($189.3) Low $221.1 ($883.3) ($1.3) $3.1 $471.1 ($189.3)

$980.1 ($264.5) $2,252.1 $637.3 ($1,281.3) ($576.2) $0.0 $1,747.5

$980.1 ($264.5) $1,994.3 $488.2 ($1,097.7) ($545.0) $0.0 $1,555.4

$980.1 ($264.5) $1,785.0 $375.2 ($954.9) ($516.8) $0.0 $1,404.1

$0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $1,747.5 $1,558.2

$0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $1,555.4 $1,366.1

$0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $1,404.1 $1,214.8

In Illustration 1, shown below, the estimated valuation ranges derived from the non-traditional actuarial valuation of the MONY Group in relation to the stock markets valuation throughout the two year prior to its acquisition. In determining the high, medium and low ends of the estimates, future projected statutory profits for existing business were discounted using discount rates of 8%, 10%, and 12%, respectively. For projected statutory profits from new life insurance business, the discount rates were increased by 200 basis points to 10%, 12%, and 14%, respectively. These selected discount rates were representative of the discount rates which tend to be utilized in traditional actuarial valuations. VI. NON-TRADITIONAL ACTUARIAL VALUATIONS versus MARKET VALUATIONS The actual stock market capitalization of the MONY Group was calculated using the closing market price of MONY Groups common shares (ticker MNY at that time) on the first business day of each month, multiplied by the number of shares outstanding. Illustration 1 Non-Traditional Actuarial Valuation Range versus Market Capitalization

The comparison of MONY Groups market capitalization, based on quoted stock prices and the actuarial valuation range, non-traditional, shows that the market valuation of MONY Group prior to AXAs announced bid was at the lower end of the range, while AXAs bid for control, was at the high end of the range. This seems to suggest a continuity between the market value pre-bid and AXAs valuation, with the variable appearing to be the discount rate. VII. NON-TRADITIONAL ACTUARIAL VALUATIONS Other Publicly Traded Groups In order to further explore the relationship between stock market valuations, non-traditional actuarial valuations of other publicly traded insurance groups were undertaken. Illustrations 2, 3, and 4 reflect non-traditional actuarial valuations of three predominately P&C publicly traded insurance groups, shown in comparison to their respective market capitalizations for the period from April 2003 through August of 2004. Again, market valuations were determined using the closing share prices on the first business day of each month. The non-traditional actuarial valuations for the three insurance groups were as of December 31, 2003. The high, medium, and low ends of the valuation ranges were developed by discounting future projected statutory earnings using discount rates of 8%, 10% and 12%, respectively; and for Allstates and Allmericas new life insurance business, discount rates of 10%, 12% and 14% were used.

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Non-traditional Actuarial Valuation Ranges versus Market Capitalizations

Illustration 2 The Progressive Corporation as of December 31, 2003

Illustration 3 The Allstate Corporation as of December 31, 2003

Illustration 4 Allmerica Financial Corporation as of December 31, 2003

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As can be seen from the three illustrations, during the course of the measurement period, all three Insurance Groups traded within the value ranges determined using non-traditional actuarial valuations. Additionally, the upper end of the value ranges seemed to represent a ceiling through which a companys share price could pierce then crest shortly thereafter. Tests of other companies over different time frames seemed to suggest similar patterns existed at the bottom end of the valuation ranges as well. Share prices could dip below the low end of the valuation range only to later reverse directions and head back towards the valuation range. VIII. NON-TRADITIONAL ACTUARIAL VALUATIONS RANGES versus MARKET VALUATIONS Multiple Time Periods Next, the non-traditional actuarial value ranges were produced for several publicly traded insurance groups in comparison to the stock market valuations over multiple time periods. In Illustration 5, the high, medium and low valuations are shown for Progressive Corporation. The non-traditional actuarial valuations were determined as of years ending December 31, 2002, December 31, 2003 and December 31, 2004. Illustration 5 Non-Traditional Actuarial Valuation Range versus Market Capitalization

The Progressive Corporation

From January 2, 2003 through January 4, 2005, Progressive Corporations common share price rose from $50.95 per share to $86.66. Coincidentally, the mid-point of the non-traditional actuarial valuation range, converted into an equivalent value per share of common stock, rose from $52.80 as of December 31, 2002 to $81.29 as of December 31, 2004. During the course of calendar year 2003, Progressives share price rose above the valuation range, which had held constant based on the December 31, 2002 valuation. Early in calendar year 2004, the share price came back within the valuation range, based on the December 31, 2003 valuation. A similar but less discernable pattern seemed to occur again at the end of calendar year 2004 and the beginning of calendar year 2005. IX. NON-TRADITIONAL ACTUARIAL VALUATIONS RANGES versus MARKET VALUATIONS Interpolated Valuation Ranges The patterns which appeared to emerge as the non-traditional actuarial valuation ranges grew stale as each year progressed led to an examination of the relationship between the stock markets valuations and the actuarial valuation ranges, non-traditional, interpolated between the year-end valuations. Illustration 6 reflects the non-traditional actuarial valuation ranges from January 2003 through January 2005. The non-traditional actuarial value range shown for January 2003 is the value range

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established as of December 31, 2002. The non-traditional actuarial value ranges shown for each month thereafter, throughout the remainder of calendar year 2003, are the linearly interpolated values between the December 31, 2002 valuation range and the December 31, 2003 valuation range. The valuation ranges for calendar year 2004 were created in a similar fashion by interpolating between the December 31, 2003 valuation range and the December 31, 2004 valuation range. Illustration 6

Non-Traditional Actuarial Valuation Range versus Market Capitalization (using Interpolated Valuations) The Progressive Corporation

Illustration 6 shows that by using a dynamic valuation, the share price of Progressive Corporation consistently fell within the non-traditional actuarial valuation range throughout the entire two year period, at least as measured by the closing share price on the first business day of each month. Results for other publicly traded insurance groups were similar to the results for the Progressive Corporation, although the share prices of some companies consistently tracked above their respective valuation ranges and a few consistently tracked below. X. NON-TRADITIONAL ACTUARIAL VALUATIONS RANGES versus MARKET VALUATIONS Interpolated Valuation Ranges and a Valuation Roll-Forwards While the historical relationship between the market valuations of publicly traded Insurance Groups and their respective non-traditional actuarial valuation ranges viewed dynamically is interesting by itself, it is somewhat an academic exercise. This is because the monthly dynamic valuation ranges pre-suppose that one has perfect knowledge of the coming year-end valuation. A counter argument might be that future valuations are very predictable because assumptions should not change dramatically from period to period. As a matter of fact, if assumptions are assumed to remain constant for the following year, rolling the valuation forward one year to arrive at the valuation for the following year becomes a relatively simple exercise. Illustration 7 reflects the stock market valuation of Progressive Corporation from January 2003 through October 2005, along with the non-traditional actuarial valuation range. For the valuation range in calendar 2005, monthly valuation ranges have been determined by interpolating between the non-traditional actuarial value range as of December 31, 2004, and the estimated non-traditional actuarial value range as of December 31, 2005. The estimated valuation range as of December 31, 2005 is developed by increasing the adjusted net worth from the prior year end valuation by the projected after-tax statutory earnings for 2004, and then taking the discounted present value of future projected statutory earnings, discounted to December 31, 2005. Adjustments for any expense overruns and outstanding debt are assumed to be unchanged from one year to the next.

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Illustration 7 Non-Traditional Actuarial Valuation Range versus Market Capitalization (Interpolated Valuations and a Valuation Roll-forwards)

The Progressive Corporation

Illustration 7 shows that even without the perfect knowledge of the following year-end actuarial valuation range, the dynamic valuation range continues to track with the stock markets valuation of Progressive Corporation throughout calendar year 2005. The most important fact is that the valuation ranges for all of 2005 would be known as of the beginning of 2005. Where the predictive abilities of the non-traditional actuarial valuation ranges using roll-forward valuations could be weakened or even break down entirely would be if the events which occur in a current year are sufficiently dramatic to cause a significant change in the next years valuation assumptions. This potential vulnerability can likely be mitigated by updating the valuation roll-forward based upon each quarters statutory results. The roll-forward valuation used in the Illustration 7, intentionally assumed no knowledge of quarterly results. XI. NON-TRADITIONAL ACTUARIAL VALUATION RANGES and DISCOUNT RATES In each illustration so far, the discount rates used to determine the non-traditional actuarial valuations have been fixed at 8%, 10%, and 12%, with 200 basis points added to the discount rates for projected life insurance new business. Having made estimates of the future, cash flows or statutory earnings, we can make the analogy that pricing the common equity of a company would be equivalent to pricing a perpetual bond with coupons or cash flows, which vary from year to year. The market price of the bonds of two distinct corporations, even with identical coupon payments and maturities can be different at any given time due to the markets perceived risk associated with each individual company. Similarly, the discount rate used in a non-traditional actuarial valuation should reflect the probability or risk that the future cash flows will develop as projected. This is a departure from the methodology used for traditional actuarial valuations. Typically, with a traditional actuarial valuation, the discount rates to be used are fixed, for example, at 8%, 10% and 12%. Oftentimes, actuaries implicitly introduce margins for risk into the assumptions. With a non-traditional actuarial valuation, the assumptions are more mechanically set, thereby creating what could be regarded as more standardized valuations. Increasing the discount rates used in a non-traditional actuarial valuation is an indirect way of introducing margins to compensate for risk in the valuation process. In order to examine the range of discount rates which would be implied by the markets pricing of various publicly traded insurance groups, the mid-point discount rate of each non-traditional valuation was adjusted in order to attempt to fit the mid-point of the non-traditional actuarial valuation range to the market valuation over the prior twenty-month period. A moving twenty-month period was selected in order

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to allow for the possibility that the markets base discount rates may change over time due to non-company specific factors, such a changes in the risk free rate of return or more indirectly the perceived yield of alternative investments. As reflected below in Illustration 8, the market price of Progressive Corporation common stock is shown in comparison to a dynamic valuation range whereby the mid-point of this valuation range has been adjusted by using an assumed discount rate of 8.79%. This discount rate was selected in order to attempt to minimize the difference between the market value of the Progressive Corporations common shares and the mid-point of the valuation range over the prior 20 months. A discount rate of 8.28% was used to establish the high-end of the dynamic valuation range. That discount rate was selected based upon the average by which the market value of Progressive Corporations stock price, during the 20 monthly periods, exceeded the mid-point of the valuation range. A discount rate of 9.29% was used to establish the low end of the dynamic valuation range. That discount rate was selected based upon the average by which mid-point of the valuation range exceeded the market value of Progressive Corporations stock price, during the prior twenty-monthly periods.

Illustration 8 Non-Traditional Actuarial Valuation Range versus Market Capitalization (using interpolated valuations and modified discount rates)

The Progressive Corporation

Illustration 8 demonstrates a reasonable fit of the non-traditional actuarial valuation range to the market valuation of Progressive Corporation over the 34-month period from January 2003 through October 2005. This would seem to suggest that the markets discount rates, if such creatures exist, do not fluctuate widely, as the band width for the non-traditional actuarial valuation range was very narrow ranging from a low of 8.28% to a high of 9.29%, a width of 101 basis points. Similar analyses were performed on thirty-three (33) other public traded insurance groups. The high medium and low discount rates are shown below for each of these insurance groups. The discount rate ranges were calculated in an identical manner to the range of discount rates determined for Progressive Corporation.

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Table 2 Adjusted Discount Rate Ranges

Company AFLAC Allmerica Financial Corporation Allstate Corporation American Financial Group, Inc American International Grpoup, Inc. Chubb Group Cincinnati Financial Corporation Conseco, Inc. Direct General Corporation Great American Financial Resources Hartford Insurance Group Infinity Property and Casualty Corp. Jefferson Pilot Corp. Lincoln National Corporation Markel Corporation MBIA, Inc. Mercury General Corporation TICKER AFL AFC ALL AFG AIG CB CINF CNO DRCT GFR HIG IPCC JP LNC MKL MBI MCY Valuation Range Discount Rates High Medium Low 11.10% 11.57% 12.31% 6.74% 10.97% 12.59% 7.51% 8.63% 9.31% 11.53% 11.55% 11.78% 5.93% 7.51% 9.08% 12.08% 12.42% 13.04% 14.64% 15.61% 16.34% 10.67% 11.19% 11.76% 7.96% 10.40% 14.85% 13.83% 14.31% 15.10% 10.93% 11.20% 11.67% 6.96% 10.51% 12.20% 3.71% 4.04% 4.28% 4.85% 5.40% 5.94% 8.46% 9.26% 10.44% 11.01% 11.79% 13.28% 6.32% 7.25% 7.92% Width 1.21% 5.85% 1.80% 0.24% 3.15% 0.97% 1.70% 1.09% 6.89% 1.27% 0.74% 5.24% 0.58% 1.09% 1.98% 2.27% 1.60% Company TICKER METLife, Incorporated MET MGIC Investment Corporation MTG Nationwide Financial Services, Inc. NFS Ohio Casualty Corporation OCAS Progressive Corporation PGR Protective Life Corporation PL Prudential Financial, Incorporated PRU Reinsurance Group of America RGA Safeco Corp. SAFC Scottish Re SCT Selective Insurance Group, Inc SIGI St. Paul Travelers Companies, Inc. STA Stancorp Financial Group SFG The Phoenix Companies, Inc. PNX TORCHMARK Corporation TMK UnumProvident Corporation UNM W. R. Berkley Corporation BER Total Valuation Range Discount Rates High Medium Low 11.90% 12.36% 12.85% 6.30% 7.67% 8.74% 9.71% 10.16% 10.75% 12.26% 12.52% 13.05% 8.28% 8.79% 9.29% 7.51% 8.26% 9.02% 3.80% 5.62% 7.20% 7.01% 8.33% 9.83% 9.35% 9.88% 10.31% 4.49% 5.79% 6.24% 12.00% 12.25% 12.96% 10.15% 10.46% 11.06% 11.30% 12.16% 12.85% 7.56% 9.18% 9.54% -0.65% -0.16% 0.18% 11.13% 11.45% 11.96% 10.02% 10.74% 11.27% 8.72% 9.68% 10.56% Width 0.94% 2.44% 1.04% 0.79% 1.01% 1.51% 3.41% 2.82% 0.97% 1.75% 0.96% 0.91% 1.56% 1.98% 0.83% 0.83% 1.25% 1.84%

It seemed both interesting and surprising that the average mid-point of the discount rates for all companies studied, 9.68%, was very close to the mid-point of the discount rates originally used based upon industry practice. Furthermore, it was interesting that many of the discount rates, as adjusted, fell in line with empirical views of risk, volatility and quality. For example, the three predominantly P&C Insurance Groups, Progressive, Allstate and Allmerica, generally would be regarded from best to less than best in that order. The mid-point of the discount rates were; 8.79% for Progressive, 8.63% for Allstate and 10.97% for Allmerica, suggesting that Progressive was probably undervalued relative to Allstate. Coincidentally, in the weeks following the completion of this study, Progressives share price increased significant while Allstates share price declined. The range of the discount rates was unexpectantly narrow, differing from high to low by 184 basis points on average. The range of discount rates predominately seen in the industry for traditional actuarial valuations has ranged from 200 basis points to 400 basis points. XII. IRRATIONAL DIFFERENCES BETWEEN VALUATIOS When the a market valuations differs from the non-traditional actuarial valuations using rational discount rates, such differences can potentially be attributed to the following: A) the cash flows projected in the non-traditional actuarial valuation are incorrect, or disagree with the implied market perception, B) the company underwent a recent unanticipated event, such as a reserve strengthening, which has caused the market to react with confusion, C) the company may have marketed itself, indirectly to investors, as being either better or worse than its historical results would support, D) the marketplace has unrealistic expectations, fueled by events outside of the company, or often times by management optimism which historical results would indicate are unfounded, or E) the basis upon which most investors rely in determining their valuations, the GAAP financials, are misleading or obscure an accurate picture of the company A.) Errors or disagreements with the markets perception of future earnings If the models developed in a non-traditional actuarial valuation are consistently more conservative than the markets collective perception of an insurance groups future earnings, a pattern similar to that shown in Illustration 9 should be expected to develop over time.

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Illustration 9 Expected Market Valuation versus Non-Traditional Actuarial Valuation (assuming NTAV consistently more conservative)

If the markets perception about future earnings is more optimistic, implying higher growth in earnings than the valuations projected earnings, it should be expected that as time periods progress, the market valuations should exhibit a pattern of divergence from the non-traditional actuarial value range. In such case, the markets valuation should be expected to increase more rapidly than the non-traditional actuarial value ranges. Similarly, if the market has a more conservative view of the future, the nontraditional valuation range should rise more rapidly and diverge from the markets valuation, as is shown below in Illustration 10. Illustration 10 Expected Market Valuation versus Non-Traditional Actuarial Valuation (assuming the Market is consistently more conservative)

In reviewing the graphs for each of the publicly traded insurance groups, the patterns described above are not readily apparent and do not seem to exist at all. Instead, the most common pattern is that of the market valuations over time cutting and weaving through and around the non-traditional actuarial valuation range. While it may not be apparent that the projected future cash flows used to develop the non-traditional actuarial value ranges are incorrect, when the discount rates used do not appear rationale, the reasonableness of the projections used is still the first item reviewed.

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B.) Market Surprises Unanticipated Events When unusual or unexpected events occur, such as a large reserve strengthening, the market often appears to over react. This is likely due to the markets inability to quickly discern if an event is acute or systemic. Items such as reserve deficiencies are adjusted for in the development of the non-traditional actuarial valuation; and therefore, an announced reserve strengthening should not impact the non-traditional actuarial valuation range, while the markets valuation may, at least temporarily, tend to over-discount. C.) Market Perception Whether deserving or not, if a company has a positive image with the investment community, it may be rewarded with a higher share price, hence, lower discount rate than other potentially comparable companies. Conversely, companies with negative views pay by way of a lower market price for their stock, and higher discount rates. Historically, there have been cases where companies have been rewarded by the market with high share prices because of perceived quality. American Insurance Group (AIG) and General Electric (GE) were examples. Both of these companies very successfully used their perception premiums to acquire other companies at what could be deemed very attractive prices because the currency used, their stocks, was richly valued. This created a self reinforcing cycle where markets perceptions were met, not necessarily due to the underlying realities but definitely as a by-product of those perceptions. D.) Unrealistic Expectations Probably one of the greatest causes of market valuations differing from a non-traditional actuarial valuation ranges occurs when the market develops unrealistic expectations. This especially happens when management provides the market with over optimistic guidance. The ability to discern a management teams ability to perform beyond levels witnessed in the past, like so many other things, is a matter of art. For the skilled practitioner of such art, the rewards will be great. The non-traditional actuarial valuation in this regard can be viewed as unimaginative in that it is limited to relying only on past performance as the starting point for projecting future performance. E.) Misleading Financial Information Often the comparison of statutory financials to GAAP financials is a simple indicator that a particular company is disseminating what could potentially be misleading GAAP financials. The paradox is that the most difficult thing to predict is: when will the public markets become aware that GAAP financial information maybe be somewhat misleading or at the very least cast with glint of optimism? When the GAAP financials are misleading, the basis by which the public markets estimates or perceived values are wrong. This can cause inflated market valuations. In the discussion below, a few of the indicators of misleading GAAP financial are discussed. Statutory earnings versus GAAP earnings In the long-run, we will all be dead. That is popular and accurate quote of John Maynard Keynes. While not as well known, a statement which is equally true is; In the long-run, statutory earnings and GAAP earnings must in the aggregate be equal. GAAP earnings differ from statutory earnings, for a closed book of business, only as to their timing not their aggregate amount. It is true that growing companies may report higher GAAP earnings compared to statutory earnings, due to the deferral of acquisition costs under GAAP accounting. However, when companies consistently report higher GAAP earnings than statutory earnings, explanations should be pursued.

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For example, below in Table 3, the cumulative difference between the statutory earnings and GAAP earnings are shown over the same four-year period for two different publicly traded insurance groups.
Table 3 Cumulative excess of reported GAAP Income over Statutory Income
(amounts in millions)

Insurance Group A Insurance Group B

Year 1 $22 $24

Year 2 $267 ($46)

Year 3 $515 ($54)

Year 4 $853 $13

Insurance Group A, over the four-year period had average GAAP earnings, pre-tax of $594.5 million while Insurance Group B had average pre-tax earnings of $534.9 million. Surprisingly, during this period Insurance Group A was not growing while Insurance Group B had significant growth. In the fifth year Insurance Group A reported a large GAAP loss, with GAAP earnings at $678 million lower than statutory earnings. The notion that GAAP earnings and statutory earnings will eventually in the aggregate be equal was reinforced through a very significant decline in Insurance Group As share price. Deferred Acquisition Costs The markets ability to reasonably estimate a publicly traded insurance groups future earnings using GAAP earnings as the basis can be impaired by the accounting practices of certain companies. Below in Table 4, the percentage of a publicly traded insurance groups total statutory commissions and expenses which were deferred on a GAAP accounting basis are shown over a three-year period. Also shown are the percentages of the deferred acquisition cost assets, at the beginning of each year, amortized during each year. Table 4
Deferred Acquisition Expenses/Total Commission and Expenses and Deferred Acquisition Cost Amortization/ Total DAC Asset Insurance Group C Year 1 Commissions and Expenses Deferred 35.1% Percentage of Total DAC Asset Amortized 14.6% Year 2 41.1% 10.9% Year 3 44.1% 7.2%

Table 4 illustrates that in each year, Insurance Group C deferred a greater portion of total commissions and expenses. In addition each year, the company amortized a smaller portion of its deferred acquisition cost asset. The share price of Insurance Group Cs stock increased in the year following year three, only to eventually adjust downward by approximately 85%. Reinsurance Assumed and Ceded Both life insurance companies and P&C insurance companies file statutory statements showing most amounts net of reinsurance assumed and ceded. In order to project earnings to be used in the development of a non-traditional actuarial valuation, it is necessary to create the financials for the direct business only. By separating reinsurance results from direct results, the potential to inadvertently assume a profit or loss due to reinsurance in perpetuity can be avoided. Additional insights emerge from viewing an insurance groups results separately for direct and reinsured business, further insights can be garnered. For example, in Table 5 below, an insurance groups underwriting results on a direct basis are shown along with their net gain on reinsurance over three years.

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Table 5 Direct Underwritings Gains or (losses) versus Reinsurance Gains or (Losses) Insurance Group D
(amounts in millions)

Direct Underwriting Gain (Loss) Gain or (Loss) on Reinsurance

Year 1 ($70.3) $52.1

Year 2 ($115.2) $44.4

Year 3 ($211.5) $107.4

As can be seen in the above example, in each of the three years shown, Insurance Group D reported large underwriting losses on a direct basis. With reinsurance however, Insurance Group D was more successful and showed net gains throughout the same time period. Whether or not the reinsurance gains reported were appropriate, any valuation which used earnings that included the reinsurance gains likely would have been inflated, given that it is unrealistic to assume that reinsurers will continue to lose money in perpetuity. For Insurance Group D, the reinsurance gains did reverse in the year following the third, causing a 60% decline in Insurance Group Ds market capitalization. XII. CORRELATION of MARKET VALUATION and NON-TRADITIONAL ACTUARIAL VALUATIONS Using the formula, shown below, sample correlation coefficients were calculated for each of the 34 companies initially studied using the monthly share prices and the mid-point of the non-traditional actuarial valuation ranges for each month over a two year period.

n xy x y r=

[ n x2 ( x )2 ][ n y2 ( y )2 ]

The correlation coefficient can range from minus 1 to plus 1. A correlation coefficient of zero would imply no relationship between the monthly share price for a publicly traded insurance group and nontraditional actuarial value range. If the absolute value of the correlation coefficient were 1, that would imply perfect linear correlation between monthly share prices and the non-traditional actuarial valuation ranges. The closer the absolute values of the correlation coefficient are to 1, the greater the degree of correlation. Below in Table 6, the distribution of the correlation coefficients is shown for the initial 34 companies included in the study.
Table 6 Distribution of the Correlation Coefficients
Coefficient 90 % and higher 80% to 89% 50% to 79% under 50% Number of Companies

10 12 8 4

As can be seen in Table 6, only 4 of the 34 insurance groups had correlation coefficients below 50%, while 22 had coefficients greater than 80%.

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XIII. PREDICTABLITY Given the apparent correlation between the share prices of the publicly traded insurance groups and the non-traditional actuarial valuation ranges, a back test was undertaken. The back test used a portfolio of stocks, comprising a subset of approximately 40 publically traded insurance groups. The shares of these companies were assumed to be purchased or sold each month based upon the closing share price on the first business day of each month beginning on January 2002 and continuing through the end of December 2008. Over the course of the study the number of companies in the study varied due to acquisitions and insolvencies. New insurance companies were added to the study to replace insurance companies which were no longer traded. During all periods the number of companies included ranged between 35 and 40. Attached as appendix A is a listing of all insurance companies, by ticker symbol included in the study. The rules which were established assigned a weight of 200 to the shares of any insurance group if the share price of the insurance group fell below the lower end of the non-traditional actuarial valuation range, based upon the closing price on the first business day of each month. If the share price of an insurance group was above the low end, that groups non-traditional actuarial valuation range but below the mid-point, a weight of 100 was used. If the share price was above the mid-point but below the high end of the range, a weight of 50 was used. And if the share price exceeded the high end of the non-traditional actuarial valuation range, a weight of zero was used. Using the weights determined as of the first business day of each month a hypothetical fund was created and assumed to be invested in proportion to the weight assigned to each individual insurance group over the total weighting assigned for the month to all of the insurance groups. Using the closing share prices on the first day of each month, the portfolio was assumed to be rebalanced. Table 7 shows the results of this back test on several bases and compares those results for the Standard and Poors (S&P) Insurance index, the S&P 500 index and the Dow Jones index over the same time periods.
Table 7 Comparison of Results based on Actuaril Valuation Approach to Major Stock Market Indexes 2002 through 2008 Dynamic/ Dynamic Discount Rate Modified 20 Month 12 Month 6 Month NA NA NA -4.47% NA NA NA 33.26% NA NA NA 41.55% 24.22% 23.54% 22.82% 22.52% 17.30% 17.04% 18.99% 15.00% -2.00% -4.73% -3.21% -3.29% 38.80% 12.66% 12.77% 3.31% FIXED Discount
NA NA NA

Period 2002 2003 2004 2005 2006 2007 2008

S&P INSURANCE INDEX

NA

25.98% 12.58% -4.41% 33.12%

15.58% 5.15% 15.04% 8.05% -10.44% -57.52%

S&P 500 INDEX 0.00% 21.94% 7.18% 6.80% 11.65% 2.16% -35.61%

DOW JONES 0.00% 20.94% 2.12% 2.04% 15.00% 4.56% -30.74%

In a few instances the dynamic discount rates resulted in irrationally low or negative discount rates. In such cases the dynamic discount rates were replaced with the fixed discount rates. These results are shown in Table 7 under the column heading Dynamic/Modified. While the initial study used a 20 month period for determining the dynamic valuation rates, beginning in 2004 shorter periods of 12 months and 6 months were also tested. In Table 7 the results using dynamic discount rates determined over 20 month, 12 month and 6 month periods, without any modification are shown. From these results it appears that there is a small amount of improvement resulting

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from using a 12 month period for determining the dynamic discount rate versus a 20 month period and using a six month period results in poorer performance than either the 12 or 20 month periods. For periods from the beginning of 2004 through 2008 back testing was also performed using the standard fixed discount rates, the same discount rates for all periods. Results using the fixed discount rates were not as good as the results using any of the dynamic discount rates but the results using the fixed discount rates were consistently better the performance of the S&P Insurance index, for all periods measured.

XV. CONCLUSION This paper has attempted to demonstrate that the actuarial methodology, which has traditionally been used within the insurance industry to value regulated insurance companies, can be broadly applied on a consistent basis to the valuations of entire publicly traded insurance groups. Like its much older cousin, the traditional actuarial valuation, the non-traditional actuarial valuation is developed based on assumptions which are created using statutory financial information. The statutory financial statement information filed with the NAIC contains far more detailed and granular information than the financial data provided in GAAP financial statements; and therefore, provides the basis for greater insights and potentially fewer surprises. Unlike traditional actuarial valuations which use inside information and rely upon access to management, the non-traditional actuarial valuation relies entirely on publicly available information. While the non-traditional actuarial valuation removes some of the actuarial art that is involved in the establishment of assumptions, the sterilization of the assumptions and methods which are used in a nontraditional actuarial valuation provide greater comparability between the valuations of various insurance groups and permits the valuation process to be automated. The standardization of the assumption setting and the mechanizing of the valuation process allows for the isolation of projected cash flows from the discount rates. This isolation of the discount rates, in turn, provides greater insights into both the rationale and irrational behavior of the stocks of various insurance groups. This analysis involved hundreds of non-traditional actuarial valuations that have been developed and repeated over multiple measurement periods. This in mass analysis has helped to begin to build bridges between fundamental equity analysis and technical equity analysis; and the initial results appear to support the notion that the two methods may have interrelationship. This study also illustrates that non-traditional actuarial valuations, which derive their assumptions from publicly available financial information, have high degrees of correlation to the stock markets valuation of publicly traded insurance groups. Whether processes similar to the development of nontraditional actuarial valuations could be adapted to other regulated industries, and the degree to which such valuations would correlate to market valuations, remains to be tested.

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