Property & Casualty Insurance
Industry
ASSUMING COVERAGE
Lets Get Personal
■
Assumed coverage. We assumed coverage of Allstate, Chubb, Navigators
Group, Progressive, Travelers, and W.R. Berkley from Charlie Gates and
reinstated coverage on ACE Limited.
■
Personal lines fundamentals superior to commercial lines. We are positive
on personal lines fundamentals since we believe rising personal auto pricing
and lower accident frequency should offset sharply higher accident severity
leading to stable personal auto margins. We are cautious on commercial
lines fundamental since pricing is declining 10-15% and should continue to
stay weak over the next 18-24 months due to excess capacity and good
current accident year profitability. Accordingly, commercial lines margins
should continue to deteriorate over the next couple of years. That said, the
industry is trading below its historical trough price to book valuation and so a
lot of the bad news on commercial lines pricing is in the stocks.
■
Personal lines fundamentals are stable.
1. We are in a moderately rising, not hard market for personal lines
insurance. Despite moderately rising pricing in the personal lines
industry, we believe we are not in a truly hard market since profitability
of personal auto insurers is near historical highs. Rates have been
increasing in response to increased loss severity, which we believe will
continue in the near term. Competition remains strong and if frequency
trends continue to be favorable and margins improve, we believe
personal auto insurers will start to cut rates.
2. Margins should remain stable despite high severity trends. We believe
investors are overly focused on loss cost severity, while deemphasizing
frequency. Total severity should increase 5% based on
severity increases of 6-9% for bodily injury, 3-4% for physical damage
and 5% for other losses. However, over the last 25 years, property
damage frequency declined on average 1.1% per year, despite vehicle
miles traveled increasing on average 2-3% per year. We believe higher
gas prices and a soft economy could reduce accident frequency even
more in the near term (say 2-3%), helping offset some part of higher
severity trends. Assuming frequency declines 2-3% and severity
increases 5%, total auto insurance loss costs should increase 2-3%.
With pricing rising 2-3%, personal auto margins should be stable.

3. High gas prices could have a more lasting favorable impact than investor think.
Investors think the recent spike in gas prices which resulted in a decline in vehicle
miles traveled is a temporary phenomenon and believe frequency will spike if gas
prices fall from current levels. Historically, vehicle miles traveled has a 58%
negative correlation with gas prices. What’s more important is that historically,
vehicle miles traveled tends to fall when gas prices are more than 3% of personal
disposable income. Gasoline and other motor vehicle fuel expenditures are
currently 3.5% of personal disposable income which resulted in vehicle miles
traveled falling for the past five months by 2.4% on average and 1.8% in April
2008. We believe that even if gas prices fall 15% from current levels, the price
will remain sufficiently high that vehicle miles driven will continue to remain flat to
negative, thereby having a favorable impact on frequency trends.
4. A recessionary economy should reduce accident frequency trends. Investors are
concerned that reported claims may increase during a recession, as more
customers file claims due to the weakening economy. Our analysis of frequency
claims during the 2001 recession indicates that the opposite is true i.e. we found
frequency actually declined. Part of this can be explained by rising auto
insurance pricing, providing customers with a disincentive to file claims for fear of
significantly increasing their auto insurance costs. Also, a recessionary economy
has a favorable impact on frequency since there are less people driving to work,
going on vacation, going out to dinner and fewer trucks on the road. In four of the
five past recessions, vehicle miles traveled increased less than the 2-3% historical
average.
5. Auto insurance pricing is increasing. The consumer price index has shown an
increasing trend of auto insurance pricing for the first six months of 2008 (+2.6%
in June 2008), and managements of auto insurers stated that they are starting to
see more price increases than decreases. Even State Farm is starting to raise
rates in April, May and June 2008. We believe that more sophisticated pricing
models, better loss monitoring systems, higher industry concentration, lower
interest rates and better discipline from GEICO and Progressive due to higher
market shares (7% now vs. 4% in 1999 for each company) will result in greater
pricing discipline on the downside. We believe that if frequency trends get less
favorable due to lower gas prices, auto insurers will raise rates sufficient to cover
their loss cost trends.
6. High loss cost inflation should cap margin expansion. Bodily injury (BI) loss costs
are rising 6-9%, and physical damage severity could spike due to commodity
inflation. BI loss costs are spiking mainly due to a higher percentage of claimants
visiting pain clinics and chiropractors and higher use of more expensive
diagnostic procedures like MRIs and CT scans which are 3-4 times more
expensive than X-Rays. Use of attorneys increased over the last 5 years,
reversing a declining trend over the previous 10 years, which could increase costs
in the future since claimants with attorneys use 2-3 times more of these services
than non-attorney claimants. Radiology spending (including MRIs and CT scans)
is growing 18-20% a year in the general population which could result in higher
costs for auto insurers, since unlike health plans, auto insurers cannot regulate
these costs. Higher rate increases by general practitioners and chiropractors, and
MRIs and CT scans than the CPI also contributes (to a lesser extent) to a higher
medical cost inflation, which could continue in the future as there could be cost
shifting between health and auto insurers.
7. Defensive in a recessionary environment. Drivers have to buy auto insurance
since it is a mandated coverage so top line premiums remain relatively stable.
However new auto sales are declining and the average price per vehicle sold is
also declining, which will likely have a slightly negative impact on top line growth.
This is a negative for a growth oriented stock like Progressive.
■
The 2008 personal lines cycle is different from the 2000 cycle.
o Shallower up cycle. We believe the cycle turn in personal lines will be shallower
on the up side since pricing turned earlier than the last cycle due to better pricing
models and better monitoring of pricing and profitability by insurers.
o Margins will stabilize, not increase dramatically since profitability by industry
leading players like Allstate and Progressive remains strong (mid teens ROE in
2007 and 2008E), and industry profitability remains near the upper end of

3. High gas prices could have a more lasting favorable impact than investor think.
Investors think the recent spike in gas prices which resulted in a decline in vehicle
miles traveled is a temporary phenomenon and believe frequency will spike if gas
prices fall from current levels. Historically, vehicle miles traveled has a 58%
negative correlation with gas prices. What’s more important is that historically,
vehicle miles traveled tends to fall when gas prices are more than 3% of personal
disposable income. Gasoline and other motor vehicle fuel expenditures are
currently 3.5% of personal disposable income which resulted in vehicle miles
traveled falling for the past five months by 2.4% on average and 1.8% in April
2008. We believe that even if gas prices fall 15% from current levels, the price
will remain sufficiently high that vehicle miles driven will continue to remain flat to
negative, thereby having a favorable impact on frequency trends.
4. A recessionary economy should reduce accident frequency trends. Investors are
concerned that reported claims may increase during a recession, as more
customers file claims due to the weakening economy. Our analysis of frequency
claims during the 2001 recession indicates that the opposite is true i.e. we found
frequency actually declined. Part of this can be explained by rising auto
insurance pricing, providing customers with a disincentive to file claims for fear of
significantly increasing their auto insurance costs. Also, a recessionary economy
has a favorable impact on frequency since there are less people driving to work,
going on vacation, going out to dinner and fewer trucks on the road. In four of the
five past recessions, vehicle miles traveled increased less than the 2-3% historical
average.
5. Auto insurance pricing is increasing. The consumer price index has shown an
increasing trend of auto insurance pricing for the first six months of 2008 (+2.6%
in June 2008), and managements of auto insurers stated that they are starting to
see more price increases than decreases. Even State Farm is starting to raise
rates in April, May and June 2008. We believe that more sophisticated pricing
models, better loss monitoring systems, higher industry concentration, lower
interest rates and better discipline from GEICO and Progressive due to higher
market shares (7% now vs. 4% in 1999 for each company) will result in greater
pricing discipline on the downside. We believe that if frequency trends get less
favorable due to lower gas prices, auto insurers will raise rates sufficient to cover
their loss cost trends.
6. High loss cost inflation should cap margin expansion. Bodily injury (BI) loss costs
are rising 6-9%, and physical damage severity could spike due to commodity
inflation. BI loss costs are spiking mainly due to a higher percentage of claimants
visiting pain clinics and chiropractors and higher use of more expensive
diagnostic procedures like MRIs and CT scans which are 3-4 times more
expensive than X-Rays. Use of attorneys increased over the last 5 years,
reversing a declining trend over the previous 10 years, which could increase costs
in the future since claimants with attorneys use 2-3 times more of these services
than non-attorney claimants. Radiology spending (including MRIs and CT scans)
is growing 18-20% a year in the general population which could result in higher
costs for auto insurers, since unlike health plans, auto insurers cannot regulate
these costs. Higher rate increases by general practitioners and chiropractors, and
MRIs and CT scans than the CPI also contributes (to a lesser extent) to a higher
medical cost inflation, which could continue in the future as there could be cost
shifting between health and auto insurers.
7. Defensive in a recessionary environment. Drivers have to buy auto insurance
since it is a mandated coverage so top line premiums remain relatively stable.
However new auto sales are declining and the average price per vehicle sold is
also declining, which will likely have a slightly negative impact on top line growth.
This is a negative for a growth oriented stock like Progressive.
■
The 2008 personal lines cycle is different from the 2000 cycle.
o Shallower up cycle. We believe the cycle turn in personal lines will be shallower
on the up side since pricing turned earlier than the last cycle due to better pricing
models and better monitoring of pricing and profitability by insurers.
o Margins will stabilize, not increase dramatically since profitability by industry
leading players like Allstate and Progressive remains strong (mid teens ROE in
2007 and 2008E), and industry profitability remains near the upper end of

the company from the S&P 500 and possible deletion from the Russell 1000
indices that led to an estimated sale of 47 mn shares. This provides an
excellent entry point to owning one of the best insurance companies in the US.
Among commercial lines players, we are bullish on ACE Ltd, due to the
company’s diversified business mix (A&H and life comprises 23% of pro-forma
net earned premiums including Combined Insurance– which has different cycle
drivers as compared to P&C insurance), strong and growing international
presence, especially in emerging markets (ACE has a presence in 50 countries
and supports business in 140 countries – 2007 geographic business mix of
gross written premiums is North America 58%, Europe 26%, Asia Pacific/Far
East 11% and Latin America 5%), and strong balance sheet with potentially
excess reserves as the company has written a lot of very profitable casualty
business during the hard market on which the company has not released much
reserves despite benign loss cost trends. ACE is similar in some respects to
American International Group 20 years ago, in that both companies have a
globally diversified business mix. Key risks are falling commercial lines pricing –
the company is largely a middle and large account writer in the US where pricing
is under significant pressure, asbestos and environment reserve development,
risk relating to the company’s exposure to D&O liability, and adverse reserve
development on the casualty business.
o Allstate Insurance – Price target $55 (was $60). We have an Outperform rating on
Allstate given our positive view on fundamentals in personal lines companies. In
a moderately rising personal auto pricing environment with low top line growth
and stable but profitable margins, we believe the stock will outperform peers and
the overall market due to, a strong ROE (15% in 2008E) and 3.8% dividend
yield. Despite the aggressive stock buyback program, we believe the company
can generate a 9% increase in book value due to the reasonable valuation (1.2x
BVPS). Our price target assumes the stock trades at 1.4x 1Q09 BVPS, a 10-
15% discount to its historical average, reasonable considering that profitability is
stabilizing and margins are above historical average levels – this also takes into
consideration the risk of further write downs of sub prime assets. We reduced
our price target from $60 to $55 to account for further write downs in sub prime
assets, the recent market declines, and Allstate’s forced rate reductions on
California auto and home business. Key risks are catastrophe losses, exposure
to sub prime assets, and the possibility of management making an acquisition.
■
Underperform -rated stock.
(1) Chubb – Price target $51 (was $57). Our Underperform rating (down from Neutral) is
based on our negative view on professional lines insurance, where we believe higher
class action frequency due to sub prime issues and general market volatility combined
with sharply lower pricing should lead to faster margin deterioration than other lines of
business. Chubb has higher than average exposure to the D&O market (22% of
premiums) vs peers and has been recording excellent results in all lines and especially
in professional liability due to low frequency of class action lawsuits which was the
lowest level in 10 years during 2006. However, class action frequency picked up in
2H07 and in 1Q08 was 50 percent higher than 1H07. We also believe Chubb will
have significant exposure to D&O and E&O losses despite its decision to either not
insure or limit exposure to D&O and E&O of large financial institutions and exit a
program of mortgage broker E&O insurance, due to the large number of mid and small
cap sub prime exposed stocks that have suffered significant market cap losses since
January 1, 2007 – the company has #1 market share (15% by policy count) of real
estate, construction D&O, #2 market share (21% by policy count) of banking D&O and
#1 market share (30% of policy count) of non-banking financial services D&O. Ours is
a relative call – while CB’s valuation is not egregious as compared to historical

averages, the stock still trades at a healthy premium to other commercial lines players
like ACE and Travelers despite facing more earnings headwinds.

Table of contents
Personal Lines 8
Summary –The Personal Auto Cycle Has Turned, Margins Should Be Stable; Top Pick
– Allstate 8
Pricing Is Starting to Turn 8
Loss Cost Inflation in BI is High and Could Remain Elevated Near Term 8
Loss Cost Inflation in Physical Damage Is High but Manageable 9
Frequency Should Be Favorable Owing to High Gas Prices and the Soft Economy 9
Total Loss Cost Trends Should Be Manageable 10
Current Personal Lines Cycle Different from the Last One 12
Why we prefer Allstate to Progressive, despite stabilizing personal lines
fundamentals. 15
Competition Is Abating; Companies Are Taking Rate 20
Auto Insurance Inflation from the CPI: 20
Recent Commentary Is Positive from Auto Insurance Peers on Personal Auto Rate
Increases 22
Rate Actions Taken by Companies 23
Accident Frequency 25
Gas Prices Historically Have Had an Inverse Correlation to Vehicle Miles Traveled 25
A Recessionary Economy Has a Negative Impact on Auto Insurance Frequency 28
Industry Growth Should Be Slowing 30
Medical Care Inflation—Increasing and Troublesome 31
Recent data from Progressive, GEICO and Allstate indicate that auto insurers are
seeing an up tick in BI severity trends. 31
BI inflation Has Been Higher for Auto Insurers Than the Medical Inflation CPI. 31
Detailed Examination as to Why BI Inflation Has Been Higher for Auto Insurers than
the Medical Inflation CPI 33
Medical Cost According to CPI Are Rising 39
Motor Vehicle Body Work Costs Increasing but Manageable 39
Commercial Lines 41
Fundamentals Remain Negative, though Some of the Downside Risk Is Reflected in
Lower Valuations 41
Professional Liability Losses Should Start To Tick Up 44
Summary 44
Recent favorable results have been driven by good frequency trends 46
Higher frequency trends and lower pricing implies higher combined ratio for the
industry 46
Increase in the loss ratio could take some time to play out. 47
Frequency trends have historically been volatile 48
Frequency is cyclical: Equity market volatility tends to drive class action filings 48
Sub prime is an area of concern. 51
Pricing continues to decline 53
Severity continues on its upward trajectory 53
Company specific sub prime disclosures 54
ACE Limited 54
Travelers Companies 54
Chubb Corporation 55
XL Capital 56
ACE Limited—Outperform, Price Target $62 58
Investment Rationale 58
Earnings Estimates 58
Investment Positives 58
Investment Risks 60
Business Description 61

Allstate Insurance—Outperform, Price Target $55 62
Investment Rationale 62
Earnings Estimates 62
Investment Positives 62
Business description 71
Chubb Corporation—Under Perform, Price Target $51 72
Investment Rationale 72
Our view of the professional lines industry 72
Earnings Estimates 78
Investment Positives 78
Investment Concerns 79
Our price target is $51. 80
Business Description 81
Navigators Group, Inc.—Neutral, Price Target $49 82
Investment Rationale 82
Earnings Estimates 82
Investment Positives 82
Investment Concerns 83
Business Description 83
Progressive—Neutral, Price Target $21 84
Investment Rationale 84
Earnings Estimates 84
Investment Positives 84
Business Description 86
Travelers Cos Inc—Neutral, Price Target $50 87
Investment Rationale 87
Earnings Estimates 87
Investment Positives 87
Investment Concerns 88
Business Description 89
W.R. Berkley Corporation—Neutral, Price Target $26 90
Investment Rationale 90
Earnings Estimates 90
Investment Positives 90
Investment Concerns 92
Business Description 92
Appendix 93