THE COST OF EQUITY CAPITAL FOR AUTOMOBILE INSURANCE FIRMS

Transcription

1 THE COST OF EQUITY CAPITAL FOR AUTOMOBILE INSURANCE FIRMS Prepared for Board of Public Utilities Newfoundland & Labrador, Canada by Dr. Cindy W. Ma Kurt G. Strunk October 13, 2004 Consulting Economists

2 Table of Contents Page I. QUALIFICATIONS...1 II. INTRODUCTION...3 III. PRINCIPLES UNDERLYING ESTIMATION OF THE REQUIRED RETURN ON EQUITY...3 IV. ESTIMATION METHODS USED BY FINANCIAL ANALYSTS...5 A. Discounted Cash Flow ( DCF )...6 B. Equity Risk Premium...6 C. CAPM...7 D. Comparable Earnings...8 V. NERA COST OF EQUITY ANALYSIS...8 A. Selection of the Auto Insurance Proxy Groups Proxy Group I Screen Proxy Group II Screen...10 B. Discussion of Results DCF Model CAPM...11 A. PROXY GROUP 1: U. S. PROPERTY & CASUALTY...11 B. PROXY GROUP II: A.M. BEST TOP CANADIAN AUTO INSURERS The Impact of Leverage Other Approaches General Industry Conditions...14 VI. RECOMMENDATION...15 Consulting Economists

3 - ii - List of Exhibits 1. Screening Process for Proxy Group I: Value Line Companies 2A. Screening Process for Proxy Group II: Auto Insurers Active in Canadian Market Included Companies 2B. Screening Process for Proxy Group II: Auto Insurers Active in Canadian Market Excluded Companies 3. Discounted Cash Flow Model Cost of Equity for Proxy Group I: U.S. P&C Companies 3A. Discounted Cash Flow Model Proxy Group I: U.S. P&C Companies Dividend Adjusted Stock Price as of October 5, B. Discounted Cash Flow Model Proxy Group I: U.S. P&C Companies Dividends 3C. Discounted Cash Flow Model Proxy Group I: U.S. P&C Companies Growth Rate Estimates 3D. Discounted Cash Flow Model Proxy Group I: U.S. P&C Companies Number of Analysts that submitted I/B/E/S estimates 4. Discounted Cash Flow Model Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market 4A. Discounted Cash Flow Model Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market Dividend Adjusted Stock Price as of October 5, B. Discounted Cash Flow Model Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market Dividends 4C. Discounted Cash Flow Model Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market Growth Rate Estimates 4D. Discounted Cash Flow Model Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market Number of Analysts that submitted IBES estimates Consulting Economists

4 - iii - 5. U.S. Gas Utility Rate Decisions (January 2002-June 2004) 6. Capital Asset Pricing Model Cost of Equity for Proxy Group I: U.S. P&C Companies 7A. Capital Asset Pricing Model Cost of Equity for Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market (Canadian Risk Free Rate and Toronto Stock Exchange Index) 7B. Capital Asset Pricing Model Cost of Equity for Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market (U.S. Risk Free Rate and S&P 500 Market Index) 8A. Capital Structure: Leverage Ratios Proxy Group I: U.S. P&C Companies 8B. Capital Structure: Leverage Ratios Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market 9A. Average Annual Earned Return on Equity Proxy Group I: U.S. P&C Companies 9B. Average Annual Earned Return on Equity Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market Consulting Economists

5 - iv - List of Appendices A. Resume of Dr. Cindy W. Ma B. Resume of Kurt Strunk C1. Capital Structure: Leverage Ratios Proxy Group I: U.S. P&C Companies 1999 through 2003 C2. Capital Structure: Leverage Ratios Proxy Group I: U.S. P&C Companies 1999 through 2003 D1. Capital Structure: Leverage Ratios Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market 1999 through 2003 D2. Capital Structure: Leverage Ratios Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market 1999 through 2003 E1. Average Annual Earned Return on Common Equity Proxy Group I: U.S. P&C Companies E2. Average Annual Earned Return on Common Equity Proxy Group II: P&C Companies Operating in Canadian Automobile Insurance Market Consulting Economists

6 - v - Data and Reliance The analyses and findings in this report represent our best estimates based on the data and information made available to us at the time of the report preparation. We reserve the right to update our findings as new information becomes available. The analyses were performed for the Newfoundland & Labrador Board of Commissioners of Public Utilities. Our report may be distributed to other parties on the condition that it is distributed in its entirety. Excerpts of this report may not be distributed to any party. Consulting Economists

7 I. QUALIFICATIONS Dr. Cindy W. Ma I, Cindy Ma, am a Vice President of NERA s Securities and Risk Management Practices. I have over 18 years of extensive training, academic expertise and hands-on experience in the application of financial theory in securities and commodities markets, and in corporate transactions. I received my Ph.D. Beta Gamma Sigma in money and financial markets from Columbia University Graduate School of Business in New York City. I obtained a B.S. degree in Accounting from Indiana University with highest distinction. I am a Chartered Financial Analyst and an adjunct member of the Futures Regulation Committee of the Association of the Bar of the City of New York. I am also a Certified Public Accountant and member of the American Institute of Certified Public Accountants. I am currently a member of the Financial Accounting Standards Board s Option Valuation Group, examining the appropriate valuation framework for employee stock options. I have served as adjunct professor at the Columbia University Graduate School of Business where I taught MBA courses in applied finance. I also developed several corporate training programs on the complex aspects of capital markets. My practice at NERA focuses on the application of financial theory in the context of litigation and advisory projects. These projects often involve the valuation of assets, liabilities and equities for both public and private companies, in which the determination of the appropriate cost of capital and the rate of return on equity are key elements. I have also collaborated on projects involving regulatory issues of public utilities. Prior to joining NERA, I was a partner in the Strategic Finance Practice of Ernst & Young and led the Corporate Risk Management Group. I advised clients on risk assessment, risk management and the optimization of risk-adjusted shareholder returns. In the course of my work, I often prepare expert testimony related to financial and commodities markets. The depth and breadth of my work in finance is also reflected in my publications in academic journals and the financial trade press. I am a co-author of a textbook on the valuation of options and futures. My full résumé is attached as Appendix A. Consulting Economists

8 - 2 - Kurt G. Strunk I, Kurt Strunk, am a Senior Consultant based in NERA s New York City office. I hold an M.B.A. in finance with Distinction from INSEAD (Institut Européen d Administration des Affaires) and an honors degree in Economics from Vassar College. I joined NERA in 1993 and have worked in both NERA s finance and energy practices. Since 1996, my work at NERA has focused on strategic and financial issues facing public utilities, particularly gas and power utilities. I have served as a consulting expert in numerous proceedings before state Public Utilities Commissions in the U. S. relating to cost recovery and ratemaking for utilities. The scope of my work in NERA s energy practice has included the determination of the appropriate allowed return on debt and equity capital for energy sector entities. In NERA s finance practice, I analyzed stock market prices and developed analytical valuation models based on the Capital Asset Pricing Model and other valuation theories. My full résumé is attached as Appendix B. Consulting Economists

9 - 3 - II. INTRODUCTION We were retained by the Newfoundland & Labrador Board of Commissioners of Public Utilities (the Board ) to estimate the after-tax cost of equity capital for insurance companies operating in the automobile insurance market in the Province of Newfoundland and Labrador. The cost of equity capital allowed by the Board is an important input when determining benchmarks that can be used by the Board in its assessment of automobile insurance premiums. This purpose of this report is to: 1 1) explain the basic principles upon which the cost of equity capital should be determined; 2) describe generally the approaches used by financial analysts to estimate the cost of equity capital; 3) describe the specific analyses NERA performed to develop our recommendation for the allowed return on common equity; and 4) set forth a recommended range for rates of return on equity for automobile insurers in the Newfoundland and Labrador market. III. PRINCIPLES UNDERLYING ESTIMATION OF THE REQUIRED RETURN ON EQUITY The Board s mandate under the Automobile Insurance Act is to regulate auto insurance rates. Regulatory economics and regulatory precedent clearly establish the principles that should govern the determination of an appropriate return on equity for regulated companies. These principles have been consistently applied to assure the legitimacy of the rates charged by regulated companies. A key tenet in the ratemaking process is that shareholders of regulated companies should be afforded a reasonable opportunity to earn a fair return on their invested 1 In the report, we use the terms cost of equity, cost of equity capital, and required return on equity interchangeably. Consulting Economists

10 - 4 - capital. The concept of rates of return that are just and reasonable is the backbone of regulatory practice in Canada, and also in the United States. The Canadian National Energy Board cites the principles for a fair and reasonable return in a recent decision on the cost of capital for TransCanada PipeLines Limited: a fair or reasonable rate of return should: be comparable to the return available from the application of the invested capital to other enterprises of like risk (the comparable earnings standard); enable the financial integrity of the regulated enterprise to be maintained and permit incremental capital to be attracted to the enterprise on reasonable terms and conditions (the financial integrity and capital attraction standards); and achieve fairness both from the viewpoint of the customers and from the viewpoint of present and prospective investors (appropriate balance of customer and investor interests). 2 In the United States, the regulatory standard for a fair and reasonable return was established by the Supreme Court in its Hope decision (Federal Power Commission et al. v. Hope Natural Gas Co., 320 U.S. 591 (1944)): the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and attract capital. (Emphasis added.) 2 National Energy Board, Decision dated June 2002, TransCanada Pipelines Limited, Cost of Capital, RH , p. 11. Consulting Economists

11 - 5 - In addition to regulatory precedent, the following observations from financial theory on the cost of equity capital offer important guidance: Reflects business and financial risks. The cost of equity capital depends on the expected risks faced by equity investors. These risks derive from two sources: the level of risk embedded in the business itself (known as business risk ) and the degree to which the firm has employed debt in its capital structure ( financial risk ). A higher level of debt or leverage amplifies risk for the equity investor because the equity investor is a residual claimant, only entitled to the firm s cash flows after the debt capital providers have been paid. Forward looking. Financial theory defines the cost of equity capital to be a forwardlooking concept. It represents the forward-looking expectations of investors who demand compensation for the use of their money. Not directly observable. Because there is no direct way to observe the expectations of equity investors, the cost of equity must be inferred or derived indirectly from the assessment of other financial data. This is in contrast to the cost of debt, which is directly observable from the coupon rates and market prices of long-term debt instruments issued by corporations. IV. ESTIMATION METHODS USED BY FINANCIAL ANALYSTS There are four widely used approaches to estimating the cost of equity: 1. Discounted Cash Flow ( DCF ) 2. Equity Risk Premium 3. Capital Asset Pricing Model ( CAPM ) 4. Comparable Earnings In the regulatory arena, the above methods are generally applied to a proxy group of comparable companies selected based on a number of criteria, including in some cases industrial classification, capital structure, credit rating and financial coverage ratios. The Consulting Economists

12 - 6 - comparable companies provide an indication of returns on investments in other enterprises having corresponding risks. We describe each method in turn below. A. Discounted Cash Flow ( DCF ) The DCF approach derives the estimated cost of equity from information on a company s current stock price and the expected future cash flows to equity shareholders. The expected cash flows used are the dividends to be paid to equity shareholders. The DCF model has its foundation in stock price valuation theory. 3 This theory expresses the current price of common equity (P0) as a function of the company s current dividend D0, the dividend growth rate (g), and the cost of equity capital (ke). P 0 = D 0 / (ke - g) The current stock price reflects the consensus estimate of market participants of the value of discounted future cash flows. As such, the analyst is able to calculate the implied required return on equity from the current stock price and consensus forecasts of the firm s growth rate. Because of its reliance on dividends, the DCF model is usually only applied to companies that pay dividends. 4 Since public utilities often pay dividends, it is commonly used in regulatory ratemaking proceedings for public utilities. B. Equity Risk Premium The Equity Risk Premium model is a build up model that starts with the expected return on riskless assets and adds various premia to reflect the increasing levels of risk faced by equity investors. The additional premia added include a general stock market return premium, and in some cases an industry or size specific premium Myron J. Gordon, The Investment, Financing and Valuation of the Corporation (Homewood, IL: Richard D. Irwin Inc., 1962; reprint, Westport, CT: Greenwood Press, Publishers, 1982). Because all dividends come from earnings, the model can be modified to derive the expected growth rate from the level of earnings and the stock price, provided that earnings are not negative and not unusually high or low in the base period. See, for example, Ibbotson Associates Stocks, Bonds, Bills and Inflation 2004 Yearbook, Valuation Edition, Chapter 5. Consulting Economists

13 - 7 - C. CAPM The Capital Asset Pricing Model ( CAPM ), like the Equity Risk Premium model, starts with the expected return on riskless assets and adds a premium to reflect the increased market risks faced by equity investors. However, CAPM offers one key insight that the Equity Risk Premium model does not. This insight is that investors need not be compensated for risks that are diversifiable. In the world of the CAPM, diversifiable risks are termed nonsystematic risks, while non-diversifiable risks are termed systematic or market risks. The degree of market risk embedded in an individual stock is measured by its beta. Technically, beta measures the level of correlation between the returns on a given stock and the returns on the broader market. 6 Investors in any given stock, therefore, should expect to earn a return equal to the return on riskless assets plus a premium that depends on beta, the degree of market risk associated with that particular stock. In equation form, the CAPM is represented as follows: k e = R f + ß * (R m - R f ) where k e is the required return on equity capital; R f is the current expected return on riskless assets; ß is the degree of systematic market risk for the stock (correlation to the broader market); R m, is the expected return on risky equity investments, and (R m - R f ) represents the premium required by investors in the average stock in the market. CAPM can therefore be viewed as a special case of the Equity Risk Premium model in which the equity risk premium is determined by the beta. 6 The more volatile the return of a particular stock relative to the broader market, the higher the beta. Consulting Economists

14 - 8 - D. Comparable Earnings The final method that is sometimes employed by financial analysts when estimating the cost of equity is the Comparable Earnings approach. The Comparable Earnings approach looks at the historical returns that have actually accrued to equity shareholders. While on average over time, the earned returns may reflect the required return to equity, in any given year earned returns may fall short of or exceed the required return. There have been many business studies of companies that consistently earn more or less than their cost of capital. Hence, this concept of earned returns does not truly measure the cost of capital. While one can try to get around this problem by using a long time series, this becomes problematic if the required return changes over that measurement period. Another issue with this model arises because it assumes that the selected proxy companies have the same ratio of debt and equity in the capital structure as the average company does. In other words, it does not generally account for capital structure differences. This approach may provide a point of reference, but in our view should not be relied on heavily in the setting of allowed returns in a regulatory ratemaking proceeding. V. NERA COST OF EQUITY ANALYSIS In order to estimate the cost of equity capital for automobile insurers in Newfoundland and Labrador, NERA employed two of the four approaches described above: the DCF and CAPM models. A. Selection of the Auto Insurance Proxy Groups NERA applied the DCF and CAPM approaches to selected companies with comparable market risks, namely comparable insurers. Two sets of potentially comparable insurance companies ( proxy groups ) are identified: Consulting Economists

15 - 9 - Proxy Group I focuses on insurers active in the U.S. property and casualty ( P&C ) market. This set is constructed from the 26 companies from the Insurance (Property/Casualty) Industry section of the Value Line Investment Survey. 7 Proxy Group II focuses on insurers active in the Canadian auto market. This set of comparables, which is obtained from A.M. Best Corporation, 8 relies on A.M. Best s ranking of the top one hundred Canadian Auto Writers in Each company is selected for the proxy groups based on the procedures and criteria discussed below. 1. Proxy Group I Screen The initial pool from Value Line Investment Survey consists of the companies in the broad category of property and casualty ( P&C ) insurers. In order to hone in on companies that are active in the automobile insurance area, we limit the comparables to companies that are also included in A.M. Best s Top U.S. Auto Insurance Underwriters for This reduces the sample from 26 to 16. We then exclude any company that has a majority of revenues coming from non-insurance segments, since companies that do most of their business in other sectors should not necessarily be viewed as comparable. 11 A summary of the insurers that are included and excluded from our U.S. sample is provided in Exhibit 1. It is worth noting that we exclude from our DCF analysis those companies that do not pay dividends or for whom growth forecasts are unavailable. However, since information on the stock price and beta of these companies is readily available, they are included in the CAPM-based estimation of the cost of equity Value Line Investment Survey, Issue 4, Part 3, Ratings & Reports, Industry (Property/Casualty) Industry section, June 25, A.M. Best is a firm that provides analysis and credit ratings for the insurance industry. A.M. Best Statistical Study, Canadian Auto Underwriting Results Improve, September 20, A.M. Best Statistical Study, Auto Writers Focused on Profitability, Saw Double-Digit Rate Hikes in 2002, November 3, was the most recent year for which data were available. 11 For example, this results in the elimination of Berkshire Hathaway. Consulting Economists

16 Proxy Group II Screen For Proxy Group II, we start with an initial pool of the 100 companies from A.M. Best s ranking of the top Canadian Auto Writers in In order to perform the cost of equity analysis, the company must be publicly traded and its financial data must be available. Many of the companies operating in the Canadian auto insurance market are privately held. These privately held firms are excluded. Those companies that are not privately held tend to be subsidiaries of larger parent companies that are publicly traded. Often, large insurance holding companies operate multiple subsidiaries in the Canadian market. From this collection, the publicly traded parent companies are included in the proxy group. 13 A summary of the insurers that are included and excluded from our Canadian sample is provided in Exhibit We also test whether our sample of comparable companies in Proxy Group II is germane to the Newfoundland and Labrador market. We compare the final list of companies to the top 25 automobile insurance underwriters in the Province, as identified by the Superintendent of Insurance in its Annual Report and reproduced in a March 2004 Report from the Board to the Minister of Government Services. 15 Twelve of the top 25 Newfoundland and Labrador underwriters are represented in our sample. Therefore, our sample includes what we view as adequate representation of the local market. B. Discussion of Results 1. DCF Model The results derived from the DCF model for Proxy Group I are presented in Exhibit 3, while the results for Proxy Group II are shown in Exhibit 4. The data (i.e., adjusted stock 12 A.M. Best Statistical Study, Canadian Auto Underwriting Results Improve, September 20, In a few cases, the U.S. parent of a Canadian subsidiary included in Proxy Group II is also included in Proxy Group I. 14 Exhibit 2 also notes whether there are sufficient financial data to include the companies in the DCF and CAPM models. 15 Newfoundland & Labrador Board of Commissioners of Public Utilities, Report on Potential Savings Arising From Various Product Changes And Other Considerations Involving Automobile Insurance In Newfoundland & Labrador, March 8, 2004, Appendix 2. Consulting Economists

17 prices, dividends and estimated growth rates) supporting the calculations of these two exhibits are contained in Exhibits 3A through 3C and 4A through 4C. A key variable in the model is dividend growth. We use two different measures of prospective growth to arrive at a dividend growth estimate. In both cases, we assume that the proxy companies will continue to maintain their current dividend payout ratios. The first measure relies on the forecasts of earnings per share published by Value Line for the companies in our proxy group. The second measure uses consensus analysts forecasts of earnings, as summarized by I/B/E/S and published by Factset Research Systems. Our DCF estimate employs an average of the two sources of growth estimates when both forecasts are available. For the proxy group operating in the Canadian insurance market, only the I/B/E/S forecasts were available. The use of I/B/E/S alone as a means of assessing future growth is, in our view, reasonable since there were generally multiple analysts making earnings forecasts. The number of analysts included in the I/B/E/S forecasts we relied upon are listed in Exhibits 3D and 4D. Based on the DCF approach, our results show an average cost of equity of 14.38% for the Proxy Group I and 13.64% for the Proxy Group II. 16 For comparison purposes, we prepare Exhibit 5, which shows the returns on equity allowed by regulatory bodies for natural gas utilities in the U. S. from January 2002 to June On average, gas utilities are allowed a return on equity equal to 11%. 2. CAPM a. Proxy Group 1: U. S. Property & Casualty In order to apply CAPM to the U. S. proxy group, we take the current yield on longterm (20-year) U. S. government debt securities to be the riskless (or risk free) rate. We then take the market risk premium to be the long-horizon expected equity risk premium as identified by Ibbotson Associates in their Stocks, Bonds, Bills and Inflation 2004 Yearbook We have not adjusted any of the figures in this report for the cost of issuing stock, which often adds as much as 15 to 25 basis points to the return on equity. 17 Stocks, Bonds, Bills and Inflation 2004 Yearbook, Valuation Edition. Consulting Economists

18 This expected risk premium is based on the differences of returns on the S&P 500 over riskfree bonds during the period The risk premium is calculated as an arithmetic average, which is appropriate for benchmarking since it reflects the expected return for an average company in any given year. Our choice of these two inputs, the risk-free rate and equity risk premium, is consistent with standard practice for CAPM implementation. For the beta calculation, we had three important choices: 1) the choice of index against which to calculate correlations; 2) the choice of estimation period; and 3) the choice of whether to use adjusted or raw betas. 18 Since the expected equity risk premium for the broader market is calculated with respect to the S&P 500 Index, it is appropriate to calculate the betas for the proxy group relative to this index as well. For the estimation period, we choose to focus on the period after September 11, 2001, since the catastrophic events of this date caused an increase in the perceived risk of the sector among investors and may have triggered an increase in the cost of capital. Our estimation period is therefore October 2001 through October 2004, and based on weekend closing stock prices for the proxy group. We choose to rely on adjusted betas, whose adjustment intends to convert backward-looking correlations to forward-looking expectations, since it is forward looking inputs that are most appropriate for setting allowed rates of return. 19 In summary, using the CAPM approach, the average return on equity ( ROE ) for the U. S. proxy group is 11.37%. 20 (See Exhibit 6.) b. Proxy Group II: A.M. Best Top Canadian Auto Insurers For the second proxy group, we apply two different approaches. The first approach estimates the cost of equity using data that are specific to the Canadian financial markets. In 18 A raw beta is the direct estimate of correlation between the stock s returns and the returns on the broader market. Adjusted betas attempt to account for differences between historically observed correlations and future systematic risks. Marshall Blume found that betas tend to revert toward their mean value, or the market beta of one. In other words, high historical betas (those in excess of one) tend to overestimate betas in the future, and low historical betas (those below one) tend to underestimate future betas. (See M.E. Blume, On the Assessment of Risk, Journal of Finance, Volume 26, 1971.) 19 We note, however, had raw betas been used, the results would not be materially different from the results using adjusted betas since the average adjusted beta is nearly equal to the average raw beta. 20 These estimates do not include the costs of issuing equity. Consulting Economists

19 this case, we take the yield on Canadian long-term government bonds and apply a Canadian equity risk premium. This equity risk premium for each proxy company is equal to the beta, measured relative to the Toronto Stock Exchange Composite Index ( TSE Index), times the long-horizon expected equity risk premium (which is defined as the long-term returns of the Canadian stock market in excess of the returns on Canadian government bonds.) 21 The second approach is the same approach as undertaken for Proxy Group I, which uses U.S. risk-free rates and market premiums from the U.S. financial markets. The beta and expected equity risk premium are calculated with respect to the S&P 500 Index. Both approaches are valid and well grounded in financial theory. The first approach, which uses this rate and a Canada-specific equity risk premium, appears to be most consistent with current regulatory practice in Canada. Exhibit 7A shows the CAPM results using the first approach. The average ROE in this case is 10.39% for Proxy Group II. Using the second approach (S&P 500 Index), as reported in Exhibit 7B, the average ROE for Proxy Group II is 11.69%. 3. The Impact of Leverage As explained earlier, the cost of equity is driven by the business and financial risks that investors face. Financial risks are important. Investors in highly leveraged companies in a given sector will require higher rates of return than investors in less leveraged companies in the same sector. To put our cost of capital estimates in context, we have graphed the average debt to total capital ratios for our two proxy groups of comparable companies. 22 These ratios are depicted in Exhibits 8A and 8B. These exhibits show that the majority of companies in our proxy groups have debt to total capital ratios of over 80%. This is a high degree of leverage, as compared to, for example, the utilities sector. It follows that an insurer with less leverage would be expected to have a lower cost of equity, ceteris paribus. To determine whether an adjustment to the estimated cost of equity to account for leverage is appropriate for the purposes of the Board s benchmarking process, we compare the 21 The source for the Canadian market risk premium is Ibbotson Associates, Canadian Risk Premia Over Time Report, Note that we include the liability associated with future claims as a component of debt. Consulting Economists

20 leverage of a subset of Proxy Group II companies that have subsidiaries operating in the Newfoundland and Labrador market to the leverage of the other companies in the proxy group. The average leverage of companies with subsidiaries operating in Newfoundland and Labrador is 87%. The average leverage for the remaining companies in Proxy Group II is 82%. 4. Other Approaches We do not apply the Equity Risk Premium model in any other format than the CAPM. We believe the CAPM is an effective means of implementing the Equity Risk Premium method because it relies on non-subjective financial market data to determine the appropriate premium over the risk-free rate. The development of a premium that is not beta based is likely to be the result of subjective judgment. It is important that the estimation of the cost of equity capital be as objective as possible. The CAPM achieves this objectivity. Further, NERA has decided not to employ the Comparable Earnings approach in the cost of equity capital analysis because of a concern related to the selection of a suitable time period from which to draw historical evidence. Exhibits 9A and 9B show respectively, the average annual returns of the P&C insurance companies in Proxy Group I and of the firms operating in the Canadian auto insurance market (Proxy Group II). As indicated, on average, the P&C companies report substantially lower returns in General Industry Conditions General industry conditions also influence our assessment of the cost of equity and choice of approach. Cash flow to equity holders is related to earnings. Earnings, in turn, are a function of both financing and operating leverage as well as sales variability. Sales variability is related to demand for a product. Since auto coverage is mandated by law, general economic conditions do not typically affect demand. Operating leverage relates to a company s ratio of fixed to variable expenses. One of the most significant variable costs to P&C carriers is reinsurance. Insurance (and reinsurance) is based, in general, on the law of large numbers, which assures that when a large number of people face a low-probability event, the proportion of people actually experiencing the event will be close to the expected proportion. The catastrophic events of September 11, 2001, represented a significant clash event, affecting many people and a variety of coverages (P&C, commercial, liability health & welfare, medical, Consulting Economists

21 etc.) and contravened many actuarial probability models. As such, claims exceeded expectations and losses paid exceeded premiums earned in many areas. This caused a general reduction in available reinsurance, which, in turn, caused a severe increase in insurance companies reinsurance costs as well as loss exposure. Insurance companies have responded since then with a general hardening of premiums and reduction of coverage (lower loss limits, larger deductibles, etc.) in several insurance markets, including the property and casualty insurance market and a general increase in the risks of the insurance industry. 23 We believe it is still too early to determine the full effects of September 11 th on the P&C insurance industry and on the economy. Other insurance crises have occurred since 9/11, including the impact of corporate scandals on Directors and Officers Liability coverage and a severe hurricane season in If it were the case that these events caused a regime shift in the insurance industry and if one would adopt a Comparable Earnings approach, there would be only two data points (returns in 2002 and 2003) be included in the calculation. Certainly, results from the relatively soft market of the mid to late 1990s would not be representative of the next several years. This would possibly lead to biased and unreliable results. For the proxy group of companies operating in the Canadian market, both 2001 and 2002 were very difficult years and are likely to be anomalous (see Exhibit 9B). VI. RECOMMENDATION In summary, our estimations of the after-tax cost of equity capital for automobile insurers are as follows: 23 According to a study published by the American Academy of Actuaries, As a result of the Sept. 11 th events, there is enormous strain on the entire insurance system. Insurance mechanisms have to bear previously existing risks as well as the unknown and largely unpriced risk associated with terrorism. Additionally, though the industry may have retained significant surplus following the Sept. 11 th attacks, such surplus is needed to support all of the risk assumed by insurers for all of the line of business they have written The enormous financial consequences of additional extreme terrorist events could overwhelm industry capacity. John J. Kollar, Terrorism Insurance Coverage in the Aftermath of September 11 th, A Public Statement by the Extreme Events Committee of the American Academy of Actuaries, April 17, Consulting Economists

22 CAPM DCF Average Proxy Group I: (Value Line U. S. P & C Insurers) Proxy Group II: 11.37% 14.38% 12.88% 10.39% % 12.02% (A.M. Best Top Canadian Auto Insurers) Average 10.88% 14.01% 12.45% In light of these analyses, we believe that a cost of equity in the range of 11% to 14% is appropriate for the Board to use when setting benchmark automobile insurance rates. As noted, the companies from Proxy Group II that have subsidiaries operating in the Newfoundland and Labrador market have nearly identical capital structures to the other companies in Proxy Group II. Further, there are a number of companies in Proxy Group I that also have similar capital structures. Hence, the above estimates for required return on equity can, in our opinion, be taken without adjustment for capital structure when applied to the Newfoundland and Labrador market. 24 This figure reflects an implementation of the CAPM using Canadian financial market inputs. The corresponding figure using U.S. financial market inputs is 11.69%. Consulting Economists

23 Included Companies Exhibit 1 Screening Process for Proxy Group I: Value Line Companies Name of Company Ticker CAPM DCF* 21st Century Insurance Group TW x x ACE limited ACE x x Allmerica Financial AFC x x Allstate Corp. ALL x x American Financial Group AFG x x Chubb Corp. CB x x Cincinnati Financial CINF x x CNA Financial Corp. CNA x Mercury General Corp. MCY x x Ohio Casualty OCAS x Old Republic International ORI x x Progressive Corp. (Ohio) PGR x x SAFECO Corp. SAFC x x Selective Insurance Group SIGI x x St. Paul Companies STA x x Transatlantic Holdings TRH x x Excluded Companies Name of Company Ticker Rationale For Exclusion Berkley (W.R.) BER Not on A.M. Best's Top U.S. Auto Insurers Berkshire Hathaway BRK.A Majority of Revenue is from Non-Insurance Everest Re Group, Ltd. RE Not on A.M. Best's Top U.S. Auto Insurers Fidelity National Financial, Inc. FNF Not on A.M. Best's Top U.S. Auto Insurers HCC Insurance Holdings HCC Not on A.M. Best's Top U.S. Auto Insurers Markel Corp. MKL Not on A.M. Best's Top U.S. Auto Insurers PartnerRe Ltd. PRE Not on A.M. Best's Top U.S. Auto Insurers PMI Group PMI Not on A.M. Best's Top U.S. Auto Insurers RLI Corp. RLI Not on A.M. Best's Top U.S. Auto Insurers XL Capital Limited XL Not on A.M. Best's Top U.S. Auto Insurers Source: "Value Line The Investment Survey," December 26, 2003 Issue. * Companies not included in the DCF model lack expected future earnings per share data and/or have irregular dividend payments.

24 Exhibit 2A Screening Process for Proxy Group II: Auto Insurers Active in Canadian Market Included Companies Name of Company Ticker Operating Subsidiary CAPM DCF* ACE Group ACE ACE INA Insurance x x Zurich Financial Services Zurich Insurance Company x x Liberty Mutual Group Ltd Liberty Insurance Company of Canada x x Liberty Mutual Group Ltd Liberty Mutual Insurance Company x x E-L Financial Group Ltd. *ELF Dominion of Canada General Insurance Company (The) x Northbridge Financial Corporation *NB Federated Insurance Company of Canada x x Northbridge Financial Corporation *NB Lombard General Ins Co x x Northbridge Financial Corporation *NB Lombard Insurance Company x x Optimum General Inc. *OGI.A Optimum Frontier Ins Co x Royal Bank of Canada *RY RBC General Insurance Company x x Aviva (UK-based ) Aviva Insurance Company of Canada x Aviva (UK-based ) Elite Insurance Company x Aviva (UK-based ) Traders General Ins Co1 x American International Group, Inc. AIG American Home Assurance Company x x AllState ALL Allstate Insurance Company of Canada x x AllState ALL Pembridge Insurance Company x x AXA Group AXA Axa Assurances Inc x x AXA Group AXA Axa Ins (Canada) x x AXA Group AXA AXA Pacific Insurance Company x x AXA Group AXA InnovAssur, Assur Generales x x AXA Group AXA Ins Corp Newfoundland Lt x x Allianz AG AZ Allianz Insurance Company of Canada x Allianz AG AZ Trafalgar Insurance Company of Canada x Baldwins & Lyons Inc. BWINB Protective Insurance Company x Chubb Group of Insurance Companies CB Chubb Insurance Company of Canada x x Credit Suisse Group CSR Citadel General Assurance Company (The) x Fairfax Financial FFH Markel Insurance Company of Canada x Fairfax Financial FFH TIG Insurance Company x The Hartford Financial Services Group, Inc. HIG Hartford Fire Insurance Company x x ING GROUP ING Belair Ins Co Inc x ING GROUP ING ING Insurance Company of Canada x ING GROUP ING ING Novex Insurance Company of Canada x Kingsway Financial Services Inc. KFS Kingsway General Ins Co x Kingsway Financial Services Inc. KFS York Fire & Casualty Ins Co x Millea Holdings Inc. (Japanesse Company) MLEA Tokio Marine and Fire Insurance Company, Limited (The) x Royal & SunAlliance Insurance Group RSA Ascentus Insurance Ltd. x x Royal & SunAlliance Insurance Group RSA Quebec Assurance Company x x Royal & SunAlliance Insurance Group RSA Royal & Sun Alliance Insurance Company of Canada x x Royal & SunAlliance Insurance Group RSA Western Assurance Company x x St. Paul Travelers Cos Inc STA St. Paul Fire and Marine Insurance Company x x St. Paul Travelers Cos Inc STA Travelers Casualty and Surety Company of Canada x x Zenith National Insurance Company ZNT Zenith Insurance Company x Source: A.M. Best's Statistical Study, "Canadian Auto Underwriting Results Improve," September 20, 2004 * Companies not included in the DCF model lack expected future earnings per share data and/or have irregular dividend payments.

25 Exhibit 2B Screening Process for Proxy Group II: Auto Insurers Active in Canadian Market Excluded Companies Name of Company Rationale For Exclusion Name of Company Rationale For Exclusion Alberta Motor Assoc Ins Company and/or Parent not publicly traded Lloyd's Underwriters Company and/or Parent not publicly traded Algoma Mutual Ins Co Company and/or Parent not publicly traded Lumbermens Mutual Casualty Company and/or Parent not publicly traded Company (1) American Road Insurance Company and/or Parent not publicly traded Missisquoi Insurance Company (The) Company and/or Parent not publicly traded Company (The) British Colombia Automobile Company and/or Parent not publicly traded Mitsui Sumitomo Insurance Company and/or Parent not publicly traded Association (BCAA) Insurance Corporation Company, Limited CAA Ins Co (Ontario) Company and/or Parent not publicly traded Motors Insurance Corporation Company and/or Parent not publicly traded Canadian Northern Shield Company and/or Parent not publicly traded Nordic Insurance Company of Company and/or Parent not publicly traded Insurance Company Canada (The) Capitale, Compagnie d Assur Company and/or Parent not publicly traded North Waterloo Farmers Mutual Company and/or Parent not publicly traded Centennial Insurance Company Company and/or Parent not publicly traded Old Republic Insurance Company of Company and/or Parent not publicly traded Canada Certas Direct Insurance Company Company and/or Parent not publicly traded Optimum Farm Ins Inc Company and/or Parent not publicly traded Coachman Ins Co Company and/or Parent not publicly traded Optimum Ins Co Inc Company and/or Parent not publicly traded Colonial Fire & General Ins Co Company and/or Parent not publicly traded Optimum West Ins Co Company and/or Parent not publicly traded Commerce and Industry Ins CA Company and/or Parent not publicly traded Peace Hills General Ins Co Company and/or Parent not publicly traded Continental Casualty Company Company and/or Parent not publicly traded Personal General Ins Inc Company and/or Parent not publicly traded Co-operators General Insurance Company and/or Parent not publicly traded Personal Insurance Company (The) Company and/or Parent not publicly traded Company Coseco Insurance Company Company and/or Parent not publicly traded Perth Insurance Company Company and/or Parent not publicly traded CUMIS General Insurance Company and/or Parent not publicly traded Portage la Prairie Mutual Insurance Company and/or Parent not publicly traded Company Company (The) DaimlerChrysler Insurance Company and/or Parent not publicly traded Primmum Insurance Company Company and/or Parent not publicly traded Company Desjardins Assur Generales Inc Company and/or Parent not publicly traded Saskatchewan Motor Club Ins Co Company and/or Parent not publicly traded Echelon General Insurance Company and/or Parent not publicly traded Saskatchewan Mutual Insurance Company and/or Parent not publicly traded Company Company Economical Mutual Insurance Company and/or Parent not publicly traded Security National Insurance Company and/or Parent not publicly traded Company Company Farmers' Mutual Ins Co Company and/or Parent not publicly traded Sentry Insurance a Mutual Company Company and/or Parent not publicly traded Federation Insurance Company of Company and/or Parent not publicly traded SGI Canada Company and/or Parent not publicly traded Canada First North American Insurance Company and/or Parent not publicly traded Sovereign General Insurance Company and/or Parent not publicly traded Company Company (The) Glengarry Farmrs Mutual Fire Ins Company and/or Parent not publicly traded State Farm Mutual Automobile Company and/or Parent not publicly traded Insurance Company Gore Mutual Insurance Company Company and/or Parent not publicly traded TD General Insurance Company Company and/or Parent not publicly traded Guarantee Company of North America (The) Company and/or Parent not publicly traded Unifund Assurance Company Company and/or Parent not publicly traded HSBC Canadian Dir Ins Inc Company and/or Parent not publicly traded Union Canadienne Cie D Assur Company and/or Parent not publicly traded Industrial-Alliance Gen Ins Company and/or Parent not publicly traded Unique Compagnie DAssur Gen Company and/or Parent not publicly traded Ins Corp Newfoundland Lt Company and/or Parent not publicly traded Waterloo Insurance Company Company and/or Parent not publicly traded Jevco Insurance Company Company and/or Parent not publicly traded Wawanesa Mutual Insurance Company (The) Langdon Ins Co Company and/or Parent not publicly traded Company and/or Parent not publicly traded Source: A.M. Best's Statistical Study, "Canadian Auto Underwriting Results Improve," September 20, 2004

26 Exhibit 3 Discounted Cash Flow Model Cost of Equity for Proxy Group I: U.S. Property & Casualty Companies Dividend 1 Growth 2 Adjusted 3 Company Yield Rate, g Stock Price, P o ROE 4 (%) (%) ($) (%) 21st Century Insurance Group ACE limited Allstate Corp American Financial Group Chubb Corp Cincinnati Financial Mercury General Corp Old Republic International Progressive Corp. (Ohio) SAFECO Corp Selective Insurance Group St. Paul Companies Transatlantic Holdings Average % Notes: 1 Dividend Yield = (Expected Dividend)/(Adjusted Stock Price), See Exhibits 3A and 3B 2 See Exhibit 3C 3 See Exhibit 3A 4 Not adjusted for selling and issuance expenses related to equity offering

27 Exhibit 3A Discounted Cash Flow Model Cost of Equity for Proxy Group I: U.S. Property & Casualty Companies Dividend Adjusted Stock Price as of October 5, 2004 Ticker Ex-Dividend Date Days to Next Adjusted Closing Adjusted Company Symbol Last Next Ex-Div Date Days Expired 1 Dividend 2 Dividend Stock Price Stock Price [a] [b] [c] [d] [e] [f]=[d]*[e] [g] [h]=[g]-[f] % $ $ $ $ 21st Century Insurance Group TW 10/04/2004 1/2/ ACE limited ACE 10/14/ /14/ Allstate Corp. ALL 10/01/ /30/ American Financial Group AFG 10/25/ /25/ Chubb Corp. CB 10/12/ /12/ Cincinnati Financial CINF 10/15/ /15/ Mercury General Corp. MCY 09/30/ /29/ Old Republic International ORI 09/15/ /14/ Progressive Corp. (Ohio) PGR 09/30/ /29/ SAFECO Corp. SAFC 10/25/ /25/ Selective Insurance Group SIGI 09/01/ /30/ St. Paul Companies STA 09/30/ /29/ Transatlantic Holdings TRH 12/10/ /10/ Notes: 1 ((90-Days to Ex-Div Date)/90))*100 for companies that pay quaterly dividend. ((182.5-Days to Ex-Div Date)/182.5))*100 for companies that pay dividend semiannually. ((365-Days to Ex-Div Date)/365))*100 for companies that pay dividend annually. 2 Expected dividend to be paid on the date stated in Column [b]

28 Exhibit 3B Discounted Cash Flow Model Cost of Equity for Proxy Group I: U.S. Property & Casualty Companies Dividends Recent Quarterly Dividends Paid Per Share (D 0 ) 2005 Expected Quarterly Dividend Company Last Dividend Q 1 Q 2 Q 3 Q 4 Exp. Dividend Q 1 Q 2 Q 3 Q 4 Date ($/Share) Date ($/Share) Date ($/Share) Date ($/Share) Date ($/Share) ($) ($/Share) ($/Share) ($/Share) ($/Share) 21st Century Insurance Group 10/04/ /28/ /29/ /23/ /14/ * ACE limited 10/14/ /14/ /14/ /14/ /14/ Allstate Corp. 10/01/ /01/ /01/ /02/ /01/ American Financial Group 10/25/ /25/ /25/ /25/ /25/ Chubb Corp. 10/12/ /09/ /06/ /06/ /07/ Cincinnati Financial 10/15/ /15/ /15/ /15/ /15/ Mercury General Corp. 09/30/ /30/ /31/ /29/ /25/ Old Republic International 09/15/ /15/ /15/ /26/ /15/ Progressive Corp. (Ohio) 09/30/ /30/ /31/ /31/ /30/ SAFECO Corp. 10/25/ /26/ /26/ /26/ /27/ Selective Insurance Group 09/01/ /01/ /01/ /01/ /02/ St. Paul Companies 09/30/ /30/ /14/ /16/ /16/ Transatlantic Holdings 12/10/ /17/ /18/ /19/ /12/ Notes: *I/B/E/S estimate of expected dividend is not available. The 2005 expected dvidend is derivied by applying the 2005 expected earnings growth rate on the 2004 dividend amount