Milliman Client Report

Transcription

1 Report of the Independent Expert on the proposed transfer of certain Italian branch insurance business from Sompo Japan Insurance Company of Europe Limited to Berkshire Hathaway International Insurance Limited Prepared for: Sompo Japan Insurance Company of Europe Limited and Berkshire Hathaway International Insurance Limited Prepared by: Gary Wells FIA 11 Old Jewry London, EC2R 8DU United Kingdom Tel +44 (0) Fax +44 (0) milliman.co.uk

2 CONTENTS 1. Introduction Regulatory Background Background on SJE Background on BHII The Proposed Scheme General Considerations of the Independent Expert The Effect of the Scheme on the Transferring Policyholders The Effect of the Scheme on the BHII Policyholders The Effect of the Scheme on the Non-Transferring Policyholders of SJE Other Considerations Conclusions APPENDIX 1. Defined Terms APPENDIX 2. List of Previous Transfers for which I have Acted as the Independent Expert or Equivalent APPENDIX 3. Terms of Reference APPENDIX 4. Key Sources of Data APPENDIX 5. Minimum Capital Requirement APPENDIX 6. NAIC Actuarial Opinion Instructions... 49

3 1. INTRODUCTION Purpose of Report 1.1. It is proposed that certain Italian branch business of Sompo Japan Insurance Company of Europe Limited ( SJE ) be transferred to Berkshire Hathaway International Insurance Limited ( BHII ) by an insurance business transfer scheme (the Scheme ) as defined in Section 105 of the Financial Services and Markets Act 2000 ( FSMA ) A list of terms defined in this report is shown in Appendix 1. Otherwise I use the same defined terms as are in the Scheme Section 109 of FSMA requires that an application to the High Court of Justice in England and Wales ( the Court ) for an order sanctioning an insurance business transfer scheme must be accompanied by a report on the terms of the scheme (the Report ) by an independent person having the skills necessary to make the report and who is nominated or approved by the Financial Services Authority ( FSA ). The Report is required in order that the Court may properly assess the impact of the proposed transfer, including the effect on policyholders of the insurance companies in question. SJE has nominated me to act as an independent expert to provide the Report and the FSA has approved my appointment This Report describes the proposed transfer and discusses its possible effects on the policyholders of SJE and BHII, including effects on security and levels of service. The Proposed Scheme 1.5. The business to be transferred under the Scheme (referred to henceforth as the Transferring Business ) consists of the contracts of insurance written and issued by the Italian branch of SJE for the underwriting years 2003 and prior; and medical expense business that continued to be renewed on a compulsory basis from business written during underwriting years 2003 and prior (these policies will now have expired). Notwithstanding that the Transferring Business excludes insurance contracts relating to commercial risks of Japanese entities, which is the on-going business of the branch and two medical expense contracts, which are still in force and therefore not in run-off (together the Excluded Policies ). The Transferring Business is intended only to transfer business that is in run-off hence the Excluded Policies are not part of the transfer. The other business of SJE will remain in SJE I note that SJE is currently in litigation with three brokers (defined as "Broker Litigation" under the Scheme) and it is expected that these cases will be concluded in the near future. Furthermore, the Broker Litigation falls outside the ambit of Transferring Business The Effective Date of the transfer is expected to be 31 December The transfer is intended to have the effect that all the liabilities under the policies comprising the Transferring Business, and appropriate assets (including reinsurance), will pass under the Scheme to BHII The business involved, the arrangements for the transfers and the effect of the transfers are discussed in more detail in Sections 3 to 11 of this Report. The Independent Expert 1.9. I, Gary Wells, have been appointed by SJE as the Independent Expert to consider the Scheme under Section 109 of FSMA. My appointment has been approved by the FSA; this is confirmed in a letter dated 2 May 2012 from the FSA to SJE I am a Fellow of the Institute and Faculty of Actuaries, having qualified in I am a Principal of Milliman LLP, Consultants and Actuaries, ( Milliman ) and I am based in its UK general insurance practice. My experience of general insurance includes the (reserved) roles as the Signing Actuary to Lloyd s syndicates and Irish non-life (re)insurance companies. A list of previous schemes for which I have acted as independent expert under the terms of FSMA, and as an independent actuary under the Insurance Companies Act 1982, the legislation replaced by FSMA, can be found in Appendix I confirm that I do not have any personal, financial, or any other interest in SJE or BHII. I have not acted on behalf of or in relation to SJE or BHII in any professional capacity. Other consultants within Milliman do some work for the Sompo Group and/or the Berkshire Hathaway Group, but revenue for this work has been 1

4 less than 0.1% of the firm s fee income over each of the last 5 years in respect of each group I do not believe that the involvement with the Sompo Group or the Berkshire Hathaway Group of other consultants within Milliman affects my ability to act independently in my assessment of the Scheme This scheme is subject to sanction by the Court under Section 111 of FSMA SJE will be responsible for payment of all fees in respect of my work as Independent Expert. The Scope of my Report My terms of reference have been reviewed by the FSA and are set out in Appendix I have considered the terms of this Scheme only and have not considered whether any other scheme may provide a more efficient or effective outcome The Report describes the proposed transfer and the likely effects on policyholders of SJE and of BHII, including effects on security and levels of service. These factors are contrasted to the position which will apply after the completion of the proposed transfer. This Report should be read in conjunction with the full terms of the proposed Scheme My work has required an assessment of the liabilities of SJE and BHII, for the purposes of describing the effect of the transfer. My review of the liabilities was based on actuarial reserve assessments conducted by internal and/or external actuaries of SJE or BHII (as the case may be). I have reviewed the methodology and assumptions used in their work and assessed the key areas of uncertainty in relation to these liabilities. I have not attempted to review in detail the calculations performed by the internal and/or external actuaries (as the case may be) or to produce independent estimates of the liabilities In addition to the liabilities, I have assessed the appropriateness, in nature and amount, of the assets to be transferred under the Scheme, and the capital position of SJE and BHII pre and post the proposed transfer. Again, I have not attempted to review in detail the calculations performed for/by SJE or BHII, or to produce independently my own capital estimates As far as I am aware, there are no matters which I have not taken into account in undertaking my assessment of the Scheme and in preparing this Report, but which nonetheless should be drawn to the attention of policyholders in their consideration of the Scheme In reporting on the Scheme as the Independent Expert, I recognise that I owe a duty to the Court to assist the Court on matters within my expertise. This duty overrides any obligation to the companies involved in the Scheme. I confirm that I have complied with this duty I am aware of the requirements regarding experts set out in Part 35 of the Civil Procedure Rules, Practice Direction 35 and the Protocol for Instruction of Experts to give Evidence in Civil Claims I confirm that I have made clear which facts and matters referred to in this report are within my own knowledge and which are not. Those that are within my own knowledge I confirm to be true. The opinions I have expressed represent my true and complete professional opinions on the matters to which they refer Shortly before the date of the Court hearing at which an order sanctioning the Scheme will be sought, I will prepare a supplementary report covering any relevant matters which might have arisen since the date of this Report. It is intended that the supplementary report will be published on the SJE website at least one week before the date of that Court hearing. 2

5 The Structure of my Report The remainder of the Report is set out as follows In Section 2, I provide some background to the regulatory environment in which the companies involved in the Scheme operate. In Sections 3 and 4, I provide some background to SJE and to BHII, i.e. the companies involved in the Scheme. Section 5 summarises the key provisions of the Scheme. Section 6 describes the matters I need to consider as Independent Expert. In Section 7, I consider the likely effects of the Scheme on the group of transferring policyholders. In Section 8, I consider the impact of the Scheme on the current policyholders of BHII. In Section 9, I consider the impact of the Scheme on the policyholders remaining in SJE. In Section 10, I cover more general issues relating to the Scheme. My conclusions are summarised in Section 11. Reliances and Limitations In carrying out my review and producing this Report I have relied, without detailed verification, upon the accuracy and completeness of the data and information provided to me, in both written and oral form, by SJE and BHII, and can confirm, in accordance with SUP (8) (see paragraph 1.40 below), that all the information that I have requested has been provided. Reliance has been placed upon, but not limited to, the information detailed in Appendix 4. My opinions depend on the substantial accuracy of this data, information and the underlying calculations The Report has been prepared for the purposes of the Scheme in accordance with Section 109 of FSMA. A copy of this Report will be sent to the FSA and will accompany the Scheme application to the Court This Report must be considered in its entirety, since individual sections, if considered in isolation, may be misconstrued Neither the Report, nor any extract from it, may be published without my specific written consent having been given, save that copies of the Report may be made available for inspection by policyholders and copies may be provided to any person requesting the same in accordance with legal requirements. I also consent to the Report being made available on the website to be operated by SJE in connection with the transfer No summary of the Report may be made without my express consent. I will provide a summary of the Report for inclusion in a document that will be made available to policyholders of SJE and the policyholders of BHII under the Scheme (the Report Summary ) The Report has been prepared within the context of the assessment of the terms of the Scheme and must not be relied upon for any other purpose. No liability will be accepted by Milliman, or me, for any application of the Report to a purpose for which it was not intended or for the results of any misunderstanding by any user of any aspect of the Report. In particular, no liability will be accepted by Milliman or me under the terms of the Contracts (Rights of Third Parties) Act Actuarial estimates are subject to uncertainty from various sources, including changes in claim reporting patterns, claim settlement patterns, judicial decisions, legislation, economic and investment conditions. It should therefore be expected that the actual emergence of claims, premiums, expenses and investment income will vary from any estimate. Such variations in experience could have a significant effect on the results and conclusions of this Report. No warranty is given by Milliman or me that the assumptions, results and conclusions on which this Report is based will be reflected in actual future experience This review does not comprise an audit of the financial resources and liabilities of SJE or BHII This Report should not be construed as investment advice. 3

6 1.36. At the date of this Report, I am not aware of any material changes in circumstances since 31 December 2011 other than those referred to in this Report. This Report also takes no account of any information that I have not received, or of any inaccuracies in the information provided to me The use of Milliman s name, trademarks or service marks, or reference to Milliman directly or indirectly in any media release, public announcement or public disclosure, including in any promotional or marketing materials, websites or business presentations is not authorised without Milliman s prior written consent for each such use or release, which consent shall be given at Milliman s sole discretion. Professional and Regulatory Guidance I am required to comply with relevant professional standards and guidance issued by the Board for Actuarial Standards and the Institute and Faculty of Actuaries. I have complied with such standards, subject to the principles of proportionality and practicability The Report has been prepared in accordance with the following applicable Technical Actuarial Standards ( TAS ) issued by the Board for Actuarial Standards: Transformations TAS ( T-TAS ); Insurance TAS ( I- TAS ); TAS for Reporting ( TAS-R ); and to the extent relevant, TAS for Data ( TAS-D ); and TAS for Modelling ( TAS-M ) The Report has been prepared under the terms of the guidance set out in Chapter 18 of the Supervision Manual ( SUP18 ) contained in the FSA Handbook of Rules and Guidance to cover scheme reports on the transfer of insurance business. 4

7 2. REGULATORY BACKGROUND Introduction 2.1. General insurers, as well as other financial services organisations, are regulated by the FSA, which has approximately 4,000 employees and an annual budget of over 400 million The FSA is a statutory body set up under FSMA, and has various strategic aims including: Promoting efficient, orderly and fair markets; Helping retail consumers achieve a fair deal; and Improving the FSA s business capability and effectiveness Under its consumer protection strategic aim, the FSA places great emphasis on achieving fair outcomes for consumers and seeks to ensure that firms adhere to its conduct principles The FSA also sets the regulations governing the amount and quality of solvency capital held by firms; these are summarised below. The solvency regime is designed to protect the benefit security of policyholders, as well as the stability of the insurance industry In June 2010, the UK government announced that the FSA will be broken up by the end of It will be replaced by the Financial Conduct Authority ( FCA ) and the Prudential Regulation Authority ( PRA ). The FCA will be responsible for regulating conduct, while the PRA (as part of the Bank of England) will have responsibility for the prudential regulation of individual insurance companies along with banks, investment banks and building societies For the purposes of this report I refer to the FSA as the sole regulator of the UK general insurance industry. Where I refer to the FSA this should be taken to implicitly refer also to the FCA and PRA as appropriate In the UK, the taxation regime taxes general insurance companies based on profits achieved by those companies at the main rate of corporation tax (24% for tax year 2012/13 1 ). FSCS 2.8. Consumer protection is also provided by the Financial Services Compensation Scheme ( FSCS ). This is a statutory fund of last resort which compensates customers in the event of the insolvency (or other defined default) of a financial services firm. Insurance protection exists for private policyholders and small businesses (annual turnover less than 1 million) in the situation when an insurer is unable to meet its liabilities. For non-life insurance business, the FSCS will pay 100% of any claim incurred before the default under compulsory insurance (such as motor third party liability) and 90% of the claim incurred before the default for non-compulsory insurance (such as home), without any maximum. The FSCS is funded by levies on firms authorised by the FSA The FSCS covers EEA risks written by UK insurers through branches in other EEA countries. Therefore, the transferring Italian branch policyholders of SJE are protected by the FSCS to the extent they meet the qualifying criteria. FOS The Financial Ombudsman Service ( FOS ) provides private individuals (and micro-enterprises 2 ) with a free, independent service for resolving disputes with financial companies. It is not necessary for the private individual (or micro-enterprise) to live or be based in the UK for a complaint to be dealt with by the FOS. It is necessary for the insurance policy concerned to be, or have been, administered from within the UK Therefore, in relation to the companies concerned in the Scheme, certain of the UK policyholders of BHII may be entitled to complain to the FOS. 1 The UK Corporation Tax rate is expected to reduce to 23% in 2013/14 and 22% in 2014/15. 2 Micro-enterprises (an EU term covering smaller businesses) can bring complaints to FOS as long as they have an annual turnover of less than 2 million and fewer than ten employees. 5

8 Risk-Based Capital Framework At the end of 2004 the FSA introduced a risk-based capital framework (known as the ICAS framework) under which companies are required to assess solvency under two regimes, referred to as Pillar I and Pillar II. PILLAR I Under Pillar I, general insurers have to meet statutory requirements based on EU Directives and, for the time being, provide their more risk-based Enhanced Capital Requirement ( ECR ) calculation to the FSA in private. This includes setting up Technical Provisions in accordance with those Directives and having sufficient available capital to meet at least the Minimum Capital Requirement ( MCR ). Details of the calculation of the MCR are given in Appendix The Technical Provisions required under the EU Directives are: The Unearned Premium Reserve ( UPR ) the UPR is the amount set aside from premiums written before the valuation date to cover risks incurred after that date; The Unexpired Risk Reserve ( URR ) the URR is the amount held in excess of the UPR, to allow for any expectation that the UPR will prove to be insufficient as at the valuation date to cover the cost of claims and expenses incurred during the period of unexpired risk; and The claims outstanding provision the reserve set up in respect of the liability for all outstanding claims at the valuation date, whether reported or not The UPR is typically calculated on a daily basis (but alternative methods may be acceptable where the daily basis is not appropriate) and makes no allowance for the time value of money (i.e. discounting) The claims outstanding provision is typically made-up of the case reserves plus the amount, if any, for claims incurred but not reported ( IBNR ) at the valuation date. Case reserves are the amounts estimated on a case-by-case basis to settle reported (open) claims. The IBNR reserve is the amount estimated (typically using statistical techniques) to provide for claims in respect of claim events that have occurred before the valuation date, but had still to be reported to the insurer by that date (plus any projected deficiencies in the case reserves) Under UK regulatory practices, the claims outstanding provision estimate cannot normally include any allowance for the time value of money. Therefore, all other things being equal, a margin exists in the provision to cover (at least in part) adverse claims development. It should be noted that there are some limited circumstances under UK regulations where the claims outstanding provision may be discounted for the time value of money. PILLAR II The capital that must be held under Pillar II is an amount based upon the Individual Capital Assessment ( ICA ), which is the company s own assessment of its capital requirements. Pillar II is intended to provide a more realistic and complete view (than under the Pillar I regime) of the risks to which the company is exposed and to provide a framework within which the company should be managed The FSA requires firms, when preparing their ICA, to identify the major risks they face and, where capital is appropriate to mitigate those risks, to quantify how much (and what type) of capital is appropriate. The FSA expects firms to conduct stress tests and scenario analyses in respect of each risk. The capital requirements so determined are then aggregated, allowing for diversification between risks where appropriate. These stress tests and scenario analyses, together with the supporting analysis, must be documented and, along with the results, submitted to the FSA (on request) as the ICA. The company is not required to publish its Pillar II capital requirement The FSA will review the ICA periodically and may prescribe an additional amount of capital that must be held by the firm in addition to the ICA. The total amount of Pillar II capital prescribed by the FSA is usually expressed as a percentage of the ECR amount, and is called Individual Capital Guidance ( ICG ). The ICG is not published and details of this remain private between the company and the FSA For the ICA, a firm will assess the amount of capital it needs to hold to remain able to meet its liabilities as 6

9 they fall due in all but the most extreme circumstances. The FSA has indicated that ICG will be given taking into consideration capital resources consistent with a 99.5% confidence level that the firm will be able to meet its liabilities over a one year timeframe or, if appropriate to the firm s business, an equivalent lower confidence level over a longer timeframe. FSA Conduct Principles The FSA has set out the high-level requirement to treat customers fairly in Principle 6 of its Principles for Businesses (PRIN 2.1.1) which states that a firm must pay due regard to the interests of its customers and treat them fairly. Principle 7 outlines that a firm must pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading while Principle 8 states that a firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client These Principles have been developed further in the FSA s document Treating customers fairly towards fair outcomes for consumers published in July This provides 6 outcomes that set out firms regulatory obligations for the fair treatment of customers. These are as follows: Outcome 1: Consumers can be confident that they are dealing with firms where the fair treatment of customers is central to the corporate culture; Outcome 2: Products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly; Outcome 3: Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale; Outcome 4: Where consumers receive advice, the advice is suitable and takes account of their circumstances; Outcome 5: Consumers are provided with products that perform as firms have led them to expect, and the associated service is of an acceptable standard and as they have been led to expect; and Outcome 6: Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint. Solvency II The regulatory solvency reporting requirements for EU insurers and reinsurers are due to undergo a major overhaul from 30 June This new regime is commonly referred to as Solvency II and aims to introduce solvency requirements that reflect better than the existing solvency regimes the risks that insurers and reinsurers actually face and to introduce consistency across the European Union. UK companies will be required to adhere to a set of new, risk based capital requirements and, in contrast to the position under the current UK Pillar II requirements, some of the results will be shared with the public Solvency II will be a principles-based regime and will be based on three pillars: Under Pillar I quantitative requirements define a market consistent 4 framework for valuing the company s assets and liabilities; Under Pillar II, insurers must meet minimum standards for their corporate governance, and also for their risk and capital management. There is a requirement for permanent internal audit and actuarial functions. Insurers must regularly complete an Own Risk and Solvency Assessment; Under Pillar III, there are explicit requirements governing disclosures to supervisors and policyholders. 3 The short amending directive to Solvency II which was adopted on 3 July 2012 resulted in the original implementation date of 1 November 2012 in the Solvency II Directive being changed, with the new timetable requiring transposition by Member States on 30 June 2013 and implementation by firms from 1 January A market-consistent framework requires the values placed on assets and liabilities to be consistent with the market prices of listed securities and traded derivative instruments. 7

10 2.26. The Solvency Capital Requirement ( SCR ) in Solvency II is the amount of capital required to ensure continued solvency over a 1 year time frame with a probability of 99.5%. The SCR is calculated based on the particular risks to which the insurer is exposed The Minimum Capital Requirement under Solvency II ( MCR 2 ), which will be lower than the SCR, defines the point of intensive regulatory intervention. The MCR 2 calculation is more formulaic and less risk sensitive than the SCR calculation The basis for the Solvency II calculations has not yet been finalised, although some illustrative calculations have been prepared separately by SJE and BHII to assess the likely impact of the new regime. I have discussed in broad terms the likely impact of the Scheme on a Solvency II basis separately with the senior management of SJE and BHII. Through these discussions, consideration has been given to the likely change in financial strength under Solvency II as a result of the Scheme. The Insurers (Reorganisation and Winding Up) Regulations Under UK law, direct policyholders rank equally and above all other unsecured/non preferential creditors in the event that an insurer is wound up. The Financial Information in this Report The ICAS framework Pillar I balance sheet items as at 31 December 2011 shown in this Report have been published, externally audited and approved by the respective Boards of SJE and BHII As stated above, under the ICAS framework, Pillar II financial information is not published and remains private between the FSA and the company. I have therefore reviewed this information, and commented on it in general terms, but have not included any Pillar II figures in this report. 8

11 3. BACKGROUND ON SJE 3.1. SJE is a UK insurance company registered in England (registered number: ). It is authorised and regulated by the FSA with permission under Part IV of FSMA to effect and carry out contracts of general insurance for the following classes of business of Part I of Schedule I of Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 ( the RAO ): Accident, Aircraft, Aircraft Liability, Credit, Damage to Property, Fire and Natural Forces, General Liability, Goods in Transit, Land Vehicles, Legal Expenses, Liability for Ships, Miscellaneous Financial Loss, Motor Vehicle Liability, Ships, Sickness and Suretyship SJE s principal activity relates to the underwriting of general insurance risks of Japanese-owned commercial enterprises located in the European Union and to provide a stable supply of general insurance services to such businesses. The main classes of the on-going business written by SJE are: Accident; Employers Liability; Marine (mainly Cargo, also Hull from the 2008 underwriting year); Motor (discontinued after the 2007 underwriting year); Property; and Public/Product Liability SJE has branches established across Europe, including in Italy, Germany, Belgium, France, Spain and the Netherlands During 2011, SJE wrote gross premiums of 40.8 million (split roughly 40:60 between the UK and mainland Europe) and net premiums of 14.9 million. On an earned basis, gross premiums were 39.9 million and net premiums were 14.6 million. The net incurred loss ratio was 131%, and the combined ratio was 171% producing a loss after tax of 4.5 million (2010: loss 6.3 million) while Total Recognised Losses (i.e. allowing for pension commitments) came to 5.4 million (2010: loss 6.6 million) SJE wrote two tranches of now discontinued non-japanese business, namely UK local business and Italian branch legacy business as outlined in paragraphs 3.6to 3.9 below The UK local business was discontinued after the 2001 underwriting year. The main classes of the discontinued UK local business are: Accident; Employers Liability; Motor; Property; and Public/Product Liability The UK local business is at an advanced stage of development, with small claim reserves (circa 54k) The Italian branch legacy business was discontinued after the 2003 underwriting year, except for a small amount of Medical Expense business that continued to be renewed on a compulsory basis (these policies have now expired and remain in run-off, save for two medical expense policies, which are still in force and not transferring under the Scheme). The main classes of the discontinued Italian branch legacy business are: Accident (including footballer injury policies); Amateur Sports Clubs policies, which provide accident and liability cover; Marine Cargo; Medical Expenses; Medical Malpractice; 9

12 Property; and Public Liability Despite the maturity of the Italian branch legacy business there is a substantial volume of reported claims reserves, particularly for the very long-tailed medical malpractice and public liability classes. As at 31 December 2011, SJE carried reserves for the Italian branch legacy business of 85.3 million ( 66.6 million net of reinsurance). Many of these claims are in litigation in southern Italy, where it can often take many years before a judicial ruling is made (and there remains significant scope to appeal) As at 31 December 2011, the authorised share capital of SJE was 128,700,000 divided into 12,870,000 ordinary shares of 10 each, all of which was issued and fully paid On 27 February 2012, SJE s share capital was increased by 45.0 million and 4,500,000 ordinary shares of 10 each were allotted. On the same date SJE sold a material amount of listed fixed interest securities. The sales proceeds were 58.4 million. The book value of these investments at the time was 56.4 million, giving rise to a gain on sale of 2.0 million At the date of this Report, SJE enjoys a Standard & Poor s credit rating of A (stable), while its immediate parent company, Sompo Japan Insurance Inc. ( SJII ), a company incorporated in Japan, enjoys a Standard & Poor s credit rating of A+ (stable) On 1 April 2010, SJII became a wholly owned subsidiary of NKSJ Holdings Inc, which became the ultimate parent company of SJE. Reinsurance For 2011, SJE had a 40% Quota Share arrangement with SJII covering Property, Casualty and Marine risks. For the remaining portion of the risks there is reinsurance protection from a whole account excess-of-loss arrangement providing cover of 60% of 4.0 million excess 1.0 million (or 60% of 6.0 million excess 1.5 million). Above the whole account excess-of-loss arrangement there is comprehensive per risk excess of loss coverage. The effect of such reinsurance arrangements is that SJE should not suffer total net insurance losses beyond its Maximum Net Retention per risk per event of 600, All reinsurance (with a few exceptions, in particular in respect of fronting for captives) is placed with reinsurers with a Standard & Poor s credit rating of A or better (including SJII). SJE has a number of external reinsurers providing the reinsurance protections described above. For the financial year ended 31 December 2011, their share of gross written premiums was 25.9 million (or 63.6%). As at 31 December 2011, the major external treaty reinsurers were Lloyd s syndicates, Munich Re, Ark Re (another subsidiary of SJII), Swiss Re and Odyssey America Re. Major facultative reinsurers were Concord Enterprises Insurance, Evergreen Re, Mitsui Sumitomo, Pool Re and Tokio Marine It is anticipated that all reinsurers with outstanding claims will be advised as part of the communication process under the Scheme (see Section 10 for further details). NICO Agreement SJE has entered into a reinsurance agreement protecting the Transferring Business (the NICO Agreement ). The reinsurer under this agreement is National Indemnity Company (NICO), which is part of the Berkshire Hathaway group. The NICO Agreement covers only certain types of business written by SJE, but all of the business being transferred (as described in paragraph 1.5 above) The NICO Agreement was entered into on 16 March 2012 based on the reserves held by SJE as of the end of 2010 and is therefore retroactive to 1 January The purpose of entering into the NICO Agreement was to secure interim protection for SJE against any adverse impact of the run-off of claim reserves held in respect of the Transferring Business until such time as the Scheme becomes effective so as to cut off the future liabilities of SJE attributable to the Transferring Business The NICO Agreement provides cover of up to 200 million in respect of the settlement of claims attributable to the Transferring Business on or after 1 January 2011 and applies at a level net of other reinsurance recoveries. Any emerging reinsurance bad debt is also covered by NICO NICO has undertaken to increase the limit of the cover by 50 million to 250 million if the Scheme is sanctioned. 10

13 3.21. SJE remains responsible for administering the run-off of the business. This includes administering, settling and paying claims. Under the terms of the NICO Agreement, SJE is obliged to delegate the administration to a claims servicer approved by NICO. SJE, pursuant to a Run-off Management Agreement, appointed Resolute Management Limited, an affiliate of NICO within the Berkshire Hathaway Group, to conduct the administration of the run-off from the commencement of the NICO Agreement The NICO Agreement is governed by UK law, and should therefore transfer under the Scheme, and furthermore, NICO has assured me that it will honour its obligations under the NICO Agreement posttransfer As described in paragraph 3.21 above, SJE is responsible for administering the run-off of the business under the direction of NICO and it assigns/sub-contracts this work to Resolute Management Limited pursuant to a Run-off Management Agreement. At the Effective Date, the Run-off Management Agreement will terminate, and the administration and servicing of the Transferring Business will continue to be undertaken by Resolute Management Limited on behalf of BHII in accordance with the existing Berkshire Hathaway UK Group Shared Services and Cost Sharing Agreement. Therefore there will be no change in administration and servicing of the Transferring Business as a result of the Scheme, and furthermore BHII has assured me that this will be the case. Risks SJE is exposed to a large number of risks in the course of its operations. The key risks may be classified under the headings of insurance, market, liquidity, credit, operational, group and pension scheme risk Insurance risk relates to the inherent uncertainties in the occurrence, amount and timing of insurance liabilities, both in the existing business and in the on-going underwriting. This covers the risk of reserve deteriorations on the existing liabilities, inappropriate pricing methodologies leading to inadequate premiums; the risk of catastrophes (e.g. earthquakes), and the risk of increased expenses Market risk relates to SJE s investment portfolios, and arises mainly from exposure to changes in interest rates, foreign exchange rates and changes in the market value of equities and other assets. A decrease in the value of the assets backing the insurance contracts could adversely affect the financial position of SJE to the extent that a movement (in particular, a fall) in asset values is not matched by a corresponding movement in liability values Liquidity risk relates to the inability of SJE to meet its cash outflows as they fall due as a result of a mismatch in the timing of cash inflows and outflows Credit risk relates to the risk of default by counterparties such as reinsurers and of corporate and government bonds. Operational risks are the risks to which SJE is exposed during its day to day operations, mainly arising from possible failures of internal processes, people and systems, or from external events SJE is exposed to risks from other parts of the NKSJ Group. Group risk could, for example, arise from reputational issues resulting in lower than anticipated new business volumes SJE operates a defined benefit pension scheme in the UK. The funding position of the pension scheme is sensitive to the assumptions made from time to time (including inflation, interest rate, investment return and mortality) to determine its long-term liabilities relative to the corresponding market value of the pension fund s assets. In particular, the financial position of the pension fund is highly sensitive to changes in bond yields and will also be impacted by changes in equity markets There is a range of actions that SJE management can take and has taken to mitigate the risks facing the business. For example, SJE uses techniques which include asset liability management strategies, monitoring the financial strength of its reinsurers, and review by external consultants of SJE s reserve risk exposure. Governance FSA Conduct Principles SJE has set up a strategy for compliance with the FSA s conduct principles. The key components of this strategy are on-going risk assessment, staff training, policies and procedures identifying key controls such as complaints-handling, management of conflicts of interest, and monitoring of management information reported on an exception basis to governance bodies. 11

14 3.33. SJE has in place a number of controls to ensure that the six outcomes for the fair treatment of customers (see paragraph 2.23 above) are met. These include production manuals for both SJE and the UK detailing SJE s policy for providing excellent customer service; complaints handing policies, set with regard to FSA and local regulatory requirements; and a conflicts of interest policy All UK staff are required to complete training in the fair treatment of customers, regional branch staff are expected to have training bearing in mind any local standards. UK staff and senior branch staff receive an induction course by the Compliance Department covering the fair treatment of customers as one of the most important regulatory topics Details of complaints are reported to the Executive Committee on a quarterly basis, and summarised and presented to the Audit and Risk Committee. The Compliance Director separately reports to the Audit and Risk Committee on key risk issues, including any breaches or weaknesses in controls relating to the fair treatment of customers SJE has assessed its risk in relation to the fair treatment of customers to be low, given its small number of retail clients and the small number of complaints or issues identified. 12

15 4. BACKGROUND ON BHII 4.1. BHII is a UK insurance company registered in England (registered number: ). It is authorised and regulated by the FSA with permission under Part IV of FSMA to carry out contracts of general insurance for the following classes of business of Part I of Schedule I of Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 ( the RAO ): Accident, Aircraft, Aircraft Liability, Credit, Damage to Property, Fire and Natural Forces, General Liability, Goods in Transit, Land Vehicles, Legal Expenses, Liability for Ships, Miscellaneous Financial Loss, Motor Vehicle Liability, Railway Rolling Stock, Ships and Sickness BHII s operations are directed from London but it also has branch offices in Switzerland and Italy BHII has three significant areas of underwriting activity: its participation in the Global Aerospace Underwriting Managers (GAUM) aviation pool; writing Energy business through agreements with major energy brokers in the London Market; and writing high level US Liability coverages through an in-house underwriting team BHII has also been developing an Italian Medical Malpractice business During 2011, BHII wrote gross premiums of million and net premiums of 30.0 million. Of the gross premiums, 26% were in respect of Aviation business, 60% Property and 14% Liability. The vast majority of these premiums were in respect of direct business, with less than 1% in respect of Liability inwards reinsurance. On an earned basis, gross premiums were million and net premiums were 26.5 million. The net incurred loss ratio was 102%, and the combined ratio was 119% producing a loss after tax of 0.9 million (2010: profit 2.4 million). BHII s 2011 result was adversely affected by the large Maersk Gryphon Floating Production and Storage Facility loss which has an estimated market loss of $1 billion, of which BHII s share is $100 million gross ($7.9 million net) As at 31 December 2011, the authorised share capital of BHII was 59,716,169 divided into 59,716,169 ordinary shares of 1 each, all of which was issued and fully paid BHII s immediate parent company is NICO, a company incorporated in the US state of Nebraska. Its ultimate parent company is Berkshire Hathaway Inc., a company incorporated in the United States of America. As at the date of this Report, BHII enjoyed a Standard and Poor s credit rating of AA+, together with the other insurance companies in the Berkshire Hathaway group. NICO 4.8. NICO is a major US insurer. It has 750,000 shares of $10 par value common stock authorised and 550,000 shares issued and outstanding, i.e. capital paid-up of $5.5 million NICO writes a wide variety of business, predominantly on a reinsurance assumed basis. During 2011, NICO wrote $6.1 billion of gross premiums of which over 98% was reinsurance assumed (about 20% being reinsurance of affiliates). Written premiums were dominated by non-proportional property and liability assumed reinsurance. The main direct lines written were commercial auto liability and aircraft As at 31 December 2011, NICO had admitted assets (excluding protected cell business) of $115.4 billion, and total liabilities (excluding protected cell business) of $45.3 billion. The excess admitted assets were therefore $70.1 billion. 13

16 Reinsurance BHII has two significant reinsurance contracts with NICO for new business. The first is a 100% quota share agreement whereby BHII cedes the first 15% of its 23.39% share in the GAUM pool to NICO (which is retroceded to SCOR SE). The second reinsurance treaty provides quota share protection by business line and covers Aviation (65%, for business not ceded under the first reinsurance), Energy, Casualty and Construction (each 80%). For each line, BHII is also protected by the following additional reinsurance protections from NICO: Risk specific cover for each and every claim above 5 million retained by BHII after the quote share; and An account wide excess of loss protection of 200% in excess of 110% of net retained premium (after quota share and risk specific protections) These arrangements are automatically renewed on an annual basis unless either party gives notice. Ceding commissions are paid to the reinsurer to pay its quota share proportions of all expenses associated with the business. Risks BHII is exposed to a large number of risks in the course of its operations. The key risks may be classified under the headings of insurance, market, liquidity, credit, operational, and group risk (as per SJE see Section 3 for a general discussion thereof) The insurance risk for BHII is magnified at a gross of reinsurance level as it is exposed to very large gross claims (as seen recently in the case of the Maersk loss mentioned above). However, as noted in paragraph 4.11 above, insurance risk is mitigated at a net level by the extensive use of reinsurance Credit risk relates to the risk of default by counterparties such as reinsurers and on corporate and government bonds. BHII is extensively reinsured, in particular by NICO, and as such has a heavy exposure to credit risk BHII is exposed to risks from other parts of the Berkshire Hathaway Group. Governance FSA Conduct Principles BHII is committed to the fair treatment of customers, and to ensure that fair outcomes are delivered to customers. The key components of this framework are culture and governance Staff are required to be fair in all their dealings with clients and others There are processes in place to report and deal with any shortcomings in maintaining the open and honest culture, of which the fair treatment of customers is an integral part The Board has overall responsibility for ensuring that the fair treatment of customers objective is met. A governance structure has been implemented to enable the objectives to be met and to embed a culture which ensures that the fair treatment of customers objective is met throughout the business. 14

17 5. THE PROPOSED SCHEME Motivation for the Scheme 5.1. SJE is seeking the elimination of the future uncertainty associated with its Italian branch legacy business. This would provide a reduction in the risk of claim volatility; relief from the burden of run-off management; and the opportunity to reconfigure SJE s business in Italy Accordingly, the Scheme has been formulated to transfer the Italian branch legacy business (as specified in paragraph 1.5 above) of SJE to BHII. To accomplish this transfer the Court s consent is needed. Outline 5.3. Under the proposed Scheme the Transferring Business will be transferred from SJE to BHII. All general insurance liabilities in respect of the Transferring Business, and appropriate assets of the same value, will be transferred on the Effective Date All future income (other than premiums) and outgoings arising from the Transferring Business will pertain to BHII (together with all future income and outgoings of the BHII insurance business) The liability for the policies issued by SJE that form part of the Transferring Business, which currently rests with SJE, will be transferred to BHII. Existing policyholders of SJE in respect of the Transferring Business will become policyholders of BHII The Scheme includes a provision that is designed to effect the transfer of each applicable reinsurance protection, including the NICO Agreement, from SJE to BHII Table 5.1 below shows the balance sheet for BHII pre and post the proposed Scheme as at 31 December The figures are based on BHII s 31 December 2011 accounts and an assessment by SJE s external actuaries of the value of the liabilities of the Italian branch that will be transferred to BHII. This assessment estimated gross outstanding claims at million. The technical provisions post-scheme shown in Table 5.1 include an amount of 85.3 million (i.e million converted to pounds at 1 = 1.2). As the existing external reinsurance and the NICO Agreement are planned to transfer to BHII, the net increase in liabilities will be nil and hence reinsurers share of Technical Provisions shown in Table 5.1 also increase by million post transfer. Table 5.1: Simplified Balance Sheets for BHII as at 31 December 2011 '000 Pre-Scheme Post-Scheme Assets Investments 171, ,839 Reinsurers' share of technical provisions 415, ,544 Debtors 39,373 39,373 Cash in hand 3,626 3,626 Pre-payments and accrued income 3,749 3, , ,131 Liabilities Capital and reserves 70,866 70,866 Technical provisions 518, ,879 Creditors 44,386 44, , ,131 15

18 5.8. Table 5.2 below illustrates the effect both of the Scheme and of the NICO Agreement on SJE s balance sheet. The pre-scheme figures are as per SJE s 31 December 2011 audited accounts. The pre-scheme post NICO Agreement figures show, approximately, the effect on the balance sheet (as at 31 December 2011) of entering into the NICO Agreement, as well as the increase in capital and sale of investments (as described above in paragraph 3.11 above) and SJE s commutation with SJII in respect of the Transferring Business (see paragraph below). These post balance sheet date events were recorded in a note to SJE s audited accounts. The post-scheme figures reflect the transfer of technical provisions and the corresponding reinsurers share of Technical Provisions to NICO as a result of the Scheme. The figures also reflect the expected costs of the Scheme. Table 5.2: Simplified Balance Sheets for SJE as at 31 December 2011 '000 Assets Pre-Scheme Pre-Scheme, Post NICO Agreement Post-Scheme Investments 133,858 97,802 97,802 Reinsurers' share of technical provisions 44, ,546 26,148 Debtors 10,749 10,749 10,749 Cash in hand 7,677 7,677 6,927 Pre-payments and accrued income 3,078 3,078 3,078 Tangible assets 1,599 1,599 1,599 Liabilities 201, , ,303 Capital and reserves 56,215 87,225 86,475 Technical provisions 133, ,079 47,681 Creditors 8,057 8,057 8,057 Accruals 2,014 2,014 2,014 Pension scheme liabilities 2,076 2,076 2, , , , Post the proposed transfers, the administration and management of the Transferring Business will be undertaken by Resolute Management Limited in the same manner as currently (see paragraph 3.23 above) No compensation will be paid to the policyholders (or to the shareholders) of SJE in consideration of the transfer of the Transferring Business (and appropriate assets) to BHII, although BHII will assume the insurance liabilities in respect of the Transferring Business The external costs of the transfer will be met by SJE Nothing in this Report should be regarded as providing a legal opinion on the effectiveness of the proposed transfer I have not considered any alternative scheme. Policyholders Affected I have considered the effects of the Scheme on three main groups of policyholders, namely: 1. those policyholders of SJE whose policies are to be transferred; 2. those policyholders remaining in SJE; and 3. the current policyholders of BHII The Effective Date of the Scheme is expected to be 31 December Compensation and Complaints After the implementation of the Scheme, as with all other insurance companies with an establishment in the UK, BHII will be required to participate in the FSCS. Therefore, to the extent they currently meet the qualifying criteria (as set out in paragraph 2.8 above), the transferring Italian branch policyholders of SJE will 16

19 continue to be protected by the FSCS if the Scheme is sanctioned The Scheme will have no effect on the eligibility of any group of policyholders to bring complaints to the UK FOS. If, as described in Section 2, they are currently able to bring complaints to the FOS, this will remain the case after the implementation of the Scheme. If they are currently not eligible to complain to the FOS this will also remain the case after the implementation of the Scheme. FSA Conduct Principles As noted in Section 2 the FSA places great emphasis on firms achieving fair outcomes for consumers, i.e. in this case that SJE and BHII provide fair treatment to their respective customers. This fair treatment requirement will still apply with respect to policyholders in SJE and BHII after the proposed transfer Under the separate SJE and BHII approaches to the fair treatment of customers, service delivery involves: Claims being handled fairly, consistently and promptly in line with customer expectations and product promises; Products performing as designed and as expected by third parties and customers; and Sales and service being in line with customer expectations and product promises SJE s current approach to the fair treatment of customers is outlined in Section 3 and that of BHII in Section 4. I have no reason to believe that implementing the Scheme will affect the way in which the claims are currently being handled and the management of BHII and SJE have separately assured me that there will be no change. Administration After implementation of the proposed Scheme, the remaining business of SJE will continue to operate as it currently does. This includes underwriting, claims, operations, risk management and systems The management of BHII has assured me that, following the proposed transfer under the Scheme, there will be no change to the approach to managing and administering BHII s business, including the approach to managing and administering the Transferring Business which will continue to be administered by Resolute Management Limited a (see paragraph 3.23 above). Excluded policies Any policies which are not capable of being transferred for legal reasons will be treated as Excluded Policies and will be fully reinsured to BHII with effect from the Effective Date. The Capital Policy after the Scheme Following the implementation of the Scheme, BHII and SJE will continue, as required by UK regulation, to maintain capital for the entirety of their businesses to support their respective ICAs Capital in both SJE and BHII is currently maintained using a risk-based approach in line with the ICA, as set out in Section 2, such that each company remains solvent relative to regulatory confidence levels over a one year (new business) time horizon The capital policy set out above will be replaced by a suitable alternative following the implementation of Solvency II, currently due to take effect for firms from 1 January

20 The Approach to Communication with Policyholders SJE and BHII have set out the approach they intend to take in communicating information about the proposed transfer of business to the affected policyholders and other parties The main objectives of the SJE and BHII communications are to: Give policyholders the information they need to understand the proposed changes; Inform affected policyholders about the implications for them of the proposed changes; Give affected policyholders access to further information (beyond that in the communications pack); Let affected policyholders know how to object to the proposed changes; Maintain customers confidence in SJE and BHII (as appropriate) to continue to meet their obligations under transferring and non-transferring policies; and Meet legal and regulatory requirements SJE proposes to contact transferring policyholders/potential claimants and third parties areas as described in Section 10. SJE does not intend to notify any of its non-transferring general insurance policyholders of the proposed transfer BHII proposes to contact brokers as described in Section 10. BHII does not intend to notify any of its general insurance policyholders directly The overall approach proposed by BHII and SJE to communication with policyholders has been constructed to be proportionate to the expected impact of the Scheme on affected policyholders. I comment on this proposed approach to communications with policyholders in Section

21 6. GENERAL CONSIDERATIONS OF THE INDEPENDENT EXPERT Introduction 6.1. I have compiled my report in accordance with Chapter 18 of the Supervision Manual of the FSA Handbook Under applicable FSA rules, the concept of the fair treatment of customers should be applied. To help ensure that customers are treated fairly in the future it is necessary to understand how they have been treated in the past. From the policyholders perspective, the acceptability of the Scheme must be on the basis that it will not have a materially adverse effect on their benefits or fair treatment I need to consider the terms of the Scheme generally and how the different groups of policyholders are likely to be affected by the Scheme and, in particular: The effect of the Scheme on the security of the policyholders contractual rights, including the likelihood and potential effects of the insolvency of the insurer; and The likely effects of the Scheme on policyholder servicing levels (e.g. claims administration) As described in Section 4 of this report, there are 2 insurance companies involved in the Scheme, each of which has a different mix of business It is therefore important that I consider whether this change in the size and nature of the companies involved will have any impact on the security of benefits or reasonable expectations of affected policyholders The main factors that determine the risks to which a policyholder of an insurance company is exposed are: Size of the company; Amount of capital held, other calls on that capital and capital support currently available to the company; Reserve strength; Investment strategy; Mix of business written; and Company strategy for example, whether it is open or closed to new business. Security of Policyholder Benefits 6.7. As part of my role as Independent Expert for the Scheme, I need to consider the security of policyholder benefits; that is, the likelihood that policyholders will receive their benefits when due, e.g. the payment of claims In considering and commenting upon policyholder security I shall consider the financial strength of each entity. Financial strength is provided by the margins for prudence in the assumptions used to calculate the Technical Provisions, by the shareholder capital and by any specific arrangements for the provision of financial support. In considering policyholder security it is also necessary to take into account the potential variability of future experience (including claim frequency and severity). Security is also affected by the nature and volume of future new business The nature of the assets which constitute each company s capital and surplus is also relevant. The shareholder is able to withdraw surplus shareholder assets (i.e. retained profits, but not share capital) in the form of realised profits, provided minimum capital requirements are met. The security provided by such assets may therefore be temporary. Policyholder Servicing Levels SUP requires me, as Independent Expert, to consider the likely effects of the Scheme on levels of service provided to policyholders This includes consideration of the likely effects of the Scheme on matters such as claims management, investment management, new business, administration, expense levels and valuation bases impacting 19

22 levels of service to policyholders. FSA Conduct Principles As Independent Expert for the Scheme I need also to consider the proposals in the context of the FSA s conduct principles and in particular the impact on levels of service provided to policyholders This involves consideration of areas where discretion is involved on behalf of the relevant insurance company with regard to charges applied to a policy and the benefits granted to the policyholder, and also to service standards applied. Development of the Scheme In the following sections I comment on the Scheme as it will be presented to the Court. During the development of the proposed terms of the transfer I have commented on drafts of the Scheme. 20

23 7. THE EFFECT OF THE SCHEME ON THE TRANSFERRING POLICYHOLDERS Introduction 7.1. Under the Scheme, the Transferring Business will be transferred from SJE to BHII The main issues affecting the transferring policyholders of SJE as a result of the Scheme arise from relative differences in: The financial strength of BHII after the transfer compared to that of SJE currently. Financial strength is derived from the strength of the reserves held, excess assets or capital, and specific capital support arrangements (and the calls on that capital support). The risk exposures in BHII compared to those in SJE. The policy servicing levels provided by BHII after the transfer compared to those enjoyed by the policyholders of SJE currently In this section I address each of the issues. The Change in Financial Strength due to the Scheme RESERVE STRENGTH OF SJE 7.4. I have been provided with an external actuarial analysis on the technical reserves of SJE as at 31 December I have also been provided with a separate external actuarial analysis (undertaken by the same actuaries) on the technical reserves for the Italian branch legacy business (the vast majority of which is to be transferred under the Scheme), also as at 31 December The results of the analysis for the Italian branch legacy business are incorporated into that for SJE as a whole These external actuarial analyses provide details on the methodologies and assumptions used in setting reserves for this business For the purpose of preparing its statutory accounts and regulatory returns as at 31 December 2011, SJE based its selected reserves on the results of the external actuarial review. Table 7.1 below shows SJE s selected reserves, as per its 31 December 2011 report and accounts. Table 7.1 SJE Booked Reserves as at 31 December 2011 ( 000s) '000s Booked Claims Reserves Gross Net Claims outstanding 59,299 39,855 IBNR 61,518 42,832 Unearned premium reserve 9,726 3,376 Claim handing expenses 1,545 1,545 Equalisation provision Total technical provisions 133,079 88, The total gross claims reserve (i.e. claims outstanding plus IBNR) projected by the external actuaries was million, as compared to million booked by SJE (as shown in Table 7.1 above). On a net of reinsurance basis the external actuaries reserve was 82.4 million as compared to 82.7 million booked. I am informed by SJE that the differences relate to slightly different exchange rates being used by the external actuaries and those used in the accounts and a small number of contracts (that do not form part of the Transferring Business) that were outside the scope of the external actuarial review The external actuaries did not make an independent assessment of the unearned premium reserve or claims handling expenses, although they undertook a high-level review of the methodology used by SJE to derive these figures Table 7.2 below shows a breakdown of the external actuaries claim estimates by segment. 21

24 Table 7.2 Breakdown of External Actuaries Reserve Estimates for SJE as at 31 December 2011 ( 000s) Region Japanese/ non- Gross Net Japanese OS IBNR Reserve OS IBNR Reserve UK Japanese 5,418 8,644 14,062 2,326 4,216 6,542 Non-Japanese Branches Japanese 11,879 7,900 19,779 4,031 4,650 8,681 Italy Japanese , Non-Japanese 40,718 44,553 85,270 32,928 33,683 66,610 Total 58,993 61, ,389 39,676 42,742 82, As can be seen from Table 7.2 above, as at 31 December 2011 SJE s liabilities were dominated by the local Italian (i.e. non-japanese) business, the vast majority of which is to be transferred under the Scheme. As described in paragraph 1.5 above, all non-japanese Italian branch business other than two medical expense policies (for which booked reserves amounted to 70,000 gross of reinsurance and 42,000 net of reinsurance as at 31 December 2011) will be transferred under the Scheme. As described above, since the 2011 year-end SJE has entered into a reinsurance agreement with NICO in respect of the Transferring Business. As a result of this, at the date of this report, SJE s net liabilities in respect of this business are estimated to have reduced to nil The external actuaries have used generally accepted actuarial methods (predominantly the chain-ladder method) to estimate reserve requirements. Their estimates are intended to represent the expected value or mean (average) value of the claims liabilities. I interpret this measure to be on a basis higher than a 50% confidence level 5 (as the claim distribution is expected to be positively skewed 6 ) I have reviewed the work carried out by the external actuaries, in order to satisfy myself that it is reasonable for me to rely on their work. This included reviewing the reports and assessing the appropriateness of the methodologies and major assumptions used I have not attempted to review in detail the calculations performed by the external actuaries. Instead, I have reviewed the process by which reserves are set, the approach followed to assess the key areas of reserve uncertainty and the apparent strength of the reserves based on this review. Local Italian business The liabilities of the Transferring Business are dominated by medical malpractice liability claims (about 75% of projected claim reserves), but there are also other significant public liability and accident claims outstanding The account has suffered poor claims experience over several years, and continues to do so. The external actuaries estimated ultimate claims deteriorated by 14.6 million gross over 2011, driven by adverse claim developments on the medical malpractice book Based on information received from SJE I understand that the legal environment, particularly in southern Italy, from where many of the claims emanate, is such that judicial rulings can take many years to be made and there is considerable scope for appeal. There also appears to be a lack of consistency in judicial rulings and there are issues with the enforceability of notification periods within contracts. These factors lead to a considerable degree of uncertainty in the estimates for the Italian liability claims Furthermore, again based on information received from SJE, I understand that recent changes to the Tables of Damages issued by the Courts of Milan and Rome for assessing the size of damages for liability claims have further complicated matters. The effect they will have on actual awards is uncertain as they are not binding on any Italian courts. In addition, the fact that past paid amounts and current outstanding claims in the triangles used by the external actuaries to make their projections have been paid/set with regard to differing sets of Tables creates a potential distortion in the claim development factors that can be derived 5 A 50% confidence level, in relation to the claim reserve, is the likelihood that the claim reserve estimate will prove adequate to meet the corresponding claims in half of the outcomes. For a symmetrical claims distribution the average corresponds to the 50% confidence level. 6 A claims distribution of potential losses is said to be positively skewed as the loss cannot be less than zero, but can be many times larger than the average loss (alternatively, this may be viewed as a distribution of potential losses having a higher frequency of lower value losses, and a lower frequency of higher value losses, e.g. observed losses of: 1, 2, 3, 4, 100). 22

25 from the triangles. The external actuaries have attempted to make an assessment of the impact of the introduction of the new Tables on the historic data and have adjusted their results to make an allowance for potentially higher awards in the future. Other business The vast majority of SJE s other outstanding liabilities is in respect of its Japanese business written in the UK and in its continental European branches SJE continues to write a variety of Liability, Marine, Property and Accident covers for Japanese companies European operations Employers Liability accounted for around 40% of outstanding claims in the UK operation as at 31 December This includes some exposure to disease claims, in particular industrial deafness for which the external actuaries have undertaken a separate projection based on a frequency-severity approach SJE also has small outstanding reserves in relation to its UK local business which was discontinued in There is apparently no material exposure to asbestos or other disease claims. The external actuaries reserves for this business amounted to just 54,000 as at 31 December Conclusion Notwithstanding the significant degree of uncertainty in the Italian liability claims, I am satisfied that the methodologies, major assumptions and results of the external actuaries (as essentially adopted by SJE) as at 31 December 2011 appear reasonable SJE does not reflect the time value of money in its claims reserves. This gives rise to an off balance sheet asset (safety margin) equivalent to the time value of money inherent in the undiscounted part of the reserves. Such a safety margin increases the security of the policyholders Overall, based on my review as described above as at 31 December 2011, the reserves of SJE appear reasonable. However, the exposures associated with the Italian liability claims mean that there is a considerable degree of uncertainty attached to the ultimate value of claims for SJE gross of reinsurance. The degree of uncertainty associated with the ultimate value of claims for SJE net of reinsurance is substantially reduced by the operation of the NICO Agreement. RESERVE STRENGTH OF BHII I have been provided with minutes from BHII s 2011 year-end reserving committee meeting, together with associated papers providing a split of the claims reserves by business line and a description of the approach taken to reserving for each line Table 7.3 below shows a breakdown of BHII s Technical Provisions, as reported in its report and accounts as at 31 December Table 7.3 BHII Technical Provisions as at 31 December 2011 ( million) m Booked Technical Provisions Table 7.4 below shows a breakdown of BHII s outstanding claims reserve by the main accounts written. Gross Net Claims outstanding (inc. IBNR) Unearned premium reserve Claim handing expenses Equalisation provision Other technical provisions Total technical provisions

26 Table 7.4 BHII Claims Outstanding by Segment as at 31 December 2011 ( million) m Claims Outstanding As shown in Table 7.4 above, BHII s principal lines of business are its participation in the GAUM aviation pool, and its Energy and US Casualty accounts. In addition, BHII has liabilities in relation to a number of other smaller lines of business Reserves in respect of GAUM, which underwrites Airline, Products, General Aviation and Space insurance lines, have been set with reference to an external actuarial review commissioned by GAUM (to which I have had access), GAUM s own internal actuarial review, and a review undertaken by NICO. The external actuarial review highlights some of the uncertainties to which GAUM is exposed including potentially very long tailed products liability claims The approach to reserving the Energy account, which is composed largely of property risks (with approximately 10% being liability risks), follows a formulaic approach up to the 10 th development quarter (to allow for the considerable lags that are anticipated in the reporting of claims), i.e. the reserves are based on defined percentages (dependent on development quarter) applied to premiums corresponding to the development quarter under consideration. From the 10 th quarter an actuarial assessment is made based on actual claims experience A formulaic approach, consistent with that used by NICO, is also used to reserve for the Casualty account, based on the policy limits, type of business and type of contract BHII is exposed to very large gross losses from both the Energy and Casualty lines, but, as outlined in Section 4 above, through its reinsurance arrangements with NICO its net exposures are limited Reserves in respect of the other lines written by BHII are mainly assessed by NICO or other parts of the Berkshire Hathaway group, and, in the case of the Swiss branch (for which gross reserves were less than 1 million), by an external actuarial firm BHII sets its reserves on a conservative best estimate basis. I interpret this measure to be on a basis higher than a 50% confidence level (as the claim distribution is expected to be positively skewed) I have reviewed the actuarial and other analyses made available to me by BHII and have discussed the liabilities and approach to reserving with key BHII personnel While there is a considerable degree of uncertainty attached to the business written by BHII, this is greatly limited by the reinsurance arrangements in place with NICO. I am satisfied that the methodologies, major assumptions and results of the actuarial and other analyses used by BHII to set reserves as at 31 December 2011 appear reasonable With the exception of a single periodical payment order ( PPO ) claim, BHII does not reflect the time value of money in its claims reserves. This gives rise to an off balance sheet asset (safety margin) equivalent to the time value of money inherent in the undiscounted part of the reserves. Such a safety margin increases the security of the policyholders. Gross Net GAUM Energy Casualty Holdsure Liability Medical Malpractice Others Total Conclusion Overall, based on my review as described above as at 31 December 2011, the reserves of BHII appear reasonable at present. 24

27 BHII RESERVE STRENGTH POST TRANSFER The main risk to consider is the risk that the liabilities of the transferring policies, or of BHII, deteriorate posttransfer to such an extent that BHII s solvency is threatened. This event could disadvantage policyholders of BHII and/or the transferring policyholders of SJE that might have remained secure had the transfer not taken place Reserves in respect of Italian branch local liabilities to be transferred under the Scheme were assessed by the external actuaries at million gross and 79.9 million net as at 31 December As explained in Section 3 above, in March 2012, SJE entered into a reinsurance agreement with NICO under which NICO reinsured the net liabilities (and any reinsurance bad debt) up to a limit of 200 million (effective from 31 December 2010). During 2011 approximately 10 million net claims were paid and so, as at 31 December 2011, the NICO reinsurance continued to provide more than 100 million of additional protection to SJE, in excess of its net reserves Under the Scheme, the benefit of the NICO Agreement will transfer to BHII. Therefore, while BHII s gross outstanding claims reserves will increase by around 85 million (about 20%); net of reinsurance they are estimated to remain unchanged. Further, the liabilities reinsured under the NICO Agreement represent a very small proportion (less than 1%) of NICO s net carried reserve as at 31 December Therefore, the NICO Agreement is very unlikely of itself to have a material impact on the financial position of NICO The reserving basis adopted by BHII after the Effective Date will continue to be on a conservative best estimate basis. I am satisfied, therefore, that the reserving levels adopted by BHII after the Effective Date will continue to be established on a basis stronger than a 50% confidence level On the basis that outwards reinsurance contracts of the transferring portfolio are transferred to BHII as part of the Scheme the net (of reinsurance) position of BHII should not be adversely impacted as a result of the Scheme Overall, therefore, I would expect BHII to be reasonably reserved after the Effective Date. Conclusion I believe that the Scheme is unlikely to have a materially adverse effect on the reserve strength provided to the transferring policyholders of SJE compared to both their current position and their projected position at the Effective Date. EXCESS ASSETS OF SJE (PRE TRANSFER) At a simple level, one measure of the capital strength of SJE is the ratio of capital resources to net written premiums. This ratio was 400% as at 31 December As at 31 December 2011 the policyholders of SJE enjoyed the security of capital resources (i.e. assets available to meet regulatory capital requirements) as recorded in SJE s 2011 FSA return of 59.4 million compared with a statutory minimum capital requirement of 10.5 million. The Solvency I cover ratio for the MCR was therefore 5.7 (available regulatory capital divided by the MCR) and the free assets equal to 49.0 million (i.e. capital resources less MCR) SJE is protected by SJII under the terms of a Net Worth Agreement whereby the parent agrees to cause SJE to have adequate capital resources (at least 250% of the MCR) to meet its obligations as they fall due. I have been provided with a copy of the unconsolidated accounts for SJII for the year ending 31 March SJII is a large Japanese general insurer with net premiums written for the year to 31 March 2012 totalling 1.3 trillion (approximately $16.1 billion based on exchange rates at the time of writing). The balance sheet of SJII showed total assets of 4.8 trillion ($57.9 billion), total liabilities of 4.0 trillion ($50.6 billion) and net assets of 0.6 trillion ($7.3 billion). SJII reported a regulatory solvency margin (excess assets) of 1.2 trillion ($15.3 billion) please note that this figure includes, amongst other items, catastrophe loss reserves which are deducted from the net assets figure of 0.6 trillion ($7.3 billion). It reported a solvency margin ratio of 502.5% relative to its risk-based regulatory solvency requirement of billion ($3.0 billion), i.e. excess assets risk-based regulatory solvency requirement On an Enhanced Capital Requirement ( ECR ) basis (a more risk sensitive and targeted capital requirement than the MCR), the policyholders of SJE also enjoyed a good level of surplus of capital resources (i.e. assets 25

28 available to meet regulatory capital requirements) relative to the ECR as at 31 December On the Solvency I and ECR measures, both in terms of the level of free assets and the solvency cover ratio, the capital resources of SJE at 31 December 2011 were satisfactory when considered alongside the risks facing the company Since 31 December 2011, SJE has entered into a reinsurance contract with NICO in respect of the Italian branch local liabilities, as described in Section 3 above. The premium paid to NICO for the reinsurance removes net liabilities estimated by the external actuaries to be in the order of 79.9 million as at 31 December In addition, SJE has received a 45 million (approximately 54 million) capital injection from its parent. Overall, following these developments, SJE s available capital has increased since 31 December I have been provided by SJE with a document showing the results of an analysis of the effect of the NICO Agreement on SJE s solvency margin using a number of different measures. The analysis is as at 30 September It shows the MCR unchanged as a result of the transaction due to the use of the prior year s MCR in the calculation (see Appendix 5). As the capital resources in SJE have increased as a result of capital injection, the solvency ratio, measured relative to the MCR, has also increased The analysis also shows a reduction in the ECR as a result of the NICO Agreement. This results from a reduced technical provision charge (which is based on net technical provisions) under the ECR formula. The analysis therefore also shows the solvency ratio improving on an ECR basis In line with regulatory requirements, SJE has made an Individual Capital Assessment ( ICA ) of its capital needs. SJE has made available to me its most recent ICA, undertaken as at 31 December 2011, as well as the previous ICA undertaken as at 31 December The 2011 ICA has been prepared on two bases: one reflecting the actual position as at 31 December 2011, the other reflecting the post-date NICO Agreement and capital injection. In each case the ICA estimates, the amount of capital required in order to maintain its ability to meet its obligations with a 99.5% confidence interval over a (new business) time horizon of one year. Additionally, SJE has also provided me with a document giving details of projections for its ICA over the next 3 years, incorporating a proposed new line of business, which I discuss further in Section The ICA sets out the risks to which SJE is exposed and SJE s approach to modelling the risks for quantifying the ICA, and its approach to managing risks more generally The main areas of risk to which SJE is exposed are summarised in Section 4. SJE commissions external actuaries to evaluate underwriting and reserving risk. I have been provided with the external actuaries reports on underwriting and reserving risk as at 31 December 2010 and draft report as at 31 December Assumptions on other major areas of risk are provided to SJII for modelling using their internal capital model. The firm has used Correlation (as defined in Appendix 1) assumptions from QIS5 to aggregate the main risk categories I have reviewed the ICA document made available to me by SJE and have discussed the results and assumption used with key personnel at SJE I have considered the appropriateness of the methodology and modelling techniques used. I have also considered the reasonableness of the key assumptions used in the calculations and the results of these calculations. In assessing the reasonableness of the methodology, assumptions and results, I have considered how they compare against my knowledge of the market The correlation assumptions adopted by SJE for ICA purposes (see paragraph 7.56 above) do not appear unreasonable, and furthermore the diversification benefit between the main risk categories used is not material measured relative to the overall ICA. However, considerable uncertainties surround the assessment of the diversification benefits utilised in deriving the ICA amount for SJE (as, in my experience, is the case for most insurers ICA estimates) I consider the methodology and modelling techniques used by SJE to be reasonable and broadly in line with current market practice for comparable companies. The assumptions used within any ICA calculation are a matter of judgement. My judgement is that the results provided appear reasonable, but I recognise that other results could have been generated using different sets of assumptions that are within the bounds of reasonableness Nothing emerged from my review of the ICA documents or my discussions to give me concerns as to the financial strength of SJE, or to conclude that the ICA does not form a reasonable basis for assessing the 26

29 capital requirements of SJE, in particular, the level of capital required so that the company can meet its obligations to the level of confidence specified by the FSA for general insurance companies Based on its ICA as at 31 December 2011 before accounting for the NICO Agreement and increased capital, SJE had capital resources comfortably in excess of its ICA. After allowing for the NICO Agreement, SJE s ICA reduced overall due to a reduced insurance risk charge for the risks associated with the Transferring Business, although this reduction was offset to some extent by an increased credit risk charge in respect of NICO. The reduced ICA taken together with increased capital resources as a result of the capital injection mean that SJE s solvency margin (relative to its ICA) is significantly improved on the post-nico Agreement, post-capital injection basis The FSA provides individual capital guidance ( ICG ) to SJE. This guidance sets out the results of the FSA s review of the ICA and the minimum level of capital that it would expect SJE to hold based on its view of the ICA and the risk management framework of SJE. The ICG is intended to target the same level of confidence as described above for the ICA, but it represents the FSA s view rather than that of SJE. The ICG is typically set as a percentage of the ECR. I have been provided with a copy of a letter dated 16 May 2008 from the FSA to SJE confirming the level of ICG (that being the most recent view expressed by the FSA) Due to limitations on the degree of disclosure permitted by the FSA, I am not able to provide details of SJE s ICA or ICG figures in this Report. Nonetheless, the capital of SJE was significantly in excess of its ICG as at 31 December 2011 (on the basis that ICG as at 31 December 2011 remained at the same percentage of ECR as previously confirmed to SJE by the FSA in 2008). Conclusion Overall, based on my review as described above concerning the excess assets of SJE, I believe the policyholders of SJE, including those transferring to BHII under the proposed Scheme, currently enjoy a reasonable level of security. EXCESS ASSETS OF BHII (PRE AND POST TRANSFER) As at 31 December 2011 BHII s FSA return indicated that it had available capital resources of 68.2 million. In 2011 it wrote net premiums of 30.0 million, the ratio of available capital to net premiums was therefore 227% At 31 December 2011 BHII s MCR was 16.6 million, giving free assets of 51.6 million and a solvency ratio of 411% BHII has provided me with its ECR at 31 December 2011, over which it also had significant surplus assets, albeit that the solvency ratio (i.e. available assets divided by ECR) was less than that of SJE Additionally, BHII has made estimates of its capital requirements under the forthcoming Solvency II rules using the QIS5 standard formula. BHII has made these estimates as at year-ends 2009, 2010 and 2011, and has provided the results of each of these. In each case the results showed a significant surplus of capital resources over the capital requirement The FSA last issued BHII with ICG, following its review of BHII s ICA and its ARROW risk assessment in As at 31 December 2011, BHII held a significant surplus over the ICG (calculated as the ECR multiplied by the factor selected by the FSA in 2008). BHII has provided me with updated draft ICAs as at 31 December 2010 and 31 December These ICAs set out the main risks to which BHII is exposed and outline the approach taken to setting its capital requirement. In both cases BHII had a significant surplus of capital resources over its ICA As part of the Berkshire Hathaway group, BHII enjoys a Standard and Poor s credit rating of AA+. This means that Standard and Poor s believes the group has a very strong capacity to meet financial commitments, and is one notch off of its top AAA rating. 27

30 Excess Assets of NICO As stated in paragraph 7.36 above, the uncertainty attached to the net position of BHII is greatly limited by the reinsurance arrangements in place with NICO. The reinsurers share of the Technical Provisions of BHII, as at 31 December 2011, represented over 80% of the Gross Technical Provisions, with the vast majority (nearly 100%) of this asset provided by NICO (its immediate parent company). I therefore need to consider the risk of ultimate exhaustion of the assets of NICO The gross carried loss and loss expense reserves of NICO as at 31 December 2011 totalled $35.3 billion ($34.1 billion net of reinsurance). These consist of reserves, under Schedule P of its return to the US National Association of Insurance Commissioners ( NAIC ), for unpaid losses and loss adjustment expenses of $15.3 billion ($14.2 billion net), retroactive reinsurance reserves of $18.4 billion (gross and net) and deposits of $1.5 billion (gross and net) The liabilities of NICO include significant exposures to asbestos & environmental risks. Much of this is in respect of the retroactive reinsurance contracts NICO have entered into. The purpose of these contracts has, in many cases, been to substantially remove the risks associated with asbestos, environmental and other long tailed liabilities of the ceding insurers. While these liabilities are subject to significantly greater uncertainty than typical insurance liabilities, the retroactive reinsurance contracts have all been written with an aggregate limit, therefore capping NICO s exposure to these liabilities Of the liabilities NICO reports in its Schedule P return, asbestos & environmental related claims accounted for $877 million gross ($861 million net of reinsurance) as at 31 December As for the retroactive reinsurance contracts the risk factors associated with asbestos & environmental liabilities make the associated Schedule P reserves carried by NICO subject to significant variability. However, as these reserves represent around 6% of the overall Schedule P carried reserves of NICO net of reinsurance as at 31 December 2011, any adverse claims development is very unlikely to have a material impact on the overall carried reserves of NICO The liabilities of NICO are subject to an annual statement of actuarial opinion ( SAO ). I have reviewed the SAO for NICO as at 31 December 2011, as provided by the appointed actuary. SAOs must cover items set out in instructions issued by the NAIC (refer to Appendix 6 for full details). The main items to be covered in a SAO are: (1) the scope of the opinion, in particular an examination of the actuarial assumptions and methods used in determining the opined upon reserves, and a review of the information provided to the appointed actuary; (2) the opinion itself; and (3) relevant comments In addition to the SAO, the appointed actuary provided an actuarial opinion summary ( AOS ) in respect of NICO as at 31 December This summary shows the appointed actuary s indicated lower and higher combined reserves (both gross and net of reinsurance) and compares them with the total carried reserves of NICO as at 31 December In order to give an opinion in the SAO that the carried reserves make a reasonable provision for the liabilities associated with the reserves, the carried reserves must be within the appointed actuary s range of reasonable reserve estimates The SAO (and AOS) were provided by the appointed actuary for regulatory purposes only, and as such I am not able to provide details of the SAO (and AOS) in this Report. Nonetheless, nothing emerged from my review of the SAO (and AOS) to give me concerns as to the financial strength of NICO, or to conclude that the SAO (and AOS) do not form a reasonable basis for assessing at a high level the reserve strength of NICO. In particular, the carried reserve amount lies within the appointed actuary s range of reasonable reserve estimates As at 31 December 2011, the admitted assets (excluding protected cell business) of NICO amounted to $115.4 billion, made up of cash and bonds (5%), common and preferred stocks (56%) and investments in its parent, subsidiaries and affiliates (39%). 28

31 7.80. As at 31 December 2011 the policyholders of NICO enjoyed the security of an excess of admitted assets over liabilities (i.e. surplus assets as regards policyholders) of $70.2 billion. This surplus taken together with a $0.2 billion adjustment for dividends from life subsidiaries generated total adjusted capital of $70.4 billion, relative to risk-based capital requirement of $30.5 billion (determined as outlined in Appendix 5), i.e. free assets of $39.9 billion, equating to a free asset ratio of 34.6% (where free asset ratio equals free assets expressed as a percentage of total admitted assets) and a surplus asset ratio of 61.0% (where surplus asset ratio equals total available capital expressed as a percentage of total admitted assets). Relative to the authorised control level of risk-based capital of $15.3 billion, free assets were $55.1 billion giving a free asset ratio of 47.7% Further, as at 31 December 2011, the ratio of free assets to carried claim reserves net of reinsurance (of $34.1 billion) was approximately 117%, i.e. claim reserves net of reinsurance could deteriorate by over 117% before NICO s free assets are exhausted The admitted assets held by NICO as at 31 December 2011 are dominated by common and preferred stocks, and by investments in its parent, subsidiaries and affiliates. As such they are not managed to a target duration which is based on the expected cash-flows of the underlying liabilities. The common and preferred stocks held by NICO are subject to significant market variability. Nonetheless, the ratio of free assets (see paragraph 7.80 above) to admitted assets (of $115.4 billion) is 35%, i.e. the value of admitted assets could fall by up to 35% before NICO s free assets would be exhausted In addition to reviewing the NAIC Annual Statement (US regulatory return) and the SAO/AOS as at 31 December 2011, I have had communications with key personnel from BHII and NICO on the assets and liabilities held by NICO, and have been informed that, broadly speaking: (1) the equity investments are held in such a way that the expected dividend income covers the expected claims payment profile; (2) that liabilities are matched to assets in such a way that if insurance liabilities increase then they could be matched, to a certain extent over a long period, by increases in equity valuations; and (3) liquidity is provided at the Berkshire Hathaway Inc. consolidated level of at least an absolute $10 billion minimum in liquid shortterm assets (cash or cash equivalents) and NICO has a reciprocal loan arrangement with Berkshire Hathaway Inc. to draw upon up to $8 billion of that cash on an immediate basis to be able to meet immediate unforeseen needs In my view, the approach adopted by NICO to matching assets and liabilities appears reasonable given: (1) the long-term nature of both the assets and liabilities; (2) the very high level of liquidity available to NICO to meet immediate unforeseen needs; and (3) the substantial policyholder surplus of $70 billion in excess of total carried liabilities of $45 billion The excess admitted assets of NICO are substantial and, while they cannot be assumed to provide an absolute guarantee, provide a very significant safety margin. Conclusion with regard to the Excess Assets of NICO Based on the excess admitted assets of NICO and the reserves carried by NICO (as opined on by the appointed actuary for year-end 2011), I have concluded that, although it is impossible to foresee every eventuality, the risk of ultimate exhaustion of the assets is small. Conclusion with regard to the pre-scheme Excess Assets of BHII I am satisfied that the excess assets of BHII currently afford the policyholders of BHII a reasonable level of security. This security is strengthened by its reinsurance arrangements with NICO, and the excess assets of NICO as described above If the proposed Scheme is sanctioned, the gross liabilities of BHII will increase by around 85 million (based on the external actuaries figures as at 31 December 2011). Net of reinsurance however (given that the NICO Agreement will transfer under the Scheme) the liabilities are estimated to be unchanged If the Scheme had been sanctioned as at 31 December 2011, BHII s MCR would be expected to have remained unchanged at 16.6 million (as the premium amount in the formula would have been greater than the claims amount, even when including the claims incurred on the transferring SJE business). The capital resources would have also remained unchanged so the excess assets and solvency ratio when calculated with reference to the MCR would have remained unchanged. 29

32 7.90. The ECR would have been slightly greater if the transfer had been sanctioned as at 31 December This would have resulted from an increased asset charge due to increased reinsurance balances; however BHII would have continued to have a significant solvency margin over the ECR (and over the ICG, calculated using the same proportion of the ECR as selected by the FSA see paragraph 7.70). In each case the policyholders of BHII, including those transferring under the Scheme, will enjoy a slightly lower level excess assets, but not be impacted in a materially adverse manner BHII have also made an estimate of their capital requirements under Solvency II using the QIS5 standard formula including the Transferring Business. The effect on the capital requirement, based on figures as at 31 December 2011, is a slightly higher capital requirement and slightly reduced surplus, resulting mainly from a larger counterparty default risk charge due to the increased reinsurance asset with NICO. BHII s estimate continues to show a significant surplus of capital resources over the Solvency Capital Requirement when the Transferring Business is included BHII have also made an assessment of the effect of the Scheme on their draft ICA as at 31 December The main effect of the Scheme is an increased credit risk charge resulting from the increased exposure to NICO through the NICO Agreement. Other than a consequent change in the diversification credit, no other changes are foreseen as a result of the Scheme, and the capital resources of BHII give a significant surplus over the revised ICA. Conclusion with regard to the post-scheme Excess Assets of BHII I am satisfied that the policyholders of BHII, including those transferring under the Scheme, will enjoy a reasonable level of security if the Scheme is sanctioned. RELATIVE SECURITY OF THE TRANSFERRING SJE POLICYHOLDERS PRE AND POST TRANSFER As I have concluded above, the transferring policyholders currently enjoy a reasonable level of security as a result of the excess assets of SJE, and will continue to do so as policyholders of BHII if the Scheme is sanctioned. The solvency ratios (i.e. available assets divided by the various capital requirements I have reviewed as outlined above) of BHII post-transfer will however be less than those of SJE pre-transfer The transferring policyholders currently derive much of their security from the NICO Agreement. This will be unchanged as a result of the transfer, given that the NICO Agreement will transfer under the Scheme; furthermore the limit will increase by 50 million (see paragraph below) as a result of the Scheme thereby, other things being equal, providing greater cover for the transferring policyholders There is a degree of reinsurer default risk attached to the NICO Agreement currently and this will continue to be the case if the Scheme is sanctioned. In the event of a default by NICO currently, SJE would be able to call on the Net Worth Agreement undertaken with SJII to ensure it continues to maintain a solvency margin of at least 250% of its MCR. While this would be lost as a result of the Scheme, this must be considered in the context of the financial strength of NICO (as described from paragraph 7.72 above). NICO s Standard & Poor s credit rating of AA+ is stronger than SJII s of A+ and its capital resources (against which regulatory solvency requirements are measured) of $70 billion are significantly greater than SJII s of $15 billion. Therefore, the risk of default by NICO is very remote, and as such the loss of the Net Worth Agreement if the Scheme is sanctioned will not materially adversely impact the policyholders of the Transferring Business SJE is also the beneficiary of a letter of credit taken out by NICO at the time of entering into the NICO Agreement. This letter of credit is intended to mitigate SJE s counterparty (reinsurer default) risk in respect of NICO until the Transferring Business is transferred to BHII under the proposed Scheme. After the sanctioning of the Scheme, the letter of credit will be terminated If the Scheme is sanctioned the reinsurer default risk arising from the NICO Agreement for BHII will not be mitigated as the letter of credit will be terminated. However, as BHII s fortunes are so closely intertwined with those of NICO (it ceding a great deal of its business to NICO and being a subsidiary company of NICO), a default resulting from the financial failure of NICO would also likely result in the insolvency of BHII. However, in my view, given the financial strength of NICO (as described from paragraph 7.72 above), the likelihood of default is very remote, and as such the loss of the letter of credit if the Scheme is sanctioned will not materially adversely impact the policyholders of the Transferring Business. 30

33 7.99. Given the financial strength of NICO, and the security afforded to the policyholders of the Transferring Business by the NICO Agreement (which will be further strengthened by the increased limit of the NICO Agreement as a result of the Scheme), I believe that the Scheme is unlikely to have a materially adverse impact on the security position enjoyed by the policyholders of the Transferring Business compared to both their current position and their projected position at the Effective Date, notwithstanding the loss of the Net Worth Agreement and the letter of credit in favour of SJE, or the fact that the solvency ratios of BHII will be less than those of SJE In the event that the NICO Agreement is exhausted then, currently, the liabilities would fall back on SJE. If the Scheme is sanctioned then in this eventuality they would fall on BHII. Both SJE and BHII have adequate solvency levels currently (as discussed above) and would be able to absorb a degree of losses from this business. SJE also benefits from the Net Worth Agreement with SJII and therefore any capital strain on SJE as a result of deteriorations on the Transferring Business would be expected to be mitigated (in whole or in part) by this. BHII does not benefit directly from any third party guarantee. However, should the Scheme be sanctioned the limit of the NICO Agreement will be increased by 50 million In connection with SJE s 2011 ICA, SJE external actuaries have made estimates, using bootstrapping 7 techniques, around the uncertainty in the reserves of the Transferring Business. These estimates suggest that the likelihood of the NICO Agreement exhausting is very remote I have been provided with a separate analysis undertaken by BHII in connection with its ICA assessing the likelihood of the NICO Agreement exhausting. The analysis, which is based on the position at the start of the NICO Agreement at 31 December 2010, involves fitting a statistical distribution to the reserves of the Transferring Business This methodology implies that at the start of the NICO Agreement the cover would not exhaust with a high level of confidence. Given the reserve deterioration booked by SJE, as at 31 December 2011, the methodology implies that this confidence level has fallen. In order to bring the contract back to a level of confidence at least as strong as that estimated at the commencement of the NICO Agreement, NICO has agreed to increase the limit on the contract by 50 million subject to the Scheme being sanctioned. Based on my review of the increased limit relative to the reserve position booked by SJE for the Transferring Business as at 31 December 2011, using the methodology adopted by BHII in connection with its ICA, I am satisfied that the NICO Agreement post-transfer will, all other things being equal, provide greater protection and likelihood of sufficiency to the transferring SJE policyholders than when the NICO Agreement commenced The methods employed by both BHII and SJE in estimating the likelihood of the NICO Agreement exhausting have their limitations and rely on subjective assumptions. Both do however indicate the likelihood of the NICO Agreement exhausting is remote, and this likelihood will be made more remote (i.e. less than a 1 in 200 likelihood) by the increased limit if the Scheme is sanctioned (all other things being equal) If the Scheme is sanctioned the policyholders of the Transferring Business will benefit from the increased security of the increased limit of the NICO Agreement. I am satisfied that, given this increased limit, the likelihood of the limit exhausting is very remote and therefore the policyholders of the Transferring Business will not be materially adversely impacted as a result of the Scheme I have also considered the relative position of the policyholders of the Transferring Business in the scenarios of a failure of SJE pre Scheme and BHII post Scheme in both cases not caused by a default by NICO and when the NICO Agreement has not exhausted. In the case of SJE, a failure would likely only occur if SJII was not able to (or unwilling to) honour the Net Worth Agreement. In the case of BHII, I have reviewed the reinsurance programme, and given the very heavy level of reinsurance protection provided by NICO (as summarised in paragraph 4.11 above), a failure would likely only occur in very improbable circumstances. In both scenarios therefore the likelihood of failure is, in my view, very remote, and I have not considered it further. 7 Bootstrapping is a widely used actuarial technique to estimate the uncertainty in claims reserves. The main assumption behind the bootstrapping method is that the residuals created in the claim triangle projection are independent of their location in the claim triangle. The method uses this assumption and redistributes the residuals to create a new simulated triangle. The simulation is then repeated many times to produce a range of possible results. 31

34 Overall Conclusion with Regards to Excess Assets Overall, based on my analysis as set out above, I believe the Scheme will not adversely impact to any material extent the security of the transferring policyholders of SJE. The Change in Risk Exposure due to the Scheme The portfolio to be transferred under the proposed Scheme consists mainly of Italian liability claims, principally related to medical malpractice. The transferring policyholders are currently exposed to the other liabilities of SJE which, as set out above, are in respect of the various property and liability insurance lines written by SJE, mainly in respect of Japanese companies European operations If the Scheme is sanctioned the transferring policyholders will become exposed to the business written by BHII. As described in Section 4 above, this business includes some particularly volatile lines including high layer US casualty business and aviation liability. This exposes BHII to potentially very large gross losses Whilst this business may be considered more uncertain than that to which the transferring policyholders are currently exposed within SJE, BHII s reinsurance arrangements with NICO significantly limit its net exposures Furthermore, the transferring business is currently reinsured into NICO, and will continue to be reinsured into NICO (with an increased limit) after the proposed transfer (and as discussed above the likelihood of this reinsurance exhausting or defaulting can be regarded as very remote). As the security of the Transferring Business is currently and will continue to be derived in large part from the NICO Agreement, it is the other risk exposures within NICO that are particularly pertinent to the transferring policyholders. These existing risk exposures will be unchanged as a result of the Scheme. Conclusion I am satisfied that, although the proposed Scheme will lead to a change to the risk exposures of the transferring business of SJE, this will not have a materially adverse effect on the security of policyholders. The Change in Policy Servicing due to the Scheme Under the terms of the Run-off Management Agreement, the administration of the Italian local business liabilities was transferred from SJE to Resolute Management Limited, another company in the Berkshire Hathaway group. Resolute Management Limited will continue to handle the administration of claims and policies following the sanctioning of the proposed Scheme (refer to paragraph 3.23 above). Conclusion I believe that the proposed Scheme will not have a materially adverse effect on the policy servicing levels enjoyed by the transferring policyholders of SJE compared to both their current position and their projected position at the Effective Date. Conclusion for the Policyholders of SJE transferring under the Scheme I am satisfied that the proposed Scheme does not affect in a materially adverse way either the security or the policy servicing levels of the policyholders of SJE transferring under the proposed Scheme. 32

35 8. THE EFFECT OF THE SCHEME ON THE BHII POLICYHOLDERS Introduction 8.1. Under the Scheme, BHII s policyholders will remain in BHII, and will be joined by the transferring Italianbranch policyholders of SJE The key issues affecting existing BHII policyholders as a result of the Scheme arise from changes in: The financial strength of BHII as a result of the transfer; The risk exposures in BHII; The policy servicing levels of the business of BHII In this section I deal with each of these in turn. The Change in Financial Strength due to the Scheme 8.4. In Section 7, I considered the current reserve strength and excess assets of BHII. I concluded that BHII is currently reasonably reserved and should continue to be so after the implementation of the Scheme I also considered in Section 7 the excess assets of BHII post the transfer, from the perspective of the transferring policyholders. As I explained, as the transferring business is reinsured into NICO, the net liabilities of BHII are estimated to not increase as a result of the Scheme, and BHII will continue to maintain a reasonable solvency margin (likely to be unchanged on an MCR basis, and only slightly reduced when considered relative to the ECR) As NICO reinsures the transferring business, the solvency of BHII post the transfer will depend to a large extent on the financial strength of NICO, as it does currently given the extent to which NICO already reinsures BHII If the Scheme is sanctioned, in the event of the insolvency of BHII the current direct policyholders would rank alongside those transferring in from SJE. In this case the current policyholders of BHII may be worse off to some extent as a result of the Scheme (the gross Technical Provisions will increase by around 16% as a result of the Scheme, based on 31 December 2011 estimates). However, given the current solvency position of BHII, and the very strong financial position of NICO, which will reinsure all of the Transferring Business (up to the limit specified in the reinsurance contract), and much of the other BHII risks, I consider such a possibility to be sufficiently remote that the security of existing policyholders will not be materially adversely impacted as a result of the Scheme. Conclusion 8.8. I believe that the Scheme is unlikely to have a materially adverse effect on the financial strength (derived from excess assets and reserve strength) enjoyed by the current policyholders of BHII after the proposed Scheme compared to both their current position and their projected position at the Effective Date. The Change in Risk Exposure due to the Scheme 8.9. If the Scheme is sanctioned, the gross Technical Provisions of BHII will increase by approximately 16%. Net of reinsurance there is expected to be no increase in Technical Provisions The extent to which the existing business of BHII will be exposed to the transferring business will be limited by the NICO Agreement which, as described above, can be regarded as very unlikely to exhaust, and given the 50 million limit increase if the Scheme is sanctioned, less likely to do so than prior to the Scheme all other things being equal Furthermore, an amalgam of the transferred portfolio from SJE with that of BHII would be expected to suffer proportionately smaller gross reserve deteriorations than any one portfolio taken individually (however, at a net of reinsurance level there is no expected change as a result of an amalgam of the transferred portfolio from SJE with that of BHII because of the NICO Agreement). 33

36 8.12. Therefore, all other things being equal, the risk profile of the combined portfolio (gross of reinsurance) within BHII post-transfer compared to the pre-transfer portfolios of the Italian branch legacy business of SJE and BHII in isolation would be expected to improve, because of the benefit of the diversification of the portfolio of risks. Conclusion I am satisfied that any change to the risk exposures of the current business of BHII after the proposed Scheme will not have a materially adverse effect on the security of policyholder benefits. The Change in Policy Servicing due to the Scheme The administration of the existing business of BHII will be unchanged as a result of the Scheme. Conclusion for BHII Policyholders For the reasons discussed above, I am satisfied that the proposed Scheme will not have a materially adverse effect on the security of existing BHII policyholders. Further, the service levels provided to the policyholders in BHII will not be adversely affected by the proposed Scheme. 34

37 9. THE EFFECT OF THE SCHEME ON THE NON-TRANSFERRING POLICYHOLDERS OF SJE 9.1. If the Scheme is sanctioned the liabilities pertaining to the Transferring Business will be removed from the balance sheet of SJE, along with all reinsurance assets related to the business (including the NICO Agreement). No other assets will be transferred to BHII While the net liabilities will be unchanged (as the business is currently wholly reinsured into NICO), SJE s gross liabilities will reduce by around 60% SJE s capital requirements on an MCR, ECR and ICA basis will reduce as a result of the removal of these liabilities and related risks from SJE s balance sheet under the proposed Scheme. As available capital (including the capital injection) will be unchanged, SJE s solvency margin will improve The remaining policyholders will also benefit from no longer having any exposure to the risks associated with the liabilities of the Transferring Business There will be no changes to the administration of the remaining business as a result of the Scheme. Conclusion for SJE Policyholders not transferring under the Scheme 9.6. For the reasons discussed above, I am satisfied that the proposed Scheme will not have an adverse effect on the security of SJE policyholders not transferring under the Scheme, and further, the service levels provided to these policyholders will not be affected by the proposed Scheme. 35

38 10. OTHER CONSIDERATIONS The approach to communication with policyholders Regulations made under the FSMA require a communication regarding the proposed transfer to be sent to every policyholder of the parties to the Scheme unless the Court waives this requirement. However, consideration may be given to the practicality and costs of sending notices against the likely benefits for policyholders of receiving such communications. In order to comply with SUP G, the companies would be expected to notify the policyholders, or interested persons, at least six weeks before the date of the Court hearing at which the application to sanction the Scheme will be heard. The companies intend to comply with this guidance The companies approach to communicating the proposed Scheme to affected policyholders is outlined in Section 5, and explained further below SJE has more than ten thousand policyholders, although the level of data that is held on them varies by the nature of the customer relationship Measured by Technical Provisions (net of reinsurance), the portfolio that is transferring into BHII has an expected value of zero. Therefore, there is a minimal expected impact on the SJE balance sheet (net of reinsurance) as a result of the transfer From a policyholder perspective, SJE believe that those policyholders who are not transferring (numbering approximately 11,200 and these are associated with approximately 54,900 policies) will see no change in the way in which they interact with the company. As such SJE considers that any such communication to these policyholders would incur a disproportionate cost relative to the effect of the Scheme Accordingly, SJE does not intend to notify any of its policyholders (save for the policyholders transferring to BHII) of the proposed transfer For the transferring policyholders (SJE has identified 10,284 insureds), SJE plans to communicate with all such policyholders as follows: Of the identified insureds (10,284 in total) 5,961 insureds have policies which are regarded by SJE as "fully developed" (i.e. (a) are within a policy line in respect of which SJE's internal actuarial reserving analysis has not estimated that further claims will develop; or (b) are in a policy line to which SJE's internal actuarial reserving analysis has allocated zero IBNR/case reserves or the amount of case reserves/ibnr is negligible relevant to the amount of business written) which means that it is highly unlikely that such insureds will have a claim in the future. Accordingly, SJE intends to exclude insureds under fully developed policies from the notification process on the basis that such insureds will be unaffected by the Scheme Of the balance of 4,323 insureds, SJE has identified duplicate records for 795 insureds. After deducting these duplicates, there is a balance of 3,528 insureds that have or may in the future have claims under policies forming part of the Transferring Business. SJE therefore proposes to limit its communication to these 3,528 insureds. Of these 3,528 insureds, SJE proposes to notify 2,179 (approximately 62%) directly; and the remaining 1,349 insureds (approximately 38%) indirectly The 2,179 insureds to whom SJE proposes to send direct notices comprise: (a) (b) (c) 784 insureds under two group medical malpractice policies (described as: SIGO (1) a group medical malpractice policy, broadly insuring hospitals for any negligence of their doctors. The "named" policyholder is SIGO. SIGO is a professional body governing the affairs of gynaecologists and obstetricians; and SIGO (2) a group medical malpractice policy under which the named policyholders are the individual doctors. There are 690 individual doctors insured under SIGO (2). These 690 insureds are also SIGO (1) insureds). SJE intends to send notices to SIGO and the 784 individual (doctor) insureds for whom it has addresses; 246 insureds with Individual Policies (i.e. policies which were arranged through brokers, but where the brokers did not bind the risk on behalf of SJE), where SJE is either the Lead Insurer or insured 100% of the risk, and for whom SJE contact details; 437 insureds with Broker Policies, where SJE is the Lead Insurer (and therefore has address 36

39 information for the insureds), and is required by contract to contact the insured via the broker, but the broker is no longer in business, having become insolvent (or for one solvent broker where in the light of a dispute, SJE proposes to send the notices direct to the insureds); (d) 712 insureds with Broker Policies, where SJE is the Lead Insurer, and there are no contractual restrictions preventing direct contact with the insured The 1,349 insureds to whom SJE proposes to send indirect notices comprise: (a) (b) (c) 1 insured under the SIGO (1) policy, for whom contact details are not available, in respect of whom SJE intends to send notice to SIGO, who purchased the cover on behalf of the individual insureds; 1,241 insureds with policies concluded under co-insurance arrangements where SJE is a Following Insurer (and therefore does not have address information for the insureds), in respect of whom notice will be sent to the Lead Insurer; 107 insureds with Broker Policies where SJE is the Lead Insurer, and there are contractual restrictions requiring all contact with the insured to be effected via the broker, where SJE will ask the brokers involved to notify the insureds In addition to the insureds to whom SJE proposes to send indirect notices, SJE has identified a category of footballer injuries policies which are subject to a settlement agreement where SJE proposes to notify the law firm representing the insured(s) or the settlement agent, as appropriate. This category is not included in SJE s electric systems (and thus not counted in the 1,349 insureds identified in paragraph above) but this category will be notified indirectly For the policyholders of BHII, the company plans to communicate with those policyholders in the following three broad lines/categories: BHII Framework business (approximately 2,000 policies/855 policyholders). In respect of this category of insurance business BHII proposes to send notice of the application to all brokers of record for this line of business. In the majority of cases (numbering 560 out of 855 policyholders) BHII does not have addresses for the underlying policyholders the addresses are retained by the brokers. The day-to-day relationship with the policyholders is via the brokers. BHII therefore proposes to communicate with the brokers and ask that they send the circular onto their policyholders. Further, BHII will cooperate with the brokers and address any additional requests for copies of the circular they may require Global Aerospace business (approximately 28,700 policies/8,500 policyholders). BHII was nominated by NICO to act as the "pool" member in 2004 and in respect of this category of policies BHII does not have address details on its systems. However, these policies were brokered and BHII proposes to send the notice of the application to all brokers and ask that they notify their policyholders. BHII will cooperate with the brokers and deal with any additional requests for copies of the circular they may require Delegated Authority business which is underwritten through brokers (where BHII estimate that there are approximately 50 open claims in respect of this line of business). The business comprises short-tail business and BHII s statistical analysis indicates that the vast majority of policies (and which number approximately 80,000) are deemed to be "fully developed". However, there may be some policies under which a claim is still possible. As BHII does not have the address details of these policyholders, it proposes to send the notice of the application to all brokers of record in this category of business, and ask that they notify their clients who are policyholders who may potentially have claims. BHII will cooperate with the brokers and deal with any additional requests they may have Except in respect of the categories noted above, BHII does not propose to notify its other policyholders on the basis that: There is limited utility for notifying all BHII's policyholders (approximately 9,400 policyholders in total, excluding short-tail policies that are written on a delegated basis that are deemed to have expired and BHII believes there is no prospect of a claim) taking account that the terms and conditions under which the policyholders of BHII hold their policies will not change in any manner as a result of the proposed transfer and there is no need for these policyholders to take any action 37

40 as a result of the Scheme; and There are no plans to change the policy administration or change the governance arrangements for any of BHII's policies. There is therefore no potential for the Scheme to have a direct impact on the servicing of BHIIL's policies SJE also plans to notify the two reinsurers (as well as NICO) protecting the SJE insurance business, and will also seek their express consent to the transfer of their reinsurances Finally for all interested parties, SJE will provide notification of the proposed Scheme through advertisements in: the London, Edinburgh and Belfast Gazettes; the Times and the Financial Times; the international edition of the Financial Times; and two national newspapers in Italy being Il Sole 24 Ore and Il Corriere della Sera I am satisfied that the proposed approach to communication with policyholders is both proportionate and reasonable. The Effect of the Scheme on the Reinsurance Asset Where reinsurance contracts to be transferred under the Scheme are not governed by UK law, there is a risk that reinsurers may challenge the Scheme and refuse to continue to meet their obligations under the reinsurance contracts. Although some EEA law-governed reinsurance contracts should transfer under the Scheme, others will not or might not do so The reinsurance asset (other than the NICO Agreement) associated with the Transferring Business was approximately 18.7 million, based on the external actuaries estimates as at 31 December In March 2012, SJE entered into a commutation agreement with SJII to commute the reinsurance asset associated with the liabilities to be transferred under the Scheme. This asset held with SJII accounted for 10.2 million of the 18.7 million booked as at 31 December Therefore, based on figures as at 31 December 2011, approximately 8.5 million of reinsurance asset will be subject to the Scheme This reinsurance asset (other than the NICO Agreement) is held with two external reinsurers, and I have seen the advice sought by SJE from its legal advisors that the reinsurance contracts are, on balance, likely to be governed by Italian law. Furthermore, I have seen the advice sought by SJE from its Italian legal advisers that the Scheme will be effective to transfer these agreements, as the Court Order sanctioning the Scheme would be recognised under relevant Italian laws enabling BHII to take proceedings in Italy against a reinsurer for the payment of a reinsurance claim. However, they do recommend that, as a cautious approach, SJE seek consents from the reinsures, which SJE intends to do. For the avoidance of doubt, as the NICO Agreement is governed by UK law, SJE need only notify NICO of the Scheme Any reinsurance bad debt on the local Italian branch business is covered under the NICO Agreement, albeit that this would erode the limit. The external actuaries estimates and estimates based on BHII s methodology both as at 31 December 2011 show that, even on a gross basis, the likelihood of the NICO Agreement exhausting is remote. Therefore, even if the external reinsurance (other than the NICO Agreement) in respect of the transferring liabilities failed to transfer under the Scheme, the transferring policyholders and the existing policyholders of BHII, would not be materially adversely impacted given the 50 million increased limit to the NICO Agreement and the financial strength of NICO The increased limit of 250 million under the NICO Agreement post-transfer provides the policyholders of BHII, including the transferring policyholders of SJE, with greater security as explained in paragraphs and above I have reviewed the NICO Agreement (and received advice from the legal advisers to SJE) and am satisfied that the NICO Agreement post-transfer contains appropriate clauses limiting NICO s ability to terminate or to avoid paying claims under it. In particular, there are no termination rights that in practice can be exercised within the NICO Agreement, and as such this contract expires at the earlier of: (i) the payment by NICO of the aggregate limit; and (ii) the extinguishment of all liabilities under all insurance policies/reinsurance contracts covered by the NICO Agreement. Assets and Liabilities of SJE and BHII As at 31 December 2011, the Technical Provisions (gross of reinsurance) of SJE to be transferred under the proposed Scheme to BHII amounted to million (as per the external actuaries estimates). The 38

41 associated reinsurance asset was 22.4 million, which, after the commutation with SJII as described in paragraph above, amounted to about 10.2 million or 8.5 million) The assets that will be transferred from SJE to BHII will comprise only the reinsurance assets of 8.5 million above and the NICO Agreement entered into with NICO in March The Court has the power to order (and the Scheme provides for) the transfer of the relevant outwards reinsurance contracts (including the NICO Agreement) of SJE to BHII as part of the Scheme. On the basis that the relevant outwards reinsurance contracts of SJE are transferred to BHII as part of the Scheme the net (of reinsurance) position of BHII should not be adversely impacted as a result of the Scheme. Operational Plans and Changes in Assets and Liabilities up to the Effective Date The balance sheets show amounts as at 31 December I have chosen this date because it is the latest date for which audited financial information is available I expect that the current activities of SJE and BHII will continue between 31 December 2011 and the Effective Date (and, as appropriate, after the Effective Date). SJE and BHII will continue to write new and renewal business and the companies will continue to settle claims and reassess reserves in the light of experience. I do not consider that any material additional risk to any group of affected policyholders will emerge as a result of the continuation of normal business Further to considering the continuation of normal business, I have discussed separately with BHII and SJE the possibility of management actions that could affect the financial position of SJE and BHII (such as corporate restructuring or significant changes in new business strategy or operational plans). I have been informed that BHII has no planned activities that would have a material effect on the security of its policyholders, either for those that were policyholders as at 31 December 2011 or those that have become policyholders since then up to the Effective Date In the case of SJE, the company plans to write a new line of business. SJE has provided me with a document giving details of projections for their ICA over the next 3 years, incorporating the proposed new line of business, a small amount of which is forecast to be written in The ICA projection over the next 3 years ( ) shows that a satisfactory level of excess capital is maintained throughout the 3 year projection period. I therefore do not believe this change in new business strategy up to the Effective Date will have a materially adverse effect on the security of its policyholders, either for those that were policyholders as at 31 December 2011 or those that have become policyholders since then up to the Effective Date I believe that it is unlikely that any events occurring between 31 December 2011 and the Effective Date would affect any conclusion that I reach based on my review as at 31 December A short time before the final Court hearing, I will consider the extent to which the operational plans of BHII and/or SJE have altered (relative to the position at the date of this Report) and the actual changes in assets and liabilities (relative to the position as at 31 December 2011) and hence whether there have been any changes (including those associated with current economic conditions) that would affect my overall opinion, and will report on these as part of my supplementary/update report (see paragraph 1.24 above) For the avoidance of doubt, it is intended that the statutory value of the liabilities transferred from SJE to BHII on the Effective Date under the Scheme will be matched by transferred (reinsurance) assets. Solvency II As described in Section 2, the regulatory solvency reporting requirements for EU insurers and reinsurers are due to undergo a major overhaul from 30 June I am informed that SJE and BHII are each progressing with their preparation for Solvency II, and currently plan to be in a position to implement the requirements of Solvency II by 1 January SJE and BHII each produced indicative SCR amounts using the standard formula approach as per the fifth Quantitative Impact Study ( QIS5 ) as at 31 December The SCR amounts so calculated indicated that the current capital resources as at 31 December 2009 for each entity exceeded their corresponding SCR by a comfortable margin. 39

42 Conclusion I am satisfied that SJE and BHII are both presently preparing to meet the requirements of Solvency II on its introduction. I do not believe the Scheme will impact in an adverse manner on the separate approaches of SJE and BHII to meeting and complying with Solvency II requirements. The SJE and BHII Pension Schemes The funding and operation of the SJE and BHII Group s pension schemes will not be affected by the Scheme. Tax I am informed by BHII that the proposed Scheme is not expected to have tax implications that would affect the existing policyholders of BHII or the policyholders of the Transferring Business under the Scheme. For the policyholders of SJE remaining post-transfer there is not expected to be any tax implications since, all other things being equal, the Scheme has a neutral impact on the net financial position of SJE. 40

43 11. CONCLUSIONS In summary, in my opinion, provided the proposed Scheme operates as intended, and I have no grounds for believing it will not do so: The security of benefits of the transferring policyholders of SJE, the non-transferring policyholders of SJE and the policyholders of BHII will not be materially adversely affected by the implementation of the Scheme on the Effective Date; The Scheme will not have an impact on the service experienced by the transferring policyholders of SJE, the non-transferring policyholders of SJE and the policyholders of BHII. Gary Wells 15 October 2012 Fellow of the Institute and Faculty of Actuaries 41

44 APPENDIX 1. DEFINED TERMS Accident Year Admissible Assets Capital Charge Co-insurance Correlation Enhanced Capital Requirement ( ECR ) Equalisation Provisions Following Insurer FSA Returns Individual Capital Assessment ( ICA ) Individual Capital Guidance ( ICG ) Lead Insurer Minimum Capital Requirement ( MCR ) Quota Share Reinsurance Reinsurance Solvency I Technical Provisions The year to which a claim is allocated based on the date of that accident/claim. Assets valued in accordance with applicable regulations, which can be taken into account for the purposes of demonstrating that a general insurance company meets its solvency requirements. In relation to a risk identified by a firm to which it is exposed, e.g. market risk, the amount of capital calculated to mitigate appropriately that risk that could otherwise cause the firm to be unable to meet its liabilities as they fall due. Is a form of insurance whereby the policyholder is insured by multiple insurers, each of whom is solely responsible for their portion of the risk. Correlation (in the context of this Report) is a number that describes the statistical relationship between two variables (e.g. equity prices and interest rates). A more risk sensitive capital requirement (than the MCR) for UK insurers as measured by the FSA. An equalisation reserve is a reserve built-up (generally from profitable years) as a cushion against periods with worse than average claims experience. An insurer that follows the terms of the co-insurance policy negotiated by the Lead Insurer (as defined below). Accounts, balance sheets, abstracts and statements relating to the business of an insurance company required under FSA rules to be submitted periodically to the FSA. An insurance company s own assessment of the capital it needs for regulatory purposes in order to mitigate appropriately the risks to which it is exposed and that could otherwise cause it to be unable to meet its liabilities as they fall due. The FSA s assessment of the minimum level of capital that it would expect an insurance company to hold based on its view of the insurance company s ICA and risk management framework. The insurer that negotiates the terms of the co-insurance policy on behalf of the other insurers. Required minimum level of capital under Solvency I rules. See Appendix 6 for further details. A form of reinsurance in which the insurer passes on an agreed percentage of every risk it insures that falls within a class or classes of business (subject to a reinsurance treaty) to the reinsurer. An arrangement with another insurer whereby risks are shared (or passed on). The system for establishing minimum capital requirements for EU insurers under relevant EU Directives presently in force. Liabilities determined for regulatory purposes. In particular, the provisions for the ultimate costs of settling all claims arising from events which have occurred up to the balance sheet date, including provision for claims incurred but not yet reported, less any amounts paid in respect of these claims; plus the provisions for future claims arising on unexpired periods of risk. 42

45 APPENDIX 2. LIST OF PREVIOUS TRANSFERS FOR WHICH I HAVE ACTED AS THE INDEPENDENT EXPERT OR EQUIVALENT 1997: Transfer of the PHI business from Norwich Union Limited to Norwich Union Life & Pensions Limited 1997: Transfer of business from Security Assurance Limited to Norwich Union Life & Pensions Limited 1999: Transfer of the business of London & Edinburgh Life to Norwich Union Life & Pensions Limited 2004: Transfer of the business of the Continental Reinsurance Company (UK) Limited to Continental Management Services Limited 2005: Transfer of the business of the UK branch of the Continental Insurance Company to Continental Management Services Limited 2006: Transfer of the IGI portfolio of CX Reinsurance Company Limited to CNA Insurance Company Limited 2008: Transfer of the Irish branch business of Royal & Sun Alliance Insurance plc to Europa General Insurance Company Limited 2009: Transfer of business from Arran Insurance Company Limited to Chevanstell Limited 2010: Transfer of business from Euler Hermes Guarantee plc to Euler Hermes UK plc 2011: Transfer of business from Euler Hermes UK plc to Euler Hermes Credit Insurance Belgium SA (NV) 2011: Transfers of business from PA(GI) Ltd to Royal & Sun Alliance Insurance plc and Marine Insurance Company Limited 2011: Rationalisation of 22 UK regulated entities of Royal & Sun Alliance Insurance plc to 5 UK companies via 3 Part VII transfer schemes (effective 1 January 2012) 43

46 APPENDIX 3. TERMS OF REFERENCE The Independent Expert s Report will consider the terms of the Scheme generally and the effect which the Scheme will have on the holders of insurance policies issued by SJE and BHII. In particular, the Independent Expert will consider the following specific matters: The likely scope for deteriorations in each of the Companies claims reserves (i.e. the likelihood and extent to which each of the Companies reserves may prove inadequate); The impact of the Scheme on the security/financial strength of the different groups of policyholders of the Companies involved in the Scheme; The impact of the Scheme on the levels of service provided to the different groups of policyholders of the Companies involved in the Scheme; The existing and proposed agreements (if any) between the Companies and their reinsurers; Guarantees and/or agreements (if any) between the Companies; Guarantees and/or agreements (if any) between each of the Companies and their respective parent company; Transactions (including other portfolio transfers and commutations) that impact upon the Companies; The terms and conditions (if any) expected to be imposed by the Scheme to be presented to the Court. The Independent Expert shall not be directly involved in the formulation of the proposed transfer although the Independent Expert should expect to give guidance during the evolution of the detailed proposals on those issues which concern me, or which I consider unsatisfactory. The Independent Expert will not provide any advice with respect to the merits of the proposed transfer. 44

47 APPENDIX 4. KEY SOURCES OF DATA In writing this report, I relied upon the accuracy of certain documents and spreadsheets provided by SJE and BHII. These included, but were not limited to the following: BHII The 2010 and 2011 report and accounts. The 2010 and 2011 FSA returns. Draft 2010 and 2011 ICAs for BHII, plus a document assessing the impact of the Scheme on the 2011 ICA. QIS5 spreadsheet as at 31 December 2009, and on a pre and post Scheme basis as at 31 December BHII s ECR spreadsheet as at 31 December 2011, plus an equivalent spreadsheet incorporating the Transferring Business. A spreadsheet showing the effect of the Scheme on BHII s MCR and ECR, based on 31 December 2011 figures. A letter from the FSA to BHII dated 8 August 2008 giving the level of ICG. A document describing BHII s reinsurance program. Minutes and associated papers from the BHII reserving committee meetings dealing with the 2011 year-end reserves. A note describing BHII s approach to reserving. A spreadsheet providing a breakdown of BHII s carried reserves at 31 December 2011 by major segment. Reserving related documents: o An external actuarial review for GAUM as at 31 December o o o An internal BHII document setting out the approach to selecting reserves for GAUM. An actuarial note summarising the reserve recommendations for the BHII energy account. An actuarial note on the Coolkeeragh account. Key Performance Indicators document for GAUM as at 31 March Presentations by Willis and Marsh on the performance of the Energy account. Berkshire Hathaway UK Group Shared Services and Cost Sharing Agreement dated 11 August NICO NICO NAIC Annual Statement for the year ended 31 December SAO and AOS for NICO as at 31 December

48 SJE The 2010 and 2011 report and accounts. The 2010 and 2011 FSA returns. A spreadsheet showing business plan projections for SJE over the period 2012 to SJE s ICAs as at 31 December 2010 and 31 December An additional version of SJE s 31 December 2011 ICA allowing for the increased capital and NICO Agreement. A document providing projected future ICA amounts for each of the 3 years to 31 December 2014, allowing for forecasted new business. Report undertaken by external actuaries on the underwriting and insurance risk of SJE as at 31 December 2010 and draft as at 31 December A letter from the FSA to SJE dated 16 May 2008 giving the level of ICG. A document providing an assessment of the impact of the Scheme on SJE s ICA as at 31 December A document summarising the impact of the Scheme on SJE s MCR, ECR and ICA based on figures as at 30 September The QIS5 spreadsheet for SJE as at 31 December ECR spreadsheets as at 31 December 2010 and 31 December Draft press release from Standard and Poor s regarding SJE s credit rating. A copy of the Net Worth Agreement between SJE and SJII. Commutation agreement between SJE and SJII in respect of the Italy local business. External actuarial report on the reserves of SJE as at 31 December External actuarial report on the Italy local business reserves of SJE as at 31 December A spreadsheet reconciling the reserves recommended in the external actuarial review to provisions in SJE s accounts. External actuarial report on certain Italian facultative reinsurance recoveries as at 31 December A document summarising SJE s fair treatment of customers framework. Documents relating to the Scheme and NICO Agreement correspondence between SJE and the FSA regarding the reinsurance and need for a letter of credit. Framework Agreement between SJE, NICO and BHII (unsigned). Aggregate Reinsurance Loss Portfolio agreement between SJE and NICO (signed by SJE). Run off management agreement between SJE, Resolute Management Limited and NICO (signed by NICO and Resolute). 46

49 APPENDIX 5. MINIMUM CAPITAL REQUIREMENT UK A5.1 In the UK the process of setting minimum solvency margins changed with effect from Nonetheless, UK general insurers continue to have to meet statutory requirements based on EU Directives and, for the time being, provide their risk-based enhanced capital requirement (ECR) calculation to the FSA in private. In addition, all UK general insurers are required to make their own individual capital assessment (ICA) of their own capital needs which will be used by the FSA when giving individual capital guidance. A5.2 The minimum capital requirement (MCR) based on EU Directives is outlined below. A5.3 The MCR is the greater of a premium measure, a claims incurred measure and a prior year MCR measure, subject to a minimum amount of currently 3.5 million. The premium measure (A) is based on gross adjusted premiums (P) as follows: If P 57.5 million then A 1 = P 18%, A 2 = 0 If P > 57.5 million then A 1 = 10.4 million, A 2 = (P million) 16% A = A 1 + A 2 A5.4 The loss provision measure (B) for other than health insurance is based on gross adjusted claims (C) as follows: If C 40.3 million then B 1 = C 26%, B 2 = 0 If C > 40.3 million then B 1 = 10.5 million, B 2 = (C million) 23% B = B 1 + B 2 A5.5 A credit for reinsurance factor (r) is then determined as the ratio of net incurred claims over the 3 year period (to the valuation date) to gross incurred claims ratio over the same 3 year period. If r < 0.5 then r is set to 0.5. A5.6 Prior year amount (M) is based on the prior year MCR and changes in outstanding claims: Where net outstanding claims are greater than zero as at the end of the current and previous financial years: M = Prior year MCR min(1, net outstanding claims as at the end of the current financial year divided by the net outstanding claims as at the end of the previous financial year); Where net outstanding claims are zero as at the end of the current and previous financial years: M = Prior year MCR min(1, gross outstanding claims as at the end of the current financial year divided by the gross outstanding claims as at the end of the previous financial year); Where gross outstanding claims are zero as at the end of the current and previous financial year: M = MCR as at the end of the previous financial year. A5.7 Minimum solvency margin = max {max (A,B) r, M, 3.5 million} A5.8 The monetary amounts stated above are those applicable as at 31 December 2011 and subject to an annual increase by the percentage change in the European index of consumer prices. 47

50 USA A5.9 In the US the minimum solvency margin is calculated using a risk-based capital (RBC) methodology based on the various risks of an insurer. The RBC methodology defines six categories of risk, labelled R 0 to R 5 as follows: R 0 asset risk in subsidiary insurance companies R 1 asset risk fixed income R 2 asset risk equity R 3 asset risk credit R 4 underwriting risk reserves R 5 underwriting risk net written premium A5.10 The quantification of R 0 to R 5 is determined by applying a series of pre-determined percentages to specific items provided in the annual statement, filed by the entity to the NAIC. A5.11 The RBC amount (for regulatory purposes) is determined as the sum of R 0 to R 5 together with a covariance adjustment (as it is unlikely that all types of catastrophic events will occur simultaneously). The authorised control level RBC (c.f. the minimum solvency margin) is set at 50% of the calculated RBC amount. 48

51 APPENDIX 6. NAIC ACTUARIAL OPINION INSTRUCTIONS The NAIC requires all property and casualty insurance companies to have an actuary provide an opinion on the company s reserves on an annual basis. The following is the NAIC s instructions for actuaries providing such statements of actuarial opinion in Note that this document is marked-up to show changes to the instructions since the 2010 version. 49

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