Corporate Strategy Weekly Radar Update

Week ending Friday 9 Novembre 2012 (Snapshot: high level look at reinsurance ) Highlights and Insights Financial Services The Australian Federal Court confirmed that S&P duped 13 NSW councils into buying toxic financial products: the councils will recover $30m in losses from failed investments in complex synthetic derivatives arranged by ABN Amro, rated AAA by S&P o Comments that this will push Ratings Agencies to "back out of Australia" causing "Institutional investors, funds and Super funds to find more protracted and expensive process" are to be balanced with the widespread consensus that bad ratings underpinned the GFC. The real risk is that a dysfunctional rating system does create an imbalance between small investors and big players who will still able to get ratings. Wetpac's Gail Kelly stepped into the ROE debate "drawing a line in the sand" to forgo lower-returning business for areas of faster growth after Westpac FY12 cash profit lifted 5% to $6.6B. She is targeting 15% ROE, announcing the prospect that Westpac will start distributing $1B excess capital in franking credits next year. o Commentators observe that once banks are confident capital strength meets the Regulator's worst assumptions and are also comfortable with their gearing, ROE becomes critical to determine the distribution to shareholders: where the sector is at CBA joined ANZ, NAB and Westpac to warn of higher bad debts from corporate after its $1.85B quarterly profit. However in the same breathe; the big 4 have fended off fears that bad debts were going to rise significantly next year. o Potential mixed messages between: provisions taken by NAB and ANZ and 'PR' warnings of more bad news to come to justify belt tightening vs the 3 year stress test recently passed by banks (real GDP -5% contraction in 1st year; unemployment rise +12%; house prices fall -35%; commercial property prices fall -40%) which should dispel fears about bad debt crisis, also reinforced by the significant balance-sheets de-risking to meet Basel3. o In fact Aust banks have transformed their funding structure since the GFC: they collect more deposits (although 'short term', TDs actually tend to stick and roll over for 3.5 years) and they reduced gearing: eg Westpac dropped its gearing from 20-25x to 13.5x its Capital and even reduced its wholesale funding costs by buying back $4.91B in Aust govt guaranteed debt that was at an expensive 70 bpps. Comparing the deposit rates with the dividend yields of banks is what make analysts (such as Goldman Sachs) believe 2013 will be a good year for bank stocks. BoQ's CFO Anthony Rose pointed at positive signs of 'bottoming' in the QLD property market with sales picking up in this market hit by falling prices. BoQ also launched a $200m offer of Tier I hybrid securities to replace securities due for redemption in Dec. o BoQ's raising brings the total funds raised by Aust banks and companies in the hybrid and listed bond market to $12.8B: banks raised $4.56B of Tier I capital ($1B by the Regionals since Sept12 The Big4 have also increased exposure to commercial property by $3B in the past 6 months as they become more comfortable with returns in the sector: CBA +$1.4B to $39.4B, NAB +$1.2B to $61.2B, Westpac marginal 100m rise to $51.37B. o Number of reasons: banks have already rationalised their exposures, getting higher spreads from lending in this sector despite impeding capital requirements, and a sector also comparatively more active compared to other business lending where there has been softer demand for credit. Competition from the 3rd tier lenders could be also picking up with Mark Bouris' deal to get fund from Macquarie and sell loans via Yellow Brick Road. Financial Services (ct'd) Now that the reporting season is over, analysts note that the Big 4 cut 6600 jobs this year as a result of major 'productivity initiatives' and in the context of a combined annual profit of more than $25.2 billion for FY12, up from $24.2B in FY11 Other industries Origin issued a profit warning in the context of regulatory pressure. A worthwhile case study. Pressure on Origin is coming from several fronts: pricing uncertainty, expensive battle to maintain market share, pressure on its BBB+ credit rating as it seeks to sell a stake in its $20B QLD LNG project. Origin is fighting for its market share, with the trade-off of negative impact on margins, which is putting a limit to price cutting as they seek to recover customer loss from last year o This is happening in the context of QLD and SA regulators adopting a market-based approach for setting power prices which many in the industry believe will end up forcing customers to pay more for their power rather than less. (NSW's decision on its pricing regime is due in March). A 2nd issue (echoing the Finance Sector) is that companies such as Origin and AGL have issued hybrid securities counted as 100% equity credit by S&Ps allowing hybrid capital to shore-up balance sheets. This has been identified as a loophole effectively giving companies a double free-pass: on the one hand they raised cheap equity at debt like interest rates; and this also helped to reduce the overall cost of capital by reducing the companys indebtedness as measured by S&P. But S&P is now reviewing the equity credit in hybrids securities (that have both debt and equity attributes): the "so what?" is it could lead to a revision of equity content for existing instruments, and force firms to raise equity to retain credit rating. S&P is said to reclassify aggregate equity up to $2.8B and Origin could face a $2B funding gap if its hybrids are given zero equity credit. WA's plans to open its mid-west region to iron ore export are on hold after a dispute between Chinese and Japanese investors derailing the $6B Oakajee Port & Rail Project. o Illustrating the impact that nationalist tensions between China and Japan can have, well beyond their regional realm Harvey Norman Q1 profit fell to $50.1m: 20.3% reduction in pre-tax profit and -10% in sales yoy. Macro Economy, Politics and Regulation RBA cash rate left at 3.25% justified by "past cuts starting to have some of the expected benefits including a stronger housing market and higher stock prices". o The RBA implies that if investors aren't happy with Deposits Rates they should consider riskier alternatives such as new housing and shares: Obama re-elected in the US. China's leadership transition: Two countries, two renewals, in the face of the task to convert the current 'stabilisation' into a systemic recovery, o Immediate US challenge is the fiscal cliff. For China it is to meet its 2012 growth target of 7.5% GDP (likely) and to make it "much more balanced, coordinated and sustainable" The Aust Parliaments new Budget Office (PBO) launched an investigation into the sustainability of govt spending and tax breaks worth $120B: a sign the independent body could rival the federal Treasury for high-level budget analysis, and is likely to play a role in as a body used by the opposition to challenge Treasury/Government analyses.

Snapshots of the week: high level over view of Re-Insurance prompted by Storm Sandy Capacity: Supply Remains Adequate Despite Catastrophes Sandy came as a quick reminder to Asia Pacific that the reprieve of natural events we seem to experience after the major disasters of the past years (incl. JPN Tsunami, NZ Earthquake, Cyclon Yasi, QLd Floods) is only temporary, and reinsurance is a vital part of an insurer's strategy. To appreciate the importance: of the $12B of capital that SUN's General Insurance uses, $9B come from Reinsurance, whilst 'only' $3B are SUN's 'own' capital. The gap between insured losses and total economic losses of Annual Insured Losses By Event Type (USD Billions) catastrophic events globally in USD billions (indexed to 2010)

Reinsurance Capital 'Capacity' Worldwide

Despite recent disasters, capacity in the reinsurance market, measured by capital, has reached an all-time high of $470 billion at the end of the first quarter of this year, meaning supply continues to outstrip demand globally. Even Sandy is not going to negatively impact capacity in a 'material manner'. This is due to factors on the supply side such as growing investor interest in catastrophe bonds or similar collateralized facilities (trying to diversify investment as other markets are still in recovery mode) and on the demand side sluggish insurance demand growth for insurance in difficult economic environment (less asset to insure, therefore less pressure on re-insurance) All sources: Swiss Re, Aon Benfield Reinsurance Market 2012, Group Strategy Analysis A closer look at the reinsurance market. It is divided between: Traditional reinsurance programmes run by reinsurers (incl. Swiss Re, Munich Re, etc) which underwrite risk and charge on a risk weighted probability. Non-Traditional programs on the other hand such as catastrophe bonds (Cat Bonds), are typically more expensive BUT 100% of the capital is held aside in funds that pay returns to investors who get their principal back if nothing occurs over the life of the bond. Should an extreme triggering event occur during the life of the bond, the sponsor (insurer) receives a payout for the appropriate amount to use the money to pay claim-holders and investors won't be paid: it's this risk of no return in case of an event that investors take, against significant yields. Trade off between those two categories: in concentrated areas such as the US, reinsurers need diversification in order not to put all eggs in the same basket: this is why Cat Bonds are successful supplement to traditional reinsurance and good to cover higher levels of losses. The market is notably different in Australia where our local economics have made Cat Bonds more expensive than traditional reinsurance.

Financial flows for a Traditional Reinsurance

Financial flows for a Catastrophe Bond

Schematic illustrative trade off between profitability and capital The strategic issue for an insurance company is that reinsurance actually depending on 'retention' (measure of how much of the risk is being underpins the capital strategy and is behind the balancing act between carried by an insurer rather than being passed to reinsurers) Profitability (Insurance trading result - ITR) and Capital (Return on Equity ITR (measure of profitability) ROE). % A key parameter is the retention of the risk by the insurer (as opposed to passing it to a reinsurer).On one hand a high retention logically means High volatility avoiding the cost of paying for reinsurance, which boosts ITR as collected premiums go straight into earnings. However not having reinsurance also means the need to set a lot of capital aside in case of disasters and significantly lowers Return on Equity. ROE On the other hand, a lower retention (passing risk to reinsurers) comes at (performance of Capital) an upfront cost diminishing profitability but does improve Capital 0 Retention performance as less of it need to be set aside. Reinsurance is a complex domain that requires more than a page to tackle, however high level major strategic challenges are: Dilemma for insurers to set up their own reinsurance arm to reduce the cost of those programs (which is what QBE has done through its own captive Equator Re) The majority of insurance companies who rely on the global reinsurance market compete for available capital capacity and price. o One question is the future availability of capital in the Asia Pacific region, which uses 25% of the global reinsurance capacity. In this regional market SUN actually has one of the largest reinsurance programs in the world. Will a rebalancing occur after the recent years? Will the US pump the available capital? o Another question is the impact of recent events on Cat Bonds investors: observers question whether they were "naive capacity" who didn't truly understand their risk appetite or whether those investors are ready to shoulder (and pay the price) for those risks: their future trade off will be between the cost of a Sandy type event vs the attractiveness of compelling return opportunities relative to alternative markets.