Aon’s P/C Operations Downgraded

May 12, 2004

Insurer ratings agency A.M. Best Co. has affirmed the financial strength ratings of “A” (Excellent) of Chicago-based Aon Corp.’s life/health operations—Combined Insurance Company of America (CICA) and Combined Life Insurance Company of New York (CLNY) , a wholly-owned subsidiary of CICA. The outlook for the life/health ratings has been revised to negative from stable.

A.M. Best has also downgraded the financial strength ratings to “A-” (excellent) from “A” (Excellent) of Aon’s property/casualty operations—Virginia Surety Co. Inc. (VSC) and FFG Insurance Co. (FFG). The outlook for the property/casualty ratings is stable.

In addition, A.M. Best has downgraded the financial strength rating to “B++” (Very Good) from “A-” (Excellent) of Resource Life Insurance Co. (Resource). The rating outlook is stable.

A.M. Best has also revised to negative from stable the rating outlook on the financial strength rating of” A-” (Excellent) of Sterling Life Insurance Co. (Sterling). Both Sterling and Resource are wholly-owned subsidiaries of CICA.

The negative outlook on CICA is based on concerns surrounding the level of concentration associated with CICA’s less-liquid high-risk assets, uncertainty with regards to parental support for the organization and ongoing operational and business profile issues.

A.M. Best remains concerned about the level of risk CICA has within its investment portfolio, particularly below investment grade holdings and future commitments, related to the group’s securitization of its sizeable limited partnership position. While Aon and CICA have a plan for reducing this risk, as it stands now, the investment quality and concentration in these particular investments are not appropriate for a highly-rated health insurance company.

Additionally, given Aon’s aborted divestiture of its insurance operations in 2002, A.M. Best does not view these operations as core to the organization. While capitalization has not been an issue for CICA, Aon dividended much of CICA’s earnings prior to 2002. This has inhibited surplus growth in earlier periods. Plans call for more modest dividends to be paid from CICA beginning again in 2004.

Furthermore, A.M. Best has discussed a number of operational issues with CICA’s management regarding foreign currency risk, market competition, and potential risks related to several of its core individual accident and health products. While management is presently addressing a number of A.M. Best’s issues, some are more related to A.M. Best maintaining a cautious view of certain industry segments.

The revising of the rating outlook to negative for Sterling is primarily based on both Medicare supplement and Medicare Advantage markets being highly-regulated commodity-type products and that these markets are becoming increasingly competitive. Moreover, while Sterling turned profitable in 2003, A.M. Best will look for it to continue a profitable growth trend going forward, with capital support from CICA as needed to maintain an appropriate risk-adjusted capital position. CICA contributed $15 million to Sterling in the first quarter of 2004, to support its below average risk-adjusted capital ratio.

The rating of Resource was downgraded based on its substantial use of financial reinsurance and the downgrade of Aon’s extended warranty insurance company, VSC, which works in conjunction with Resource.

The rating downgrades of the property/casualty companies are a result of the poor operating results of the lead property/casualty company, VSC, in 2002 and 2003. VSC’s operating performance has not been commensurate with its A (Excellent) rating and it has resulted in weakened capital strength over that time. As a result of VSC’s downgrade, FFG was downgraded too. The largest driver of VSC’s financial underperformance was a poorly performing apartment liability book written in 2001 and 2002. Between 2002 and 2003, VSC recorded approximately $100 million in pre-tax reserve charges on this book–the equivalent of one-third of total year-end 2003 reserves.

A.M. Best remains concerned about the reserve adequacy of the apartment liability book. In addition, VSC has recorded approximately $30 million of restructuring charges on its core extended warranty business over the same time, which significantly reduced the profitability of what historically has been a very profitable business for VSC. Finally, VSC’s capitalization, as measured by A.M. Best, would have deteriorated materially in 2003 if not for the stock price performance of a single large investment–equivalent to approximately 70% of surplus–which resulted in an unrealized gain of approximately $150 million.

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