The D

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The DO Market Current Issues and Pricing
ApproachesCAS Seminar on Reinsurance

• June 6, 2005

John Lewandowski (ACE USA) and Will Garland (Guy
Carpenter) New York
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Directors Officers LiabilityOverview
Part I
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Directors Officers LiabilityOverview

• Directors Officers Liability provides
  coverage for claims arising from the wrongful
  acts of insured persons (corporate malfeasance)
  while serving in their capacity as directors or
  officers, including any act, error or omission in
  their capacity as DO.
• Three types of traditional coverage
• Side A coverage for non-indemnifiable claims
• Side B reimbursement coverage to companies for
  settlements, judgments defense costs
• Side C - coverage for securities-related claims
  made directly against companies.
• Coverage often includes Employment Practices
  Liability (excluding professional services).

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Directors Officers LiabilityOverview
Who Purchases DO Coverage?
By Ownership Type
For Profit by Account Size
Small Assets lt 100M Mid 100M lt Assets lt
1B Large 1B lt Assets lt 10B Very Large Assets
gt10B

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Directors Officers LiabilityAn Historical
Perspective

• 1997 - 2001 Softening Market
• Expanded capacity/larger limits offered
• Consistent reductions in rate levels
• Expanded coverage, introduction of entity
  coverage brings an end to pre-set allocation
• Free/automatic reinstatements
• Multi-year policies with significant discounts
  and no re-
• underwriting

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Directors Officers LiabilityAn Historical
Perspective

• 2002 2003 - Hard Market Underwriting and
  Pricing
• Reduction in limits, increased insured retentions
• Large rate increases - more than 150 were
  common (risk dependent)
• Coverage restrictions eliminate investment
  banking, entity
• coverage, other terms and conditions
• Elimination of multi-year deals

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Directors Officers LiabilityAn Historical
Perspective

• 2004/2005 Eye of the Storm?
• Entry of new capacity
• Reductions in both renewal and new business rates
• Intense competitive pressure in mid/small market
  segments
• Demand for additional coverage Side A

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Current Issues in the DO Marketplace
Part II
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Current Issues in the DO Marketplace

• Rate adequacy
• Declining rates on excess business
• How do you benchmark a portfolio over time?
• Entity coverage, multi-year policies, other
  changes in coverage (e.g. Side A cover)
• Uncertainty of results
• Length of time to class action settlement
• Financial Institution events
• Mutual funds, Insurance brokers/companies,
  Investment banks
• Claim Trends
• Impact of recent legislation Sabanes-Oxley

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Claim TrendsRecent Developments

• 2004 saw increases in filings against foreign
  companies (Increase of more than 90 over 2003
  100 over historical average)
• 2004 filings up 16 over 2003 and 7 over 8-year
  average
• Sarbanes-Oxley section 404 compliance has delayed
  IPOs
• Sarbanes-Oxley section 404 compliance has caused
  the de-listing of some smaller public and
  foreign firms
• PCAOB established to oversee public company audit
  - development of new standards
• Emerging trend in settlements seeking
  non-financial, remedial action composition of
  BOD and Audit committee
• Settlements requiring independent directors to
  pay out-of-pocket

Source 2004 PwC Securities Litigation Study
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Securities Class Actions Suits Filed through May
2005
Claim TrendsSecurities Class Action Activity
Source Stanford Research
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Claim TrendsHistorical Legislation Impacting DO
Suits

• 1933/34 Securities Acts
• DO Liability for misrepresentations, omissions
  in public offerings, statements
• 1995 PSLRA
• Intended to prevent abuses of securities class
  action lawsuits.
• Heightened Pleading Standard
• 2002 Sarbanes-Oxley Act
• Blackout trading barred
• CEO and CFO certifications
• Faster insider trading disclosure
• Increased Audit Committee duties and SEC review
• More criminal penalties and fines

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Claim TrendsSecurities Class Action Activity
Source 2004 PwC Securities Litigation Study
Excl. Cendant/Worldcom
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Securities Claim SeverityLies, Statistics

• Average 2005 settlement is 27m1 (20 annual
  trend)
• Includes all shareholder recoveries, even those
  recovered from third parties
• Only non-zero settlements, i.e., no dismissals
• Dismissals average greater than 20 of filings
• Does not contemplate insured loss, e.g. Cendant
  3.2b settlement vs. 125m DO program
• Includes amounts uninsurable
• Fines, non-cash amounts (options, warrants)
• Broker disclosure Does not include defense costs

1. Recent Trends in Shareholder Class Action
Litigation, NERA, Elaine Buckberg, Ph.D, et al.
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Securities Claim SeverityBehind the Average

• Headline settlements drive average
• Top two cases 20 - 50 of total settlement
  dollars since 1998
• Top three cases 25 - 75
• Median settlement is 5.3m1 (10 annual trend)

1. Recent Trends in Shareholder Class Action
Litigation, NERA, Elaine Buckberg, Ph.D, et al.
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Securities Claim SeverityImpact on Attachment
Points

• Settlements greater than 50m increasing
• Nine in 2002 and 2003
• 5 of settlements
• Seventeen in 2004
• 10 of settlements
• Bread and Butter settlements (between 2m and
  50m) exhibit stable trend
• Average about 10m
• 4 trend since 1996

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Traditional Problems in DO Reinsurance Pricing
Part III
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Problems with DO Reinsurance Pricing

• No uniformity in price monitoring
• How do you monitor new business rate change?
• Divergent loss development methods
• Length to settlement makes reserving difficult
• Primary vs. Excess
• Motion to Dismiss key
• Multi-year business
• Differing views on trend assumptions

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Solutions should be evident

• Claims made business
• Frequency is known within 12 months
• Loss information readily available from numerous
  credible sources
• Stanford, PWC, NERA
• Reinsurers need to be consistent in the
  information they request from ceding companies
• Class action information
• Should make up 90 of DO loss (portfolio
  dependent)
• Rate changes across the entire portfolio
• New and renewal business

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Reinsurers Have Reacted!

• Reinsurance markets have shown discipline since
  late 2004
• Reductions in capacity
• Limits offered as well as treaties supported
• Tighter terms and conditions to address
  uncertainty of results
• Lower ceding commissions
• Loss limitations

However, there is still work to be done!
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There are ways to price this business
Part IV
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DO Pricing

• Add More Science to the Art of DO Underwriting
• Development of exposure-based pricing model using
  both market cap and asset size.
• Develop loss costs as a combination of
• Non-securities exposure anti-trust
• Securities exposure non-accounting, revenue
  recognition, earnings restatement
• Include impact of size, sector, insider holdings.

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DO Pricing
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DO Pricing
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DO Pricing Individual Risk Adjustments

• Consider account-specific characteristics
• Financial performance,
• Claim history,
• Corporate governance, vendor scoring,
• SP credit rating,
• MA activity, IPOs

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DO Pricing Establish and Enforcement of
Underwriting Guidelines

• Define authority levels limits, price, rate
• Define target market and risk appetite
• Establish benchmarks for pricing
• Monitor Rate achievement
• Track adjust variance between market and
  indicated pricing

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LEAD DO Model Genesis

• Loss and Exposure Analysis for DO
• Identified a need to help clients supplement
  existing experience-based risk selection and
  portfolio management
• Recognized existence of available data which
  might portend a model that could identify the
  absolute and relative riskiness of U.S. publicly
  traded companies
• Teamed with National Economic Research Associates
  (NERA) who possessed the technology and
  intellectual capital to develop a predictive model

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LEAD DO Model Potential SCAS Indicators

• Examined the effects of more than 70 variables
  covering four distinct categories
• issuer characteristics
• financial statement items
• stock ownership
• stock trading characteristics
• Analyzed the effects of variables individually
  and in combinations
• e.g., goodwill and goodwill as a percentage of
  market cap

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LEAD DO Model Methodology

• Regression-based
• uses independent variables to predict the
  behavior of a dependent variable
• compares companies that have experienced SCAS vs.
  companies that have not
• looked for statistical significance above
  confidence levels

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LEADTM DO ModelTakeaways

• Not an underwriting or pricing model, but ideal
  comparison of exposure relativities between
• Companies you insure
• Companies you might insure
• Segments of your portfolio
• No bias in model construction
• Identification of potential problem areas and
  opportunities
• Supplements ceding company and reinsurer
  understanding of underlying portfolios

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Key Takeaways

• Uncertainty surrounds the DO market
• DO claim frequency and severity continue to
  increase
• However, statistics can be misleading
• There are traditional problems in DO reinsurance
  pricing
• There are solutions out there
• Reinsurers have reacted
• There are ways to price this business
• Add more science to DO pricing
• Other ways to analyze DO risk
• New models, others