John Lewandowski (ACE USA) and Will Garland (Guy Carpenter)New York

The D&O Market: Current Issues and Pricing ApproachesCAS Seminar on Reinsurance

June 6, 2005

Part I

Directors & Officers LiabilityOverview

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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 D&O.

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”).

Directors & Officers LiabilityOverview

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Not for Profit10%For Profit

Private10%

For Profit-Public80%

By Ownership Type For Profit by Account Size

Very Large20%

Large25% Mid-

Market30%

Small25%

Small: Assets < $100MMid: $100M < Assets < $1BLarge: $1B < Assets < $10BVery Large: Assets >10B

Who Purchases D&O Coverage?

Directors & Officers LiabilityOverview

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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

Directors & Officers LiabilityAn Historical Perspective

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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

Directors & Officers LiabilityAn Historical Perspective

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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

Directors & Officers LiabilityAn Historical Perspective

Part II

Current Issues in the D&O Marketplace

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Current Issues in the D&O 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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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 IPO’s

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

Claim TrendsRecent Developments

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Securities Class Actions Suits Filed through May 2005

Source : Stanford Research

Claim TrendsSecurities Class Action Activity

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1933/34 Securities Acts D&O 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

Claim TrendsHistorical Legislation Impacting D&O Suits

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* Source : 2004 PwC Securities Litigation Study – Excl. Cendant/Worldcom

0

5

10

15

20

25

30

SettlementValue

1996-2000 2001 2002 2003 2004

Year Settled

Securities Settlements

MeanMedian

Claim TrendsSecurities Class Action Activity

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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 D&O 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

Part III

Traditional Problems in D&O Reinsurance Pricing

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Problems with D&O 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 D&O 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!

Part IV

There are ways to price this business

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Add More Science to the Art of D&O 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.

D&O Pricing

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Private Securities LitigationHistorical Claim Frequency by Firm Size

0.00%

2.50%

5.00%

7.50%

<$100 m $100 - $500 m $500 m - $1 b $1 b- $ 10 b $10 b - $25 b > $ 25 b

Size Category

Fre

qu

en

cy

D&O Pricing

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Private Securities LitigationHistorical Claim Frequency by Sector

0.00%

2.00%

4.00%

6.00%

Sector

Fre

qu

en

cy

D&O Pricing

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Consider account-specific characteristics: Financial performance, Claim history, Corporate governance, vendor scoring, S&P credit rating, M&A activity, IPO’s

D&O Pricing Individual Risk Adjustments

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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

D&O Pricing Establish and Enforcement of Underwriting Guidelines

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LEAD™ D&O Model Genesis

Loss and Exposure Analysis for D&O

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™ D&O 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™ D&O 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 D&O 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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Uncertainty surrounds the D&O market

D&O claim frequency and severity continue to increase

– However, statistics can be misleading

There are traditional problems in D&O reinsurance pricing

– There are solutions out there

– Reinsurers have reacted

There are ways to price this business

– Add more science to D&O pricing

Other ways to analyze D&O risk

– New models, others

Key Takeaways