June 6, 2005
The D&O Market: Current Issues and
Pricing Approaches
CAS Seminar on Reinsurance
John Lewandowski (ACE USA) and Will Garland (Guy Carpenter)
New York
Part I
Directors & Officers Liability
Overview
Directors & Officers Liability
Overview
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”).
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Directors & Officers Liability
Overview
Who Purchases D&O Coverage?
By Ownership Type
For Profit
Private
10%
For Profit by Account Size
Not for
Profit
10%
Very
Large
20%
Large
25%
For ProfitPublic
80%
Small
25%
MidMarket
30%
Small: Assets < $100M
Mid: $100M < Assets < $1B
Large: $1B < Assets < $10B
Very Large: Assets >10B
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Directors & Officers Liability
An 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 reunderwriting
5
Directors & Officers Liability
An 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 Liability
An 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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Part II
Current Issues in the D&O Marketplace
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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Claim Trends
Recent 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 IPO’s

Sarbanes-Oxley section 404 compliance has caused the “delisting” 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-ofpocket”
* Source : 2004 PwC Securities Litigation Study
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Claim Trends
Securities Class Action Activity
Securities Class Actions Suits Filed through May 2005
Source : Stanford Research
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Claim Trends
Historical Legislation Impacting D&O Suits
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
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Claim Trends
Securities Class Action Activity
Securities Settlements
30
25
Settlement
Value
20
15
Mean
Median
10
5
0
1996-2000
2001
2002
2003
2004
Year Settled
* Source : 2004 PwC Securities Litigation Study – Excl. Cendant/Worldcom
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Securities Claim Severity
Lies, 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 Severity
Behind 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 Severity
Impact 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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Part III
Traditional Problems in D&O
Reinsurance Pricing
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!
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Part IV
There are ways to price this business
D&O Pricing
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.
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D&O Pricing
Private Securities Litigation
Historical Claim Frequency by Firm Size
Frequency
7.50%
5.00%
2.50%
0.00%
<$100 m
$100 - $500 m
$500 m - $1 b
$1 b- $ 10 b
$10 b - $25 b
> $ 25 b
Size Category
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Frequency
D&O Pricing
Private Securities Litigation
Historical Claim Frequency by Sector
4.00%
2.00%
0.00%
Sector
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D&O Pricing
Individual Risk Adjustments
Consider account-specific characteristics:
 Financial performance,
 Claim history,
 Corporate governance, vendor scoring,
 S&P credit rating,
 M&A activity, IPO’s
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D&O 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™ D&O Model
Genesis

Loss and Exposure Analysis for D&O

Identified a need to help clients supplement existing experiencebased 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 Model
Takeaways

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 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
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