TRENDS AND ISSUES IN THE D&O
AND E&O MARKETPLACE
Michael F McManus, FCAS, MAAA
Senior VP and Actuary
Chubb Group of Insurance Companies
Casualty Loss Reserve Seminar
September 19, 2008
DISCLAIMER
The views, information and content expressed
herein are those of the author and do not
necessarily represent the views of any of the
insurers of the Chubb Group of Insurance
Companies. Chubb did not participate in and
takes no position on the nature, quality or
accuracy of such content.
INDUSTRY D&O RESULTS



Tracking of industry results for D&O and E&O is
generally difficult because results are included in
the Other Liability-Claims Made section of
Schedule P.
Data on federal securities class actions (SCA’s)
however is readily available and widely followed
by the industry as key indicator of profitability.
SCA’s account for most of Public D&O loss costs.
Source: NERA 2008 Mid-Year Update
SCA FREQUENCY 1996-2008

1997-2004 averaged 230 “standard” SCA’s, then
significant declines in 2005 (188) and 2006 (131)
but increases in 2007 (195) and 2008 (278
projected).

Systemic events caused spikes in 2001 (IPO
laddering – 300) and 2002 (analyst claims - 47).

Increase in 2007 and especially 2008 is due to
subprime and auction rate securities cases.

Options backdating was a systemic event in 2006
(24 SCA’s) but was primarily a derivative claim issue
(about 200 cases).
Source: NERA 2008 Mid-Year Update
SCA FREQUENCY 2002-2008



Looking at recent data in six month intervals
shows dramatic decline began in 2H/05 and
continued through 1H/07.
Increase in 2H/07 and 1H/08 primarily due to
credit crisis cases.
Cornerstone study found that these SCA
patterns are largely explained by the level of
stock market volatility in each period.
Source: NERA 2008 Mid-Year Update
AVERAGE SCA SEVERITY



Average settlement data by calendar year is
quite volatile because of small # of very large
cases > $1 billion (Enron, Worldcom, Nortel,
AOL)
When these mega cases are removed, averages
are much more stable and show reasonably
steady upward trend.
These numbers exclude defense costs, which
can be very significant.
Source: NERA 2008 Mid-Year Update
MEDIAN SCA SEVERITY

Because of impact of large cases, median
is more useful indicator of general severity
trends.
Source: NERA 2008 Mid-Year Update
DRIVERS OF SETTLEMENT VALUES


NERA has found that investor losses due to
decline in share price are single most powerful
determinant of settlements.
However ratio of settlements to investor losses
decreases steadily as investor losses rise.
Source: NERA 2008 Mid-Year Update
OTHER KEY DRIVERS OF SEVERITY




Defendant company’s market capitalization
Institutional investors serving as lead
plaintiff
Allegations of accounting impropriety
Involvement of professional firms as
codefendants, especially accountants.
Source: NERA 2008 Mid-Year Update
WHERE ARE FUTURE
SETTLEMENTS HEADING?


Median investor losses for cases settled in
2005-2008 averaged $350M.
For cases filed in 2005-2008, however, there is
a sharp increase in median investor losses,
especially in 2008 ($800M) and especially 2008
subprime cases ($4.3B).
Source: NERA 2008 Mid-Year Update
Source: NERA 2008 Mid-Year Update
TRENDS AND ISSUES IN THE D&O
AND E&O MARKETPLACE
Michael F McManus, FCAS, MAAA
Senior VP and Actuary
Chubb Group of Insurance Companies
Casualty Loss Reserve Seminar
September 19, 2008
Credit & Liquidity Crisis:
D&O Reserving – A Reinsurance
Perspective
Agenda
Introduction
Liquidity Crisis
Credit Crisis
Mortgage Crisis
Securities Class Action Law Suits
Sector / Industry
Loss Reserving
Introduction
Introduction
139 securities class action law suits (H1 2008)
Bank failures (Bear Stearns, Indy Mac, etc)
Mortgage lender failures (Countrywide Financial, etc)
Federal assistance for Fannie Mae and Freddie Mac
Expectation of future failures of financial institutions
Anticipated total cost of $1.0 – $1.5 trillion
Introduction
Reinsurers set a plan loss ratio for the following year
 Represents a loss pick until claim data is gathered from
primary companies
 Availability and quality of data varies
 Remains D&O loss pick even after market conditions
have reversed
Liquidity Crisis
Liquidity Crisis
When an entity experiences a shortage of cash
 To pay for day-to-day business operations (e.g., Payroll)
 To meet debt obligations on time
 To expand inventory and production
Does not necessarily mean that the business is insolvent
Liquidity Crisis
Comparison to credit crisis
 A sound business can experience a liquidity crisis by
temporary inaccessibility to required financing
 A credit crunch is based on insolvency of entities
 Due to steep decline of previously over-priced assets
(mortgage-backed securities, CDO, etc)
Credit Crisis
Credit Crisis
Widening of credit spreads
Increase in credit default rates
Weak corporate financials
Unstable capital bases
leading to…
A material reduction in available credit and / or
A significant increase in cost of credit
Credit Crisis
Crisis of insolvency
Anticipated decline in value of collateral
Increased perception of risk
Change in monetary conditions
Credit Crisis
End of “housing bubble” (August 2005)
U.S. Home Construction Index falls 40% in 12 months (August
2006)
First national house price decline since 1991 (March 2007)
Subprime industry begins to collapse (March 2007)
Bear Stearns Hedge Funds collapse (July 2007)
Countrywide Bank run (August 2007)
Global Credit Crisis revealed as many banks declare holding
mortgage backed securities (August 2007)
Northern Rock Bank (U.K.) run (September 2007)
Credit Crisis
Federal Reserve makes $41 billion available to U.S. banks
Federal reserve injects $43 billion into the money supply and
more later
European central Bank adds €156 billion and more later
Bank of Japan injects ¥1 trillion
Bear Stearns is acquired by JP Morgan for $2 per share with
a $30 billion backing from Federal Reserve
Fannie Mae and Freddie Mac rescue (cost: over $25 billion)
Mortgage Crisis
Mortgage Crisis
Bank Failures in 2008
 IndyMac Bancorp – 7/11 (Assets: $32 billion, Deposits: $19 billion)
 3rd largest bank failure in the U.S. after Continental Illinois National Bank
and Trust, Chicago (1984) and First Republic Bank, Dallas (1988)
 First Integrity Bank – 5/30 (Assets: $55 million, Deposits: $50 million)
 ANB Financial – 5/9 (Assets: $2.1 billion, Deposits: $1.8 billion)
 Hume Bank – 3/7 (Assets: $19 million, Deposits: $14 million)
 Douglas National Bank – 1/25 (Assets: $59 million, Deposits: $54
million)
According to FDIC, there have been 32 bank failures in the U.S. since
2000
IndyMac is bigger than all the other 31 banks put together
Mortgage Crisis
The cost to economy
 Recession
 Lack of financing for solvent companies and individuals
with good credit
 85,000 job losses so far in the financial industry
 Unemployment could reach 6.5 – 7.0%
The cost to financial institutions
 Lack of confidence
 Bear Stearns acquired. Who is next?
 Lack of capital for growth
Mortgage Crisis
Key Drivers
 Housing market
 Unemployment
 Interest rates
Mortgage Crisis
Other concerns
 Mortgage equity loans
 Student loans
 Credit cards
 Corporate real estate
Mortgage Crisis
Exacerbation of the credit cycle
 Major corporate failures
 High unemployment (6.5 – 7.0%)
 Stagflation (inflation and economic stagnation)
 Recession
Mortgage Crisis
BORROWER
MORTGAGE
LENDER
CDO
Mezzanine
BANK
HIGH RISK
INVESTOR
Senior Tranche
LOW RISK
INVESTOR
Equity
Tranche
SPE MBS
Commercial
Paper
SIV
Mortgage Crisis – Perfect Storm
Liquidity crisis
Credit crisis
Mortgage crisis
It may not be over!
Securities Class Action Law Suits
Securities Class Action Law Suits
Projected number of securities class action law suits in 2008:
278 all filings
139 filed law suits as of July 2008 is mainly driven by the
mortgage crisis
Clearly correlated with stock market volatility
Severity of these claims could be high because investor
losses have been very high
The effect of recent legal trends yet to be quantified
Resources: Cornerstone Research and NERA
Sector / Industry
Sector / Industry
Financial Institutions materially affected during the current
crisis
Other sectors show competitive pricing, enough limits and
favorable terms
Credit and liquidity crisis affect all sectors
Seems to be ample capacity keeping rates low
Sector / Industry
Easier to file law suits based on one or two major themes
(mortgage crisis and related investor losses)
Next crisis:
 Energy sector (when price of oil / gas drops)
 Manufacturing or retail (?)
 Other
There will always be a cause and a crisis
Loss Reserving – A Reinsurance
Perspective
Loss Reserving: A Reinsurance Perspective
Plan loss ratio  Loss reserve pick
Plan loss ratio based on recent loss experience
 Adjusted for
 Trend
 Rate changes
 Limits / attachment points
Loss Reserving: A Reinsurance Perspective
If 2004, 2005 and 2006 loss
experience is used to indicate
plan loss ratio for 2008
If 2000, 2001 and 2002 loss
OR experience is used to indicate
plan loss ratio for 2004
The analyst would have indicated
materially inaccurate plan loss ratios
Loss Reserving: A Reinsurance Perspective
Key Reason
Systemic issues that are not captured by traditional actuarial
methods
Contagion (correlation) is not considered in the plan loss ratio
pick
Loss Reserving: A Reinsurance Perspective
Considerations
 Equity market movement and volatility
 Debt market movement (widening of credit spreads)
 Change in legal environment
 Paradigm shifts in the market/economy
 Effect of correlation
 Disaster loss scenarios (1:100 or 1:200)
Loss Reserving: The Big Picture
Plan loss ratio pick should include economic, financial and
political considerations based on broad and intuitive
understanding of market conditions
Q&A
Athula Alwis, Senior Vice President, Global Credit Practice
September 19, 2008
TRENDS AND ISSUES IN THE
D&O AND E&O MARKETPLACE
Michael F McManus
Senior VP and Actuary
Chubb Group of Insurance Companies
Casualty Loss Reserve Seminar
September 19, 2008
DISCLAIMER
The views, information and content expressed
herein are those of the author and do not
necessarily represent the views of any of the
insurers of the Chubb Group of Insurance
Companies. Chubb did not participate in and
takes no position on the nature, quality or
accuracy of such content.
D&O/E&O RESERVING
CHALLENGES



Traditional reserving models assume that recent
loss history (adjusted to current conditions) is
the best predictor of future losses.
D&O and E&O business can be subject to
systemic events that can cause unexpected
spike in a current accident year loss ratio.
Need to build reserving models that provide
early insight into recent accident years results
POLICY LIMIT TO LOSS MODEL



Public D&O loss experience is driven by security
class action (SCA) claims
Look for relationship between historical ultimate
losses and policy limits exposed by segment
(primary, excess and side A).
Need to include loading for non-SCA claims.
INDIVIDUAL SCA CLAIM MODEL


Ultimate SCA settlements are clearly impacted
by the size of market cap losses
(NERA/Cornerstone)
Cornerstone compared median settlements to
market cap loss and found consistent decline in
this relationship
MEDIAN SETTLEMENT AS A PERCENTAGE OF
DISCLOSURE DOLLAR LOSSES (DDL) BY DDL RANGE
Dollars in Millions
60
54.8
50
Through 2006
2007
40.5
40
30
20
10
10.1
8.9 8.6
12.9
5.1 3.8
3.4 3.3
005$ - 152$
2.1
4.1
0
Total sample
N=774 N= 109
52$ <
001$ - 52$
052$-101$
N=215 N=21
N=212 N=26
N=140 N=25
Source: Cornerstone 2007 Review
N=76 N=16
005$>
N=131 N=21
INDIVIDUAL SCA SEVERITY MODEL

Try to build regression model to estimate SCA
severity, including factors such as:







Plaintiff’s estimated damages.
Whether financials were restated.
Is there a corresponding SEC action?
Whether accountants and/or underwriters are named
as co-defendants.
Existence of corresponding derivative action.
Whether lead plaintiff is a public pension plan.
Whether securities other than common stock are
alleged to be damaged
INDIVIDUAL SCA CLAIM MODEL




If you can develop an estimate of ground up
settlement potential, need to also estimate
probability of dismissal and load defense costs for
initial motion to dismiss for all cases.
If case is not dismissed, then add defense costs to
get through subsequent phases.
Compare ground up settlement (if any) and
defense costs estimate to your limit/attachment
point to estimate your exposure.
Include significant discount if your policy is side A
only.
CONCLUSION

Regardless of how you model this business, it
will take many years to see how accurate your
model is, as this is truly a volatile, long tail line
of business.
TRENDS AND ISSUES IN THE
D&O AND E&O MARKETPLACE
Michael F McManus
Senior VP and Actuary
Chubb Group of Insurance Companies
Casualty Loss Reserve Seminar
September 19, 2008