Reinsurance Boot Camp on Pricing Techniques
Professional Liability – Director’s & Officers
John Lewandowski, FCAS, MAAA
August 9, 2007
Reinsurance Boot Camp
I.
D&O Profile
II.
D&O Individual Account Pricing Model
III.
Frequency Model
IV. Severity Model
V.
Additional Considerations
VI. Loss Cost Model
VII. Results
VIII. Next Steps
Reinsurance Boot Camp
I. D&O Profile - Coverage
 Directors & Officers Liability Policy – provides coverage for claims arising from the
“wrongful acts” – i.e., any act, error or omission -- of insured persons while serving
in their capacity as directors or officers. Expanded to included Entity coverage for
“securities claims.” D&O coverage is simply a specialized type of Errors &
Omissions coverage, often referred to as Management Liability.
 Management Liability product line typically also includes EPL, Fiduciary Liability
(PTL), Fidelity, Financial Institution E&O
 Errors & Omissions Professional Liability Policy – provides coverage for claims
involving alleged “errors and omissions” arising out of professional services
rendered by the insured, e.g. banks, investment advisors, insurance companies,
mutual funds…
Reinsurance Boot Camp
I. D&O Profile - Claims
•
Some interesting D&O statistics for Public Companies*
 Half of all suits against D&O’s are filed by Shareholders
 21% of claims brought by employees
 Shareholders are claimants in 49% of claims
 60% (or more) of all suits are accounting-related
 36% of all claims are class actions
Securities Class Actions
 Low Frequency – typically less than 200 suits per year (excl IPO) – Public Co.
 High Severity –mean settlement of $50-60 m, median of $5-7 m – Public Co.
 Most active Circuit courts are Southern District of NY (2nd) and California (9th)
 Most frequently sued Sector is Technology (30% of cases)
 Most frequently sued Industry is Biotechnology & Drugs
 Most resolutions achieved through settlement, not judgment
*Source : Tillinghast 2006 D&O Report and Stanford Research
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I. D&O Profile - Claims
Class Action Securities Suits Represent Vast Majority (> 85%) of Loss
Dollars Paid by Public Company D&O Policies
Source : Stanford Research
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II.
D&O pricing model

Current approaches to Public D&O Pricing

Typically market based pricing and/or outdated base rates

Often Vendor supplied models and parameters


Heavy reliance on judgment rating – lack of statistical support
for pricing
Public D&O Securities Pricing Model

Get “Back to Basics” - Frequency/Severity model

Public Company focus – excludes Not for Profit or Private Cos.

Class Action Securities Suits only

Ready access to publicly available data including Stanford
Research and Company Financial data
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II. Frequency Model

Financial information for 1999 through 2005

Stanford Class Action Securities filings for same time period

Predictive modeling (GLM)

Uses Historical data to construct a statistical model that will be
predictive of the future

Dependent variable - claims, losses

Weight – exposures, premium

Independent variable – market cap, revenue, stock volatility, etc..
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II. Frequency Model (cont.)
Considered 24 rating variables, 7 were included in final model
1.
2.
3.
4.
5.
6.
7.
Sector/Industry Group
Market Capitalization
Stock Volatility
Net income / Revenue
Change in Revenue
Change in Market Capitalization
Volume traded / Shares Outstanding
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II. Frequency Model (cont.)
Observed Frequency Values
30.0%
25.0%
Frequency
20.0%
15.0%
10.0%
5.0%
0.0%
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III. Severity Model

Closed Claim study of 760 settled securities claims

From ground-up settlement data, but does not include defense cost!

Manually adjusted to incorporate settlements exposing D&O policies –
exclude fines, disgorgement

Trended settlements to current loss cost levels

Claim Severity Distribution based on firm size (market capitalization)

Severity model recognizes differing loss exposure in excess layers due to
potential investor loss (size of firm).

Modeled relationship between firm size (market cap) and mean/median loss
using weibull curves

Once mean and median were determined, assumed loss distribution was
lognormally distributed
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III. Severity Model (cont.)
Increased Limit Factor
Average Limited D&O Severity Across Firm Size
$5
$10
$15
$20
$25
$30
$35
$40
$45
$50
$55
$60
Limit in $Millions
MCAP = $100M
MCAP = $2,000M
MCAP = $5,000M
MCAP = $25,000M
MCAP = $100,0M
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III. Severity Model (cont.)
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IV. Additional Considerations
Dismissal Rate –some of the filed suits will be dismissed

Based on Tillinghast report, PLUS journals and Advisen data

Recognizes global settlements and recent trends
Defense Costs - provision for defense reimbursement applied to lognormal
severity µ parameter:

10% if settled

5% if dismissed
Profit and Expense loadings –set based on local practice
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V. Loss Cost Model
Final loss cost components:
–
Loss cost for dismissed claims
–
Loss cost for non-dismissed claims
–
Risk load – percentage of standard deviation in layer
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VI. Key Takeaways

There exists a strong relationship between company financials and
securities class action claim frequency.

There exists a strong relationship between company financials and
securities class action claim severity.

Predictive modeling can be used to interpret these relationships.