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 (2 nd ) and California (9 th )  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

Reinsurance Boot Camp 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

Reinsurance Boot Camp II.D&O pricing model  Current approaches to Public D&O Pricing  Typically market based pricing and/or outdated base rates  Often Vendor supplied models and parameters  Heavy reliance on judgment rating – lack of statistical support for pricing  Public D&O Securities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

Reinsurance Boot Camp 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..

Reinsurance Boot Camp II. Frequency Model (cont.) Considered 24 rating variables, 7 were included in final model 1. Sector/Industry Group 2. Market Capitalization 3. Stock Volatility 4. Net income / Revenue 5. Change in Revenue 6. Change in Market Capitalization 7. Volume traded / Shares Outstanding

Reinsurance Boot Camp II. Frequency Model (cont.)

Reinsurance Boot Camp 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

Reinsurance Boot Camp III. Severity Model (cont.)

Reinsurance Boot Camp III. Severity Model (cont.)

Reinsurance Boot Camp 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

Reinsurance Boot Camp 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

Reinsurance Boot Camp 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.