John Lewandowski (ACE USA) and Will Garland (Guy Carpenter) New York The D&O Market: Current Issues and Pricing Approaches CAS Seminar on Reinsurance June 6, 2005

Part I Directors & Officers Liability Overview

3 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 Liability Overview

4 By Ownership Type For Profit by Account Size Small: Assets < $100M Mid: $100M < Assets < $1B Large: $1B < Assets < $10B Very Large: Assets >10B Who Purchases D&O Coverage? Directors & Officers Liability Overview

– 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 Liability An Historical Perspective

– 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 Liability An Historical Perspective

7 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 Liability An Historical Perspective

Part II Current Issues in the D&O Marketplace

9 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

10  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 Trends Recent Developments

11 Securities Class Actions Suits Filed through May 2005 Source : Stanford Research Claim Trends Securities Class Action Activity

/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 Trends Historical Legislation Impacting D&O Suits

13 * Source : 2004 PwC Securities Litigation Study – Excl. Cendant/Worldcom Claim Trends Securities Class Action Activity

14 Securities Claim Severity Lies, Statistics Average 2005 settlement is $27m 1 (+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.

15 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 $5.3m 1 (+10% annual trend) 1. Recent Trends in Shareholder Class Action Litigation, NERA, Elaine Buckberg, Ph.D, et al.

16 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

Part III Traditional Problems in D&O Reinsurance Pricing

18 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

19 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

20 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

22 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

23 D&O Pricing

24 D&O Pricing

25 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

26  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

27 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

28 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

29 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

30 LEAD TM 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

31 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