Large Firm Errors and Omissions: A Challenge Renewed for 2002 and Beyond By Joseph Kirley, ACAS Consulting Actuary (phone: )

What is a Large Firm? The Big 5 (now 4) –billions in revenue, ten thousand partners, hundreds of thousands of employees, worldwide operations “Public” /Headline Exposures –Practices dominated by publicly traded corporations and other clients with two things in common: large value at risk and third party reliance on accounting and other services

How Large? Large: Worldwide revenues for FY 2000, in billions of USD : –PWC19.6 –DTT11.2 –KPMG13.5 –E&Y9.2 –Andersen 8.4 –(source: Public Accounting Report, Feb 28,2001)

With size comes risk Universally perceived as a “deep pocket” E&O Exposure is on country firm level (usually local LLP) and arises from “covered work”: –failure to detect accounting fraud and mistakes –other forms of accounting malpractice –direct accusations of securities fraud and collusion –conflicts of interest –occasionally breach of contract /fiduciary duty

Risk Management Commercial insurance market: –offers little capacity –mainly fronting and local in-fill coverage on self-insured retentions (if reinsurers allow). –More readily available for consulting rather than audit and attest exposures Alternative Market: –captives that then buy reinsurance are the primary risk management device. –Worldwide captives are legally independent entities issuing policies to individual firms

Why Captives? Usual reasons: –assures availability of “some” coverage to member firms –more cost effective way to fund expected losses –accelerated tax deductions for member firms Other reasons: –excellent focal point to access reinsurance markets - the captive individually insures local partnerships scattered around the world, and then focuses reinsurance capacity for benefit of all –Discrete, dedicated claim handling that takes account of the firm’s worldwide reputation and brand value- reinsurers cede controls, no duty to defend –Better forum for resolving insurance disputes and enforcing risk management guidelines (political dynamic between member firms)

The Reinsurance Underlying captive policies are mature claims-made, and are issued in over 100 different countries with occurrence and aggregate limits - geographically diversified risk pool Local firms keep self insured per occurrence retentions (SIR) that range widely by locale and year (100k to 50mm USD) Captive attaches over SIR, with some per occurrence limit Captive then buys financial reinsurance or structured finite for working layers, and then guaranteed cost for higher severity layers - high capacity reinsurers only need apply Relationship-centered reinsurance, heavy intermediary involvement

Pricing Usually some combination of Experience and Exposure Rating An accurate exposure base has been elusive: most use revenues or number of employees Loss data is credible for large firms Accurate ultimate loss modeling absolutely requires attention to the details of large events

Losses to Ultimate Whether pricing or reserving, most important actuarial feature is loss development. Excess layer nature means claim mix and claim volatility usually dwarf other considerations in modeling any one year. Individual claim development is useful but is not widely used involves examining the historical development of individual claims, rather than in aggregate triangulations that assume homogeneity “Reserving for Excess Layers: A Guide to Practical Reserving Applications”, by Edward Dew and Barton Hedges, CAS Summer 1997 Forum (DH). DH was excellent survey of all excess development methods, and describes individual claim development methods, including a simulation technique that is very useful for large firms

Individual Claim Development - Fit Distribution to LDFs

Perform a Simulation - Ultimate Distribution by Claim and In the Aggregate - (This Assumes No Correlation between Events)

General Trends Past Decade: Lower frequency, higher severity, more randomness and volatility, low inflation, globalization of claims De-linking consulting and audit Disproportionate exposure outside U.S., but U.S. still dominates losses Rising prominence of internal risk management at firms More discriminating plaintiff industry since c.1998 (when SRA 1995 reforms began having a more pronounced affect) because ….. Dismissal rate on federal securities lawsuits has gone up dramatically due to greater procedural hurdles before discovery, and proportionate liability is now a more dominant influence in claim settlement Impact of Enron, Worldcom, etc: TBD, but have so far not observed obviously adverse consequences - Andersen’s demise may have perversely accelerated some plaintiffs towards lower and quicker settlements (anecdotal)…but….. Recent Sarbanes-Oxley legislation extended statue of limitations for filing federal suits from 2 years to 5 years…more legislative changes coming?

Myths and Misconceptions Myth 1: Every bankruptcy, business failure, and stock drop generates liabilities to the Big 5 Myth 2: Large D&O Claims mean large E&O claims Myth 3: Large headline losses and fines always mean horrible results to reinsurers Myth 4: One firm doing consulting and auditing together (even for one client) are riskier Myth 5: Captive insurance is a sham designed to hide the firm’s assets Myth 6: High tech clients are riskier to Big 5 than all others

The Future Even more capacity needed to handle run away severity cases Contingent and catastrophic finance mechanisms? Will private partnerships and international relationships be modified because of Andersen’s demise?