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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.

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TRENDS AND ISSUES IN THE D&O AND E&O MARKETPLACE


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    1. 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

    2. 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.

    3. 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.

    4. Source: NERA 2008 Mid-Year Update

    5. 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).

    6. Source: NERA 2008 Mid-Year Update

    7. 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.

    8. Source: NERA 2008 Mid-Year Update

    9. 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.

    10. Source: NERA 2008 Mid-Year Update

    11. MEDIAN SCA SEVERITY • Because of impact of large cases, median is more useful indicator of general severity trends.

    12. Source: NERA 2008 Mid-Year Update

    13. 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.

    14. Source: NERA 2008 Mid-Year Update

    15. 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.

    16. Source: NERA 2008 Mid-Year Update

    17. 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).

    18. Source: NERA 2008 Mid-Year Update

    19. Source: NERA 2008 Mid-Year Update

    20. 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

    21. Credit & Liquidity Crisis: D&O Reserving – A Reinsurance Perspective

    22. Agenda • Introduction • Liquidity Crisis • Credit Crisis • Mortgage Crisis • Securities Class Action Law Suits • Sector / Industry • Loss Reserving

    23. Introduction

    24. 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

    25. 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

    26. Liquidity Crisis

    27. 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

    28. 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)

    29. Credit Crisis

    30. Credit Crisis • A material reduction in available credit and / or • A significant increase in cost of credit • Widening of credit spreads • Increase in credit default rates • Weak corporate financials • Unstable capital bases • leading to…

    31. Credit Crisis • Crisis of insolvency • Anticipated decline in value of collateral • Increased perception of risk • Change in monetary conditions

    32. 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)

    33. 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)

    34. Mortgage Crisis

    35. 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

    36. 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

    37. Mortgage Crisis • Key Drivers • Housing market • Unemployment • Interest rates

    38. Mortgage Crisis • Other concerns • Mortgage equity loans • Student loans • Credit cards • Corporate real estate

    39. Mortgage Crisis • Exacerbation of the credit cycle • Major corporate failures • High unemployment (6.5 – 7.0%) • Stagflation (inflation and economic stagnation) • Recession

    40. Mortgage Crisis MORTGAGE LENDER CDO BORROWER Mezzanine Senior Tranche LOW RISK INVESTOR HIGH RISK INVESTOR BANK Equity Tranche Commercial Paper SPE MBS SIV

    41. Mortgage Crisis – Perfect Storm • Liquidity crisis • Credit crisis • Mortgage crisis • It may not be over!

    42. Securities Class Action Law Suits

    43. 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

    44. Sector / Industry

    45. 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

    46. 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

    47. Loss Reserving – A Reinsurance Perspective

    48. 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

    49. Loss Reserving: A Reinsurance Perspective • The analyst would have indicated materially inaccurate plan loss ratios If 2004, 2005 and 2006 loss experience is used to indicate plan loss ratio for 2008 If 2000, 2001 and 2002 loss experience is used to indicate plan loss ratio for 2004 OR