Large Firm Errors and Omissions: A Challenge Renewed for 2002 and

Beyond

By Joseph Kirley, ACAS

Consulting Actuary

(phone: 914 439 5669)

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 :– PWC 19.6

– DTT 11.2

– KPMG 13.5

– E&Y 9.2

– 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

(1) (2) (3) (4)

Claim NumberCase Incurred

(000 USD)Lognormal

Sigma Lognormal MuLognormal Mean LDF

1 25,000 1.378 -0.400 1.732 10,000 1.414 0.160 3.193 1,000 2.025 1.400 31.50

Total 36,000(1) Case reserved by cedent (2) Resulting from lognormal fit to the given claim cohort(3) Resulting from lognormal fit to the given claim cohort(4) =exp [ .5 * (2) *(2) + (3) ], mean of lognormal LDFs

Lognormal has been an excellent fitting distribution. Parametersare influenced by age of claim, size of claim, locale of claim, andother claim-specific parameters. Heterogeneity is stressed over homogeneity.

Example 30mm xs 30mm Excess Layer, Lognormal Simulated Loss Development Factors - Sample Iteration

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

Events)Percentile Claim 1 Claim 2 Claim 3 Total

1.0% 0 0 0 05.0% 0 0 0 025.0% 0 0 0 030.0% 0 0 0 035.0% 0 0 0 040.0% 0 0 0 045.0% 0 0 0 050.0% 0 0 0 055.0% 0 0 0 4,35160.0% 0 0 0 11,00365.0% 0 0 0 20,79670.0% 0 0 0 30,00075.0% 5,809 0 0 30,00080.0% 18,875 1,419 0 30,00085.0% 30,000 12,526 0 30,00090.0% 30,000 30,000 10,918 30,43295.0% 30,000 30,000 30,000 54,66897.0% 30,000 30,000 30,000 60,00099.0% 30,000 30,000 30,000 60,00099.9% 30,000 30,000 30,000 90,000100.0% 30,000 30,000 30,000 90,000Mean 6,518 4,356 2,854 13,729

Median 0 0 0 0St Dev 11,631 9,828 8,267 18,066

Skewness 1.37 2.02 2.77 1.18

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?