reinsurance boot camp on pricing techniques professional liability – director’s & officers

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


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…


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 (2nd) and California (9th) 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


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


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Typically market based pricing and/or outdated base rates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


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..


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


II. Frequency Model (cont.)

Observed Frequency Values

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Fre

qu

en

cy


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


III. Severity Model (cont.)

Average Limited D&O Severity Across Firm Size

$5 $10 $15 $20 $25 $30 $35 $40 $45 $50 $55 $60

Limit in $Millions

Inc

rea

se

d L

imit

Fa

cto

r

MCAP = $100M MCAP = $2,000M MCAP = $5,000M MCAP = $25,000M MCAP = $100,0M


III. Severity Model (cont.)


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


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


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.

reinsurance boot camp on pricing techniques professional liability – director’s & officers

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