The Condition of the Professional Liability Market

Brian Turner, FCAS, MAAA, CPCU

2002 CAS Annual Meeting

E&O - A Changing Environment

Recent rate increases of 10-20% per year for the last 2 years with more to come

Medium to large carriers pulling out of many lines of E&O

Multi-year offerings have been reduced substantially

First dollar defense and zero deductible offerings are being pared back

E&O - Rate IncreasesWhy Now, Why So Much?

Poor underwriting results in late 90’s Lower Investment Income Hard reinsurance market Economic downturn’s effect on loss costs Certain unprofitable market segments have

been subsidized by better performing segments

Professional Liability Overview

Drivers of Profitability within a Class– Mix of business - Size of firm– Mix of business - State– Underwriting (in house vs. MGU or similar)– Claims staff expertise

Professional Liability Overview

Size of Firm– Large firms demonstrate higher loss ratios

• Marquis accounts always see many competing markets; leverage from national brokers

• Rating is more flexible on large accounts• Instant production - profitability, a secondary

motive• Higher deductibles, harder fought large claims

result in longer payout patterns

Professional Liability Overview

State by State Differences– Regulatory differences make some states

difficult to file rate changes in– Legal environment varies significantly from

state to state• State rate relativities often smoothed,

resulting in significant loss ratio differences by state

• Impact on ILF’s often ignored

Professional Liability Overview

Underwriting– In House Underwriting

• More control and accountability• Able to adapt to changes quicker

– Rate increases– Form changes

– MGU or Program Manager• Can work if:

– Profitability goals are aligned– Both partners keep expenses down– Black box rating plan is used

Professional Liability Overview

Claims Expertise– Dedicated In-House Claims Staff

• Most effective in controlling claims settlements and minimizing defense costs

• Effective communication between Claims & U/W can prevent problems from perpetuating

– Generalized In-House Claims Staff• Maintain control, but lose out a little on expertise

– Third Party Administrator or MGA• Lose control, but expertise may be strong

Architects & Engineers

Basics– Claims Made Coverage for errors &

omissions– Full coverage for pollution, asbestos, mold– Full Prior Acts, First Dollar Defense, and

Multi-Year Policies are common– Exposure base is billings– Discipline factors modify base rates

Architects & Engineers

Small to Medium Size Firms– Admitted (filed) rates, rules and forms– Specialist firms– 3 year policies still common for the small

firms– Average annual premium ~ $8,000– Typical limits of $500,000 - $1,000,000– Typical deductibles of $0 - $10,000

Architects & Engineers

Large to Jumbo Firms– Often non-admitted for rate and form

flexibility– Multi-discipline firms– Design-Build firms– Very high limits - large excess marketplace– Typical SIR’s of $100,000 - $10,000,000

Architects & Engineers

Most Hazardous Disciplines– Structural Engineers– Geotechnical Engineers– At-Risk Construction Managers

Least Hazardous Disciplines– Landscape Architects– Land Surveyors– Electrical Engineers

Architects & Engineers

Most Common Causes of Loss– Design Errors– Inadequate oversight of construction– Specification Errors– Negligent preparation of cost estimates– Survey Errors (Land Surveyors)

Architects & Engineers

Most Common Claimant Types– Owner (will occupy)

• Private• State Government• Local Government• Federal Government

– Developers (will not occupy)– Contractors

Architects & Engineers

Emerging Issues– Economic downturn increases loss exposure

• Cost overruns less likely to be tolerated• Fewer projects > More competition > Lower Bids > Thinner

Staffing > More mistakes– Mold

• Not frequent, but can be attached to the more frequent complaint of leaky roofs/walls

– Computer Aided Design (CAD)• Reduced the incidence of design errors, but...• A CAD error can manifest in many separate

projects

Architects & Engineers

Historical Trends– Exposure Trend

• 2% to 4% based on Bureau of Census Implicit Price Deflator (Construction Values)

– Severity Trend• Keeping pace with exposure trend

– Frequency Trend• Flat

– Net Trends seen in recent filings• 0% to 4%

Architects & Engineers

Average Rate for Sample of Insureds

0

10

20

30

40

50

Small

Medium

Large

Real Estate Agents

Basics– Claims Made Coverage for errors &

omissions– Coverage for failure to advise (not detect)

pollutants, asbestos, lead, radon, etc.– Full Prior Acts, First Dollar Def. are common– Exposure base is # of agents or revenue or

some combination of the two

Real Estate Agents

Residential Real Estate– Sales, Leasing, Property Managers– Frequency driven - low severity– Claims made by homeowners - often

emotionally charged– Frivolous claims lead to high alae costs, often

as high as indemnity in the aggregate– ULAE is significant– Short payout pattern

Real Estate Agents

Commercial Real Estate– Sales, Leasing, Property Management,

Business Consulting– Severity driven, low frequency– Clients demand higher level of expertise,

due diligence & professionalism– Commercial plaintiffs have more legal savvy

and the financial resource to go the last mile.

Real Estate Agents

Most Hazardous Services– Business Consulting/Brokerage– Sales where the agent is also the seller– Residential firms dabbling in commercial real

estate transactions– Commercial Appraisal & Property Management

Least Hazardous Services– Residential Sales and Appraisals– Mortgage Brokering

Real Estate Agents

Common Causes of Loss– Misrepresentation

• Innocent, Negligent, or Intentional– Failure to disclose– Breach of Fiduciary Duty– Fair Housing Violations

• Few claims, but usually costly judgements– Antitrust Laws– Environmental Liability

Real Estate Agents

Claimant types– Buyers (70-75% of all claims)– Sellers (~20%)– Lessees (2-3%)– Others (2-3%)

• Landlords• Other real estate agents• Contractors

Real Estate Agents

Historical Trends– Exposure Trend

• Varies depending on the exposure base– Revenue trend difficult to determine (my guess, 2%)

– Severity Trend• Estimated to be 1%

– Frequency Trend• Estimated to be 3%

– Net Trends seen in recent filings• 2% to 4%

Real Estate Agents

Average Rate for Sample of Insureds

0

1

2

3

4

5

6

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Rate Per $1000Revenue

Big 5(4) Accountants

Generally reinsurance of captives Two types of programs

– Straight Excess of Loss– Structured Deals

• More complex (e.g. aggregate attachment points)

• Protect against multiple big losses in same year A lead (re-)insurer with over 25% share of a layer

sets the terms Covers Attest Services Only

Big 5(4) Accountants

Claimant Year Firm Market Cap Loss Settlement

Cendant 1997 E&Y $30B $335M

Waste Management 2000 AA $24B $220M

AZ Baptist Foundation 1999 AA $590M $217M

Sunbeam 1997 AA $3.7B $110M

Top 4 Accountants E&O Claims

Top 5 Pending ClaimsClaimant Year Firm Market Cap Loss Settlement

WorldCom 2002 AA $116B ???

Enron 2001 AA $59B ???

Xerox 2000 KPMG $25B ???

Tyco 2002 PWC $25B ???

Adelphia 2002 DT $5.5B ???

Big 5(4) Accountants

Life After Enron– Public attitude towards accounting firms may

adversely impact court proceedings and settlement values.

– Is Accountants E&O becoming the UI/UIM coverage for D&O??

– Insurance availability for Second Tier firms is drying up.

Big 5(4) Accountants

Where does the audit work go?– D&T acquired 70% of AA’s European Firms– U.S. partners spread out to other Big 4.– Second Tier firms not seeing much.– For a summary of defecting accounts go to

http://www.forbes.com/2002/06/28/0627andersen.html

Conclusion

Recent E&O rate increases are:– Certainly justifiable– A few years overdue– Insufficient in many cases

Profitability in this hardening market:– Must meet stricter targets– Is not automatic - must still find the profitable

market segments