Impact of Financial Crisis on D&O

15 September 2009

Lessons Learned

We need to improve risk management practices for D&O insurance exposure

We need better models and better understanding of models, particularly understanding of limitations of models

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Is D&O the same type of risk as Property Cat?

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Is D&O the same type of risk as Property Cat?

Property Cat D&O

Frequency Low Low

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Is D&O the same type of risk as Property Cat?

Property Cat D&O

Frequency Low Low

Severity High High

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Is D&O the same type of risk as Property Cat?

Property Cat D&O

Frequency Low Low

Severity High High

Accumulation Risk High High

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Is D&O the same type of risk as Property Cat?

Property Cat D&O

Frequency Low Low

Severity High High

Accumulation Risk High High

Consistency of Risk Low Low over time

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Is D&O the same type of risk as Property Cat?

Property Cat D&O

Frequency Low Low

Severity High High

Accumulation Risk High High

Consistency of Risk Low Low over time

Available Historical Data About 100 yrs Limited

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Low Frequency/High Severity Business What is an Actuary to Do?

Lack of a complete historical catalogue of events We have difficulty estimating the expected loss. It is even more difficult to estimate the

tail There are many black swans.

Risk is enormously complex to model Hurricane – wind speed, central pressure, sea surface temperature, landscape, etc. D&O – legal climate, complexity of corporate structure, etc.

Exposure changes over time Property cat – climate change, improvements in building codes, improvements in

engineering, improvement in loss mitigation D&O – M&A, judicial rulings, Sarbanes-Oxley

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UncertaintyWhat does this mean?

Model risk and parameter risk are hugeￚWe don’t fully understand the riskￚ No model can reflect every aspect of the risk, even if we understood it perfectlyￚ Model and parameter risk far outweigh the process risk

Pricing estimates have enormous uncertainty; i.e. you can not calculate the price precisely

What do you do? Create models but don’t over-rely on themￚ Unbiased, consistent benchmark for risk selection – which risks are better than

others?ￚ Sensitivity test to try to understand uncertaintyￚ Create decision rules to go with the model – but be flexibleￚ Don’t forget to use judgment

Understand correlations within the portfolio and with other portfoliosￚ Measure accumulationsￚ Management must set risk tolerances for accumulations

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Putting it to Work

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Portfolio Management Monitoring Accumulations

Hypothetical D&O PortfolioUnderwriting Review

Industry Type Industry Group Policy Count Limit

Policy Count Limit

Policy Count Limit

Policy Count Limit

Policy Count Limit

Policy Count Limit

(1) (2) (4) (5) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16)

Financial Asset Mangers 16 290.0 0 0.0 10 175.0 0 0.0 5 100.0 1 15.0

Financial Banks 12 201.5 4 86.5 3 60.0 2 20.0 1 10.0 2 25.0

Financial Finance Companies 0 - 0 0.0 0 0.0 0 0.0 0 0.0 0 0.0

Financial Insurance 1 10.0 1 10.0 0 0.0 0 0.0 0 0.0 0 0.0

Financial Professionals 0 - 0 0.0 0 0.0 0 0.0 0 0.0 0 0.0

29 501.5 5 96.5 13 235.0 2 20.0 6 110.0 3 40.0

E & O E P LCombined All Coverages Side A - D & O Full - D & O Fiduciary Liability

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Portfolio Management Tool

An exposure model simulating industry losses based on financial data Company loss based on in-force portfolio Model captures:

ￚ Endurance loss and alae for each category, and in totalￚ Industry claim frequency above various attachments for each categoryￚ Average severity of industry losses in various layers for each categoryￚ Industry increased limits curves

Uses for Model Enterprise Risk Management Verification of pricing model parameters Reserving Strategy

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Warren Says It Best

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Warren Buffet’s 2001 Letter to Shareholders

“What counts in this business is underwriting discipline. The winners are those that unfailingly stick to three key principles:

They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors, including remote scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish pricing or policy conditions.

They limit the business they accept in a manner that guarantees they will suffer no aggregation in losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlations among seemingly unrelated risks.

They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn’t work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.”