2. Casualty Actuarial Society 2002 Spring Meeting C18: Umbrella Liability Russ Buckley, FCAS, MAAA - American Re-Insurance Company Tom Ghezzi, FCAS, MAAA - Tillinghast-Towers Perrin Dave Westberg - Towers Perrin Reinsurance May 20, 2002 San Diego, CA

3. 2 This session will focus on recent significant developments in the umbrella market Recent experience Difficult exposures Current state of the market Provider perspective Buyer perspective Professional liability

4. 3 Russ Buckley, FCAS, MAAA Started his career at Aetna Life & Casualty Transferred to American Re-Insurance in 1989 Experience includes pricing almost all lines of P/C reinsurance 10 years with Munich American Risk-Partners  Works with Fortune 1000 risks, government entities, insurance pools, reciprocals, and other organizations which retain significant insurance risk Currently responsible for American Re’s Direct Facultative Division $1 billion of 2002 written premium $500 million of commercial and personal umbrella Licensed soccer referee

5. 4 Dave Westberg Consultant in Towers Perrin Reinsurance’s Consultative Placement Division 20 years of experience Risk financing consultant with Watson Wyatt Treaty reinsurance broker with BEP Underwriter with CIGNA, Allstate, Royal Expertise in Design and implementation of alternative risk financing strategies Self-insurance and reinsurance Captives Professional liability exposures

6. 5 Tom Ghezzi, FCAS, MAAA Consulting actuary with Tillinghast since 1984 Areas of expertise include Loss reserving and pricing for all types of insurance entities Strategic analyses Line of business expertise in Medical malpractice E&O Products liability Personal lines Past president of CANE Proceedings paper on federal income taxes

7. 6 We have split up this presentation as follows Topic PresenterSlides State of the Market Russ 7 -27 Difficult exposures Tom28-40 D&O, Fiduciary Liability, E&O Dave41-69

8. 7 Umbrella coverage characteristics Umbrella policy is excess of underlying coverage Underlying policies generally include automobile liability, general liability and employers liability Can include other liability exposures Underlying limits generally $1 million per occurrence or higher Trend toward $2 million aggregate Forms include Follow form excess - generally larger risks Standard umbrella - generally smaller risks Leading writers AIG, Chubb, Kemper, Royal, Zurich

9. 8

10. 9 News Headlines – Part 1 Summer of 2001 – CNA posts a $1.47 billion loss for the first half of the year, which the insurer said reflected reserve strengthening, an IT restructuring charge, and realized losses associated with certain subsidiary operations.

11. 10 News Headlines – Part 2 October 22, 2001 – SAFECO announces a $240 million charge for strengthening of reserves in the third quarter. Included in this amount is $90 million for recent developments to prior- year claims for construction-defect claims.

12. 11 News Headlines – Part 3 November, 2001 – Berkshire Hathaway 3 rd quarter report on General Re “Underreserving occurred principally in the casualty treaty, commercial umbrella and casualty individual risk reinsurance lines, and primarily for accident years from 1998 through 2000.”

13. 12 News Headlines – Part 4

14. 13

15. 14 “National” Umbrella Carriers Estimated Loss Ratios by Accident Year

16. 15 “Regional” Umbrella Carriers Estimated Loss Ratios by Accident Year

17. 16

18. 17 News Headline – Part 5 June 14, 1999 – Business Insurance Commercial rate cuts slowing, predict that buyers will see rates leveling off rather than increasing, according to a Conning & Co. study.

19. 18 News Headline – Part 6 July 5, 1999 – Business Insurance Reinsurance rate-cutting less prevalent, reinsurers are pushing for modest increases, while retrocessional reinsurance rates are rising sharply. “There is a bottoming, and I think we have gotten there” says one reinsurance executive

20. 19 Commercial Lines – Pricing Trends Representative commercial lines pricing trends 1997 1998 1999 2000 2001 2002 Q1 -5.1% -3.7% 1.8% 9.9% 14.3% 17.9% Courtesy of the Travelers website

21. 20 Commercial Umbrella – Pricing Trends Information provided by Conning and Co. 22.4%9.9%0.8%-3.5% 2002200120001999

22. 21 News Headline – Part 7 Business Insurance – April 22, 2002 CIAB sees rate increases across all lines for the first quarter of 2002, with the increases in the range of 10% to 30% for all commercial lines.

23. 22 News Headline – Part 8 Business Insurance – April 22, 2002 - Commercial Umbrella information Rate Increases % Respondents Less than 10%10% 10% to 30%29% 30% to 50%32% 50% to 100%18% Greater than 100%11%

24. 23 “National” Umbrella Carriers Estimated Loss Ratios by Accident Year - 5.1% -3.7% 1.8% 9.9% 14.3%17.9%

25. 24 Commercial Auto Loss Trends Between 1993 and 1999, the average settlement for commercial auto liability claims has increased over 200% during that time period. - this will have a disproportionate impact on umbrella insurers and reinsurers, as the leveraged impact of trend drives more losses into the higher layers.

26. 25 Limits and Attachment Points Changes in attachment points vary by market and type of risk The amount of limits available from carriers is greatly reduced from two years ago

27. 26 Terms and Conditions Terrorism Mold Sexual Misconduct Construction Defect Incidental Professional Liability

28. 27 Reinsurance Support Reinsurers are reducing limits across the board Some major carriers are having problems putting together umbrella treaties, or are doing so with smaller limits Increased pressure on guidelines for restrictions on classes, minimum premium levels and minimum attachment points

29. 28 Several high profile developments have hit umbrella coverage especially hard and pose significant challenges These events/exposures affect underlying policies and expose the umbrella coverage Terrorism Construction defect claims Toxic mold

30. 29 September 11 terrorist attacks caused virtual elimination of coverage for terrorist acts After September 11, availability of coverage for terrorist events was almost non-existent Some improvement lately High rates and narrow terms Umbrella policies follow terms/exclusions of underlying coverage Federal legislation Possible federal backstop

31. 30 Construction defect claims have had a significant impact on primary general liability and umbrella coverages Claimants include Homeowners Associations Class actions Defendants/Insureds Developers General contractors Additional insureds Subcontractors Design professionals

32. 31 Construction defect loss exposure was increased significantly by the Montrose decision in California Montrose Chemical Corporation of Califoria v. Admiral Insurance Company, 10 Cal. 4th 645 (1995) Montrose applied the continuous injury trigger to third party claims “Manifestation” vs “Continuous Injury Trigger” Manifestation triggers policy in effect at the time the damage appears Continuous injury - triggers all policies in effect during the time the damage begins to occur and the time it ceases This trigger increases the number of policies exposed, creating all sorts of unusual difficulties

33. 32 A secondary issue in Montrose was “loss-in-progress” or “known loss” rule This rule provides that a loss that is already known to an insured at the time a policy coverage starts cannot be covered by that policy Only contingent or unknown events can be insured The Court found that since Montrose was not certain of its legal liability, the loss was contingent

34. 33 Impact of Montrose on construction defect claims Which construction defects are “continuous” or “progressively deteriorating?” Defective wiring Faulty foundations Water leakage Dry rot

35. 34 The industry’s response Montrose endorsement routinely added to liability coverages, and therefore to umbrella policies Incorporates known loss doctrine into the CGL policy language Loss intended to be covered only by the policy during which it first became known

36. 35 Actuarial and claim handling issues related to evaluating construction defect exposure There are significant differences in exposure among different insured types General contractors the highest severity, but relatively lower frequency Subcontractors and “artisans” lower severity, but potentially very high frequency Data should be available by insured type Definition of accident year is difficult Report year data should be used Allocated loss adjustment expenses can be significant Time on risk

37. 36 A more recent development relates to Stachybotrys chartarum AKA … TOXIC MOLD There are over 100,000 known species of mold Stachybotrys chartarum is considered to pose the greatest risk May cause physical reactions in some individuals

38. 37 There have been large losses incurred because of toxic mold claims Several recent multi-million dollar cases Texas homeowner - $32 million award (Ballard) California homeowner - $18.5 million award Florida courthouse - $60 million North Carolina motel owner - $6.7 million New York community college employee filed suit for $65 million Insurers incurring large losses One insurer reported mold-related claims during Q1 2002 jumped to $119m, up from just $7m the year before. Texas homeowners premium indications up 40%

39. 38 Coverage issues - homeowners Homeowners forms are emerging that can include a variety of mold related clauses or endorsements Absolute exclusion Coverage if a direct result of leaking plumbing, heating, or other system or domestic appliance Coverage only is resulting from a covered peril Some states may not allow the exclusions There are internal limits Mitigation required

40. 39 Coverage issues - CGL Current form excludes losses related to “pollutants” Mold may not be considered a pollutant Endorsements limit coverage Similar to homeowners

41. 40 Typical toxic mold claims Potential damages Investigation and testing costs Containment and remediation expenses Abatement and mitigation Loss of use Relocation expenses Diminution expenses Bodily injury Loss of earnings Emotional distress Potential defendants Property owners and managers Architects and engineers Developers Contractors  Construction  HVAC Construction materials manufacturers Testers, remediators, etc.

42. 41 The session description includes Professional Liability Not usually part of umbrella coverage Errors & omission exclusions for all except innocuous risk However, professional liability coverages are coming under increasing pressures Similar market conditions as faced by umbrella coverages  Restrictions in capacity  Significant price increases  Coverage restrictions

43. 42 Market update for several significant Professional Liability exposures We will look at Directors and Officers (D&O) Fiduciary Liability Actuarial E&O

44. Directors & Officers Liability

45. 44 Trends in current D&O market place 2002 D&O renewals should expect: Substantial premium increases Restrictions in capacity Attachment point increases Possible restriction of coverage

46. 45 D & O price increases and coverage availability varies by type of risk “Standard” business rates increasing 50-100% “Non-standard” such as aviation, financial institutions, technology, public health care, etc. up to 300% increase No multi-year agreements or automatic extensions Underwriters requiring more detailed exposure information Underwriters concerned about financial restatements and m&a activity

47. 46 Possible D&O coverage restrictions include Security claims co-insurance Warranties Pending & prior litigation exclusions Deletion of retention waivers Automatic subsidiary coverage reduced Maintenance of insurance clauses Reduced discovery periods with higher premiums

48. 47 Class action trends show...

49. 48 SEC pursuit of financial fraud has intensified “Accounting fraud” has become a major factor in many recent cases with extremely large D&O losses 100 brought in 2000 alone 260 investigations currently in progress Due to Enron, it is likely that this number will increase

50. 49 Financial fraud (continued) 40 investigations target the largest 500 corporations in the US (8%) 233 financial restatements in 2000 (twice that in 1997) Major SEC investigations include Enron, ConAgra Foods, Boeing, Cendant, Xerox, Oxford Health, Comp USA, Rite Aid, Sunbeam

51. 50 Along with frequency, the size of D&O settlements has increased dramatically in recent years Prior to a couple of years ago Difficult to identify any settlement or judgment for more than $100 million for the “typical” D&O suit  Even the most difficult to defend cases cost less than $100 million Since mid-1999, severity has increased dramatically More than a dozen settlements or verdicts over $100 million  One-third of these over $200 million Securities class action suits most problematic

52. 51 D & O Market Trends (continued) The result of all this is that, “D & O insurance purchasers in 2001 faced the largest premium increases since the hard D&O market of the mid-1980’s” These trends will continue and likely intensify through 2002. D&O & Ficuciary Information sources: Aon March 2002 Executive Liability Market Update & Tilllinghast-Towers Perrin 2001 Directors & Officers Liability Survey

53. Fiduciary Liability

54. 53 Fiduciary Liability Market Trends Enron claim a watershed event This claim is not likely in isolation but illustrative of more to come The fiduciary suits against Enron are over losses in the company-stock portion of their 401(k) plans The suits allege the plan trustees breached their fiduciary duties by continuing to offer company stock, even after they became aware of serious business problems that would hurt the stock price

55. 54 Fiduciary liability claim trends Not just post-Enron claims environment Examples Airline pilot retirement plan alleging under-funding of $1,000,000,000 Financial services firm - alleged improper use of employee retirement funds- $26,000,000 Health care company - alleged improper use of health care plan funds - $3,000,000 Consumer goods co-alleged improper investment management involving company stock - $100,000,000

56. 55 Issues to consider with respect to fiduciary liability Employee benefit plan asset size (aggregated for all plans) The number of employee benefit plan participants Method and form of corporate matching or funding of asset bearing employee benefit plans such as pension plans, 401(K) plans, ESOP’s, etc. What is the maximum exposure to the plan related to a market capitalization drop in the common stock? Percentage and amount of plan assets invested in corporate stock. What is the maximum exposure to the plan related to a market capitalization drop in the common stock?;

57. 56 Investments in company stock under greater scrutiny Given recent developments like Enron Focus that regulators and the plaintiff’s bar now have on employee benefit plans in general and, specifically, with respect to 401 (K) and ESOP investments in company stock, the duties of the plan fiduciaries and trustees responsible for safeguarding those plans will be under increasing scrutiny and may point toward increased litigation.

58. Actuarial E & O

59. 58 Actuarial Liability - We saved the best for last! Actuarial liability is traditionally classed as part of miscellaneous E&O Lately, we have been distinguishing ourselves by emerging with our own unique risk profile Liability claims against actuaries have been on the rise, but the most dramatic change over the past five years has been in severity

60. 59 Considerations with actuarial liability Is actuarial science perfect? Some (mostly lawyers) seem to think it should be High standard of expectation applied to inexact science of predicting the future Occasionally mistakes are made and real damages are sustained. These need to be compensated for, however…...

61. 60 Recently the rules of the game seem to be changing For the most part actuarial E&O needed to result in real, objective damage or loss to sustain a claim Inappropriate actuarial appraisal price leads to wrong sale price in mergers or acquisitions Inadequate loss reserves lead to inappropriate growth or lack of funds to pay claims. Incorrect assumptions lead to under-funding of pension or benefit plan

62. 61 Changing Rules (continued) Recent damage theories put forward have tried to change the standard Something went wrong, so everyone involved (or somebody with “deep pockets”) has to pay The basis for some of these claims would not have been sustained ten years ago

63. 62 A real life example provides some insights Public service pension fund Contribution calculation assumption error which in isolation causes lower funding than the correct assumption would have indicated Years pass, interest rate variations from original assumptions more than offset any potential shortfall due to the error Pension fund in surplus position What’s the problem?...

64. 63 The plaintiff’s damage theory was If contributions had been calculated correctly years ago, Pension fund would be in an even greater surplus position Damages to be based on difference between current surplus and what it could have been.

65. 64 There are varying levels of exposure by type of work product Pension and other benefit consulting Reserving and rate making Heightened exposure with mergers & acquisitions and work for companies facing financial difficulties

66. 65 Is it a crisis? Actuarial E&O is an emerging class of risk E&O premiums have been in the 1% of revenue range for actuarial firms Accountants E&O premiums in double digit territory

67. 66 What can be done about it? Loss prevention & mitigation Consistent application of professional standards Clear written contractual engagements Rigorous application of peer review guidelines New risk management initiatives such as…..

68. 67 Contractual limits of liability in client engagements Most major consulting actuarial firms are committed to implementing or are considering this approach Limit of liability is linked to the fee associated with the work performed Contractual limitations of liability are not likely “iron clad” but they should be effective tools for managing expectations in many instances

69. 68 We are still in the woods It will take some time for limits of liability to be in place on all business There is a lot of potential liability from work already completed Plaintiff lawyers are as bright and busy as ever

70. 69 As actuaries, you must be aware of the: Nature of the work Expectations of market place Appropriate loss prevention and mitigation measures

71. 70 Questions

72. 71 On that note... Let’s go to the beach!