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 2

Is D&O the same type of risk as Property Cat? 3

Property CatD&O  FrequencyLowLow 4

Is D&O the same type of risk as Property Cat? Property CatD&O  FrequencyLowLow  SeverityHighHigh 5

Is D&O the same type of risk as Property Cat? Property CatD&O  FrequencyLowLow  SeverityHighHigh  Accumulation RiskHighHigh 6

Is D&O the same type of risk as Property Cat? Property CatD&O  FrequencyLowLow  SeverityHighHigh  Accumulation RiskHighHigh  Consistency of RiskLowLow over time 7

Is D&O the same type of risk as Property Cat? Property CatD&O  FrequencyLowLow  SeverityHighHigh  Accumulation RiskHighHigh  Consistency of RiskLowLow over time  Available Historical Data About 100 yrsLimited 8

9 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

10 Uncertainty  What does this mean?  Model risk and parameter risk are huge ￚ We don’t fully understand the risk ￚ No model can reflect every aspect of the risk, even if we understood it perfectly ￚ 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 them ￚ Unbiased, consistent benchmark for risk selection – which risks are better than others? ￚ Sensitivity test to try to understand uncertainty ￚ Create decision rules to go with the model – but be flexible ￚ Don’t forget to use judgment  Understand correlations within the portfolio and with other portfolios ￚ Measure accumulations ￚ Management must set risk tolerances for accumulations

11 Putting it to Work

12 Portfolio Management Monitoring Accumulations

13 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 total ￚ Industry claim frequency above various attachments for each category ￚ Average severity of industry losses in various layers for each category ￚ Industry increased limits curves  Uses for Model  Enterprise Risk Management  Verification of pricing model parameters  Reserving  Strategy

14 Warren Says It Best

15 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.”