Directors & Officers (D&O) liability policy primer and claim modeling potential. Presenters. Purpose of D&O insurance

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1 Directors & Officers (D&O) liability policy primer and claim modeling potential Casualty Loss Reserve Seminar September 15, 2011 Presenters Moderator Connie Kurpick Senior Ernst & Young Presenter Mark Millard Senior Manager Ernst & Young Presenter Benny Yuen Senior Manager Ernst & Young Page 2 Purpose of D&O insurance Protect the personal assets of directors and officers in the event of a claim Page 3 Page 1

2 Who are the officers of a company? Past, present and future duly elected or appointed director, officer, trustee or governor of a corporation, management committee member of a joint venture and member of the management board of a limited liability company (or equivalent position); Past, present and future person in a duly elected or appointed position in an entity organized and operated in a foreign jurisdiction that is equivalent to an executive position listed in Definition (j)(1); or Past, present and future General Counsel and Risk Manager (or equivalent position) of the Named Entity. Page 4 Responsibilities of directors and officers Duty of care What a prudent person would do in a similar circumstance Duty of loyalty Act in good faith for the companies best interest Page 5 State statute example Delaware A corporation shall have power to indemnify any person who was or is a party, or is threatened to be made a party, to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative. Page 6 Page 2

3 Corporate by-laws Corporate by-laws Outline the firm s indemnification obligations to the directors and officers Are based on the statute of the state of incorporation Set the stage for how directors and officers liability policies will respond in the event of a claim Page 7 Where do claims come from? Shareholders Shareholders derivative actions Claims Customers Regulators Competitors Page 8 Policy coverage parts Side A Side A provides the individual directors and officers with coverage in the event the company cannot, or will not, indemnify them. Side B Side B reimburses the company for its indemnification obligation to its directors and officers. Side C Side C provides the entity itself with coverage in the event it is named in the suit (some insurance policies may narrow this to securities-type claims only). Page 9 Page 3

4 How limits and retentions are structured D&O policy structure Deductible levels Limit options Tower Side A, B and C Side A DIC Sharing limits E&O Crime EPLI Separate limits $35M $10M x $25M Side A $10M x $15M D&O $15M $15M EPLI D&O Shared limits $35M $10M x $25M Side A $36,000 $10M x $15M D&O only $36,000 $15M Shared D&O EPLI Page 10 Consistency in the tower structure Does the excess form follow the terms of the primary? Does the excess form provide drop-down coverage in the event of underlying erosion? Page 11 Typical coverage exclusions Fines and penalties Punitive or exemplary damages Tax liability Dishonesty Personal profit Remuneration without stockholder consent Coverage typically insured by other policies Bodily injury and property damage Employment practices liability Page 12 Page 4

5 Impact of legal trends, laws and regulation Policy coverage grants and exclusions change frequently as the market evolves Examples include Market timing Subprime exclusion Failure to maintain insurance Page 13 Definition of claim Understanding the variety of definitions surrounding claims Coverage can be triggered by Criminal proceedings Written demands for monetary and non-monetary relief Administrative investigations Arbitration proceedings Example from Chartis D&O first policy specimen Claim means: 1. a written demand for monetary, non-monetary or injunctive relief; 2. a civil, criminal, administrative, regulatory or arbitration proceeding for monetary, non-monetary or injunctive relief which is commenced by: (i) service of a complaint or similar pleading; (ii) return of an indictment, information or similar document (in the case of a criminal proceeding); or (iii) receipt or filing of a notice of charges; or 3. an Investigation Claim. means a civil, criminal, administrative or regulatory investigation of an Insured Person by the SEC or a similar state or foreign government authority, but only after service of a subpoena upon such Insured Person and subject to the Investigation Claim Sublimit of Liability stated in Item 3(a) of the Declarations. Policy excerpt from IRMI.com Page 14 Definition of wrongful act Wrongful act means any error, misstatement, misleading statement, act, omission, neglect or breach of duty committed, attempted or allegedly committed or attempted, by an insured person, individually or otherwise, in his insured capacity, or any matter claimed against him solely by reason of his serving in such insured capacity. Page 15 Page 5

6 Definition of loss Loss means damages, settlements and costs, charges and expenses incurred by any of the directors and officers, but shall not include: 1. Punitive or exemplary damages, or that portion of any multiplied damage award which exceeds the amount multiplied 2. Taxes, criminal or civil fines or penalties imposed by law 3. Matters deemed uninsurable under the law pursuant to which this policy shall be construed Page 16 Claim examples Philip Morris Anti-trust violation Wachovia Securities class action Xerox Securities class action Mattel Securities class action Page 17 Mega-claim examples Countrywide Financial Corporation Subprime Bernard Madoff Investment Securities Ponzi scheme JP Morgan Securities Bid rigging Broadcom Corp. Options backdating Page 18 Page 6

7 Defense cost and settlement allocation Aspects potentially excluded from the claim settlement Professional services failure to supervisor Insured capacity Entity coverage Defense costs May or may not be subject to allocation Similar to the definition of claim, there is no standard definition of allocation Use of best efforts Relative legal and financial exposures to the parties Use of arbitration if failure to agree Page 19 Characteristics of D&O losses Lower frequency/higher severity than commercial general liabilities claims Large events, such as subprime and stock backdating, behave more like catastrophe losses Case reserving philosophy varies greatly between companies Trigger of claims contains much uncertainties Expenses often can exhaust limits provided Settlements of cases far outweigh payment of suits Page 20 D&O loss projections Traditional methods, such as loss development, BF, ELR and frequency/severity, may be appropriate Need to understand company s claims-handling process Reported claims Initial reserves setting Monitoring Reserves changes Settlement philosophy By coverage type Page 21 Page 7

8 D&O loss projections Differential normal losses from systemic losses Normal or attritional losses random typical losses Systemic event(s) driven that affect many corporations or megalosses Will want to consider examining these losses separately Expected loss ratio should have these two components separate Page 22 Attritional losses Analogous to non-cat. losses in other PC lines No formal definition like catastrophe code (cat. Code) Need to be consistent in defining attritional vs. systemic Determine expected loss ratio and loss development pattern Projections can be easily handled by traditional actuarial methods Page 23 Systemic losses Examples Subprime crisis Madoff claims Bid rigging Options backdating Analogous to catastrophe (cat.) losses in other PC lines Lack of similarity between events Need a systemic load for the expect loss ratio Projections of the IBNR need for actual events are not easy Page 24 Page 8

9 Systemic losses Need to anticipate and identify these claims Ability to track and understand the book of business is important Constant communication with claims department is crucial Need to track legal development and settlement pattern, if any Bottom-up and top-down approaches Individual claims evaluation Macro level evaluation Page 25 Bottom-up evaluation Track by exposures and submission of claims Assign probabilities by types of claims/exposures Need to consider coverage type Side A may have a lower probability if entity is not bankrupt Need to consider retention (or trigger) level The higher the retention, the lower the probability Need to consider the status of claims Existence of case reserves Place-holder reserves Watch-list Determine size of the claims Limits provided Layers exposed Pure incurred but not reported provision Page 26 Top-down approach Macro modeling approach Based a set of key assumptions Derive a set of model parameters Project losses in aggregate based on exposures Does not predict how individual loss will fare Can separate out claims and reserves Most useful in early stage of systemic event Lack of individual claims details Page 27 Page 9

10 About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 141,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. Ernst & Young is a leader in serving the global financial services marketplace Nearly 35,000 Ernst & Young financial services professionals around the world provide integrated assurance, tax, transaction and advisory services to our asset management, banking, capital markets and insurance clients. In the Americas, Ernst & Young is the only public accounting organization with a separate business unit dedicated to the financial services marketplace. Created in 2000, the Americas Financial Services Office today includes more than 4,000 professionals at member firms in over 50 locations throughout the US, the Caribbean and Latin America. Ernst & Young professionals in our financial services practices worldwide align with key global industry groups, including Ernst & Young s Global Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to our clients. With a global presence and industry-focused advice, Ernst & Young s financial services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, process improvement, risk and technology, to financial services companies worldwide. It s how Ernst & Young makes a difference Ernst & Young LLP. All Rights Reserved. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither Ernst & Young LLP nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor NY Key assumptions and parameters considerations Expected value of D&O losses is a function of the drop in market capitalization Distribution of claim e.g., lognormal Claims dismissal rate Severity assumptions Side A vs. Non-Side A consideration Page 28 The next wave What will it be? Are the companies prepared? Page 29 Ernst & Young Assurance Tax Transactions Advisory Page 10