Assessing Public D&O Industry Performance

Transcription

1 Assessing Public D&O Industry Performance A Benfield Professional Liability Specialty Practice Report April 2008

2 Contacts William Henriques SVP & Team Leader, Professional Liability Specialty Practice Michael Redstone AVP, Professional Liability Specialty Practice Ed Murphy Account Representative, Professional Liability Specialty Practice T: E: T: E: T: E: Benfield Inc Benfield Inc. (for and on behalf of each group company within its group of companies) (collectively "Benfield") reserves all rights to the content of this document. This document is provided exclusively for the use of the directors and employees of the organization to which it was originally delivered. Copies may be made by that organization for its own internal purposes, but no part of this document may be made available to any third party without Benfield s prior written consent. Benfield will accept no liability to any third party to whom this document is disclosed whether in compliance with the proceeding sentence or otherwise. This document does not constitute any form of legal, accounting, taxation regulatory or actuarial advice. Without prejudice to the generality of the proceeding sentence this document does not constitute an opinion of reserving levels or accounting treatment. The recipient acknowledges that in preparing this document Benfield may have based analysis on data provided by the recipient and/or from third party sources. This data may have been subjected to mathematical and/or empirical analysis and modeling. Benfield accepts no responsibility, and provides no warranty, for the accuracy or completeness of any such data. In addition, the recipient acknowledges that any form of mathematical and/or empirical analysis and modeling (including that used in the preparation of this document) may produce results which differ from actual events or losses and Benfield does not warrant the accuracy of any analysis or modeling herein. Where this document includes a recommendation or an assessment of risk, the recipient acknowledges that such recommendation or assessment of risk is an expression of Benfield's opinion only and not a statement of fact. Benfield will not be liable, in any event, for any special, indirect or consequential loss or damage of any kind arising from any use of the information contained in this document. Any decision to rely upon any such recommendation or assessment will be solely at the risk of the recipient, for which Benfield accepts no liability. Benfield will be pleased to consult on any specific situations and to provide further information regarding the matters discussed herein.

3 Contents I. Introduction II. Estimating Public D&O Insurance Losses from Securities Class Actions III. Estimating D&O Industry Performance IV. Sensitivity of Loss Ratios V. Conclusion VI. References and Sources

4 Assessing Public D&O Industry Performance A Benfield Professional Liability Specialty Practice Report I. Introduction Assessing the performance of the D&O industry is a challenging task. Unlike many other lines of insurance, where information is available in Schedule P of regulatory filings or through publications like Best s Aggregates and Averages, D&O results are grouped together with other lines of claims-made liability insurance and are not individually disclosed. As a result, premium and loss experience is difficult to determine unless one has access to proprietary and confidential insurer financials. This report attempts to develop a reasonable analysis of the public D&O insurance market for the years since the passage of the Private Securities Litigation Reform Act of 1996 using publicly available information. When estimating D&O insurance industry losses, we focused exclusively on securities class action lawsuits against public companies filed in Federal courts, and did not address other segments of the D&O market, such as opt-out settlements, shareholder derivative lawsuits against directors of public companies or actions against privately-held companies and not-for-profit organizations. We used various techniques to estimate D&O losses from settlement data, with the goal of developing a better understanding of the public D&O underwriting cycle. Since D&O insurance is underwritten on a claims-made basis, losses are attributable to the policy that is in force when a claim is filed. To account for this, we associated reported settlement amounts with the year in which the underlying claims were filed. Analyzing frequency and severity of public D&O losses by filing year rather than settlement year provides a much better matching of results with the underwriting environment, including pricing and contractual terms, at the time the policies were produced. An even truer matching of underwriting to financial results would arise from analyzing policy year information. Policy year data would allow us to more properly account for multi-year policies one of the most damaging product trends of the last soft market by matching some claims reported in 2001 and 2002 to policy years 1997 through This would likely reveal poorer performance in those policy years. Unfortunately, policy year information can not be accurately determined from publicly available information, but our point is well established by concentrating on a report / filing year analysis at this time

5 The difference between settlement year and filing year results is demonstrated in Figure 1. The left panel shows the total settlement amounts from securities class action suits that were concluded each year, while the right panel shows the same settlements, but matched to the year in which the suits were filed. To clearly see the effect of these different representations, observe the highlighted years 2001 and While the left panel shows only minor settlement payouts in those years, the right panel reveals the significant financial damages ultimately incurred by the companies and their insurers who were served with securities class action suits in those years. Filings from those two years resulted in 24 mega-settlements 1 in excess of $100 million each, including five of the six largest settlements of all time with combined settlements exceeding $20 billion. Figure 1 - Securities Class Action Settlements by Settlement Year (left) and (right) Total Settlements (by Settlement Year) Total Settlements (by ) $20.0 $18.0 $18.0 $16.0 $16.0 $14.0 $14.0 $12.0 $ in Billions $12.0 $10.0 $ in Billions $10.0 $8.0 $8.0 $6.0 $4.0 $2.0 Settlement Year $6.0 $4.0 $2.0 1 In this report, we use the term mega-settlements to refer to settlements of $100 million or more. While this is most common definition of the term, the reader should be cautioned that it may have a different meaning in other industry publications

6 II. Estimating Public D&O Insurance Losses from Securities Class Actions Although associating securities class action settlements with their filing year allows us to more accurately evaluate D&O settlements on a reported basis and match them to the appropriate time in the underwriting cycle, the reported settlement amounts are not the true financial losses incurred by insurers. Factors such as defense costs and policy limits significantly alter insurers losses from the publicly announced settlement amounts. In this section we will discuss the modifications we made to the settlement data to account for these two issues. Figure 2, an enlarged version of the graph seen earlier, shows publicly announced settlement amounts. The dramatic peaks reached in 2001 and 2002 of $10.6 billion and $17.0 billion are attributable to huge investor losses from corporate fraud, which led to many of history s largest settlements, including Enron ($7.2 billion), WorldCom ($6.2 billion), and Tyco ($3.2 billion). Figure 2 Total Securities Class Action Settlements by Total Settlements (by ) $18.0 $16.0 $14.0 $ in Billio n s $12.0 $10.0 $8.0 $6.0 $4.0 $2.0 While many reported settlements are extremely large, the actual losses incurred by D&O insurers are moderated by their policies limits. To account for this, we limited every settlement to a maximum insurance loss of $400 million. While some of the largest Fortune 100 companies purchase D&O limits in excess of $250 million, Benfield s analysis suggests that the vast majority of companies have limits for full cover D&O well under this amount and that limits higher than $400 million are rare

7 The result of simulating insurance policy limits with this loss cap is shown in Figure 3. When a portion of uninsured losses is removed from announced settlement amounts, estimated insurance industry D&O losses drop dramatically. The change is most visible in the years 2001 and 2002, where capped losses were $7.6 billion and $10.8 billion lower, respectively, than reported settlements. Figure 3 Total D&O Losses from Securities Class Actions Capped at $400 Million Total D&O Losses With Settlements Capped at $400M $7.0 $6.0 $5.0 $ in Billions $4.0 $3.0 $2.0 $1.0 It is interesting to note that after applying a cap to settlements, losses from cases filed in 2001 were lower than losses from cases filed in This is surprising, because the uncapped data shown previously in Figure 2 indicated the opposite results. This inconsistency is due to the severity and frequency distributions for settlements related to those two years. In terms of severity, 2001 had two settlements above the $400 million cap Enron at $7.2 billion and Nortel Networks at $1.1 billion, with a combined total of nearly $8.3 billion. In 2000, only Lucent s $667 million settlement exceeded the cap. Because of this contrast, capping settlements at $400 million affected 2001 much more than After adding the cap, losses from cases filed in 2001 decreased by $7.6 billion, but losses from cases filed in 2000 decreased by only $267 million. With frequency, however, the situation was reversed, with many more large cases resulting from 2000 filings. Excluding the specific cases just mentioned, there were more than twice as many mega-settlements (settlements greater than $100 million) from cases filed in 2000 than from cases filed in There were eleven settlements between $100 million and $400 million due to cases filed in 2000, but only five such settlements due to cases filed in

8 In developing our loss estimates, we assumed that settlements below $400 million generally fall within D&O policy limits, and that insurers pay the full reported cash settlement amounts. This assumption may be partially inaccurate in certain cases due to considerations including, but not limited to, limits shaving, coverage disputes, and policy exclusions. To the extent that these factors played a role, our loss estimates could be overstated. A further consideration when using settlement amounts as a proxy for insurance losses is that reported settlements do not include defense costs, which are covered as part of loss under a D&O policy and may be as high as 50% of total settlement amounts. To account for defense costs in settled cases, we increased losses by 25% while maintaining the $400 million cap. To reflect defense costs incurred for cases that were dismissed before trial or settlement, we added $1.5 million in expenses for each such case. Defense costs, while already high, are expected to steadily increase due to costs such as e-discovery, and in future analyses, we plan to assume a higher cost of $2.0 million per dismissed case. Figure 4 represents estimated public D&O insurance industry losses related to securities class action suits for cases filed during the years 1996 through 2007 after accounting for the impact of both policy limits and defense costs. Figure 4 Securities Class Action Settlements with Defense Costs, Capped at $400 Million Total D&O Losses With Defense Costs and $400M Cap $8.0 $7.0 $6.0 $ in B illio n s $5.0 $4.0 $3.0 $2.0 $

9 Figure 5 shows average loss per closed case, accounting not only for settled cases and their related defense costs, but also for cases that incurred defense costs but were ultimately dismissed without settlement. Driven by a large number of accounting-fraud cases with very high levels of investor loss, average costs per closed case reached a peak of $36.3 million in 2002, but this figure has historically been in the range of approximately $10 million to $20 million. Figure 5 Average Cost Per Closed Case With Defense Costs and $400 Million Cap Average Cost per Closed Case With Defense and $400M Cap $40.0 $35.0 $30.0 $ in M illio n s $25.0 $20.0 $15.0 $10.0 $

10 III. Estimating D&O Industry Performance In order to develop a better understanding of the public D&O industry s performance, we next turned our attention to matching the losses we calculated in the prior section with estimated D&O premiums earned each year. We developed our premium estimates from a combination of public filings, market indices and other sources of industry data. The resulting estimate of industry performance on a paid loss basis is shown in Figure 6. Figure 6 Paid Loss Ratios for Public D&O Insurance Public D&O Paid Loss Ratios Includes Defense Costs and $400M Loss Cap $ % $7.0 $ % 113% 127% 123% 130% 120% 110% 100% $5.0 $4.0 $3.0 $2.0 $1.0 23% 66% 78% 47% 47% 28% 11% 90% 80% 70% 60% 50% 40% 30% 20% 10% 1% 0% $ in Billions Paid Loss Ratio Public D&O Premiums Paid Losses & Defense Paid Loss Ratio - 7 -

11 The major contributor to the downward trend in losses since 2002 is obviously the undeveloped experience of the more recent years. Since few cases settle within the first two years of their filing, it normally takes years for a D&O insurer to know its ultimate losses on a given book of business. Over 50% of settled cases take two to three years to reach settlement and over 30% take four years or more (Figure 7). Figure 7 Number of Years to Settlement of Securities Class Actions 6 0 % Y e a rs t o C a s e S e ttle m e n t 5 0 % % of all Settlements 4 0 % 3 0 % 2 0 % 1 0 % 0 % 0-1 Yea r s 2-3 Y ea r s 4-5 Yea r s 6 + Y ea r s There are still 50 active cases from 2003, representing 23% of that year s filings, and 193 active cases from 2007, representing 91% of that year s filings (Figure 8). Figure 8 Current Trial Status of Securities Class Action Suits 100% 90% 80% Current Status of Filed Cases % 60% 50% Active 40% 30% 27 Settled Dismissed 20% 10% 0%

12 To account for the fact that paid losses only reflect a portion of ultimate losses, we extended our approach by projecting ultimate losses for the active cases. We forecast how many active cases would be dismissed and how many would reach settlement based on average historical ratios 3, and estimated a settlement amount of $25 million for each filed but yet to be settled case based on recent trends. To reflect defense costs, each dismissed case was assumed to contribute $1.5 million to losses and each settled case was allocated an additional 25% of its settlement amount 4. The resulting industry performance is shown in Figure 9. Figure 9 Ultimate Loss Ratios for Public D&O Insurance Public D&O Projected Ultimate Loss Ratios Includes Defense Costs and $400M Loss Cap $ in Billions $9.0 $8.0 $7.0 $6.0 $5.0 $4.0 $3.0 $2.0 $ % % % % % % % % 65% % 41% Public D&O Premiums Projected Ultimate Losses Loss Ratio % 150% 140% 130% 120% 110% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Loss Ratio Viewed from this perspective, the loss ratio trend corresponds well with broader industry events. The soft market of the late 1990 s with decreasing rates, broadening policy coverages, and multi-year contracts locking in unfavorable terms led to sharply weakened performance for the industry overall. Rate decreases in every year from 1995 to 1999 led to a dramatic increase in loss ratios, which peaked at an estimated 139% in Approximately 75% of all cases filed since 1996 have closed, either due to dismissal (38% of closed cases) or settlement (62% of closed cases). 4 After adjusting for the 25% defense cost, the average settlement in our projection period is $31.25 million, which is consistent with our results for average industry losses per settlement in recent years

13 Rates did not stop falling until the March 2000 collapse of the dot-com bubble in NASDAQ technology stocks. However, once the rate trend reversed, rates began to increase rapidly; industry premium indices indicate that rates more than doubled from 2000 to Higher rates quickly led to a turnaround in the industry. Aided by a lower frequency of mega settlements, the estimated loss ratio for 2001 dropped to 89%, a decline of approximately 50 percentage points from the prior year. Even with higher rates, the return to profitability was not completely without challenges. Cases filed in 2002 resulted in 17 settlements over $100 million, leading to an estimated 136% loss ratio. However, in the following years, more adequate rates and more restrictive policy terms, coupled with the running off of unprofitable multi-year policies written years earlier, led to more stable profits for public D&O. The industry reverted to profitability in filing year 2003, and loss ratios improved regularly from 2004 to mid-2007 as claim frequency declined. Profitability has also benefited from a decline in the frequency of mega-settlements involving allegations of corporate fraud, although the long lag time to case settlement may make final judgment on this matter premature. The decline in these settlements could be due to many factors, including the passage of the Sarbanes-Oxley Act, the strong deterrent effect of high-profile criminal indictments of top executives resulting in lengthy prison terms, and lower investor losses resulting from positive stock market performance each year since Applying a 25% estimated expense ratio to industry results produces the combined ratio illustrated in Figure 10. By this measure, the industry returned to profitability in 2003 and generated steadily improving profits from 2004 to 2006, with estimated combined ratios declining from 90% to 66% over that period. Figure 10 Combined Ratios with Losses Projected to Ultimate Public D&O Projected Ultimate Combined Ratios Includes Defense Costs, $400M Cap and 25% Other Expenses $ in Billions $9.0 $8.0 $7.0 $6.0 $5.0 $4.0 $3.0 $2.0 $ % % % % % 161% 114% 100% Public D&O Premiums Projected Ultimate Loss Combined Ratio % % % % % 170% 160% 150% 140% 130% 120% 110% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Combined Ratio

14 However, as profitability has risen in recent years, rates have dropped every year since 2004 and frequency has recently begun to increase. Driven by 38 subprime mortgage related filings, 2007 had more class action lawsuits filings than any year since 2004, and by March 31, 2008, 35% more class action lawsuits were filed than during the same time period in the two previous years (Figure 11). Based upon our methodology, the combined ratio for publicly traded D&O in the 2007 filing year is estimated to reach 100%, indicating that the industry may be entering a more challenging environment than in recent years. Is this a sign that the D&O market is ready to change direction? Figure 11 Number of Securities Class Action Lawsuits Filed by March 31st of Each Year Class Action Lawsuits Filed by March # of Filings Up 35%

15 IV. Sensitivity of Loss Ratios While we feel that the estimates used in our analysis are reasonable, the reader is cautioned to view our results as approximations rather than as precise numbers. For example, a sensitivity test showing the effect on loss ratios of a 10% increase / decrease in our loss estimates is illustrated in Figure 12. Increasing or decreasing 2007 s losses by 10% causes the loss ratio to swing by nearly 15 percentage points, from a low of 67.8% to a high of 82.9%. Figure 12 Sensitivity of Loss Ratios to a 10% Increase / Decrease in Premium Estimates Loss Ratio Sensitivity to a 10% Increase/Decrease in Estimated Losses 160% 140% 120% L o ss R atio 100% 80% 60% 40% 20% 0% Losses Down 10% Base Case Losses Up 10%

16 V. Conclusion The results we have presented in this study represent trends on a filing year basis for the public D&O industry as a whole, however, individual insurers results may differ depending on the particular risks that make up their book of business. An insurer s portfolio of risks can vary by many factors including industry composition, company size, business classification, coverage terms and conditions, limits, and attachment points. This mixture can dramatically change an insurer s profitability as compared to the overall industry. To illustrate this point, Figures 13 and 14 below show average settlement amounts for the health care and financial services industries and the frequency of lawsuits within those industries. Results for the two industries show low correlation, indicating that an insurer would have had very different results from insuring one industry rather than the other. Figure 13 Average Settlements in the Healthcare and Financial Services Industries Average Settlement Amounts - Health Care Industry Average Settlement Amounts - Financials Services Industry $80 $80 $70 $70 $60 $60 $ in Millions $50 $40 $30 $ in Millions $50 $40 $30 $20 $20 $10 $10 $ $ Figure 14 Frequency of Class Actions in the Healthcare and Financial Services Industries Frequency of Class Actions - Health Care Industry Frequency of Class Actions - Financials Services Industry

17 In our final analysis, we have shown premiums and losses decreasing from 2004 to The industry appears to have been profitable during these years. However, with the recent subprime meltdown and related credit issues casting a cloud over the market, this trend may be moving in a different direction. There are signs of higher frequency and severity: lawsuits relating to subprime and credit liquidity have led to increased frequency in 2007 and early 2008, and recent stock market volatility could be an indication of higher settlement sizes in the future. However, there are reasons for optimism as well. Sarbanes-Oxley has led to improved corporate governance and could continue to motivate directors and officers to be more transparent and forthcoming with less aggressive, but more accurate, financial disclosure. Recent important legal decisions, including the Supreme Court decisions in the Tellabs and Stoneridge Partners cases and the favorable JDS Uniphase verdict, have been highly favorable to the defense-side, and could strengthen defense arguments in future class action negotiations. Observers typically cite securities class action settlement data when estimating D&O industry losses. However, in its rawest form, such data is not directly applicable for this purpose. Our goal in preparing this report was to use this reported settlement data, but with appropriate modifications, in order to better portray actual D&O industry experience. The scarcity of publicly disclosed data on the D&O industry and the powerful outside forces influencing settlements makes it difficult to accurately assess industry performance and forecast the underwriting cycle. We feel that our results, while imperfect, are useful in measuring trends for the publicly traded D&O industry. We believe that more accurate information on public D&O losses and premiums will allow insurers to make better pricing decisions, ultimately reducing volatility in the underwriting cycle. Generating such data remains an important goal, and we will continue to refine our approach over time. VI. References and Sources Our analysis was based on shareholder securities class action lawsuits filed in Federal courts and excludes shareholder derivative cases and other cases filed in state courts. We also exclude IPO allocation, mutual fund market timing, and Wall Street research analyst cases, and opt-out settlements. All results are as of March 31, Our sources for raw data on securities class action filings and settlements included ISS / RiskMetrics, the Stanford Law School Securities Class Action Clearinghouse, and Advisen, Ltd. Other sources of information for this report include research papers by Professors Tom Baker and Sean J. Griffith, and publicly available information from Cornerstone Research, Towers Perrin and many other industry sources