Risk Management in the Boardroom

Risk Management in the Boardroom Ann Gariti, Aon Corporation Eric Blanchard, United Stationers Inc. Jeff Stolle, Career Education Corporation Steve Shappell, Aon Corporation Kelly Superczynski, Aon Corporation Laura Taylor, Aon Corporation John Landis, Foley & Lardner LLP Gordon Chip Davenport, Foley & Lardner LLP 1

Directors and Officers Liability Trends Steve Shappell Chip Davenport John Landis Federal Securities D&O Class Action Litigation Severity Severity: Securities Class Action Litigation D&O Settlements 1997 2008 (Excluding $1B and Outliers; dollars in millions) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Number of Settlements 174 168 155 140 130 148 134 160 171 119 146 111 114 108 21 Avg ** $11.17 $9.41 $10.62 $12.07 $14.72 $14.04 $19.69 $20.94 $22.12 $32.03 $33.89 $38.07 $26.25 $36.73 $39.24 Median [includes $1B+] $3.65 $4.15 $4.40 $5.43 $4.05 $4.50 $5.43 $5.53 $5.60 $7.00 $8.08 $7.26 $7.73 $9.75 $5.00 St. Dev ** $20.36 $19.88 $23.61 $19.79 $40.75 $31.97 $48.46 $59.09 $57.75 $71.56 $103.16 $77.51 $70.35 $118.02 $122.15 $100M+ [includes $1B+] 2 1 1 2 5 4 6 7 9 11 15 12 8 6 2 Year End* ** Excludes settlements of $1B or greater * Source: Aon FSG, Stanford Law School Securities Class Action Clearinghouse as of 01/28/2009 Note: Settlement information generally reflects settlements as of the date a settlement is announced. As additional parties reach settlements and they 2

Federal Securities D&O Class Action Litigation Frequency # Suits Filed Per Y ear 231 188 111 173 Federal Securities Fraud Class Action Litigation 312 of the 498 include IPO Allocation Allegations 498 23 of the 119 filings included stock options backdating 241 266 227 238 209 216 182 Includes 20 Auction Rate Suits; 6 Mortgage Certificates Suits; 1 Principal Protection Notes Suit & 5 Madoff Related Suits 37 of the 177 filings include subprime issues 119 176 4 Mortgage Certificates Suits; and 7 Madoff Related Suits 226 40 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Pre-Reform Act Post-Reform Act SOX Passed PCAOB Running Sources: Stanford Securities Class Action Clearinghouse D&O Pricing Index Comparables 160.0% 600 D&O Pricing Index 498 DJIA S&P 500 Index 500 120.0% Nasdaq Composite Index Securities Class Action Litigation 400 80.0% 300 266 40.0% 209 216 226 238 182 226 200 176 0.0% 119 100-40.0% 0 Q4 2008 Q3 2008 Q2 2008 Q1 2008 Q4 2007 Q3 2007 Q2 2007 Q1 2007 Q4 2006 Q3 2006 Q2 2006 Q1 2006 Q4 2005 Q3 2005 Q2 2005 Q1 2005 Q4 2004 Q3 2004 Q2 2004 Q1 2004 Q4 2003 Q3 2003 Q2 2003 Q1 2003 Q4 2002 Q3 2002 Q2 2002 Q1 2002 Q4 2001 Q3 2001 Q2 2001 Q1 2001 Q4 2000 Q3 2000 Q2 2000 Q1 2000 Q4 1999 3

Observations 2000 vs. 2008 2000 unprofitable D&O underwriting year for Markets 2000/2001 underwriting results led to violent price upswing in 2002/2003 2000 claim frequency similar to 2008 Severity is up dramatically since 2000 2008 premium volume similar to that of 2000 Rates at same levels Number of insureds fairly constant 2008 likely to be poor D&O underwriting year Underwriter perspective; industry diversity/concentration is the key Potential Mitigator - Dismissal Rates Status of Securities Class Action Cases by Year Filed 1996-2008 Settled Dismissed Continuing 110% 100% 3% 9% 13% 90% 15% 33% 29% 18% 80% 36% 41% 35% 32% 41% 35% 70% 41% 60% 44% 44% 78% 94% 50% 31% 40% 67% 30% 71% 64% 63% 66% 57% 56% 20% 46% 41% 38% 28% 15% 10% 7% 6% 0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Corne rstone Researc h - Securit ies C lass Actio n Case Filings - 2008: A 4

Potential Mitigator - D&O Capacity (01/01/09) Insurer Maximum Capacity Insurer Maximum Capacity Ace BDA / CODA $50 Freedom Specialty $15 ACE USA $25 Great American $25 Ace Westchester $15 Hartford $25 AIG Cat Excess $50 HCC $25 AIG Cat Excess BDA $50 Hudson $10 Arch BDA $25 Ironshore $25 Arch US $25 Liberty $25 Ariel Re $10 London $40 Argo Re $15 Max Ltd $25 AWAC BDA $25 Monitor $10 AWAC US $25 National Union $50 Axis BDA $25 Navigators $25 AXIS US $25 Old Republic $15 Beazley US $10 RLI $25 Berkley Pro $15 RSUI $15 Chubb $25 Swiss Re $50 CNA $25 Travelers $25 Crum & Forster $15 Valiant $15 Darwin $10 XL BDA $50 Endurance BDA $25 XL US $50 Endurance US $25 Zurich $25 Total $1,085,000,000 Litigation Involving Private Companies No discernable decrease in frequency of suits against private companies, officers and directors Primary factors in 2008 Shareholder disputes Employee claims Customers According to Chubb Private Company Survey: 62% experienced some type of management/professional liability event 22% of all private companies had D&O suit in last 5 years 24% of private companies had employment practices matters in last five years 5

D&O Pricing Index Renewal Results Quarterly Change in D&O Pricing: Year-Over-Year Q1 2002 Q4 2008 Base year: 2001 190.0% 154.7% 140.0% 112.1% 90.0% 63.8% 90.9% 65.6% 40.0% 40.4% -4.2% -6.7% -20.0% -26.4% -25.0% -24.7% -11.8% -13.3% -9.0% -1.1% -10.0% -5.3% 7.3% 3.1% -10.0% -8.1% -19.4% -19.1% -16.2% -19.6% -12.1% -6.1% -5.0% -60.0% Q1 2002 Q2 2002 Q3 2002 Q4 2002 Q1 2003 Q2 2003 Q3 2003 Q4 2003 Q1 2004 Q2 2004 Q3 2004 Q4 2004 Q1 2005 Q2 2005 Q3 2005 Q4 2005 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 2008 4th Quarter Renewal Results by Industry 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% -10.00% Utilities -5.13% Energy Materials -12.00% -10.89% Consumer -3.23% Industrials -9.84% Telecommunications Services 0.00% Consumer Discretionary -12.50% Information Technology 0.75% Healthcare Financials -0.68% 50.00% 20 00% 6

Fourth Quarter Pricing Relativity by Industry Sector 60.0% 65.3% 40.0% 20.0% Utilities Energy Materials Consumer Staples Industrials Telecomunications Services Consumer Discretionary Information Technology 3.8% Healthcare 14.1% Financials 0.0% -8.4% -3.8% -20.0% -18.5% -40.0% -34.3% -32.8% -32.3% -47.3% -60.0% Key Points Carrier sound-bites Pricing elevator going up We will increase rates by 15% We are surely in a hard market Realities Rates today are 62% less than the hard market Non-incumbent markets quoting renewals at 4.7% increase Incumbent markets quoting renewals at.6% decrease Frequency and severity trends are troublesome Hard market could happen 7

Policy Issues Under Scrutiny Validity of coverage of international operations U.S. issued policies in other countries may not be valid Considerations for companies facing financial challenges Importance of coverage audit Bankruptcy related provisions A-Side-Only coverage SEC Investigations Key points for private companies Enterprise Risk Management in Today s Environment Laura Taylor Eric Blanchard Jeff Stolle Ann Gariti 8

Risk Landscape - Current Environment Risk bar is getting higher and higher Margin for error getting smaller and smaller Key external and internal stakeholders expecting enhanced risk management and asking a lot of risk-related questions Companies at varying levels of ERM maturity S&P ERM rating announcement driving discussions with CEOs, CFOs and Treasurers Examples of Enterprise Risk Strategic Brand / Reputation Partnerships Social / Ethical Corporate Social Responsibility Social / Demographic Change Public Health Competitors Mergers and Acquisitions Trends/Fashion Research/Development Manufacturing Supply Chain Product Recall Weather Energy Water Availability Shipping / Transport Industrial Action Production Capacity Explosion / Disaster Pandemic Operational Financial Debt Management Foreign Exchange Credit Contractual Liabilities Lawsuits Product Recall Taxation Market Volatility Confusion Over Regulatory Protections Copyright Infringement Regulatory Change Legal Compliance Corruption Licensing Non-Admitted Insurance Intellectual Property Regulatory 9

Key Internal and External Stakeholder Risk Questions Risk Awareness What are the organization s top risks? What is the potential impact of the organization s top risks? Which lines of business bring the most risk to the organization s overall profile? Has the organization quantified any of its key risks? If so, which? How is risk information communicated to the Board and other key parties? How is the organization s risk profile changing? Risk Improvement What activities are in place to manage the organization s key risks? Does the organization have the capabilities to execute this risk response strategy? What key metrics does the organization use to monitor current risk exposure levels? Who is responsible for monitoring the completion of action plans? Did the mitigation activity yield the appropriate level of benefit for the cost? Risk Governance What is the organization s risk appetite? Is there a senior level or Board committee on risk? Do employees understand their risk management roles? Where is the risk management department located in the organization? How does management incorporate risk into its strategy development? Is the organization taking an appropriate amount of risk? Driving Value through Enterprise Risk Management Core ERM Model Risk Strategy & Objectives Risk Identification & Prioritization ERM Sustainability Growth Profitability Risk Assessment & Quantification Continuity Risk Response Implementation Risk Response Strategy ERM frameworks help organizations: Demonstrate proactive understanding and management of risk Advance Management and Boardlevel understanding of existing business risks and results and emerging risks and future prospects Improve organizational health Enhance corporate governance Streamline existing risk processes Improve business decision-making Support financial reporting Gain competitive advantage Anticipate and effectively respond to risk Improve the risk / reward ratio Better allocate resources 10

Addressing ERM in the Current Environment Focusing on: Risk Management Culture Current frameworks or structures Roles, responsibilities, policies and metrics Internal and external communications Influence of risk management on budgeting and management compensation Strategic Risk Management Role of risk management in strategic planning and decision making View of top risks, including likelihood and potential effect on credit Frequency and nature of updating top risks Influence of risk sensitivity on liability management and financing decisions S&P s timeline for incorporating ERM reviews into ratings Discuss at management meetings, gather information OCT 2008 2009 NOV DEC JAN FEB Descriptive text in reports; Begin benchmarking process MAR Comparative text in reports APR MAY JUN Publish criteria JUL Opinions issued AUG SEP Key S&P Rating Discussion Topics How are key risks identified, updated and dealt with? How is risk tolerance defined and communicated? Who owns risk in the organization and how is success measured? What is the board s involvement in risk management? How did you company respond to? S&P is looking for evidence of effectiveness. Even though many companies have not had serious inquires from S&P yet, these questions are a good litmus test 11

Insurance Company Credit Analysis Kelly Superczynski Current Market Conditions Soft underwriting cycle Intense price competition Relaxed pricing and underwriting terms The P&C industry has been experiencing this for the past couple of years Worst financial crisis since 1930 s Current Industry Outlooks Sector S&P A.M. Best Moody's Fitch Personal Lines Negative Stable Stable Negative Commercial Lines Negative Stable Stable Negative Reinsurance Stable Stable Stable Negative Health Negative Negative Negative Negative Life Insurance Negative Negative Negative Negative First time in recent history that both the insurance markets and financial markets have both been struggling concurrently During past soft cycles insurance companies were able to offset underwriting losses with investment income Not possible now, so companies need to focus on underwriting management Added potential for significant future losses to emerge from D&O and E&O claims related to the capital markets disruptions $10B according to a report by Advisen, an insurance industry information provider $1.8B resulting from the Madoff ponzi scheme alone per an Aon Benfield analysis This is the best estimate; the range is $760M to $3.8B 12

A. M. Best Impairment Study Cause (1969-2002) Deficient Loss Reserves Rapid Growth Alleged Fraud Overstated Assets Significant Change Reinsurance Failure Catastrophe Losses Impairment of Affiliate Miscellaneous Pct Total 37.2% 17.3% 8.5% 7.8% 5.0% 3.7% 6.9% 3.7% 9.8% Change in Business 1% Primary Causes of P/C Impairments 1991-2002 Impairment of Affiliate 8% Catastrophe Losses 8% Fraud / Overstated Assets 12% 4.0% Misc 11% Average Impairment Frequency Deficient Loss Reserves / Rapid Growth 60% 562 impairments* over 34 year period 1969-2002 Note low impairment rate for mutual companies Consistent with higher survival rate on previous slide Source: A. M. Best Impairment Study, 2004 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Stock Mutual All Other AMB Secure AMB Vulnerable Data Sources Inundated with information GAAP Financial Statements Statutory Financial Statements Rating Agency Reports Analyst Reports Broker market security reports What to do with information / how to prioritize? 13

Key Analytical Points Mix of qualitative and quantitative Operating performance Underwriting performance Cycle management Balance sheet strength Capital adequacy Asset quality / Investment leverage Reserves strength/stability Liquidity Of particular importance today given unrealized investment losses Financial flexibility Reinsurance Enterprise Risk Management ( ERM ) Management and Corporate Strategy Catastrophe exposure Key Quantitative Analytical Measures Ratings Financial Strength ERM (S&P only) Operating Performance Combined Ratio Return on Surplus Investment performance Balance Sheet Strength Capital Adequacy A.M. Best discloses BCAR ratios for US insurance companies S&P will state if capitalization is excellent, strong, adequate, etc. Change in Surplus Reserve strength (separate reserve releases from underwriting profit) Investment Leverage Asset credit quality/concentrations Debt to Equity ratios Underwriting Leverage NPW / Surplus and NPW + Reserves / Surplus Holding Company/Group analysis 14

Example Assessment Matrix 5% 5% 40% Rating Underwriting Metrics 9/30 Investment Losses FSR Combined Ratio ROE Realized Unrealized A.M. Best S&P S&P ERM 9/30 1 yr 5yr Avg 1yr 2yr 5yr Losses Losses State Farm A++ AA Adequate 113% 99% 99% 12% 12% 14% 156 (5,150) Allstate A+ AA- Adequate 102% 91% 94% 20% 20% 21% (977) (1,657) Nationwide A+ A+ Strong 102% 93% 92% 4% 12% 13% 492 (754) Parameters 'A-' 'A-' Adequate < 100% < 100% < 100% 10% 10% 10% 50% Balance Sheet Strength 2007 9/30 Change AY Reserve Development Investment Asset Debt to NPW / NPW + Res Surplus in Surplus BCAR 1yr 2yr 5yr Leverage Leverage Equity Surplus / surplus State Farm State Farm 58,118 (5,616) 291.2 (2.1) (0.8) (14.1) 1.93 2.14 20% 0.8 1.7 Allstate Allstate 13,211 (4,952) 223.0 1.0 (11.7) (6.3) 2.68 3.32 33% 1.5 3.1 Nationwide Nationwide 13,143 (436) 171.2 (1.7) (4.5) (0.9) 2.31 2.94 11% 1.2 3.0 Parameters Parameters $100M >160% Negative Negative Negative <7.0 <9.0 < 25% < 2.0 <3.0 15