By BENNY YUEN, senior actuarial advisor in the Ernst & Young's Insurance and Actuarial Advisory Services practice, and JAY VOTTA, principal and leader of the property/casualty practice in the Insurance and Actuarial Advisory Services group
The latest estimate of aggregate directors' and officers' and errors-and-omissions losses from the current financial crisis is $9.6 billion, according to Advisen. This estimate falls within a broader range of combined potential D&O and E&O losses of between $6.8 billion and $12.1 billion. These estimates include potential losses from class-action lawsuits, derivative lawsuits, government investigations and other losses.
Such a strikingly large range of potential losses--$5.3 billion--suggests that many current unknown factors could continue driving upward the total impact.
THE LITIGATION HIT
The dramatic rise in securities class-action lawsuits is a key driver behind the uncertainty of total D&O potential losses. It is now estimated that 2008 filings were up about 40 percent over 2007, reaching at least 255 and representing a 10-year high.
The outcome of the lawsuits obviously will not be known for several years. The final costs and losses of defending this volume of litigation--in terms of fees, management distraction, and the potential negative impact on insurers' agency ratings and stock performance--will be difficult if not impossible to calculate entirely.
Although most companies expect only a relatively small number of cases to go to trial, defense costs and settlements will take their toll. As settlements are made and accounted for with reserves and actual payouts, companies will be dealing with downward earnings pressure as well as balance sheet hits.
A less high-profile reverberation from recent marketplace events is in the E&O space as parties involved in transactions associated with home purchases and securitizations of mortgage loans have E&O-related liability exposure.
The most likely candidates are alternative investment funds, investment advisors, credit ratings agencies, real estate agents, real estate attorneys and mortgage brokers. As of November 2008, more than 400 E&O lawsuits have been filed relating to the subprime crisis, and more are expected.
Early estimates put losses between $2 billion and $5 billion, with an expected value at $3.7 billion. The E&O market is more fragmented, so quantification of the losses is more difficult. Unlike D&O losses, E&O losses tend to be high frequency and relatively low severity. Many of these claims are expected to materialize in 2009 and 2010.
DOWN BUT NOT OUT
Both life and property/casualty insurance companies still expect several more quarters of unsatisfactory results. However, many P/C and some life companies are still relatively well capitalized and should be able to ride out the financial crisis and market volatility. Nonetheless, most companies are concerned about how they are perceived by the ratings agencies, regulators and investors. Concerns are only heightened if litigation continues to increase. The question remains: Can things get even worse?
The litigation aftermath after nearly two years of a rolling, worsening financial crisis will continue to play out. As we have seen, estimates of losses to come are necessarily incomplete because of suits still to be filed.
At the same time, the demand for D&O and E&O coverage has increased in the marketplace. Unless losses take on truly unexpected dimensions, most companies with competitive positions in the D&O and E&O markets should continue to meet this demand.
In fact, the industry still has relatively high capacity, which will likely prevent significant rate hikes or major changes in policy terms for the industry overall. However, pricing has increased and will likely continue to do so for the financial institutions and real estate sectors.
LEARNING FROM THE PAST TO PREPARE FOR THE FUTURE
Now is the time for D&O and E&O insurance companies to look ahead--carefully. They must examine their current positions and future offerings. They need to apply the recent lessons learned about managing risk under conditions of unusual, possibly unparalleled, uncertainty in order to thrive in the coming years.
To do so, insurers should consider the following steps as they move forward:
--Measure and assess current exposure. Build models for Side-A-only policies and full D&O policies. In doing so, look at worst-case scenarios--including systemic events and paradigm shifts in individual markets and the economy, particularly regarding a potential continued freeze on credit.
--Reassess underwriting application processes and policy language, particularly regarding exclusions and limits.
--Put a "radar" system in place to assess the state of the market and monitor industry trends, including pricing, coverage enhancements and exclusions, and product competitiveness.
--Anticipate the next wave of systemic claims. Take a disciplined approach in evaluating the potential future class-action suits that may lead to D&O and E&O losses.
The one market certainty in 2009 is uncertainty. Those who learn to cope with it will mitigate risks, while those who become paralyzed by it may pay a steep price.
March 3, 2009
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