E%amp;O Should Be On Liability Radar Screen

While directors and officers losses resulting from recent market events are garnering significant attention, errors and omissions liability seems to be falling below the radar screen.

As new cases of alleged securities fraud grow, so do potential E&O losses. So unless insurers want to awaken to a nightmare in three-to-five years, they must begin to address this "sleeper" issue.

Potential losses from E&O litigation may not be as high as those of D&O cases, but the road to the eventual settlements will be tedious, distracting and, ultimately, expensive.

The E&O market is fragmented, so quantification of the losses is more difficult. Unlike D&O losses, E&O losses will be high frequency (with many claimants) and low severity (with relatively low policy limits). However, the numbers will add up.

Every new revelation about alleged malfeasance on the part of investment funds, brokerage firms and lenders triggers a new spate of filings up and down the extensive investment food chain.

Potential E&O losses are already estimated at an eye-popping $3.9 billion, according to Advisen. This estimate, which includes class-action lawsuits, derivative lawsuits, investigations and other losses, falls within a broader range of combined potential E&O and D&O losses of between $6.8 billion and $12.1 billion, according to Advisen's November 2008 analysis.

E&O-based securities class-action filings reached a 10-year high by the end of 2008, up more than twofold compared with 2007, with no signs of a slowdown. More than 400 E&O lawsuits related to the subprime crisis have already been filed, and still more are expected, according to Advisen.

Obviously, the results of the increasing number of lawsuits will not be known for several years. The final costs of and losses from defending this volume of litigation--in terms of fees, eventual settlements, management distraction, and the potential negative impact on insurers' agency ratings and stock performance--will be difficult, if not impossible, to calculate entirely.

Thousands of parties involved in transactions associated with home purchases and securitization of mortgage loans have E&O liability exposure. The most likely targets are alternative investment funds, investment advisors, credit rating agencies, real estate agents, real estate attorneys, mortgage brokers and warehouse lenders. Even in best-case scenarios, the picture is not pretty and remains out of focus.

However, insurers cannot allow themselves to become paralyzed by uncertainty. They must work their way through pending litigation, size up their possible cumulative exposure, examine their current and future E&O products, and contemplate the potential impacts of new regulation on the financial services industry.

Insurers should take several key steps to manage the situation.

o First, fully quantify and understand existing liability exposures for claims relating to in-force E&O coverage.

This is critical for companies to set reserves that are adequate and credible.

Until now, insurers have primarily focused their risk management analytics on potential D&O claims exposures, the majority of which are related to the credit crisis and, more recently, securities class-action suits.

E&O claims from the current financial crisis are lagging the D&O claims, but they could rapidly sneak up. With both the mortgage crisis and securities fraud issues, the participant chain is extensive, including both direct and peripheral defendants.

Examining this chain to determine the extent of exposures represented in the E&O in-force portfolio will allow companies to quantify the possible impact in advance and eliminate the need to present shareholders with unwelcome surprises.

o Second, companies need to apply bottom-up and top-down analytics to determine liability estimates.

A bottom-up, policy-by-policy review allows companies to calculate gross-level exposure ranges--from best-case to worst-case scenarios.

While difficult to accomplish in the short term, top-down modeling of litigation outcomes, policy payouts and reserve requirements must be a goal as well.

For the bottom-up review, it is most critical to analyze the key operative factors in quantifying exposures:

o Explicit policy coverage triggers, minimums and points of attachment.

o External, environmental events and trends that are likely to trigger claims and litigation and that could drive higher settlements and awards.

o Policyholder events such as S-1 filings; extreme volatility in stock price and trading levels; large write-downs and significant declines in capitalization; large on- or off-balance sheet risk positions such as securitizations; executive officer turnover; and rapid increases in potential exposures due to securities class action suits.

o Investor behavior, including proxy fights and shareholder proposals, as well as other governance issues.

o Analyst, rating agency and media coverage of a company, its peers and its sector, which drives negative public perception, investor behavior and overall quarterly financial performance.

Top-down models based on the specific types of exposure a company has and the scope of exposure relative to its market share and the industry sector risk profile are useful in helping a company "put a box" around its risk exposures and reserve requirements.

Reserve models must be updated frequently as the significant incidents and issues rise and fall in prominence and materiality. The tracking of early settlements and dismissals and, eventually, awards will steadily affect the degree of realism of estimated claims and reserves.

In addition to estimating liabilities, companies must objectively assess the performance of their risk management and underwriting practices in the harsh light of lessons learned during the recent crises.

While property-casualty insurers, including E&O writers, may generally have exercised more cautious and rigorous risk management than other sectors of the financial services industry, it is clear that risk management can and must be improved.

Most companies with competitive positions in the E&O markets will continue to write coverage, but they must not forget that shocks can occur even after the economy recovers.

Negative systemic incidents and paradigm shifts in markets are not the one-in-a-million events they were recently thought to be, and risk management and underwriting practices must take into account all possibilities.

Ultimately, it will take at least three-to- five years to tally E&O losses, but this by no means suggests that companies with potential exposures can take a wait-and-see approach. Systematic and disciplined steps should be taken to track exposures relating to subprime issues.

At the same time, companies must keep an eye out for the next big wave of claims--many of which may be unrelated to the subprime issue--as the economy continues to degrade.

As market vicissitudes continue, it is crucial that companies put together as many pieces of the E&O exposure puzzle as possible, while acknowledging that they may not yet be able to offer the full picture. The key to avoiding future unpleasant surprises is continuously reevaluating present knowledge.

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