Large Firm Errors and Omissions: A Challenge Renewed for 2002 and Beyond

1. Large Firm Errors and Omissions: A Challenge Renewed for 2002 and Beyond By Joseph Kirley, ACAS Consulting Actuary (phone: 914 439 5669)

2. What is a Large Firm? • The Big 5 (now 4) • billions in revenue, ten thousand partners, hundreds of thousands of employees, worldwide operations • “Public” /Headline Exposures • Practices dominated by publicly traded corporations and other clients with two things in common: large value at risk and third party reliance on accounting and other services

3. How Large? • Large: Worldwide revenues for FY 2000, in billions of USD : • PWC 19.6 • DTT 11.2 • KPMG 13.5 • E&Y 9.2 • Andersen 8.4 • (source: Public Accounting Report, Feb 28,2001)

4. With size comes risk • Universally perceived as a “deep pocket” • E&O Exposure is on country firm level (usually local LLP) and arises from “covered work”: • failure to detect accounting fraud and mistakes • other forms of accounting malpractice • direct accusations of securities fraud and collusion • conflicts of interest • occasionally breach of contract /fiduciary duty

5. Risk Management • Commercial insurance market: • offers little capacity • mainly fronting and local in-fill coverage on self-insured retentions (if reinsurers allow). • More readily available for consulting rather than audit and attest exposures • Alternative Market: • captives that then buy reinsurance are the primary risk management device. • Worldwide captives are legally independent entities issuing policies to individual firms

6. Why Captives? • Usual reasons: • assures availability of “some” coverage to member firms • more cost effective way to fund expected losses • accelerated tax deductions for member firms • Other reasons: • excellent focal point to access reinsurance markets - the captive individually insures local partnerships scattered around the world, and then focuses reinsurance capacity for benefit of all • Discrete, dedicated claim handling that takes account of the firm’s worldwide reputation and brand value- reinsurers cede controls, no duty to defend • Better forum for resolving insurance disputes and enforcing risk management guidelines (political dynamic between member firms)

7. The Reinsurance • Underlying captive policies are mature claims-made, and are issued in over 100 different countries with occurrence and aggregate limits - geographically diversified risk pool • Local firms keep self insured per occurrence retentions (SIR) that range widely by locale and year (100k to 50mm USD) • Captive attaches over SIR, with some per occurrence limit • Captive then buys financial reinsurance or structured finite for working layers, and then guaranteed cost for higher severity layers - high capacity reinsurers only need apply • Relationship-centered reinsurance, heavy intermediary involvement

8. Pricing • Usually some combination of Experience and Exposure Rating • An accurate exposure base has been elusive: most use revenues or number of employees • Loss data is credible for large firms • Accurate ultimate loss modeling absolutely requires attention to the details of large events

9. Losses to Ultimate • Whether pricing or reserving, most important actuarial feature is loss development. Excess layer nature means claim mix and claim volatility usually dwarf other considerations in modeling any one year. • Individual claim development is useful but is not widely used • involves examining the historical development of individual claims, rather than in aggregate triangulations that assume homogeneity • “Reserving for Excess Layers: A Guide to Practical Reserving Applications”, by Edward Dew and Barton Hedges, CAS Summer 1997 Forum (DH). • DH was excellent survey of all excess development methods, and describes individual claim development methods, including a simulation technique that is very useful for large firms

10. Individual Claim Development - Fit Distribution to LDFs

11. Perform a Simulation - Ultimate Distribution by Claim and In the Aggregate - (This Assumes No Correlation between Events)

12. General Trends • Past Decade: Lower frequency, higher severity, more randomness and volatility, low inflation, globalization of claims • De-linking consulting and audit • Disproportionate exposure outside U.S., but U.S. still dominates losses • Rising prominence of internal risk management at firms • More discriminating plaintiff industry since c.1998 (when SRA 1995 reforms began having a more pronounced affect) because ….. • Dismissal rate on federal securities lawsuits has gone up dramatically due to greater procedural hurdles before discovery, and proportionate liability is now a more dominant influence in claim settlement • Impact of Enron, Worldcom, etc: TBD, but have so far not observed obviously adverse consequences - Andersen’s demise may have perversely accelerated some plaintiffs towards lower and quicker settlements (anecdotal)…but….. • Recent Sarbanes-Oxley legislation extended statue of limitations for filing federal suits from 2 years to 5 years…more legislative changes coming?

13. Myths and Misconceptions • Myth 1: Every bankruptcy, business failure, and stock drop generates liabilities to the Big 5 • Myth 2: Large D&O Claims mean large E&O claims • Myth 3: Large headline losses and fines always mean horrible results to reinsurers • Myth 4: One firm doing consulting and auditing together (even for one client) are riskier • Myth 5: Captive insurance is a sham designed to hide the firm’s assets • Myth 6: High tech clients are riskier to Big 5 than all others

14. The Future • Even more capacity needed to handle run away severity cases • Contingent and catastrophic finance mechanisms? • Will private partnerships and international relationships be modified because of Andersen’s demise?