2002D&O Insurance

White Paper

Understanding Board Member Risk

Executive Summary

It is a trying time for corporate directors and officers. Corporate scandals have put the

actions of executives under greater scrutiny. New corporate governance initiatives, while a

positive step in addressing valid concerns of the investing public, have created new liability

exposures for directors and officers, some of which may not have been intended. The personal

assets of directors and officers are at risk now more than ever. The specter of prison time

also looms large. With good reason, talented people are asking themselves whether being a

director is worth the risk.

In the current environment, it is critical that directors and officers investigate and under-

stand how their directors and officers liability insurance (D&O) protects or fails to protect

them. The findings could surprise them. As the nation’s leading provider of D&O insurance,

National Union feels strongly that the industry’s ultimate customer—individual directors

and officers—should understand why changes to the D&O insurance policy are needed.

Modifications must be made in order to refocus the policy on its original intent: protecting

the personal assets of directors and officers. These changes will serve the best interests of

directors and officers.

The modifications being made are not only in response to the recent corporate scandals and

the increased exposure that directors and officers face. They are being made because the

fundamental economics of the D&O insurance industry have been extremely negative ever

since the passage of the Private Securities Litigation Reform Act of 1995 (the “Reform Act”).

With this in mind, we thank PricewaterhouseCoopers for their assistance and input, included

herein, into some of the underlying causes behind recent securities litigation trends and the

reasons these trends have not tracked to pre-Reform Act expectations.

Despite the Reform Act’s good intentions, securities claims soared to record levels of fre-

quency and severity after its passage. The number of companies sued in securities litigation

rose nearly 300% from 1996 to 2001.1 Settlement values jumped 150% during the same time

period.2 However, given the competitive environment that was created by new entrants to

the marketplace, the premiums insurers charged to cover these increasing exposures reduced

by more than half. In 2000, the implausible economics of the situation begin to take a visible

toll. Two large D&O carriers became insolvent. Since then, several more insurance carriers

have been downgraded.

Currently, the balance sheets of many D&O insurance carriers are dangerously weakened.

In dozens of recent cases, due to the insolvency of a D&O insurer or a problem inherent in

the D&O insurance policy itself, directors and officers have been left without protection for

their personal assets. One large D&O insurance company recently went from an A- credit

rating to liquidation in 18 months, leaving many insureds with a D&O policy that was not

worth the paper it was printed on.

The inclusion of coverage for the corporation in the D&O policy has also had several

unforeseen effects, adverse to the interests of directors and officers. First, the inclusion of

“entity coverage” has diluted the amount of coverage available for directors and officers.

Policy limits intended for individuals are being eroded by the corporation’s own liabilities

when a claim occurs. Second, the existence of entity coverage has also reduced corporate

incentives to hold down litigation costs and settlements: Corporations no longer have a

vested financial interest in mitigating damages—only in settling suits within policy limits.

Since the introduction of entity coverage, settlement amounts, as well as legal expenses, have

skyrocketed. Third, in certain instances, such as the corporation’s bankruptcy, directors and

officers have found access to their policy proceeds (including funds to pay for their defense)

wholly blocked due to the inclusion of entity coverage.

Despite certain well-publicized instances of fraud, the vast majority of directors and

officers are innocent and deserve protection. If the D&O industry is unable to protect these

individuals, they will not continue to expose themselves to the threat of personal litigation.

And in order for D&O insurance and the D&O insurance market to protect innocent

directors and officers, immediate changes must be made:

• Entity coverage, which has diluted the protection available to directors and officers, needs

to be regulated. In order for the contract to provide clarity as to what it will and will not

cover, the industry needs to adopt a pre-set allocation clause, which articulates how much the

D&O policy will pay on behalf of the individuals as opposed to how much the corporation

will pay on behalf of its own exposure in securities claims.

• The quality of the insurance companies participating at every level of the D&O program

must be sound, lest insured directors and officers be blindsided by a carrier that is financially

unable to pay losses when a claim occurs. Directors and officers need to realize that their

D&O insurance is not a commodity.

• D&O underwriters must understand the true nature of the risk that they are being asked

to assume. The industry will not be able to survive if it is required to pay claims on behalf

of policyholders who provide inaccurate or misleading information as part of the under-

writing process.

• D&O insurance premiums must be aligned with the current level of securities exposure.

For this to occur, premium rates must continue to climb rapidly.

By returning the D&O policy to its original focus of protecting the personal assets of directors

and officers, these changes will also ensure that the D&O policy provides proper economic

incentives for all parties involved in defending securities claims. This will result in a reestab-

lishment of the traditional partnership among the insurer, defense counsel, directors, officers

and corporation. Individual directors and officers will be better served when this is achieved.

With recent corporate scandals, and the quick passage of the Corporate Auditing and

Accountability Act of 2002 (officially titled, “Sarbanes-Oxley Act of 2002”) in response to

these scandals, significant additional exposures have been created for directors and officers.

Because of this, the need for change in the D&O insurance industry has become particularly

urgent. The need for knowledgeable, experienced brokers is critical. D&O insurers and

brokers must act quickly to enact the changes needed to ensure a stable, enduring D&O

insurance market. An in-depth analysis of the issues facing directors and officers in today’s

marketplace is attached. We hope that you will find this useful and informative in understanding

why, and how, the D&O industry needs to change.

Table of Contents

Executive Summary

Introduction ...................................................................................................................

I. Background: The PSLRA .................................................................................

II. Expectations: Post 1995 ...................................................................................

• Capacity ..................................................................................................................

• Premium Rates .......................................................................................................

• Coverage .................................................................................................................

• Entity Coverage ......................................................................................................

• Multi-Year Contracts .............................................................................................

III. Reality: Post 1995 .............................................................................................

• Frequency Rises ....................................................................................................

• Severity Increases ..................................................................................................

• Accounting Allegations ..........................................................................................

IV. What Went Wrong? .............................................................................................

• Record Rise in Restatements ................................................................................

• Accounting Rules Lag Behind ..............................................................................

• Complex Disclosure Requirements .......................................................................

• SEC Activism .........................................................................................................

• Greater Focus by Plaintiff Firms ..........................................................................

• Large Valuations ....................................................................................................

• Lack of Risk Sharing .............................................................................................

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V. Economics of the D&O Industry ................................................................

• Failed Economics ...................................................................................................

• Reinsurance Problems ...........................................................................................

• Unintended Repercussions of Entity Coverage ...................................................

VI. Corporate Auditing and Accountability Act of 2002 ..........................

• Securities Litigation Reform .................................................................................

• No Bankruptcy Discharge of Securities Law Liability .......................................

• CEO/CFO Certification ........................................................................................

• Real Time Disclosure .............................................................................................

• Increased Frequency of SEC Review ...................................................................

• Audit Committee Requirements ............................................................................

• Executive Compensation .......................................................................................

• Insider Transactions ...............................................................................................

• Disclosure of Off-Balance Sheet Transactions ......................................................

VII. Solutions for the D&O Industry ................................................................

• Regulate Entity Coverage .....................................................................................

• Price Coverage Properly ........................................................................................

• Embrace the Flight to Quality ..............................................................................

• Risk Sharing ...........................................................................................................

• Side A Excess Program .........................................................................................

• Resurrecting the Partnership ................................................................................

• Consequences of Misleading Information ............................................................

• Protecting the Innocent .........................................................................................

Conclusion ......................................................................................................................

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“What happens when the Prime Movers go on strike?

This means a picture of the world with its motor cut

off...This is the actual heart and center of the novel ...

I set out to show how desperately the world needs

Prime Movers, and how viciously it treats them.”

— Ayn Rand on Atlas Shrugged 3

In 2002, investors have been exposed to unprecedented corporate scandals. Fraud has occurred on

a massive scale. Financial statements and the auditors who validate them have been called into

question. Executives’ compensation is under scrutiny. Investors have been left suffering, during

what appears to have been a time of unbelievable corporate greed gone unchecked.

But investors are not the only victims of this dismal securities market. Innocent corporate directors

and officers are seeing their personal assets jeopardized by corporate crimes they did not commit.

Shareholder Class Action lawsuits against corporations and their boards are rising unabated, with

damages alleged to be in the hundreds of millions, if not billions, of dollars.

Insurers who underwrite directors and officers liability insurance to protect the personal assets of

directors and officers in securities litigation are affected as well. The frequency and severity of

securities claims has skyrocketed. The number of cases involving accounting allegations, an

especially costly breed of shareholder litigation, has increased dramatically. Given the content of

the newly passed Corporate Auditing and Accountability Act of 2002 (Sarbanes-Oxley Act of 2002),

and the requirement of all CEOs to attest to the validity of their company’s financial statements,

litigation will only continue to increase into the foreseeable future.

While D&O insurance policies provide coverage for events other than shareholder (securities)

litigation, securities litigation settlements make up the lion’s share of loss costs to the D&O industry

and are the major source of concern for directors and officers. Developments in securities litigation

over the past six years have strained the D&O insurance market and significantly heightened

exposure for the industry, as well as for those it insures. The corporate scandals of 2002 have put

the personal assets of directors and officers even more clearly in the spotlight, attracting the

lawyers who make a career out of suing executives.

As a result, the D&O policy is more important than ever to the directors and officers of corporate

America. Yet directors and officers must realize that the D&O insurance policy in its current state

may not be able to fulfill its fundamental purpose of protecting their personal assets. If this situation

is not remedied, talented people will ask themselves whether being a director is worth the risk.

In such an event, Ayn Rand may have shown us what our world will look like.

It is in everyone’s best interest that the D&O insurance marketplace functions as a viable source

of protection. The intent of this paper is to explore some of the causes and the consequences of

today’s securities litigation trends, and how the D&O insurance industry has come to its current

state. It is also to outline solutions that the D&O industry needs to implement immediately in order

to remain a viable source of protection for the “Prime Movers” of Corporate America.

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I. Background: The Private Securities Litigation Reform Act of 1995

Roughly 220 securities cases were filed in 1994, representing a 41% increase over the prior year

and a 30% increase over the average number of filings in the prior three years.4 Corporate

America had long lobbied for tort reform, arguing that the filing of securities litigation suits

was in many cases tantamount to blackmail, since the exorbitant cost of discovery, including

depositions of top management, generally far outweighed the cost of settlement.

A Wall Street Journal news article5 aptly sums up the primary problem with the state of the

tort system at the time. The article recounts the story of a Mr. Hutchens, a plaintiff who filed

more than 30 shareholder fraud cases and convinced several companies to settle these suits

for relatively low amounts. These settlement amounts represented almost pure profit for

Mr. Hutchens, because he never actually bought stock in any of the companies that paid him

off. Additionally, his overhead was low since, as the Journal notes, “His rent is covered by

the government—because his place of business is a 6-by-12 foot cell in federal prison.”

According to the article, Mr. Hutchens was serving time for attempting to bilk the IRS out

of ill-gotten tax refunds.

Mr. Hutchens, corporate America believed, was symptomatic of the shortcomings of the tort

system. So when the Private Securities Litigation Reform Act of 1995 (the “Reform Act”)

was passed by Congress, corporate America breathed a sigh a relief, believing that positive

change was imminent.

II. Expectations: Post 1995

The passage of the Reform Act was seen as a clear-cut victory for corporate America and

its D&O insurers. Overall settlement costs were expected to decline as a result of fewer

filings, and many of these filings were not expected to survive the Reform Act’s heightened

pleading standards.

Several changes occurred in the D&O insurance industry in the post- Reform Act era:

• Insurance Capacity: Up until the passage of the Reform Act, the D&O insurance industry

had a relatively stable claims history. With the passage of the Reform Act, the industry

estimated that future costs would be only more predictable. Therefore, the amount of capital

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offered by the insurance industry to provide D&O insurance increased dramatically.

New players, lured by potential profits yet lacking any D&O underwriting and claims

experience, stampeded into the market.

• Premium Rates: As insurance capacity became overabundant, basic economic forces

drove premiums down. In the competitive D&O insurance market of 1996 through 2001,

premiums charged for D&O protection reduced by more than half.

• Coverage: Insurers significantly expanded the coverage granted under the “standard”

D&O policy. Policies soon encompassed employment practices, errors and omissions,

fiduciary liability and other exposures. All of these were in addition to the coverage for

“traditional” securities and breach of duty claims.

• Entity Coverage: Protection grew beyond its original focus of protecting the personal

assets of directors and officers to insuring the corporate entity for its own exposure.

This “entity coverage” was designed to align the interests of insurers and insureds in

defending and settling securities claims, avoiding unproductive disputes over allocation

of loss. Before the introduction of entity coverage, corporations named in securities class

actions had no coverage for their own liabilities. As a result, it was typical for insurance

carriers and the defendant companies in securities litigation cases to negotiate how much

the D&O policy would contribute to the settlement and how much of the loss would be

“allocated” to the corporation for its own exposures.

In the mid-1990s, there were a series of coverage disputes over the concept of “allocation,”

with corporations arguing that the D&O policy should pay 100% of the settlements and

defense costs regardless of any liabilities that the uninsured corporation might have.

Different jurisdictions applied different interpretations of allocation. Entity coverage was

designed to eliminate allocation disputes so that the interests of the corporation and

individuals would be properly aligned with the insurance company and litigation could

be properly and aggressively defended.

• Multi-year Contracts: Insurers allowed insureds to “lock in” coverage and coverage terms

over multiple years.

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III. Reality: Post 1995

Despite the high expectations for securities litigation reform, data on securities litigation

since 1995 makes it clear that the Reform Act has not had its expected effect.

• Frequency of Securities Litigation Has Increased: The number of securities fraud

litigation cases filed has risen nearly 300%, from 122 in 1996 to 483 in 2001.6

• Severity of Settlements Has Increased: Of even greater significance than the heightened

frequency of filings is the increased severity of settlements in securities suits, especially in

those suits containing accounting allegations. Since 1996 to 2001, the average settlement

value of a security class action increased almost150% (from $7.0M in 1996 to $17.2M in

2001).7 Even worse than this, however, in 2001 suits containing accounting allegations cost

280% more to settle than suits without such allegations. The settlement value of these

accounting suits relative to prior years is also rising rapidly.8

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Federal Securities Class Action Litigation

• Lawsuits Containing Accounting Allegations Have Increased: The percentage of securi-

ties lawsuits containing accounting allegations has risen steadily since the passage of the

Reform Act, especially compared to pre-Reform Act levels.9

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Average Settlement Value ‘96-’00 Average Settlement Value 2001

% of Cases Involving Accounting Allegations

All Cases Accounting Cases Non Accounting Cases

IV. What Went Wrong?

Neither Corporate America, nor its D&O underwriters, could have predicted these trends.

This is because they were fueled by numerous and diverse developments, several of which

are discussed below.

• A Record Rise in Restatements: From January 1, 1997 to December 31, 2001, there were

a total of 990 restatements of financial statements of publicly traded companies (excluding

restatements due to a change in accounting).10 As evidenced by the graphs on the following

page, there has been significant growth in restatements every year, prior to the accounting

scandals of 2002. Furthermore, all industry segments are at risk for restatements.

The largest securities litigation settlements in the recent past have resulted from restatements:

Consider Cendant at $2.83 billion; Miniscribe at $550 million; and Waste Management

at $220 million. The reason is simple. Restatements are an admission by a company’s

management and outside auditors that accounts were materially misstated. Hence, while the

requisite scienter, or intent, still needs to be proven for plaintiffs to recover, when companies

restate their financial statements plaintiffs have, in effect, already won half the battle.

• Accounting Rules Lag Behind: Many believe that accounting rule making has not kept up

with the market and the ingenuity of financial institutions and executives. This stands to

reason, since it takes Wall Street just weeks or months to launch a new financial instrument,

but it can take years for new accounting rules to wind their way through the public due

diligence process and clear the Financial Accounting Standards Board (FASB). In the

meantime, the appropriate accounting characterizations can be up for debate. Moreover,

unforeseen economic developments can make disclosures that seemed adequate at the time

appear inappropriate in hindsight, subjecting registrants to fraud claims.

• Complex Accounting and Disclosure Requirements: The accounting practice, often

thought of in terms of exactitude, is now, due to such debacles as Enron, Adelphia and

Global Crossing, becoming known for what it is: “more art than science.” It is impossible to

write specific accounting rules to cover the array of transactions and financial instruments

extant in the marketplace today, yet this does not seem to have deterred the FASB and the

SEC, both of whom continue to publish pages upon pages of often difficult to understand

guidelines for various financial vehicles. Whether guidelines are understood or not, when

registrants are found not to have followed accounting rules, restatements and the inevitable

lawsuits ensue.

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Restatements by Year Filed

Agricultural, Mining and Construction

5%

Manufacturing25%

Software16%

Finance14%

ComputerManufacturing

11%

Services10%

Transportation,Communication

10%

Wholesale and Retail Trade

9%

Restatements by Industry (1997-2001)

• SEC Activism: The SEC’s rule-setting and enforcement activity under former Chairman

Arthur Levitt is well documented. Two of the three Staff Accounting Bulletins (“SABs”)11

issued in the closing months of 2000, while declaring no changes to current rules, signifi-

cantly transformed the application of generally accepted accounting principles, or GAAP,

by virtually every registrant. The most insidious of the SABs, from the perspective of a

registrant, was SAB 99 relative to materiality. The SEC made it clear that the application

of materiality was no longer strictly subject to mathematical rules of thought, leaving regis-

trants in a state of perpetual uncertainty over whether their treatment of an issue deemed

immaterial will be challenged by the SEC. The concepts outlined under SAB 99 are not

lost on the plaintiffs bar.

• Greater Focus by Plaintiffs on Cases That Survive Dismissal: Based on both anecdotal

and empirical evidence, the Reform Act seems to have succeeded in keeping many

frivolous cases out of court. While dismissals comprised only 12% of case dispositions prior

to the Reform Act, dismissals comprise fully 26% of case dispositions post-Reform Act.12

However, the cases that do pass through the motion to dismiss of the heightened pleading

standards are viewed as having a stronger basis, leading to greater settlements. Accordingly,

plaintiffs’ strategy appears to have shifted, out of necessity, from one of filing and settling

many cases to pursuing cases that survive for all they are worth. The emergence of institu-

tional shareholders as lead plaintiffs has only strengthened this strategy.

• Large Valuations Amplify Losses: Higher stock valuations mean a harder fall when things

go wrong.With market valuations at stratospheric levels in the late 1990s, earnings expec-

tations missed by only a penny a share often caused a stock price to plummet. In such an

environment, allegations that a securities fraud caused a false run-up in value, and that the

subsequent disclosure of the purported fraud caused a precipitous drop in value, will be

accompanied by extremely large damage calculations—often in the hundreds of millions of

dollars, and frequently in the billions.

• Risk Sharing Is Lacking: With settlement costs borne 100% by the insurer, corporations

that faced protracted and costly litigation began immediately settling suits, perhaps even

for unreasonable amounts, and even if they had a good chance of prevailing. While it is not

possible to illustrate empirically, this inclination to settle may have contributed to the rapid

rise in settlement costs and the “mega-settlements” that are increasingly common today.

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V. Economics of the D&O Industry

Starting around 1996, and confident that the Reform Act would reduce exposure to meritless

securities claims (which had cost the D&O industry untold millions), the D&O insurance

marketplace became very competitive. Up until this point, the industry had relatively stable

and predictable earnings. Since the Reform Act had the intended purpose of limiting securities

lawsuits, the insurance industry predicted that the D&O product would only become more

profitable. As a result, barriers to entry were lowered, coverage terms were broadened and

premium rates fell dramatically.

• Failed Economics: Among the most pronounced problems the D&O insurance industry

faces in the wake of the Reform Act is inadequately priced D&O policies dating back

to 1996.

By the time the industry began raising premiums in early 2001, rates were approximately

half of those charged back in 1996. Meanwhile, the industry’s total exposure (in terms of

loss costs and including the impact of entity coverage) had increased an estimated 1000%,

from $427 million in 1996 to $5.6 billion in 2001.13 Due to the long-tail nature of D&O

claims, which often do not settle until three-to-four years after a claim is filed, the pricing

of D&O risks was woefully inadequate in light of the actual increase in exposure that had

occurred. The ramifications of this are just beginning to emerge.

In 2000, two large D&O insurers became insolvent, leaving countless directors and officers

without access to coverage and with their personal assets at stake in claims. Several other

carriers have since had their credit ratings downgraded or placed on credit watch with

negative implications.

• Reinsurance Problems: The reinsurance industry also recently awoke to the serious

problems of the D&O marketplace. Reinsurers had been subsidizing the underwriting of

many recent entrants to the D&O marketplace, sometimes providing up to 90% of their

underwriting capacity, without exerting any control over the allocation of this capacity and

the underwriting practices of these new, inexperienced players. Furthermore, reinsurers

suddenly realized that they had a serious aggregation problem. They were exposed to the

same loss multiple times for the different insurers they reinsured. With severity increasing

drastically, reinsurers paid out exorbitant losses on an excess of loss basis.

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In 2002, reinsurance capacity has rapidly withdrawn from the marketplace and reinsurance

rates have soared, creating even greater instability among D&O insurers. Which D&O

carriers depend on reinsurance to pay claims, and what is the state of their reinsurer

relationship? Answers to these questions have become critical for many D&O insureds

and their brokers.

• The Unintended Repercussions of Entity Coverage: Despite its good intentions, entity

coverage has actually been harmful to directors and officers, as well as to D&O insurers.

The reasons are several.

First, at the time entity coverage was created, D&O insurers typically negotiated a 50% to

70% allocation of coverage between the insurance policy and the uninsured exposure of the

corporation, depending upon the circumstances of the case. Therefore, by granting entity

coverage across the spectrum of its customer base, the D&O industry almost doubled the

amount of cover it granted under its policies. Yet during the time that entity coverage

became widely adopted, premium rates dropped in excess of 50%. In hindsight, it is clear

that insurers were not pricing for this cover.

Second, while entity coverage was meant to align the interests of insurers and insureds, by

insuring both corporations and directors and officers in securities claims, it unintentionally

removed the corporate insured’s financial interest in how claims were resolved. Pre-entity

coverage, the corporation had a significant uninsured liability. As a result, it had a vested

financial interest in negotiating the lowest possible settlement. With that uninsured liability

now covered, companies’ concern shifted to simply settling a suit within the D&O policy

limits. Settlement amounts skyrocketed. This, along with a lack of restraint in controlling

defense expenses (which are paid for by the D&O policy as well), has had a tremendous

negative impact on the economics of the D&O industry and has strained the insurer-

insured relationship.

Third, because of entity coverage, bankruptcy courts have interfered with the payment of

defense expenses and settlements in shareholder cases. D&O policies have routinely been

treated as assets of a company’s bankrupt estate; often Bankruptcy Court orders are

required to permit payment of defense expenses and grant relief from the automatic stay.

Recently, bankruptcy trustees have become aggressive in targeting any and all assets for

potential recovery. By allowing a D&O policy to insure the corporation, directors and

officers face the reality that the bankruptcy trustee will target their policy, so it will be used

for the benefit of the creditors as opposed to the protection of directors and officers.

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The lesson is that in a bankruptcy situation—when proper D&O coverage is a paramount

concern of directors and officers—the existence of entity coverage can impede the policy’s

ability to respond to protect the personal assets of directors and officers. In non-bankruptcy

situations, the D&O policy, and the amount of coverage available for individuals, is eroded

because the policy pays for the liabilities of the corporation. Protecting the personal assets

of directors and officers should be the fundamental purpose for which directors and officers

liability insurance is purchased. Any impediment to achieving that purpose should not be

allowed to continue.

VI. The Corporate Auditing and Accountability Act of 2002

On July 25, 2002, the United States Congress passed The Corporate Auditing and Account-

ability Act of 2002 (Sarbanes-Oxley Act) by an overwhelming majority of 423 - 3 in the

Congress and 99-0 in the Senate. On July 30, 2002, President Bush signed the Bill into law.

The Corporate Auditing and Accountability Act of 2002 (Sarbanes-Oxley Act) will have

a direct and immediate impact on directors and officers, as well as on D&O insurance.

The Act’s mandates may create additional civil liabilities as well. The Act’s mandates include16:

• Securities Litigation Reform: The Act extends the current statute of limitations for

securities litigation to the earlier of five years after the alleged violation or two years after

its discovery. The previous statute of limitations was within three years of the alleged

violation or within one year of its discovery.

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“Provisions in the Bill that expand the ability of people to sue may have a positive effect on making people

pay attention to their business, but we all know based upon our legal system that this is going to be abused.”

— Senator Phil Gramm14

“ ‘The law gives a straight path of liability’ to the pocketbooks of individual executives.”

— Wall Street Journal 15

• No Bankruptcy Discharge of Securities Law Liability: The Act amends the federal

bankruptcy laws to immediately prevent the discharge of debts under any claim relating to

a violation of state or federal securities laws, or any securities fraud or manipulation.

• CEO/CFO Certification: The Act requires the CEO and CFO of any publicly traded

corporation to make personal certifications in each quarterly or annual report filed to the

SEC certifying:

• The officer has reviewed the report.

• The report does not contain any untrue statements.

• The report is not misleading.

• The officer is responsible for maintaining internal controls.

• The officer has reviewed the internal controls and has commented on their effectiveness in the report.

• The officer has disclosed to the company’s auditor any deficiencies in the internal control systems.

• Whether there were any significant changes in any internal controls.

• Real Time Disclosure: The Act requires companies to disclose on a “rapid and current basis”

information concerning material changes to their operations and/or financial condition.

• Increased Frequency of SEC Review: The Act requires the SEC to review the disclosures

of all publicly traded companies at least once every three years.

• Audit Committee Requirements: The Act requires the SEC to direct companies to have

Audit Committees that are made up entirely of “independent” directors. Companies will be

required to publish in their financial reports that at least one of these directors is a

“financial expert.”

• Executive Compensation: The Act requires that any CEO or CFO of a company preparing

to make an accounting restatement forfeit any bonus or other incentive-based compensation

(including profits from any sale of company stock) received during the 12 month period

following the publication of the financials being restated. The Act further prohibits any

loans to be made to directors and/or executive officers, as well as freezes any “extraordinary

payments” to be made to an insider during the course of any investigation for possible

securities law violations.

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• Insider Transactions: The Act requires directors, executive officers and/or any entity

owning more than 10% of the company’s outstanding stock to disclose any transaction

(as required under a Form 4) within two business days following the transaction. The Act

also makes it illegal for any insider to purchase or sell any security of his/her company

during a blackout period, as defined by the Act.

• Disclosure of Off-Balance Sheet Transactions: The Act requires the SEC to issue rules

requiring disclosure of all material off balance sheet transactions, as well as requiring the

disclosure of all relationships with unconsolidated entities that may have a material impact

on the financial condition of the registrant. Further, the Act directs the SEC to issue rules

prohibiting the presentation of “pro forma” information.

VII. Solutions for the D&O Industry

National Union Fire Insurance Company of Pittsburgh, Pa.® (National Union), an AIG member

company, believes the following steps are required to return stability to the D&O insurance

market and to return the focus of D&O insurance to protecting the personal assets of directors

and officers:

• Regulate Entity Coverage: The D&O policy should exist for the exclusive benefit of

individual directors and officers. Entity coverage has so diluted the coverage afforded to

the individuals that it can no longer serve this function. The solution is to regulate the use

of entity coverage in the D&O insurance contract, and to reinstate allocation for securities

claims against both the corporation and its directors and officers.

The purpose entity coverage was originally intended to serve, i.e., eliminating disputes

between insurers and insureds in a claim situation, can be served instead by broadly

adopting a pre-set allocation clause. As a result, corporations will have a vested interest

in resolving cases in a financially responsible manner. More important, directors and

officers will have certainty that the policy exists for their exclusive benefit.

Regulating entity coverage is also essential to ensure that individuals are protected in the

event of the corporation’s bankruptcy. This can only be done by making the directors and

officers the only insureds under the contract.

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Some corporations will resist removing entity coverage from the D&O insurance contract.

However, it is important that the directors and officers of these companies be made aware

of the consequences they may face as a result of this decision.

• Price Coverage Properly: In line with traditional economic models, D&O insurance rates

have been steadily increasing over the past year as D&O capacity has constricted with

D&O insurers becoming insolvent or retreating from the market. Reinsurers have also

impacted prices significantly by either withdrawing from the marketplace or imposing

greater restrictions on those insurance companies still allowed to use their capital.

As mentioned earlier, there has been an exponential increase in severity and frequency of

claims covered by the D&O policy since 1996. As a result, the insurance industry is paying

billions of dollars in claims and is underfunded as a result of inadequate pricing levels.

To align with today’s escalated exposure, D&O insurance rates must continue to increase

drastically.

• Embrace the Flight to Quality: All D&O insurance capacity is not created equal. Nor is

the quality of underwriting and claims servicing. In order to ensure that the D&O insurance

market continues to operate effectively for directors and officers, companies and brokers

should scrutinize the quality of the underwriters they choose to participate at every level

of their D&O program. The significant liabilities emerging from asbestos and medical

malpractice claims, coupled with the overall poor performance of the property and casualty

insurance industry, have weakened the financial resources of some insurers and could

impair their ability to pay directors and officers claims in the future.

Insureds should be wary of carriers who offer aggressive terms, or large commissions, in

order to make up for weaknesses in their balance sheet. The market should also be wary of

those who during economic booms relied on inflated investment returns to mask financial

vulnerabilities. On average, D&O claims take three-to-four years to resolve. Because of

this, insureds should not only be concerned with the present stability of their insurance

carrier, but must also consider whether the insurance carrier will be around when it comes

time to pay a claim.

14

Consider the hard lessons learned from the recent case of a well-known insurance company,17

a prominent and aggressive underwriter of D&O policies during the 1990s. A known

“brand,” and so assumed by many to be stable, this company wrote a significant number

of primary and excess D&O policies during the years that the industry’s loss costs grew

exponentially. In 2001, the company went from A- rated to liquidation, in 18 months.

Many claims involving this company’s insureds are only now being settled, and insureds

and brokers are for the first time realizing the real costs of doing business with this carrier.

Due to its liquidation, this insurance company is unable to meet its financial obligations

under its D&O insurance contracts. This leaves “holes” of millions of dollars in uninsured

amounts in D&O insurance programs underwritten in the late 1990s. Turmoil surrounds

the resolution of claims of any insurance program involving this insurance company, and

the personal assets of directors and officers are exposed.

• Reinstate Risk Sharing: On policies where entity coverage continues to exist, adding

coinsurance or other risk sharing provisions may counteract some of the ill effects of entity

coverage by aligning the financial incentives of the insured and insurer in managing securities

claims. These elements of risk sharing will need to be properly aligned with the relative size

and financial capabilities of the insured, as well as with its appetite for risk.

• Establish Side A Excess Program: Side A coverage is pure directors and officers

coverage. It provides coverage for directors and officers only for claims in which the

corporation is not permitted to provide an indemnity. A Side A excess program, sitting on

top of a “traditional” program of D&O insurance, can provide real value. However, the

underlying program needs to be fundamentally sound.

A properly functioning Side A excess program can only sit on top of a program that has

substantial limits and appropriate risk sharing between the insured and insurer. With this

structure, the underlying policy with a pre-set allocation can protect and align the interests

of the co-defending company and individual directors and officers. The “A side tower,” as

this is called, permits limits to be reserved exclusively for the directors and officers in the

event that the pre-set allocation policy(‘s) limits are used settling shareholder securities

class actions, and shareholder derivative actions are still pending against the individuals.

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• Resurrecting the Partnership Among the Insurer, Insured, Law Firm and Broker:

The need for this partnership is critical to the litigation strategy that requires a united

front in opposing the plaintiff’s bar to achieve the most cost effective result. The corporation

has the documentation and knowledge needed to mount the defense and is in the best

position to control defense expenses. An experienced insurer has significant expertise to

contribute in dealing with plaintiff firms and will have a broad knowledge of recent settle-

ments and strategies. The right law firm has the expertise needed to mount an aggressive

defense. This is the very reason behind National Union’s Panel Counsel, i.e., to ensure that

our insureds are provided with the best defense possible and to ensure a united front in

opposing plaintiffs.

Very few securities cases actually ever go to trial. Companies and executives do not want

their business strategies held up by this type of litigation; they do not want their liquidity

to be threatened, and perhaps most important of all, they do not want to face the threat of

having their reputations tarnished by a possible guilty verdict. Against that threat, responsible

insurance companies provide a valuable service in negotiating cost effective resolutions

due to their vast amount of experience in handling these types of settlement negotiations.

However, if there is a breakdown in the partnership, the people that ultimately lose are the

individual directors and officers.

• Consider the Consequences of Misleading Information: Most critical to an underwriter’s

ability to understand risk is the quality of information provided by the insured or broker.

The underwriter relies upon a wide range of information, financial statements, applications

and representations made in meetings or conversations, etc., to evaluate a risk.

The financial soundness of a corporation is one of the most critical assumptions made in an

underwriter’s decision to put his/her company’s capital at risk for the directors and officers

for that particular corporation. Regardless of the innocence or guilt of individual directors

or officers as to the accuracy of the financial statements, if the corporation’s financial

statements are inaccurate, then the risk as presented to the underwriter is misrepresented.

As in any contract that relies upon information that was incorrect, the party relying upon that

information has an obligation to its own shareholders to seek appropriate remedies, which

could include rescission of the contract. The contract of D&O insurance is no different.

16

• Protecting the Innocent: Underwriters recognize that even though certain individuals

may put the overall D&O coverage at risk, there will still be innocent individuals who

need, and deserve, coverage. More often than not, these will be independent directors

who were unaware of the actions that subsequently jeopardized their D&O coverage and

their personal assets. Typical D&O policies try to address this consequence through the

application of severability. However, severability will not protect these individuals if the

policy has been rescinded or otherwise excludes the specific claim.

To resolve this issue, National Union has created a new product which provides coverage

for independent director liability. This policy covers independent directors only and

is non-rescindable.

Side A excess coverage, previously discussed, serves a similar function, protecting all

innocent directors and officers. However, a traditional Side A coverage does not offer complete

protection in the event a restatement exclusion applies or the primary or Side A polices

have been rescinded. In order to protect innocent insiders as well as independent directors,

we have developed a non-rescindable Side A policy for all directors and officers, which

“drops down” in the event of a rescission or application of a restatement exclusion, as well

as fulfilling the traditional Side A role.

Both of these policies become effective if the underlying traditional D&O policy is rescinded

or excludes the claim outright.These policies are offered only for insureds who have their

primary policy underwritten by National Union.

Corporate America, and the American economy, needs the best and brightest to serve as

directors and officers. However, without adequate financial protection, many individuals

will not expose themselves to the potential abuses of shareholder litigation. The solutions

outlined above will allow individuals to continue to serve as decision-makers, knowing that

if they behave properly and lawfully, their personal assets will be protected by insurance.

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A Final Note

In order to do what it was originally created to do—protect and defend the personal assets

of directors and officers—the D&O liability insurance policy needs to provide appropriate

incentives for all concerned: the insurer, defense counsel, directors, officers and corporation.

All must work together toward a common end in defending a claim.

National Union believes that fundamental change is needed to ensure that the personal assets

of Corporate America’s directors and officers are truly protected. In order to do this, the

industry needs to remain viable. Entity coverage must be removed from the contract and

replaced with a pre-set allocation, with significant risk sharing between insurers and the

corporations served by insured directors and officers. The quality and financial strength of

D&O carriers must be foremost in the mind of insurance purchasers, and the product must

be adequately priced. These changes will enable the D&O industry to sustain itself and to

provide sound protection for directors and officers as they confront unprecedented scrutiny

in today’s marketplace.

William Cotter is Chief Underwriting Officer of National Union Fire Insurance Company

of Pittsburgh, Pa., a member of American International Group, Inc. (AIG), and the nation’s

leading provider of directors and officers liability insurance.

Christopher Barbee is a partner in the Dispute Analysis & Investigations practice of

PricewaterhouseCoopers LLP (“PwC”) in Philadelphia, specializing in forensic accounting

matters and internal corporate investigations, including securities litigation.

Insurance underwritten by member companies of American International Group, Inc. The description herein is a summary

only. It does not include all terms, conditions and exclusions of the policies described. Please refer to the actual policies for

complete details of coverage and exclusions. Coverage may not be available in all jurisdictions.

18

EndNotes:

1 PricewaterhouseCoopers Data - The 2001 litigation activity includes the 308 “laddering” cases filed in 2001.However, it is important to note that a substantial number of these cases involve other allegations outside of, and in addi-tion to the allocation allegations. IPO tie-in or so-called “Laddering” cases are those in which the principal allegations relateto allocation of shares to purchasers of stock in IPO’s and post-IPO activity. These cases arose in large numbers during2001 and may have temporarily diverted the plaintiffs bar from filing traditional securities litigation claims. Filings of such“traditional” claims has picked up substantially in 2002.

2 National Economic Research Associates, Securities Litigation Study, Figure 12; PricewaterhouseCoopers, 2001Securities Litigation Study, 7.

3 Ayn Rand, Atlas Shrugged (New York, Random House, 1957).

4 PricewaterhouseCoopers, 1997 Securities Litigation Study, 1.

5 Wall Street Journal 26 October 1998.

6 PricewaterhouseCoopers Data. - The 2001 litigation activity includes the 308 “laddering” cases filed in 2001.However, it is important to note that a substantial number of these cases involve other allegations outside of, and in additionto the allocation allegations. IPO tie-in, or so-called “Laddering” cases are those in which the principal allegations relate toallocation of shares to purchasers of stock in IPO’s and post-IPO activity. These cases arose in large numbers during 2001and may have temporarily diverted the plaintiffs bar from filing traditional securities litigation claims. Filings of such “traditional” claims has picked up substantially in 2002.

7 National Economic Research Associates, Securities Litigation Study; PricewaterhouseCoopers, 2001 SecuritiesLitigation Study, 7.

8 PricewaterhouseCoopers, 2001 Securities Litigation Study, 6-7.

9 According to a 1999 PricewaterhouseCoopers Securities Litigation Study, the number of suits containing accountingallegations in 1995 was roughly 25% of total suits filed, 2.

10 Huron Consulting Group, A Study of Restatement Matters, 4.

11 SAB’s issued during Levitt’s term included SAB 99 relative to the concept and application of “materiality,” SAB100 regarding restructuring reserves, and SAB 101, which deals with a variety of aspects of revenue recognition.

12 National Economic Research Associates, Securities Litigation Study, figure 11.

13 Avg Settlement amount in 1996 = $7.0M x 50% (allocation) x 109 companies sued = $427M. Avg settlement amountin 2002 = $17.2M x 100% (entity coverage) x 327 companies sued (estimate to exclude laddering only cases) = $5.6B.

14 Brian Gruley, “New Kind of Badfly Turns Public Firms Into Sitting Ducks,” Wall Street Journal 26 October 1998, 1.

15 Richard B. Schmitt and Henry Sender, “CEO’s Personal Wealth May be at Stake in Investor’s Lawsuits,” Wall Street Journal 9 August 2002.

16 Sullivan & Cromwell, Memorandum entitled “Congress Passes Broad Reform Bill in Substantially the Form Passedby the Senate Last Week: President’s Signature Expected Shortly, 26 July 2002.

17 Christopher Oster, “When the Boss Caused the Loss, Who Pays?” Wall Street Journal 13 June 2002, Page C1.

For a bound copy of this document, please send an e-mail to managementliability@aig.com.