July 2004

It may be difficult to believe, but it appears that the Executive Liability market (D&O, General Partners Liability, Errors & Omissions, Fiduciary Liability and Employment Practices Liability), previously hardened primarily from pervasive corporate fraud, is diminishing. We commented in 2002 that double-digit rate increases and contractions in policy terms and conditions were becoming the norm due to the frequency and severity of securities class action claims and we would continue to see such increases and restrictions for the next 12-36 months. Here we are at 24 months commenting on what appears to be a softening (or at a minimum, stabilizing) D&O market for most sectors. D&O premiums increased approximately 33% on average from 2002 to 2003 according to Tillinghast Towers Perin’s 2003 D&O survey. However, despite record premium increases throughout 2003, the survey indicates that the market started stabilizing towards the end of 2003 with premium increases beginning to level off. And, in fact, most of our clients with renewals during the first half of 2004 have seen premium decreases. However, don’t get your hopes up. An "intoxicated" market is driving the softening and there appears to be a strong argument that the softening market period will disappear almost as fast as or faster than it appeared.

Similar to most cyclical markets, pricing is the first sign that a market is starting to turn. While it is difficult to generalize percentage decreases for D&O coverage, very few insureds will be hit with rate increases the remainder of 2004, and most will see a 10% to 20% decrease. Expanded capacity has driven underwriters to compete, but many market executives say those conditions will not last too long. The market is attracting more competitive underwriters because the number of large D&O securities claims settlements has decreased over the past year. But, that lull has occurred only because much more time has been needed to resolve the complex claims that are in the litigation pipeline. At a recent D&O symposium, it was estimated by seasoned D&O plaintiff attorneys that the outstanding balance of pending securities class action claims in the U.S. is $75.0 billion (obviously, not all $75.0 billion is insured). In part, this inflated number is due to the fact that more lead claimants are now institutional investors that, unlike individual investors, have no interest in settling for pennies on the dollar. Many pending cases will ultimately settle in the "mega" category in excess of $100 million each. The prospect of such "mega" settlements has increased given the investing public’s negative view of corporate America. When these "mega" settlements start to occur, we believe it will once again force underwriters to sober up, boost rates and tighten terms and conditions. The exact timing of when this will occur is anyone’s guess.

D&O underwriters offer insurance solutions for board members to be gatekeepers of the integrity of a corporation’s financial controls and solid corporate governance. On November 7, 2003, Cynthia A. Glassman, SEC Commissioner, stated, "Companies must improve their governance, disclosure must be clearer, gatekeepers must be more independent and diligent, investors need to be better informed, and regulators need to be more proactive." D&O underwriters in part serve indirectly as the private sector’s proxy to keep sound corporate governance and ethical business practices at the forefront of corporate America. D&O underwriting analysis involves evaluating severity and frequency of exposures. Due to the inherent asymmetrical information flow from the insurance buyer to the D&O insurer, it is often difficult for the insurance underwriting community to assess risk. D&O pricing is based upon sound actuarial analysis that factors both the exposure and experience loss costs.

What can be done to alleviate what appears to be an inevitable return to a hard D&O market? Prominent D&O underwriters assess risk based on the following:

1. Quality Management
   – An effective, experienced, and high-caliber management team that is accountable to shareholders.
2. Independent Board
   – A majority of the board of directors should be independent and true stewards of corporate governance with an eye to "constructive skepticism".
3. Ethical Corporate Culture
   – The corporate culture should be principle-based and foster an environment that is open, transparent, honest, and responsible and that rewards integrity.
4. Consistent Performance
   - Corporations that execute on business objectives will lead to lower stock volatility and higher long-term returns to shareholders. (Substance over hype)
5. Strong Market Position
   – Corporation’s product life cycle, competitive market position and strategy are critical predictors for continued success. (Category Leaders)
6. Financial Flexibility
   – Lofty stock price valuation based upon "capitalized reputation" may evaporate overnight with a scandal. An assessment of internal and external sources and uses of capital needs to include cash flow for operations, debt capacity and equity markets. Wall Street’s "flavor of the month" may get caught in a capital market freeze.
7. Sound Disclosure
   – Compliance with Sarbanes Oxley and securities laws are the base line. Disclosure practices ought to be accurate, timely, comprehensive and clear. Reporting needs to reflect the true economic reality of transactions and the risks facing the company.
8. Financial Management
   – The protection of corporate assets is paramount to a corporation’s long-term viability. The financial statements are indicators of a corporation’s health and ability to manage the organization. The financial statements are material to and relied upon in the underwriting process and become part of the application for D&O insurance.
9. Robust Internal Controls
   – Internal controls over the financial reporting and operation that institutionalizes performance and integrity.
10. Risk Management
    – Risk management should be effective to prevent "shocks" to operations.

What can a broker do to help alleviate costs and ensure broad program terms and conditions in any market, soft or hard? While they have little control over the uncertainty of the marketplace, a broker can educate the marketplace about individual risks specific to their clients. The following are examples of "to go the extra mile" for clients and prospects:

1. Market account to appropriate underwriters without saturating the marketplace
   Since a broker should be in the marketplace everyday, they should know which carriers will be interested in a particular risk. Whether it be a General Partnership Liability placement for a Private Equity firm, a Directors & Officers Liability placement for a publicly traded portfolio company, a stand alone Employment Practices Liability placement for a large portfolio company or a Professional Liability (E&O) placement for a financial services related company, the appropriate carriers should be approached on your behalf given the dynamic insurance market that we are living in.
2. Build and maintain an ongoing relationship with the carrier after the initial placement of coverage.
   It is extremely beneficial to establish and maintain a relationship with a recommended insurance carrier over the long-term. We do not believe in insurance buying decisions based solely on price. Paying a premium to the same highly rated, well-established carrier year after year will do wonders when it comes to negotiating and settling a claim as opposed to moving your insurance business to several different carriers year after year for minimal premium savings. If the market dictates a better program at compelling premium savings with similar or broader coverage terms, we have and will continue to recommend carrier changes. But, if your broker is doing their job and has strong well-established relationships with the key insurance players, changing carriers on a regular basis will not occur.
3. Get senior management/deal partners involved directly in the marketing process.
   D&O underwriters love to interact with key executives and hear the story "straight from the horse’s mouth". Whenever possible, whether it be a renewal or new placement, have the key individuals involved in conference calls and face-to-face meetings with carriers. This allows the underwriters to ask questions and get answers to key underwriting issues, helps alleviate concerns with respect to these questions and demonstrates to the underwriter the commitment by senior management/deal partners. This process goes a long way in negotiations with carriers on your behalf and, ultimately, benefiting you with an enhanced product.
4. Manage the timeline appropriately.
   Underwriters are inundated with new business and renewal submissions from brokers. Requesting initial underwriting information from you should be done no more than 120 days from the renewal date. A full submission should be sent to the marketplace no more than 75 days and no less than 45 days from the renewal date. Sending a submission more than 75 days out will ensure that it gets put at the bottom of a pile in "never-never land". Securing the underwriters’ attention at the appropriate time is vital to a successful timeline.
5. Submit full and appropriate information.
   A full submission done right the first time is always appreciated by insurers. Sending information piecemeal to underwriters will cause problems and headaches with the negotiating process and will help ensure a last minute renewal. A full General Partnership Liability submission would include the following:
   • Annual and most recent financial statements for each fund
   • Annual and most recent financial statements for each portfolio company
   • Most recent quarterly report to LP’s for each fund
   • Partnership agreement for each fund
   • Purchase/Sale agreement for each portfolio company
   • Description of operations for each portfolio company
   • Employee count by state for each portfolio company
   • Offering memorandum for each fund
   • Listing of all pending litigation
   • List of LP’s for each fund (some insurers)
6. Negotiate, negotiate, and negotiate some more.
   Ask, and often times, you shall receive.

Private Equity Litigation Verdict (Forstmann Little):

Forstmann Little & Co. was found liable on Thursday, July 1, 2004 of breaching its contract with the State of Connecticut, and for having breached its Fiduciary duty. The verdict came less than two days after a Vernon, CT jury had begun deliberations on the case, and was notable for its absence of damages awarded to the plaintiff. The State had been seeking in excess of $100 million.

"The verdicts are bizarre in some respects because it’s hard to imaging that they could characterize Forstmann Little in a worse light as a professional manager of assets. The jury found that Forstmann Little had committed malpractice in terms of being an asset manager, but the actual outcome is that Forstmann Little won the case because there were no monetary damages," says John MacMurray, a private equity attorney with Ropes & Gray LLP.

The case was first filed in February 2002, and accused Forstmann Little of breaching its fiduciary responsibilities to Connecticut (which had invested a total of $198 million into a pair of Forstmann Little managed funds), contract law violations, securities law violations, bad faith practices and unfair dealing. The securities law violations, bad faith and unfair dealing allegations were later dismissed.

This verdict is fresh off the presses and a State of Connecticut appeal seems likely. However, even though no damages were awarded, the guilty verdict tarnishes Forstmann Little’s once sterling reputation. Additionally, although the exact amount is unknown, it is fair to say Forstmann Little paid several million dollars defending themselves in this case. It is important to note that defenses costs are covered under the definition of Loss in a General Partners Liability policy and are included within the limit of liability. The entire episode sends a message to other private equity firms; they should develop better risk management precautions and seriously entertain risk transfer options (i.e. buying General Partnership Liability coverage) before being tagged with a lawsuit of their own.

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Ben Gibb is a Director at Equity Risk Partners, the only full service insurance brokerage and risk management advisory firm dedicated exclusively to the needs of the private equity industry and its portfolio companies. For more information, visit www.equityriskpartners.com. Mr. Gibb can be reached at (415) 874-7108 or bgibb@equityriskpartners.com.