October 1, 2001

Dear Clients and Friends:

The tragic events of September 11, 2001 will have a significant detrimental effect on the property/casualty insurance marketplace. An already tightening market will now see high double-digit rate increases and major contractions in policy terms and conditions for the next 24-48 months. What follows is a discussion of the methods available for navigating the insurance marketplace during late 2001 and 2002, specifically as respects the issues facing private equity firms and their portfolio companies.

Overview

The most noticeable impact of insurance losses arising from 9/11/01 will be on renewal rates and policy terms. As reinsurers absorb up to $50.0 billion in losses from the terrorist attacks, the 1/1/02 reinsurance treaty renewals will include significant rate increases. Since treaties cover entire “books of business,” these increases will impact all lines of property/casualty insurance. Primary insurance companies will pass along treaty rate increases to you, their insureds.

Reinsurers will also limit certain types of risks from their treaties. In turn, primary insurers will be forced to either decline such risks due to lack of reinsurance or retain such risks in their entirety - charging more for the increased risk. Certainly, more specific attention will be paid to the “war risk exclusion” on most policies. “Act of terror” exclusions may now be included on policies for insureds with no international exposure.

Lastly, we will see a “flight to quality” by primary carriers seeking (and paying for) high quality, financially stable reinsurance. We believe such a flight to quality will also take place by insureds seeking high quality, financially stable primary insurers. This erosion of customer base will magnify the decline in second tier insurers and reinsurers, further exacerbating the lack of financial capacity in the marketplace.

Ultimately, new capital will flow into the insurance marketplace seeking enhanced returns due to the demand/supply imbalance. Unfortunately, such capital flows will focus on high-end liability and catastrophe property coverages and have little or no impact on the cost of risk of middle market insureds.

As a result, Equity Risk Partners is advising its clients to prepare for 15%-50% (or more) renewal rate increases, as well as a much more time-consuming and diligent underwriting process.

Directors’ and Officers’ Liability and Related Coverages

Prior to 9/11/01, the marketplace for D&O insurance and its related coverages (Errors and Omissions, General Partners Liability and Employment Practices Liability) were already reeling with losses arising from the implosion of the “dot.com bubble.” Further declining stock prices, layoffs and restructurings associated with the attacks will only add to the claims parade.

What should private equity firms and their portfolio companies do going forward?

• Use your portfolio. The ability of private equity firms to spread their overall risk of loss among a portfolio of companies remains the single best way to mitigate the volatility of the insurance marketplace.
• Eliminate the “gray areas.” As a result of their multi-faceted nature, private equity firms routinely face exposures that are covered by several different specialty coverages, but which should be consolidated into a single, comprehensive policy form, specifically:
  1. Directors’ and Officers’ Liability - specific partners serving on boards of non-controlled portfolio companies, for the entire board of controlled portfolio companies and for GP advisory boards.
  2. General Partners’ Liability - coverage is needed for liability arising out of actions taken as a GP.
  3. Employment Practices Liability - liability/allegations of wrongful termination, discrimination and harassment exists at both the GP and the portfolio company level.
  4. Investment Advisors' Errors and Omissions - E&O exposure as a result of providing “investment advice”/oversight.
  5. Management Errors and Omissions - Most GP’s collect a management fee from their portfolio companies in return for providing some contractually specified services. Such advice, if alleged to be improper, untimely or incorrect, will generate a potential liability not covered under a “standard” D&O policy.
• Use the “bully pulpit.” We recommend that our clients schedule meetings with prospective underwriters to communicate a constructive picture of the firm and its portfolio. We have found a direct, positive correlation between these meetings with underwriters and final policy terms and premiums.
• Use time to your advantage. Historically, significant credit was given to firms willing to pay for multi-year policies upfront. While the premium discounts associated with multi-year policies have evaporated, the underlying wisdom of such a risk financing approach remains sound. For clients with growing portfolios, new fund commitments, or expectations of raising new funds, multi-year program options should be thoroughly explored. If a firm expects to add portfolio companies or new funds, the resulting exposure increase, coupled with certain rate increases, makes the prospect of purchasing a three-year policy for 3.0 to 3.5 times the annual premium an economically desirable option.

Property/Casualty

While subject to the same issues discussed above, the impact on the property & casualty coverages of portfolio companies should be slightly less complex due to a greater supply of insurance carriers and underwriting capacity. The basis of the issue can best be described in the following example:

• On 9/10/01, a widget manufacturer has expected losses (claims) from all lines of property/casualty insurance of $100. Its corresponding cost of risk (losses plus premiums) is $200.
• On 9/12/01, the same widget manufacturer still has expected losses of $100. Its underlying operations and exposures have not changed. However, its new cost of risk is $300, as a result of premium increases.

Most middle-market portfolio companies of private equity firms will not, on a stand-alone basis, have any remedy other than to pay the increased premium.

What are the options/alternatives facing private equity firms and their portfolio companies in the post-9/11/01 property/casualty marketplace?

• Be prepared for long lines at the check-in counter. In much the same way that our process of air travel has changed, the renewal underwriting process will be affected also. Expect the renewal process to take 60-90 days. Insurance companies will be looking for reasons to say “no.” Expect more questions regarding your operations and insurance exposures. Expect to provide more details. Insurance companies will want all of the “i’s” dotted and “t’s” crossed.
• Know your exposures. The information requirements of the underwriters - both historical and prospective - will increase significantly. The more thorough the data presented to the underwriters, the more thoughtful the response will be.
• Know your risk. Take the time with your broker or risk management consultant to assess your exposure to loss and the expected financial implications of your historical claims patterns. Why? It is likely that insureds will face higher deductibles across all lines of coverage. It is important to understand the cash flow and other financial implications of these higher deductibles.
• Know your advisor. Equity Risk Partners was created to work exclusively with private equity firms and their portfolio companies. Evaluate how your firm and/or your portfolio company are being presented to the insurance community. Ensure that the insurance advisors with the in-depth understanding of your fund or company are negotiating on your behalf. Insurance companies are developing industry-specific exclusions and pricing models that will need to be negotiated, reviewed and understood by your advisor. A volume-oriented marketing department will not be able to best represent your needs in this changing environment. Insist that your advisor understand your needs and represent you to the underwriter community.
• Look to the alternative market. Equity Risk Partners recommends that each of its private equity firms examine the various options for leveraging their portfolios. Consolidating the insurance purchasing power of all controlled portfolio companies may have a significant positive impact on overall pricing and policy terms.

Equity Risk Partners believes that captive insurance companies will now be an attractive alternative for many private equity firms. Captives can provide many benefits to their owners, including positive tax requirements, funding flexibility, the ability to purchase “direct” reinsurance, as well as the investment flexibility associated with many of the offshore domiciles.

If a captive insurance company is not practical, then self-insurance, high deductible programs and retrospectively rated programs should be considered.

Other Issues

 

• Due Diligence - While our ability to react within your time constraints will not cease, expect the traditional insurance due diligence process to require more time and data in order to successfully analyze the deal/target company risks. Due to the increased data requirements and conservative underwriting standards, the ability of the insurance advisor to perform due diligence reviews and new program development with restricted data and under compressed time frames will not be as achievable as in the past.
• Transactional Products - the underwriting appetite for transactional products remains relatively strong. As such, we encourage our clients to continue to challenge us to find unique solutions to deal hurdles.

Equity Risk Partners was created to provide specialized, focused, creative and timely insurance due diligence and risk management consulting to the private equity industry and its portfolio companies. We look forward to demonstrating our focus and expertise to our clients and friends during these challenging times. Together, we will find the most cost-effective and efficient solutions to deal and portfolio company issues.

We appreciate your continued support and we look forward to serving you in the future.

Very truly yours,

Michael C. Marcon
President
Equity Risk Partners, Inc.