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					BRAVE Partners LLP: Insurance - Finance and Capital                                                        2009

        Insurance Industry: Deep pockets
        Lloyds is the shining example of how the insurance industry has emerged
        from the credit crunch unscathed - or has it? Claims on professional
        indemnity covers lurk beneath the surface.

        When investments go wrong, investors - spurred on by class action lawyers in the USA - look for the
        deepest pockets to sue. It is clear that the major banks have holes in the bottom of their pockets, so;
        regardless of how deep they are, there is unlikely to be much cash down there. However, these major
        organisations do buy significant amounts of professional indemnity insurance. These covers, such as
        Directors & Officers (D&O) and Errors & Omissions (E&O), are the likely target of the emerging law suits
        against the banks.

        The exposure
        Professional Indemnity (PI) cover insures against claims of negligence, or even fraud, that arises from
        directors or employees of a professional services business. Certain financial services businesses must
        have a defined level of cover as a regulatory requirement. Others choose to take the cover as a general
        protection against risks.

        PI experienced high claims during the last credit downturn. The decision that some institutions had not
        presented investors with a proper analysis of the risk of investing in securities issues by; Enron,
        WorldCom, Global Crossing and the like, pushed those investor losses onto the distributing banks and
        from them into the bank PI covers and the insurance markets. Some underwriters were hit hard. The
        SVB syndicates at Lloyds being one example. SVB is now rebranded as Novae, the management team
        having done an outstanding job of turning the business around and rebuilding it.

        Madoff with the money
        The Bernie Madoff scandle is a prime candidate for PI claims. $50bn has disappeared and investors,
        some of whom tragically lost everything, are looking to recoup. Here financial institutions were
        recommending the Madoff funds to investors and channelling money in through feeder funds. If it is
        found that the financial institutions should have undertaken better due dilligence, so that they might
        spot the irregularities, then this would lead to a claim of negligence. A PI insurance is likely to cover that
        claim. In fact the Wall Street Journal dated May 27, 2009 reports that Banco Santander SA, one of the
        largest conduits of investor money to the Madoff funds, agreed to pay $235m to settle potential legal
        claims by the trustee of the defunct Madoff firm. If Banco Santander has PI insurance that will almost
        certainly be a claim.
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BRAVE Partners LLP: Insurance - Finance and Capital                                                    2009

        Occurrence vs claims made
        Casualty business, which PI insurance falls under, is the problem child of the insurance industry. Most
        insurers that fail are brought down by casualty claims in some form. BRAVE Partner Richard Enos has
        some insights here. He was a treaty reinsurance broker for US casualty lines. As the BRAVE partners
        travel, as they do from time to time, up the coast of Long Island Sound, Richard always has a brief
        comment about how many reinsurers there used to be around Stamford. Most are gone and most are
        gone due to issues with long term casualty liabilities. We should briefly mention, lest we upset them, the
        excellent team at Berkshire Hathaway owned National Indemnity who are still in Stamford and still going
        strong because they are far to savvy to find themselves on the wrong side of bad business.

        One of the consequences of the demise of so many casualty reinsurers was a restructuring of the risk.
        Most casualty business is now written on a claims made basis, rather than an occurrence basis. The
        difference is straightforward.

        Occurrence basis claim
        Insurance or reinsurance on an occurrence basis means that the insurer or reinsurer is liable for a claim
        that is made for a loss that occurred in the year that the party was insured. Asbestos is perhaps the best
        example of how this can lead to problems. Insurers are liable for
        claims that arise from workers inhaling asbestos dust in the 1960s         "What's asbestos"
        when the problem did not even become apparent, let along get
        settled, for 20 years or more. There are still claims emerging even        "Don't know, but the premiums are
        today. Pricing and reserving under these scenarios is all but              good"
        impossible. Large swathes of occurrence casualty business should
        also be a red flag for potential acquirers of a business. All those        Parody of a conversation on the
                                                                                   Lloyds floor in the 1980s
        reserves can quickly turn into a black hole. A somewhat witty friend
        of BRAVE Partners, who is general counsel of a major insurer,
        imagines the conversations between underwriters at Lloyds:

        "What is asbestos?"

        "Don't know, but the premiums are great!"

        Claims made basis
        In contrast, a claims made insurance contract covers for losses that arise from claims that are actually
        made during the year of cover. To return to the asbestos issue, a claims made cover would only pay as
        people began to fall sick from inhaling asbestos dust and the link to the asbestos exposure was made so
        that liability was established. A claims made cover has many advantages, all of which arise from the fact
        that a lot more is known about the claim when the cover kicks in.

        The next shoe to drop
        Curiously, among the major writers of PI cover are the very insurance companies that got themselves
        into difficulty whilst dabbling in capital markets business: AIG and XL Capital. There is an interesting
        lesson in diversification here! |                                     Page 2
BRAVE Partners LLP: Insurance - Finance and Capital                                                   2009

        AIG and XL were two of the main underwriters of PI insurance. Both are currently on the more
        distressed end of the market, leaving a wide open opportunity for the Lloyds syndicates who write the

        An attractive business
        The PI market looks attractive. Capacity is seriously down and demand is up. Rates must be rising and
        terms must be tightening. Furthermore, banks - driven by regulators - must be cleaning up their
        operations. The question is how to take advantage of this.

        Investors who wish to get involved in this risk might look no further than Lloyds. However, backing the
        right underwriters at Lloyds is extremely important (see "First Class" also available on this site). As a
        stark reminder, just look at the adverse development at SVB from about 2002 to 2006. Once again,
        congratulations to the new management team there who did turn the business round.

        Insurance linked securities
        Insurance linked securities (ILS) are designed to allow opportunistic capital enter the insurance and
        reinsurance markets. It would seem that the ILS route might hold the key for interested investors to
        enter the market.

        The Avalon Re story
        Third party liability has been securitised before in a cat bond called Avalon Re which was sponsored by
        OCIL, the oil industry risk pool. The website for Oil Casualty Insurance, Ltd. (OCIL) states that OCIL is a
        major provider of Excess General Liability insurance and is totally
        dedicated to servicing energy companies. A quick check of the
                                                                                   "Third party liability was
        current policyholders tag will reveal the major oil companies that
                                                                                   securitised in the Avalon Re deal.
        hold policies.                                                             Investors in the bonds lost money
                                                                                  on two tranches.
        The Avalon Re bond was a three year bond. Losses accumulated on
                                                                                  The mistake that investors made
        events. The exact details are not important. We will assume that
                                                                                  was that they acted as their own
        events 4 to 6 impacted the C tranche of the bond; events 7 to 10 the      underwriter. Underwriting liability
        B tranche and; events 11 to 14 the A tranche. An event was a liability    risk requires a seasoned
        claim of more than something like $150m against OCIL policyholder.        professional - and a good one at
        In other words, a liability claim of more than $150m against sixty-       that."
        something major, international energy and chemicals companies.
                                                                                  Christopher Cloke-Browne
        As records show, Avalon Re bonds did not turn out well, with both         Managing Partner
        the B and C tranches losing money for investors.                          BRAVE Partners LLP

        The BRAVE partners had a very different view of the likelihood and
        frequency at which the trigger events would occur to the credit
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BRAVE Partners LLP: Insurance - Finance and Capital                                                     2009

        proprietary credit traders with whom they worked at the time. Maybe that is why BRAVE Partners looks
        at both the insurance and energy sectors - there are some interesting overlaps. The result would suggest
        that the BRAVE partners view was right - and note we did not buy the bond.

        Do ILS - but do it right!
        It would seem as if the solution might be for an entity that knows the market well to approach the best
        underwriters to discuss the provision of some short term
        opportunistic capital. But wait! That would be a sidecar deal.
                                                                                      • Financial market losses lead to
        To BRAVE Partners the PI insurance market and similar are ripe for              claims on Professional Indemnity
        opportunistic capital to back the best underwriters. Prices are high            (PI) insurance.
        and recent losses mean that risk should be better controlled. Liability       • The major players in PI are
        is not like hurricane where mother nature alone determines whether              stressed, leading to opportunity
        three major hurricanes smash into the south east USA two years in               in the market.
        succession (as happened in 2004 and 2005).
                                                                                      • BRAVE Partners LLP can advise
                                                                                        on the market and the business.
        BRAVE Partners services
                                                                                      •   BRAVE Partners suggests a
        BRAVE Partners LLP can advise on the risks and dynamics of the full
                                                                                          Professional Indemnity sidecar
        range of insurance markets.
                                                                                          deal and can advise an arranger
        It is essential to understand the background and legacy risks to all              on the structure and market.
        insurance markets when deciding whether to invest in catastrophe
        bonds, sidecars or other insurance linked securities; or when seeking
        to buy an insurance business, either that is actively writing or that is in
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