March 2003

Dear Clients, Prospects, and Friends:

It has been 16 months since I last wrote to you about the state of property/casualty insurance market. To many of you, the past 16 months has felt like 16 years. The numbers hit as hard as "Terry, the Office Linebacker":

• $53.0 billion industry wide underwriting loss in 2001
• $80.0 billion estimated industry wide under reserving
• 24-36 months of additional 20% - 30% price increases

With sincere apologies to Casey Kasem and Dick Clark, the following Equity Risk Partners' Greatest Hits sum up the State of the Insurance Market - 2003:

"Don't Stop Believing"

As the Journey song implies, the cyclical nature of the insurance industry lends itself to such results. While the current hard market will be much more of an inverted "U-shape" than its "V-shaped" predecessor of the mid-1980s, more reasonable pricing and terms will ultimately return. The issues of the past 24 months have been the result of a "perfect storm" in the property/casualty industry. Just like the tidal wave that wiped out the Andrea Gail, the combination of

September 11th,
Enron, K-Mart, Tyco, WorldCom, Qwest, Global Crossing,
Adverse reserve development for asbestos, mold, tobacco, D&O litigation,
Significantly decreased investment results,
Implosion of the telecom industry,
Increased unemployment and general economic downturn,
Threat of (now, actual) war with Iraq,

has wiped out Reliance and Kemper, hammered Royal/Sun, and beaten up Swiss Re, Zurich, CNA, and Crum & Forster. Even the seemingly invincible AIG took an unprecedented reserve strengthening last month.

Arch Capital, AXIS, and Endurance Specialty all outperformed over the past 16 months since raising capital and entering the fray. January 2003 saw the creation of Employers Direct Corporation, a new California-based specialty workers' compensation insurance company. Don't stop believing. There is "smart money" betting on the near term and long term prospects for the industry.

"Private Eyes, They're Watching You"

As Hall and Oates crooned in 1981, "Private Eyes, they're watching you. They see your every move", underwriters have become much more focused on risk assessment and risk quantification.

During the most recent "soft" market, underwriters were focused on premium generation first and risk quality second. As a result of the decline in their investment portfolios, insurers can no longer expect investment returns to offset poor underwriting results. In 2003, underwriters are actually underwriting. This represents a dramatic shift in perspective for many insurance buyers that are not used to having their operations assessed as starkly as they are currently. Moreover, underwriters actually expect insurance buyers to implement their risk management recommendations. For example, an insured recently received a notice of non-renewal as a result of not implementing safety provisions in a timely manner.

The return to underwriting discipline is a long-term, systemic change in the insurance industry. Insurance buyers need to recognize that the renewal process will be more time consuming, more data intensive, more drawn out, and less competitive than ever. Insurers are declining risks and contracting their risk appetite at an unprecedented rate.

"Badlands"

"Keep pushing 'till it's understood and these Badlands start treating us good", was the refrain of this 1978 Bruce Springsteen classic. There are several lines of business in the insurance industry that are "pushing to be understood" and several insurance carriers are waiting for those lines of business to "start treating them good".

Surety
As discussed in our Guest Commentary, The State of the Surety Market, no line of business had a more devastating underwriting performance than surety. While major insurers are retreating from their surety lines, many smaller, more nimble surety carriers are picking up the slack. In the short term, pricing and capacity will be the primary issues. In the intermediate term, pricing should become more reasonable. The ultimate issue will not be the cost of surety, but whether it is available at all. Collateral remains a significant issue, especially with post-buyout portfolio companies. Investors should be prepared to allocate some portion of their post-closing revolver to LOCs in support of surety bonds.

Executive Liability
Directors' and Officers' Liability, General Partnership Liability, and Employment Practices Liability insurers have been absolutely hammered over the past two plus years.

Corporate failures and senior management scandals have had a dramatic impact on the underwriting results of D&O carriers. Even when factoring in the rescinding of coverage after willful acts were discovered, the results are still tremendously poor. These results have lead to a significant increase in rates over the past 26 months, as well as a noticeable contraction of terms and conditions.

General Partnership Liability results have been dogged on two fronts.

First, overall investment results for private equity (led by venture capital investments) have been very poor over the past 24 months. As a result, unhappy investors have voiced their displeasure through litigation against GPs, dramatically increasing GPL claims.

Second, underwriters are paying for grossly underpriced policies from the late 1990s. The "used car dealer" approach to underwriting - "three years for the price of two" and "if you buy now, I'll throw in a free spare tire" (automatic coverage for new acquisitions at no additional premium) - has been replaced with discipline, strict underwriting guidelines, and a more knowledgeable underwriting force.

As sure as Joe Paterno's Penn State teams will wear black shoes and have no names on their jerseys, the insurance industry will identify a claim trend and begin excluding those types of claims from its policies. Then, the industry will create a stand-alone coverage specifically for those types of claims. This was the case for Employment Practices Liability (EPL). The challenge to the industry has been to find the proper balance of coverage, premium, and deductible level. Until very recently, premiums and deductible levels for EPL shared a common trait - they were too low. Carriers have been blasted with EPL claims for which they collected too little premium, based on sketchy underwriting, and supported by thin deductibles. As with D&O and GPL, the EPL results of the past 24 months have resulted in more thorough underwriting, higher premiums, and larger cushions (higher deductibles).

Property
How do you succeed in real estate? Location, location, location

How do you succeed in sports or music? Practice, practice, practice

How do you build a property insurance placement? Capacity, capacity, capacity

The state of the property market can be summed up as follows: there is no capacity.

Reinsurers and primary insurers have dramatically reduced their appetite for risk. Underwriting requirements have tightened noticeably. As we discussed in our whitepaper, The State of the Property Insurance Market (5/2/02), the changes are pervasive and not just reactions to current conditions. In order to obtain coverage in this environment, insureds must be willing to work with loss control engineers, accept higher deductibles and assume some co-insurance risk. In essence, property insurance has finally become a backstop against catastrophic loss and no longer a cash management tool.

"War"

"War, huh! What is it good for? (Insurance speaking) Absolutely nothing".

The war with Iraq, the increased threat of retaliatory terrorist strikes, and fundamental global instability all support a more conservative insurance environment. Global deals will receive much greater scrutiny by underwriters. The options available on global deals will be dramatically reduced. The length and breadth of due diligence for global deals will reach levels previously unforeseen. Political risk, marine/cargo, and property coverages will be impacted by the geo-political environment.

"Superfreak"

Rick James never dreamed his 1983 disco hit would wind up in an insurance industry treatise. The "Superfreak" deals of the late 1990s - loss portfolio transfers, loss mitigation policies, reps and warranties policies, aborted bid cost insurance, and all other "risk financing schemes" have gone the way of the song - you can remember how you danced to it back then, you know others that are still dancing to it today, but you cannot bring yourself to do it.

With insurance carriers generating record premium increases on standard lines of insurance (workers' compensation, etc.) where their level of risk comprehension is high, there is no economic incentive to venture outside of the comfort zone. As a result, non-traditional, transactional products are much more difficult to obtain and much more expensive.

"(I Can't Get No) Satisfaction"

As the Rolling Stones rocked, "I can't get no satisfaction. And I try. And I try. And I try. And I try. I can't get no - no, no, no."

The need has never been greater for a risk management consulting and insurance brokerage firm dedicated to the private equity industry and its portfolio companies - 24 hours a day, seven days a week, in all 50 states, and just about any foreign location, we'll be there.

We will not hand off your portfolio company to a local office that has no knowledge of your transaction or your firm. The team that works on the deal will provide the service throughout the life of the relationship.

We will not rely on a marketing department whose sole job is to cram premium through the pipeline. Our account executives are responsible for presenting your risk to the insurance community. After all, what is the ultimate function of an insurance brokerage? Who understands the risk better, the marketing department or the due diligence team?

We will not utilize internal resources whose perception of the "middle market" is companies 200 through 400 on the Fortune 500. We will systematically and diligently obtain resources based on the specific needs of the transaction or the portfolio company, regardless of the short term economic impact to our firm.

Please do not hesitate to contact your Equity Risk Partners professional for advice, counsel, concerns, or a sympathetic ear. We look forward to working with you, your portfolio companies, and your advisors.

Thank you for your consideration and continued support.

Sincerely,

Michael C. Marcon
Founder & CEO
Equity Risk Partners, Inc.