NIA | In The News | Corporate Trends Likely to Put Increasing Pressure on D&O Market

PHILADELPHIA February 09 (BestWire) - Directors and officers insurance has become a more interesting line of business since the collapse of energy trader Enron Corp. in late 2001, and it's likely to become more so in 2004, though perhaps not in a good way for underwriters.

Attorneys working in the D&O field said factors ranging from the Sarbanes-Oxley Act to more aggressive institutional investors would continue to drive up loss costs. "The D&O business will become much more risky and uncertain in the next few years," said Daniel Aronowitz, an attorney with Shaw Pittman. "You're likely to see the less financially stable D&O carriers come under more stress."

Addressing a recent conference on insurance legal issues in Philadelphia, Aronowitz said that, "today, more than ever, corporate America is under attack. There's been a dramatic increase in the frequency and severity of securities claims."

The size of the average settlement in such lawsuits has gone from $8 million in 1995 to $25 million in 2003, he said. "It's a great business for plaintiffs' lawyers," he said.

Bankruptcies have been a major driver of securities lawsuits, followed by restatements of financial reports. "With the Sarbanes-Oxley reforms, you're going to see more restatements, which will give more fodder for plaintiffs' lawyers," said Aronowitz.

The numbers involved tell a disturbing story of underwriting trends, said Aronowitz: D&O insurers have seen the frequency of claims rise 137% since 1995, and while severity of such claims has gone up 459%, premium pricing had actually declined over that same seven-year period. For the clients--publicly traded companies--the risk of earnings restatements increased 184% over the past six years, while the risk of bankruptcy went up 198% over the same period.

According to A.M. Best Co. statistics, average premium increases for D&O coverage were 11% in 2000 and 29% each in 2001 and 2002. But those years followed a five-year period in which premiums fell nearly 38%. "This strongly suggests that a lengthy catch-up period is still ahead for most D&O writers, given the increased frequency, and substantially greater severity, of D&O claims that occurred since the mid-1990s and the likely need for continued significant D&O reserve strengthening through at least 2003," A.M. Best said in a report on the D&O market last year.

Premium increases averaged 33% from 2002 to 2003, according to a survey released this year by consultancy Tillinghast-Towers Perrin. But at the same time, capacity has shrunk. Citing information provided by D&O insurers, Tillinghast said full-limits capacity fell to $1.35 billion in 2003, from $1.5 billion the year before. The segment's 2003 capacity fell to a level not seen since 1997, according to Tillinghast.

"Premiums are higher than they were historically, but the rate of price increases has been declining," said Linda Johnson, executive vice president and a D&O expert with reinsurance broker Benfield Group plc. "There were price increases in January, but in February price increases were not as large as one might have expected."

A "major variable" in determining where pricing should be is that there are "a lot of claims in the pipeline," said Johnson. Possible damages in some of those pending claims are "very dramatic," and more questions are arising between insurers and insureds as to the correlation of the actions that precipitated the claims with the terms of the policy coverage, she said. Those factors are making it more difficult for insurers to determine loss costs.

"While insurance carriers by and large are feeling confident that prices are at an acceptable level, there is a cloud of uncertainty around this," said Johnson. "I would encourage the few entrants in this business to be extremely cautious."

While the strength of D&O pricing is uncertain, underwriting conditions are likely to get worse in 2004 and beyond, reflecting a number of factors. "D&O writers and corporations face significant pressure over the next several years," said Aronowitz. An increase in litigation related to derivatives will account for some of that pressure. That increase will be driven partly by aggressive efforts of plaintiffs' attorneys to find new avenues for litigation, and partly by recent court rulings making it easier for plaintiffs to gather information.

The Sarbanes-Oxley Act, passed by Congress in 2002 after the failures of Enron, WorldCom Inc. and other companies, puts more responsibility on high-level officers to anticipate and report potential risks. "There is a heightened concern about future losses, and directors are becoming more active in their governance," said Johnson.

"Tag-along" class-action complaints are becoming common, relating to 401k plans and whether corporate officers have a fiduciary responsibility to warn participants of pending problems, said Aronowitz.

On top of that, the apparent looming pension crisis in corporate America, stemming from pension plans that are underfunded or weighted heavily with a company's own stock, are likely to be a "huge potential liability bubble" that might burst within the next few years, said Aronowitz.

Another worrying trend is the rise of the institutional investor as a potential plaintiff. "Large, institutional investors are no longer willing to settle for small amounts," said Aronowitz. "These are more active plaintiffs with greater leverage, and they're demanding additional litigation where they can assert that leverage."

The ongoing battle between MONY Group Inc. and some of its top institutional investors over MONY's proposed merger with Axa Financial Inc. is an example of such investors' increasingly vocal challenges to management. MONY's top three institutional investors vigorously oppose MONY's $31-a-share sale to Axa, claiming the price is too low and MONY's management is poised to gain too much at the expense of MONY's stockholders. Those dissident shareholders have gone so far as to launch a recruitment effort to find a new chairman and chief executive officer for MONY (BestWire, Jan. 23, 2004).

Duane Sigelko, an attorney with Sachnoff & Weaver, said one ironic twist is that insurers themselves might be among the institutional investors wanting to become more aggressive in their pursuit of compensation when a company flounders. "Institutional investors are a diverse group, with a number of divergent interests," he said.

As an attorney who often represents the policyholders in D&O issues, Sigelko said D&O policies, unlike many other types of insurance policies, generally don't have a standard form. "They are customized to the particular situation," he said.

While the "classic origin" of the D&O policy had been to protect the individual officer of the company, the policy has evolved into something that more widely protects the interests of the corporation, said Sigelko. "One type of coverage that has become much more common is entity coverage, which is designed specifically to protect the corporate entity against the effects of actions by individuals," he said.

One problem with such entity coverage, said Aronowitz, is that a defendant company might not be as willing to fight a claim, since it knows it is covered. "Insurers are concerned that, if the company doesn't have skin in the game, they're not going to fight," he said. "Some insurers have tried very hard to get rid of entity coverage, but the market won't allow it."

Originally, D&O coverage would cover only the individual directors and officers, said Johnson. Eventually, however, shareholder lawsuits began to name the corporation, along with individual officers, as defendants. At that point, D&O insurers began to work out with clients what percentage of a payout would come from the D&O coverage and how much the corporation itself would kick in.

"Over the years, as the market got softer, entity coverage was provided, in addition to the coverage for the individual officers," said Johnson. "There was a significant increase in exposure for insurers, without a proportionate increase in premiums. Now, you see insurers going back to the original D&O forms, protecting only the individuals."

But that retreat gives rise to yet another problem, said Sigelko. Now, he said, directors and officers could be exposed to litigation if they decide not to take out entity coverage, on the theory that they failed to protect the company from a known risk.

"It does become a challenge for companies, given the significant rise in D&O premiums they are now seeing," said Johnson. "They may be exposing themselves to further risks."

The rising cost of claims for D&O coverage, coupled with high-profile charges of management wrongdoing in so many cases stretching from Enron to WorldCom to Tyco International Ltd. to Arthur Andersen and beyond, lends a feeling of greater strain in the relationship between D&O insurers and their clients. "Insurers want the financial information from clients that they need to make underwriting decisions, and in some cases they're concerned they may not have gotten the information they should have," said Johnson.

"As claims adjusters try to protect the interests of the insurers they work for, there is an area for conflict," she said. On top of that, D&O claims can get emotional for insureds, who through a shareholder lawsuit suddenly find their entire history and all their work called into question. "It can get very emotional," she said.