Trillions of dollars in lost shareholder equity and class-action securities lawsuits are just two of the consequences arising out of the flood of corporate catastrophes we have seen over the last few years. Another result is a legacy of insurance claims costing the insurance industry well into the tens of billions of dollars. As these losses mount, many have questioned whether D&O insurers can profitably underwrite this line of insurance. Based on some lessons learned however, companies may be safe to expect a vibrant, active and competitive, although different, D&O insurance market.
Understanding the Risk
Many factors may have affected the underwriting risk for D&O insurers. First, D&O insurers probably did not fully appreciate the gravity of Federal Reserve Chairman Alan Greenspan remarks concerning the “irrational exuberance” of the over-inflated stock market. There was also unprecedented corporate fraud as insiders attempted to maintain the image of corporate prosperity. Additionally, D&O insurers made the mistake of dangerously under pricing their product while offering liberal policy terms and conditions.
Five years ago, shareholder class action securities litigation settlements or judgments greater than $100 million dollars were rare. As the stock market reached record levels, however, any corporate earnings stumble created severe repercussions. One result was the filing of numerous shareholder class action securities lawsuits alleging damages of a billion dollars or more. Many of these lawsuits are now settling for well over $100 million dollars. For example, Cedent Corporation settled a shareholder class action suit for $2.83 billion. Lucent Technologies settled a $600 million dollar shareholder class action suit while Waste Management was involved in a $457 million dollar settlement. Even more recently, a suit alleging misrepresentations and omissions relating to the 1998 merger of Chrysler Co. and Daimler-Benz AG was settled for $300 million.
A 1992 decision by the United States Court of Appeals for the 9th Circuit in Nordstrom, Inc. v. Chubb & Son, Inc. is perhaps the most well known decision impacting D&O insurance in the last decade. The Nordstrom case, which concerned the loss allocation between the company and the directors and officers, involved a $7.5 million-dollar settlement of a class-action securities suit against the company and its directors and officers. Although its D&O insurer had offered to pay approximately half of the loss, the company successfully sued the insurer to pay the entire loss. D&O insurers at first responded to the Nordstrom case by strengthening the allocation language in their policies. However, in a very short time (probably due to the softening insurance market) insurers embraced the concept of entity, side-C coverage (100% allocation) for securities claims.
Even though a number of courts have not followed Nordstrom, the decision markedly changed the nature of the D&O insurance risk. Prior to Nordstrom a de facto “partnership” had existed between insurers and insureds with respect to jointly battling the plaintiff in a shareholder class action securities suit. As the company and the directors and officers both had substantial potential exposure, the company and the D&O insurer would in effect join together to each shoulder a portion of the potential loss. In the post-Nordstrom world, however, so long as there was enough available D&O insurance, the risk to the corporation in connection with a shareholder class action securities suit was conceivably limited to the amount of the self-insured retention. Likewise, once companies recognized that other than the self-insured retention, they might have very little additional exposure, the company’s incentive to control defense counsel and defense costs in connection with the underlying claim was not as compelling as it once was.
Faced with premium increases of 100% or more, companies and their brokers now need to have an insurance purchasing strategy to get the most out of the dollars budgeted for insurance. One strategy may look for lower rates and broad coverage. Unfortunately, D&O insurers who fit into this category may have less-than-stellar financials or a strong track record in selling D&O insurance than others in the industry. More experienced D&O insurers typically can justify charging higher prices since they provide financial stability, proven commitment to the business, experience and expertise.
An insured working with an insurance broker who has a good appreciation of where the potential claims exposure lies can approach the market and purchase coverage for that discrete exposure. While fairly straightforward, this strategy requires sophisticated knowledge and understanding of the insurance product as well as an appreciation of the would-be exposure. For example, a company may have a relatively clean history of operating results and is preparing to embark on a radically different corporate strategy. It may make sense for the company to forsake coverage for any acts occurring prior to the change in corporate strategy. As the insurer does not need to worry about this company’s past history and only needs to focus on the future, it may be prepared to discount the cost of the coverage.
Another strategy might be to forego a coverage part. In just the last few years, some leading insurers have re-introduced traditional A- and B-side coverage specifically excluding coverage for losses incurred by the entity (side-C coverage). If the insurer believes its risk is reduced by only offering A- and B-side coverage, a corresponding reduction in premium may be expected, although not in every case. Consider the $2.83 billion Cendant Corporation securities litigation settlement. The size of the loss was so substantial that regardless of whether there was or was not entity coverage, the primary insurer would very likely have had a total policy limit loss.
An A-side only policy triggered only when the company is unable to indemnify the directors and officers is generally less expensive than A-, B- and C-side coverage, principally because nonindemnifiable claim situations occur less frequently then indemnifiable claim situations. Another advantage of the A-side only policy is that it is designed to provide coverage solely to the directors and officers, not the company. Therefore, directors and officers need not be concerned with a claim made solely against the company exhausting the policy limit.
D&O insurers may also be willing to trade a larger retention for a lower premium. A substantially larger retention works to weed out smaller claims thereby insulating the insurer. For instance, if a company has a $1 million retention, the chances that a wrongful termination suit involving a mid-level employee earning $75,000 a year piercing the retention is fairly remote. However, if the same company has a $150,000 retention, there is a reasonable possibility that the retention will be pierced and the insurer will pay a portion of the loss. The benefit of a larger retention is that relatively small claims will not needlessly erode policy limits, thus preserving the policy limit for catastrophic claim situations.
A number of insurers have been offering co-insurance or a pre-set allocation of loss whereby the insured company assumes a portion of the loss in excess of the retention. Co-insurance or a pre-set allocation of loss literally obligates the insured company to actively and materially participate in the litigation along with the insurer right through to the end. While the idea of requiring the company to have “skin in the game” makes sense, it may not be right for every situation. All told in the Cendant securities litigation there was approximately $150 million of D&O insurance available for the aforementioned litigation. Knowledgeable insurance industry insiders have estimated defense expenses incurred in connection with the Cendant securities litigation were approximately $50 million. Consequently only $100 million was available for what was to be a $2.83 billion settlement. It is doubtful the result would have been much different if Cendant had to pay 50 cents of every dollar even after the self-insured retention was satisfied. Pre-set allocations of loss or co-insurance seem to work best in those situations where the claim does not have the potential to completely wipe out the policy limit.
The Sarbanes-Oxley Act of 2002 focuses on the conduct of corporate executives, accountants, lawyers and financial analysts and empowered the SEC with additional authority and resources. In the short run, Sarbanes-Oxley should help to lessen some of the recently seen corporate troubles.
Hopefully, D&O insurers and policyholders have learned some important lessons over the last few years. For one, broadening insurance coverage at the same time that insurance rates are falling must be done with a full appreciation of the corresponding risk. Historically, D&O insurance has been a low-frequency, high-severity catastrophic line of business. Even after many years, it is not a line of business that is subject to simple underwriting formulas but rather necessitates an experienced, thoughtful and creative analysis of each risk. In addition, D&O insurance risk is highly susceptible to a fast changing business environment and insurers need to be cognizant of changes in the environment and be prepared to quickly react to them. And, for some time to come, it will be important for insurers to keep on reminding themselves of the these lessons.
Steven Gladstone is the senior vice president of XL Professional, a Hamilton, Bermuda-based subsidiary of XL Capital Ltd. XL Professional provides various professional liability insurance solutions to domestic and multinational businesses worldwide.