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Are your D&O premiums about to soar? That depends on which industry you're in.
Russ Banham, CFO Magazine
April 1, 2009
Even as they seek bailout dollars from Washington, financial-services firms shouldn't expect any relief from their insurers. Premiums for directors'-and-officers' (D&O) liability insurance are soaring, financial limits are contracting, and policy terms and conditions are tightening. The situation is so acute that the cost of D&O policies for some firms is nearing the actual coverage limits provided. Is 95 cents for a dollar of insurance really worth it?
Not all CFOs in the embattled sector confront the same woes, however. Jill Paterson, executive vice president and CFO of Fireman's Fund Insurance Co., had it relatively easy. Allianz, parent company of Fireman's Fund, was able to renew its D&O coverage with only a slight increase in premium and no change in terms and conditions. "Our experience was well below industry average," says Paterson, chalking it up to Allianz's conservative investment philosophy. "From an investment standpoint, we're actually kind of boring," she says.
Boring is good these days if a company is seeking decent treatment by D&O insurers at renewal time. More daring plays in subprime mortgages and credit default swaps have decimated investment portfolios, invited regulatory intrusions, and incited shareholder wrath. As share prices swoon for many banks, investment banks, and insurance companies (in some cases reaching zero, with many others watching to see how Washington's actions will affect them in this regard), securities class-action lawsuits against their directors and officers are keeping lawyers busy. Of the 210 federal securities class actions filed last year, almost half (103) involved firms in the financial-services sector, according to Stanford Law School Securities Class Action Clearinghouse. "This level of litigation intensity against a single industry [financial services] is unprecedented," says Joseph Grundfest, director of the clearinghouse.
The financial firms named as defendants in a securities class-action suit last year represented more than half the sector's total market capitalization, with nearly a third of all large financial firms named as defendants. NERA Economic Consulting cites 110 securities class actions related to the credit crisis, an increase of almost 300 percent from 2007. So far, only three settlements in the subprime/credit crisis have been reached, two for less than $10 million and the other a $475 million tab absorbed by Merrill Lynch.
Given the volume of lawsuits and the possibility of other large settlements, insurers are skittish in the extreme, and not only regarding D&O coverage; errors and omissions, fiduciary liability, and employment-practices liability are also under scrutiny and are similarly tightening.
Fortunately for industries outside of financial services, it's a completely different story. D&O insurance premiums remain largely unchanged, with the same coverage terms, conditions, and limits. "From an insurance standpoint it's an odd dynamic: two different D&O markets, one for financial institutions and one for everyone else," says Dan Bailey, a partner at law firm Bailey Cavalieri, which specializes in D&O litigation. "One market is relatively flat, the other has been hit very hard, with prices more than doubling for many."
Dave Hennes, director of risk management at The Toro Co., a $1.8 billion manufacturer of turf-maintenance equipment, says negotiations on his upcoming property/casualty (P&C) insurance–policy renewals, including D&O, have been about as exciting as watching grass grow. "We're hearing from our brokers that after several years of softening prices, the market is flattening and we should expect roughly the same or slightly lower costs, as well as the same terms and conditions in the expiring policies," he says.
No Casualties in P&C
In a bit of good news, P&C insurance (not including D&O) is posing no issue at all. "Thirty-four banks have failed since the beginning of the financial crisis; no insurers have failed," says Robert Hartwig, president and chief economist at the Insurance Information Institute. "Banks are reducing and eliminating their lines of credit; insurers are renewing existing policies and paying claims. Not a single [P&C] claim has gone unpaid since this crisis reared." (See "P&C Survives the Storm" at the end of this article.)
That may provide scant consolation to financial-services firms, which have little choice but to bear the extra cost for D&O coverage. Directors and officers on the losing side of a securities class action are personally liable financially for both legal defense costs and the ultimate payout or settlement. D&O insurance, particularly Side A coverage, which protects the directors and officers in the event the overall policy's financial limits are exhausted, is vital in recruiting and retaining top-notch senior executives and board members. Despite the current economic climate, forgoing full coverage to save a few million dollars is unwise. "This is not the time to save money on premiums by taking on more D&O risk internally," Paterson says.
Still, at a time when cash and credit are scarce, stratospheric D&O prices are adding insult to injury. "We just plunked down $17 million for our D&O, errors and omissions, and other professional liability lines, on top of much higher deductibles — $25 million for everything but the E&O, and $50 million for the E&O," says the risk manager at an Eastern superregional bank who insisted on anonymity. Overall, the premium increase was in the 20 percent range, not too shabby, as the bank acknowledges modest subprime-mortgage exposure and was a recipient of federal TARP (Troubled Asset Relief Program) dollars.
Larger financial institutions with more-problematic risk profiles, on the other hand, are forking over veritable fortunes. "Last year we had a 90 percent premium increase in the primary layer of our D&O program, where the first few millions of dollars in a loss are absorbed, and we expect even larger price increases as we prepare for this year's renewal," says the risk manager at a major global financial-services firm, also off the record. "We have a blended program that combines D&O with E&O and other professional liability lines, for which we're paying around $150,000 per $1 million of coverage in the primary layer. That's about 18 percent or so of the amount covered, and I'm told to brace for closer to 40 percent — or $400,000 for a million in coverage — next renewal. And we're doing much better than other firms.
"I wouldn't be surprised to see some banks take a $200 million deductible," he adds. "Carriers are simply uncomfortable insuring the primary layer of troubled firms unless it's nearly a dollar for a dollar. At that point you might as well self-insure."
The Last Details
Nevertheless, insurance brokers insist that stable and reputable firms — the two-thirds not named in securities litigation — can reap much better D&O deals than their distressed brethren. "With a lot of hard work, you can differentiate yourself with underwriters and still do reasonably well," says William A. Boeck, a senior vice president of the Lockton Financial Services group at insurance brokerage Lockton Cos.
To get a break, commercial firms should demonstrate the merits of their liquidity, debt obligations, balance-sheet soundness, and other financial metrics. "If your story is a really good one, there is still a chance of a flat renewal," says Lou Ann Layton, a managing director at global insurance broker Marsh. "If you didn't take TARP money you have something to boast about [to insurers]. If you took it but can show you really didn't need it, you can still distinguish yourself. That's the key."
That's what Russell Investments did. "You need to determine the issues the insurance markets are concerned about and then position your risk- control system and business model as being different," says global risk manager Jeffrey Vernor. "If you don't have known claims problems, there is little evidence to warrant a significant D&O premium increase." Nevertheless, Vernor acknowledges that the firm's D&O premium at renewal increased slightly. "It wasn't flat, but it was reasonable," he says.
Bank of New York Mellon fared even better, renewing its D&O policy at the same premium in its expiring policy. "We differentiated ourselves by pointing out that we're not a commercial bank per se," says Carmelo Casella, vice president of corporate insurance. "Since our merger with Mellon and the sale of our retail branches to JPMorgan Chase, we've focused on asset management, securities servicing, and treasury services. We also don't have much subprime exposure, particularly relative to others in the banking industry, and even though we got TARP money, we took only $3 billion and not $25 billion like other firms. Our capital ratios remain strong."
Warren Mula, chairman of insurance broker Aon 's U.S. retail business, has additional advice. "It's vital for the CFO to make an appearance during the renewal process," he says. "A CFO is best-equipped to convey to underwriters that this is an organization that anticipates problems, knows where its risks are, is very closely managed, and would not bear a risk that falls outside its own and industry best practices."
Better days may lie ahead. Significant decreases in D&O litigation are anticipated, if for no other reason than all the big fish have already been reeled in. "Litigation activity against the financial sector may decline next year because the supply of new defendants might be drying up," says Grundfest of Stanford Law School's clearinghouse. A single D&O market for all industry sectors may yet rise again.
Russ Banham is a contributing editor of CFO.
Mix and Match
Many companies renewing their directors'-and-officers' liability insurance programs this year are moving around the key players in their layered D&O programs to shift the burden of risk from troubled insurers to more financially viable ones. Since D&O insurance policies typically carry very high financial limits (in the hundreds of millions of dollars), no one insurer can bear all the risk, requiring several to pitch in and share potential losses. "Diversification, at the moment, seems generally like a good idea," says Patrick Regan, CFO of global insurance broker Willis Group.
Other brokers offer similar advice. "We're counseling clients to reduce, reallocate, or remove from their D&O programs any insurance companies that have been downgraded by the rating agencies in the past 12 months," says Lou Ann Layton, managing director at insurance brokerage Marsh.
With the financial condition of AIG and another major D&O player, XL Insurance, the subject of scrutiny and rating-agency downgrades, their placement in D&O programs seems to be suffering. "We took XL off our D&O program," says Pete Fahrenthold, managing director of risk management at Continental Airlines. "D&O is one line I don't want to take chances with, since the coverage personally impacts our officers and directors. I'm waiting for further developments before I decide to renew any line of coverage with AIG."
Carmelo Casella, vice president of corporate insurance at Bank of New York Mellon, adjusted AIG's participation in his firm's D&O policy from a 10 percent share to a smaller piece of the pie. "When AIG's troubles hit the fan, management was concerned about our exposure," says Casella. "I wanted to show them we didn't have our heads in the sand. I did the same thing with XL, reducing their share."
Some risk managers see it differently. "My CFO asked me about the health of AIG, but after several conference calls and a visit by a senior AIG executive, we decided there was little cause to replace them," says Dave Hennes, director of risk management at The Toro Co. "AIG's problems are due to its investments; the financial condition of its insurance companies is sound. We think they can get through it." — R.B.
P&C Survives the Storm
Large surpluses offset investment losses.
Pete Fahrenthold, managing director of risk management at Continental Airlines, is among the many buyers of D&O insurance outside the financial-services sector who found recent policy renewals to be a breeze. But does the same hold true for property/casualty insurance? "We're expecting flat pricing to a slight increase in our property program when that comes up for renewal, due in part to the catastrophic costs from Hurricane Ike," he says. "Our aviation-insurance pricing went up slightly, after years of this market softening. It seems the industry's cycle is slowly turning the other way, as investment income impacts insurer profitability, causing the market to be slightly more conservative."
While investment income losses have increased "significantly" for property/casualty insurers, the industry overall "is not in trouble by any means," says Andrew Colannino, vice president of property/casualty at rating agency A.M. Best Co. "We expect a [drop] in surplus of about 10 percent from 2007 to 2008, mostly due to investment declines, but after several years of strong surplus growth the industry can handle it."
Even longtime industry critic Robert Hunter, a former Federal Insurance administrator and Texas insurance regulator, says the industry's coffers are overflowing. "The financial meltdown happened at a very good time for the property/casualty industry, with many companies enjoying a string of profits going back several years," says Hunter, director of insurance at the Consumer Federation of America. "Their balance sheets are stuffed with money and their reserves are pretty generous, giving them the ability to release billions and billions of dollars, even in a year like this one. The industry's cycle has, for the most part, yet to grind the other way." — R.B.