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Should You Buy D&O ASAP?

Rates have dropped, but recent settlements may swing the pendulum in the other direction.
Alix Stuart, CFO Magazine
December 1, 2006

Just three years ago, directors' and officers' (D&O) insurance rates were so high that Ron Foster, then CFO for troubled fiber-optics giant JDS Uniphase, threatened to set up a self-insured facility with other companies rather than pay the prices insurance companies were demanding.

That approach would have tied up millions of dollars in escrow and led to potential legal complications, but Foster was willing to risk those headaches because the rates for D&O liability coverage "were verging on outrageous." Indeed, premiums rose an average 33 percent between 2002 and 2003 across all industries. Foster ultimately got a more reasonable bill from his insurers, but only after tough negotiations.

These days the market looks completely different. Foster, now CFO of semiconductor test-equipment maker FormFactor, says rates were down "substantially" when he renewed last May, and he's not alone. "It's a very good market for buyers of D&O insurance," says Mike Rice, managing director for Aon Financial Services. Rates have dropped about 46 percent from their 2003 high and are expected to fall another 5 to 7 percent this year, according to Aon. At the same time, many companies are finding it easier to get better terms, so much so that "you can probably buy as broad a contract today as at any time in the past 20 years," says Rice.

But how long can these good times last? Prices have fallen in large part because officers and directors have faced less fire: the number of annual securities class-action filings has decreased by more than 40 percent since early 2004. An absence of major scandals has helped, and the fact that law firm Milberg Weiss, renowned for its indefatigable efforts in securities class-action litigation, has been hamstrung by its own legal problems may not have hurt either. But cases that have reached settlement have become more expensive, up from an average of $28 million in 2004 to $71 million in 2005, according to PricewaterhouseCoopers's Securities Litigation study. Add to that the growing prevalence of claims related to the backdating of stock options, and the next renewal season could spell the end of the buyer's market. As Rice notes, "The combination of more-frequent and more-costly suits is what typically leads to problems," and half that equation already seems to be in evidence.

No company seems in imminent danger of surpassing the Enron and WorldCom settlements ($7.2 billion and $6.2 billion, respectively), but plenty of companies have been hit with outsized claims, according to the Stanford Law School Securities Class Action Clearinghouse. Nortel and AOL Time Warner each faced settlements totaling about $2.5 billion, for example, while Royal Ahold was on the hook for $1 billion. And those large claims may set the stage for others because, as Daren McNally, an attorney with Connell Foley LLP who specializes in insurance-coverage litigation, notes, "highly publicized and extraordinarily large cases threaten to redefine what's considered an appropriate settlement."

Covering Your "A" Side
Supersize settlements are leading many companies to load up on so-called Side A coverage, which covers officers and directors personally (as when, for example, bankruptcy or state law prohibits companies from reimbursing them via Side B coverage, which applies to the company itself) and which has become critical as standard indemnification gets harder to come by. About 9 percent of directors and officers received partial or no indemnification from their companies when charged in securities-litigation cases, according to Tillinghast, a division of Towers Perrin, and another 60 percent said their companies were undecided. "Side A coverage is definitely on the rise as individuals become more concerned about decreasing indemnification and competing claims for policy limits," says Carol Zacharias, senior vice president at insurance company ACE Ltd.

Concerns about protecting the personal assets of directors and officers are only likely to grow as suits related to backdating stock options play out. So far, most claims (about 80 percent) have been in the form of derivative lawsuits, in which shareholders sue officers or directors on behalf of the company. Since the company is effectively bringing the suit (and reaping any gains), it is prohibited from indemnifying officers and possibly from reimbursing them for legal-defense costs. Side A is the only type of insurance that covers officers and directors in such cases.

As demand for Side A coverage grows — in 2005, companies increased excess coverage lines, which include Side A only, by 10 to 11 percent on average, compared with 2 to 3 percent increases in primary-coverage limits, according to Tillinghast — there is concern that insurers will shift some of the burden back on the insured. To date, directors and officers have had to put up their own money in "only a handful of cases," says McNally, the best-known being WorldCom and possibly Enron. "But there is a real risk going forward that directors and officers will have to contribute their personal assets, primarily because the settlements are getting so large."

Some insurance companies are coming out with new products to help quell the fear that there won't be enough coverage to go around. One option is a new "enhanced" line of Side A coverage that offers separate additional limits for directors only or for officers only should a policy's standard limit of liability be exhausted. "This is in response to the increasing frequency of partial settlements we've seen," where directors are sued separately from officers and claims are settled separately, says ACE Bermuda executive vice president Patrick Tannock. Directors, he says, often seem to be able to settle sooner, "leaving officers holding the bag" when the policy is shared.

But Aon's Rice says that there are few breakthrough products coming to market. Rather, he says, insurers are now trying to get an edge by offering fully nonrescindable options, improved severability, and other options as standard equipment.

The Who and How of Options
Finance executives who want to get more bang for their premium bucks can take several useful steps. One, of course, is to be prepared for a litany of questions about stock-options granting procedures. "There's no one-size-fits-all," says ACE's Zacharias. "We accept that there are different ways to do it." But "we're asking companies how they issue options, who reviews them, and who gets stock options."

Careful attention to language — and a willingness to negotiate — can also work in a company's favor. Peter Fahrenthold, Continental Airlines's managing director of risk management, says that one of the more contentious areas in D&O coverage concerns which party gets to decide when to cut off coverage to a particular director or officer who seems to be guilty.

While Fahrenthold says it hasn't been possible to "write into the contract that the carrier can't make the decision," he was able to change the language to gain more-favorable terms for the company. Instead of relying on so-called dispute arbitration, where a third party would decide guilt or innocence, Continental's policy rests on a "final adjudication," meaning a court decision or an outright confession of guilt.

FormFactor CFO Foster says that face-to- face meetings with insurers are a great way to get favorable policies. He hits the road every year to meet with all of his D&O carriers (the only type of insurance he does this for) because they know that "the CFO is the one minding the store, so they want to see the whites of your eyes."

Finally, a CFO can help the cause by keeping in good stead with big investors. Securities litigation that involves pension funds and unions carried an average price tag three times higher than ones that lacked those key investors, according to PwC's study. While companies can't control who sues them, of course, "it's become more important than ever to manage relationships with institutional investors," says Zacharias.

Alix Nyberg Stuart is senior writer at CFO.

Stating the Case for Federal Oversight
A new approach to insurance regulation may lead to lower rates.

If you're like most finance executives, you don't stay up nights thinking about the structure of insurance regulation. But a move to create a federal oversight office, as an option to the patchwork of legislation that property/casualty and life insurers now face from state regulators, is one development that might be worth tracking.

Senators John Sununu (R-N.H.) and Tim Johnson (D-S. Dak.) introduced a bill proposing such a structure into the Senate this past spring, while Rep. Ed Royce (R-Calif.) followed with a similar one in the House. While few expected the bills to become law during this session, experts say they lay important groundwork for needed change.

At the very least, a single regulator could reduce administrative and licensing costs for national insurers, translating into lower costs for corporate buyers. Proponents say it could also grease the skids for new products to come to market. "If you ever loosened up the regulation on insurance, the capital markets might well step in and offer risk financing-type credit that would be far more valuable and efficient to corporate buyers," says Felix Kloman, retired principal of Towers Perrin and editor of Risk Management Reports newsletter.

Workers' compensation, which falls under casualty insurance, could also get less expensive, particularly for companies that use some type of self-insurance facility. "There's no question" that state-based regulations drive up costs, says Wayne Salen, director of risk management for Labor Finders International. The staffing firm now has five different workers' comp policies with varying administrative requirements to cover operations in 32 states, using AIG "to avoid the nightmare" of the paperwork and as a last-resort backstop. If AIG could file at a single point, though, Salen believes he could save anywhere from 5 to 25 percent off current premiums.

Absent congressional authority, the Treasury is still gathering expertise in the property/casualty insurance arena. The department has become better-versed in insurance matters over the past several years, since it is responsible for administering the Terrorism Risk Insurance Act. And because it's a top issue for groups like the Risk and Insurance Management Society and property/casualty group American Insurance Association, efforts to gather more support on Capitol Hill for federal regulation look likely to push ahead in 2007. — A.N.S.

Good Rates, for Now
D&O insurance premiums are at a four-year low.*
Year Average Premium
2005 $260,345
2004 296,956
2003 486,717
2002 309,654
2001 229,059
2000 187,296
1999 221,470
1998 286,521
1997 349,341
1996 $396,845
Source: Tillinghast
*Note that the size and number of companies surveyed year-to-year varies, reducing year-to-year comparability.