Risk Management

Risks and Benefits: D&O’s Moral Peril

The WorldCom and Enron settlements could trigger directors to demand that CFOs and risk managers buy greater amounts of higher-quality insurance.
David KatzJanuary 13, 2005

Besides providing coverage for board members’ legal risks, a directors’ and officers’ insurance policy can supply them with cover for their laxities.

That, at least, seems to have been on shareholders’ minds when they insisted that last week’s settlement with 10 ex-directors of the former WorldCom contain the almost-unheard-of proviso that the board members cough up $18 million of their own money. Enron investors seem to have had similar thoughts in pushing for $13 million in personal payouts in an agreement also announced on January 7 and involving 10 ex-board members.

By demanding that the outside directors pay for a big chunk of the $54 settlement themselves, with the balance of the tab picked up by insurers, the WorldCom plaintiffs were upholding the venerable principle that the presence of insurance can be a “moral hazard” for society at large. If your policy shields you from the consequences of polluting a river, the theory goes, you have little incentive to avoid a chemical spill.

By stripping the former WorldCom directors of a large swath of their insurance coverage — exposing them to the tune of 20 percent of their cumulative personal net worth — the plaintiffs were apparently attempting to get board members everywhere to share the consequences if they let their guards down.

The settlement “sends a strong message to the directors of every publicly traded company that they must be vigilant guardians of the shareholders they represent,” said Alan Hevesi, trustee of the New York State Common Retirement Fund and the court-appointed lead plaintiff in the case. “We will hold them personally liable if they allow management of their companies on whose boards they sit to commit fraud.”

Unlike the WorldCom ex-directors, who reportedly did nothing wrong, the 10 former Enron board members (of a total of 18 included in the settlement) were asked to pay “personal contributions of insider trading proceeds,” according to a release issued by the University of California, the lead plaintiff in the securities lawsuit. Another difference was that the Enron defendants’ payments composed a smaller piece of a much bigger $168 million pie. The language of Enron lead counsel William Lerach, however, was much the same as Hevesi’s: “Hopefully, this will help send a message to corporate boardrooms of the importance of directors performing their legal duties.”

But the message, at least as it concerns insurance, may end up being mixed. On the surface, this seems like a bad time to be setting a precedent — if that’s what the settlements do — for depriving board members of personal financial protection. Under the Sarbanes-Oxley Act, they’ve gained heady new powers and responsibilities, such as hiring and monitoring outside auditors. If the WorldCom and Enron settlements mark the beginning of a trend, well-qualified directors might suddenly grow shy of the job, knowing that, with or without D&O coverage, they could lose considerable fortunes if scandals crop up at the companies they serve.

Further, the Sarbox requirement that companies must get their financial internal controls in order will be reflected in company 10-Ks for the first time in the next few months. “Plaintiffs’ lawyers will have a roadmap” of possible glitches in company financial workings they could possibly use in suits against companies and their directors and officers, according to Steven White, a vice president in executive-assurance claims for Arch Insurance Group in New York.

If they discourage strong directors from serving, such legal threats could reverse the moral hazard: the lack of insurance might lead to bad corporate governance. It’s more likely, however, that board members will demand that CFOs and risk managers buy greater amounts of better D&O coverage. “They’re going to have to be assured that the amount of insurance in place is going to be adequate and that terms are so tight they won’t lose their coverage” if insurers try to rescind a corporation’s policy when a fraud occurs, according to Steve Shappell, director of client litigation for the financial services group of Aon, the big insurance broker.

In most any other industry, the increased demand for a product would likely boost prices. In the insurance business, particularly in the D&O line, insureds’ search for airtight protection could heat up competition — and keep prices down — in an already competitive market.

Indeed, the WorldCom and Enron settlements supply a great marketing angle for insurers. Carriers could, for instance, offer to allay directors’ anxieties about personal payouts with a “severability” provision stipulating that only the bad actors would lose coverage if a fraud occurs.

Despite their companies’ increased demand for coverage, the many finance chiefs and risk managers negotiating policy renewals with their carriers this month are likely to find budget-friendly prices and broad policy language. Indeed, a D&O “premium index” of 2,455 U.S. and Canadian companies culled by Tillinghast, a risk management consulting firm, fell 10 percent from 2003 to 2004. This drop in the index, which gauges price movements in terms of the coverage offered, was the first since 1999.

But corporate insurance buyers shouldn’t expect the good times to roll, since D&O carriers have decided to lower their prices with little regard to the risk that those revenues fund. As premiums dropped last year, the number of claims per participant rose 11 percent and the number of participants with at least one claim rose 6 percent, according to the 1,347 respondents to Tillinghast’s 2003 and 2004 surveys.

Insurers thus derived their pricing not from actual claims experience but from competitive pressures from carriers willing to write new business in the United States and Bermuda, according to Elissa Sirovatka, a Tillinghast consultant who directs the survey.

As good as D&O prices and coverage terms look now, the disconnect between pricing and claims experience bodes ill for corporate insurance buyers over the long run. Adding to the problem is a big boost in open claims — 56 percent of participants in 2004 compared with 37 percent in last year’s Tillinghast survey — which makes it harder for insurers to measure how much cash to put away in reserve. Couple that with “premature pricing declines and a softening market,” says Sirovatka, “and insurers could be heading toward a D&O reserve shortfall if we don’t start to see more disciplined underwriting and adequate pricing.”

The consequences of such a shortfall could be the rapid exit of some insurers from the market, a sharp uptick in prices, and — in an extreme case — the loss of coverage through insurer bankruptcy, she thinks. Indeed, she predicts a return to a hard D&O market by 2006.

That would put a rise in insurance prices and a loss of protection at about the time corporations and their boards would need it most — just when lawsuits stemming from allegations of Sarbox-related breaches in internal controls could start rolling in. In that scenario, neither coverage nor cover would be available for errant directors and officers.

David Katz’s column “Risks and Benefits” appears every other Thursday. Contact him at [email protected].