Risk Management

A D&O Dilemma

Although a few big lawsuits will not rattle the market for directors and officers insurance, the effects of the credit squeeze just might.
Alan RappeportOctober 17, 2007

Flashy settlements and harsh-worded rulings may rebuke corporate leaders, but they are unlikely to have an immediate impact on the price of the insurance that covers them. But continuing fallout from the subprime mortgage crisis could be another matter, experts say.

High-profile decisions have taken aim at executives during the last several months, and more may follow. In August the influential Delaware Chancery Court denied a motion by Tyson Foods to toss shareholder claims of “spring-loaded” options and was shocked by the company’s “uncanny parsimony with the truth.”

Further, the ongoing Supreme Court case of StoneRidge v. Scientific-Atlanta could likely affect future litigation, as it raises the question of whether a business partner of a company that took part in a sham transaction is guilty of fraud, even if the business partner did not publicly say anything to mislead investors. And the $117.5 million settlement between Mercury Interactive Corp. shareholders, its auditor PricewaterhouseCoopers, and its former executives over the alleged backdating of stock-option grants widened eyes earlier this month.

But such cases will not likely tighten the soft market for directors’ and officers’ liability insurance, as abundant capital continues to suppress prices. “I don’t think this is going to have an overnight effect,” says Michael Turk, a senior consultant with Towers Perrin, a reinsurance strategy firm.

Although certain cases attract great attention and might increase the perception of risk, prices for D&O insurance remain low. A September report by Bear Stearns notes that prices have fallen by 50 percent since the end of 2002, since corporate scandals have subsided and given way to greater profitability. Last April, Towers Perrin reported that its index gauging liability insurance premiums dropped by 18 percent in 2006. Along with more profits, a reduction in shareholder class-action litigation has led underwriters to lower their prices. Meanwhile, the buoyant stock market usually translates into fewer lawsuits and cheaper insurance.

Despite some costly settlements, commercial insurance buyers are swamped with increased “entrants to the market with capital they want to put to work,” says William Passannante, co-chair of Anderson, Kill, and Olick’s insurance-recovery group. “If they have to lower the price because there’s a lot of capital in the market, they do it.”

A tightening of the market for D&O insurance, which offers companies and their directors and officers protection against legal action, would require such larger forces as a stock market crash or a sharp rise in litigation. “It would take an aggregation of a number of different events to be able to counter the forces of the cycle at this point,” says Kevin LaCroix, a director of OakBridge Insurance Services, a Connecticut-based firm. While the D&O market remains firmly entrenched in its soft cycle, some of those forces could be at work.

While the number of shareholder lawsuits has been historically low during the last two years, there have been signs the number may be rising. After just 136 cases were filed last year, 76 were filed in the first six months of 2007, according to NERA, an economic consultancy. The 12 percent projected increase is particularly meaningful, NERA says, as options-backdating cases—which burgeoned 2005 and 2006—have all but vanished this year. Moreover, each of the top 10 shareholder class-action settlements exceeded $1 billion for the first time (previously, just 3 settlements exceeded the $1 billion mark) and the median settlement in the first half of 2007 reached a high of $9 million.

There are certain industry classes that are increasingly problematic, says Glenn Dockery, an executive vice president at Hilb Rogal and Hobbs, a big insurance brokerage. Insurers are becoming particularly wary of anything relating to the housing industry and the subprime mortgage sector, which collapsed this summer. “Everyone’s taking a wait and see attitude,” says Dockery.

And big losses may be in sight. According to Bear Stearns, the D&O insurance industry could potentially lose $3 billion this year as a result of the credit squeeze that followed the subprime crisis. “With shares of 58 financial institutions losing at least 40 percent of their market value, including three high-profile bankruptcies, our view is that insurance companies will begin to post both D&O and E&O [errors and omissions] losses over the next few quarter,” says Bear Stearns.

In August Marsh, an insurance brokerage, also warned that more D&O liability claims could be coming thanks to the subprime real estate sector. “Although the D&O and E&O insurance market has been largely stable, if there are a high number of costly claims under these insurance policies, this trend may reverse and costs may begin to rise,” said Jill Sulkes, a managing director in Marsh’s financial institutions practice.

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