Cover charge: Premiums for professional liability insurance for public companies are likely to skyrocket following years of escalating claims and recent high-profile cases. (Property/Casualty: Professional Liability).

Past problems combined with present headaches are reducing capacity and increasing pricing for directors and officers and errors and omissions coverage.

The D&O market is in "considerable disarray," reeling from years of under-priced premium, rising claim costs and the legacy of Sept. 11, according to a study from broker Willis Group Holdings. As a result, D&O policyholders are seeing premium increases, a moratorium on multiyear contracts and tight underwriting.

The Willis report says insureds with healthy balance sheets and favorable or no claim experience can expect to see an average rate hike of 35% this year, compared with increases of 5% to 10% last year. But companies that specialize in telecommunications, the Internet or biotechnology are apt to see rate increases exceeding 50%.

D&O insurance is a niche market, accounting for $3.5 billion to $6 billion in annual gross premium written. It protects a company's board of directors against claims of mis-management from employees and shareholders. The top three D&O insurers based on premium--American International Group Inc., Chubb and Lloyd's--write about 65% of the business.

Typical D&O claims involve bankruptcy and accounting restatements or irregularities. The current rash of high-pro file D&O claims is tied to three companies that are experiencing such problems--energy trader Enron Corp., conglomerate Tyco International and telecommunications specialist Global Crossing Holdings Ltd.

"D&O claims happen when Wall Street is surprised," said Fred Podolsky, chief executive officer of the global financial and executive risks practice at Willis and co-author of a recent D&O report.

Publicly held corporations often feel pressured to put on their best possible face in accounting statements to garner money for successful initial public offerings and to meet quarterly earnings expectations. In fact, 50% of all lawsuits brought against publicly traded companies and their executives come from shareholders, according to a 2001 Tillinghast-Towers Perrin D&O study.

Errors and omissions insurance is a slightly smaller niche market than D&O--about $5 billion annually in gross premium written. E&O covers the liability of service professionals for financial loss due to negligence. Typical E&O losses include claims by a third party, such as a bank that loaned money to an entity that subsequently went out of business. It's not unusual to see claims in the seven figures, said Tim Covello, E&O product manager for Chubb Executive Risk. About 40% of the professional E&O line is written for attorneys and 20% for accountants. In the past, Chubb has provided E&O coverage for the Big Five accounting firms, but the bulk of its current business is for the second-largest tier of accounting firms. Other writers of E&O coverage for accountants include Zurich North America, Travelers, Safeco, Fireman's Fund and Aon.

Current Problems

While the Enron bankruptcy and the resulting repercussions for its accountant/auditor Arthur Andersen & Co. exacerbated the problems of D&O insurance, the line's present challenges have been years in the making.

The Private Securities litigation Reform Act of 1995 was supposed to be the anti-dote for rising D&O claims costs caused by frivolous litigation, but the number of cases actually hit a record high in 2001.The reform act's heightened pleading standard was supposed to eliminate frivolous lawsuits. Instead, it created an environment for more well-researched cases seeking higher amounts.

The 327 federal securities class-action lawsuits filed in 2001 are a 60% increase over the number of filings in 2000, according to the Stanford Law School Securities Class Action Clearinghouse. "The data indicate there has been no material decrease in the volume of litigation activity since passage of the Private Securities Litigation Reform Act of 1995," said Professor Joseph Grundfest of Stanford Law School. "Plaintiffs continue to have powerful economic incentives to sue many companies for large sums of money Whether these claims have merit is an entirely different issue, but the incentive to sue is alive and well," said Grundfest, a former commissioner of the Securities and Exchange Commission.

The increase in D&O claims came after insurers optimistically lowered rates and offered broad coverage expecting that the reform act would create a better claims environment by reducing the frequency and severity of securities cases. "The reality is that's not what happened. The frequency of securities litigation went up, and 2001 saw the all-time record average settlement," said John Keogh, president and chief operating officer of National Union Insurance Co., a member of AIG.

The events of Sept. 11 further complicated the situation. While the disaster didn't trigger D&O claims, the losses are expected to cost insurers $30 billion to $70 billion, taking that capital out of the marketplace. "Sept. 11 put the moon and stars in alignment in property/casualty insurance. It gave insurers pause to look at underwriting and pricing and change direction completely;" Podolsky said. In the past, parent company reserves bolstered the ability of the D&O insurers to offer favorable coverage terms that didn't reflect the loss ratios of the D&O book of business, the Willis report said. "Such reserves are now being redirected to address the financial impact of Sept. 11 and other unrelated lines of insurance."

The Enron bankruptcy, which was tied to allegations of accounting irregularities, refocused corporate America on D&O coverage. "Enron showed how severe a D&O loss could be. On its own, it would have been a pause for change in the D&O world," Keogh said. Various sources put Enron's D&O coverage at $350 million.

The Enron/Arthur Andersen situation also has corporate board members paying greater attention to D&O coverage. In the past, it was considered a "necessary evil" that the company's general counsel or chief financial officer bought and then provided board members with a one-page synopsis of it, Podolsky said. "Now, board members want detailed information of the coverage. There are more detailed questions from the board members' personal attorneys about the coverage. The directors are focused on the minutiae of the contract," Podolsky said.

Enron's troubles may lead to regulatory and legislative changes. And corporations may find it difficult to recruit board members. It's become more dangerous to sit on a board in corporate America, Keogh said.

Putting Skin in the Game

During the previous soft market, D&O policyholders were quick to use their policies as easy settlement vehicles. This is reflected in a recent study by Cornerstone Research that reports the average class-action case settled in 2001 for $16 million. Prior to last year, the median settlement value of post-reform act cases had been $5.5 million. That compares with a median settlement value of $4 million for cases settled before the reform measurers.

These numbers are causing insurers to ask clients for more skin in the game, and one way they're doing that is to raise rates. "Over the last 18 months, there has been more than $100 million in losses in the D&O area; that never happened before. The high severity, coupled with significant premium reductions over the last 15 years, put together with broadened coverage features, makes it not surprising to see significant rate increases," said Jim Swanke, a principal with Tillinghast.

The hard market also has prompted D&O insurers to reintroduce restrictions like coinsurance, said Keogh. In coinsurance agreements, when a loss occurs, the insurer and the insured each pay half. "It's getting back to the fundamentals of what proper risk sharing should be. We're seeing $2.5 million in self-insured retention being requested now for large companies," Keogh said, Waiving the self-insured retention is also a thing of the past. Just last year if a company was successful in defending a lawsuit, the insurer would reimburse the self-insured retention. That "extra" coverage isn't showing up in policy renewals. Insureds also are being offered reduced limits of $10 million to $15 million, compared with $25 million last year, and multiyear contracts are all but obsolete, he said.

D&O insurers also are questioning the future of entity coverage, where in addition to insuring board members, the corporation itself is insured. "With this type of coverage, the corporation isn't fighting lawsuits as hard--corporations had no skin in the game," Swanke said.

Richard Bortnick, a member of the Philadelphia-based law firm of Cozen O'Connor, advises D&O insurers to take an extra step and interview a policyholder's senior management. "This standard of care should be used today, especially given the hardness of the market and given the obligations of the underwriters and insurance companies' own management to their own stockholders," Bortnick said.

Accounting for Problems

SEC Chairman Harvey Pitt is introducing reforms for the accounting industry These changes, including disclosure about critical accounting policies, are important to D&O insurers because they involve management's judgments. The new rulings will require closer scrutiny of a board's actions by insurers. "They won't be like accounting restatements, which in some extreme cases may be analogous to a doctor leaving a rubber glove inside a patient from a plaintiffs law standpoint," Bortnick said. Bortnick has heard discussions about excluding claims arising from alleged accounting fraud, but "we haven't seen any [exclusions] yet. They would make underwriting easier, reduce premium and eliminate a degree of risk," he said.

As for E&O insurance for the Big Five accounting firms, their risks post-Enron are certainly under greater scrutiny by investors, Congress, regulators and the SEC, said Peter Wilson, executive vice president of global specialty lines at CNA Financial Corp.

The second-tier accounting firms are more likely to count among their clients privately owned businesses that are usually centralized and easier to manage. E&O rates are going up across Chubb's book of business by 15% to 25%, driven less by the Arthur Andersen situation and more by the general increase in severity seen in most lines of business, Covello said. Underwriting restrictions in the E&O line also are beginning to surface. Multiyear policies are becoming scarcer, particularly for larger firms, although the need for coinsurance or limits on coverage isn't an issue yet.

E&O insurers like Chubb also are keeping an eye on the possible trend of public companies migrating from Arthur Andersen and other Big Five firms to the secondtier accounting companies. "There's going to be closer scrutiny of firms that have SEC exposure in their books of business," Covello said.

Market Share for Primary D&O Coverage

The U.S. directors and officers market is concentrated--84% of premium
sold is written by the top 10 companies.

                  Policy     Premium
                 Count (1)  Volume (2)

AIG                 22%        35%
Lloyd's             20         14
Chubb               18         13
Admiral              5          3
Great American       5          3
CNA                  3          2
Special Program      3          2
Genesis              3          5
Aegis                2          5
Hartford             2          2

(1)Policy count: % of total policies sold by survey respondents

(2)Premium volume: % of total premium sold by survey respondents

Source: 2001 Directors and Officers Liability Survey--Tillinghast-Towers
Perrin

RELATED ARTICLE: Taking Care of Themselves

Four of the Big Five accounting firms rely on their own captive insurance companies for at least a portion of their errors and omissions coverage. According to A.M. Best Co.'s 2001 Best's Captive Directory, they have the following coverage:

* Arthur Andersen: Professional Service Insurance Co., a captive domiciled in Bermuda and managed by Marsh Inc.

* KPMG Peat Marwick: Park Indemnity Ltd., a captive domiciled in Bermuda and managed by Aon.

* PricewaterhouseCoopers L&F Indemnity Ltd. and WDB Insurance Ltd. Both captives are domiciled in Bermuda and managed by Aon.

* Ernst & Young: Canterbury Insurance Ltd., a captive domiciled in Ireland and managed by IRMG.

* Deloitte Touche & Ross doesn't have a captive, according to A.M. Best information.