D&O [directors and officers insurance] recovery linked to realistic rate base: Reeling from the effects of corporate scandals, D&O insurers are tying rates to true risk, while hoping Sarbanes-Oxley will prevent future pitfalls. (RIMS Conference: Property/Casualty).

The pain in the directors and officers insurance market is set to continue for some time, as insurers seek to regain control of pricing, coverage and losses in the wake of corporate-governance and accounting scandals that exposed a decade of mistakes in writing the business, specialists in the field said.

Writers of D&O are juggling multiple tasks--managing the claims already in progress; anticipating the claims yet to come; responding to the new Sarbanes-Oxley Act; restoring prices to levels that cover the risk, and rolling back the expansion of coverage that left insurers with disastrous levels of exposure.

"The industry definitely lost its way," said Tony Galban, vice president of D&O liability at Chubb Corp., citing not only price cutting but the erosion of risk sharing through the 1990s as traditional D&O coverage was supplemented with "entity" coverage that took more and more risk away from the insureds. An aggravating factor, he noted, was multiyear contracts that were written in anticipation of the Year 2000 computer disaster that never materialized. With insurers locked into those contracts, recovery in the D&O market was delayed, said Galban at the Risk and Insurance Management Society annual conference, which was held in Chicago, April 6-10.

Meanwhile, trouble was waiting to explode in the form of scandals such as the collapses of Enron Corp. and WorldCom Inc. "There's been a lot of income management, playing financial games," said Keith Thomas, senior vice president of the management solutions group at Zurich North America Specialties. As managements faced "pressure to hit that penny a share" in their earnings, they lost sight of running the day-to-day business, he said.

Insurers also discovered as claims began to escalate that they had priced coverage on a basis that didn't reflect the true risk they faced, Thomas said. That pricing was based on factors such as assets or revenue, but as D&O settlements have become tied to the magnitude of drops in companies' stock prices, Zurich is moving toward pricing on the basis of corporate governance, he said.

In one session at the conference on corporate governance, John A. Kuhn, executive vice president of Axis Financial Insurance Solutions, noted that plaintiffs' attorneys are extending the periods covered in their suits further and further back in time, seeking to capture the maximum loss of market capitalization to form the basis for their claims.

Closer scrutiny of corporate governance has helped to mitigate risk somewhat, but it hasn't been enough to make a significant difference in the pricing environment. There are issues such as pension accounting that still could surface outside the scope of reforms under Sarbanes-Oxley, and the explosive growth of settlements has continued, Thomas noted. "While the scrutiny is there and market caps are down, they're still at multiples of the level they were when the business was priced," he said.

Among the first steps for the market in righting itself has been re-establishing a realistic base of rates, Thomas said. That process is nearing an end, and future rate hikes will be tied more to the risks of individual accounts, he said, although some companies have seen added increases based on their risk profiles since the early stages of the market's hardening.

Across the industry, premium increases for D&O averaged 11% in 2000 and 29% for both 2001 and 2002, according to Tillinghast-Towers Perrin's premium index.

"The underlying trend will start to temper," Thomas said, but pricing should remain firm through 2004--and possibly longer, depending on the emergence of any new, unforeseen issues and on the development of the reinsurance market, he said.

Sarbanes-Oxley

"We still have pretty juicy revelations coming from time to time in this business," Chubb's Galban cautioned, adding that it's not clear how effective the Sarbanes-Oxley reforms might be. "It's too early to tell if they got it right," he said, "It was put through very quickly, and there's a lot of detail that needs to be hashed out"

Galban said it's become clear that D&O insurance policies are the target in many shareholder suits, and in many cases, the damages sought are "suspiciously similar to the insurance program."

Large, public companies are feeling the brunt of the turmoil in D&O coverage, according to John A. Rafferty, vice president and head of Hartford Financial Products' D&O operations. Changes in retentions have been more extreme than changes in pricing for such companies, he said. It wasn't unusual for a Fortune 500 risk under a D&O policy to have self-insured retention of $500,000 or $1 million. Now, it is commonplace for those to be $10 million or $25 million, Rafferty said.

"Some insureds are making the decision to look at the premium price of taking $50 million or $100 million self-insured retentions," he said. "Those are still the exceptions, but you are really starting to see the buyer soul searching about 'why are we buying this cover?' It's certainly not to swap dollars, premiums for claims; it's really for a catastrophe. A lot of insureds are measuring what a catastrophe could do to our balance sheet, and they are concluding it's not $500,000; it's $10 million or $25 million for that loss to be material to our balance sheet."

Earlier this year, Lucent Technologies, the telecommunications equipment maker, announced a $315 million settlement of 54 shareholder lawsuits that accused it of violating federal and state securities laws. The company, based in Murray Hill, N.J., plans to seek partial recovery of the settlement amount from its insurance carriers.

"There's certainly a lot of anxiety on several fronts," Rafferty said. "We certainly understand brokers and clients are concerned with the rate increases, the retention increases, the form tightening. There's much more anxiety in terms of underwriting to make sure we bring this marketplace back to profitability."

Insurers also are stepping up their loss-control efforts in relation to D&O. Chubb has recently updated a D&O handbook that had been in print for 10 years, and it sponsors a study by the Conference Board on best practices in corporate governance. Zurich's Thomas said his company is developing loss-control initiatives on several fronts: creating a service to help customers comply with Sarbanes-Oxley and using accountants to train board members.

Senior Associate Editor Meg Green contributed to this article.

RELATED ARTICLE: Broker Sees Softening Of U.S. Property Rates

Rates have begun to fall for some property insurance customers in the United States, marking an early turning point in the hard market that has gripped the property/casualty industry for the past two years or more, according to a report by insurance broker Aon Corp.

"Rates have plateaued," said Gail Norstrom, property managing director at Aon, noting that poor risks can still be an exception to the generally steady or declining property rates. But he said there's little immediate danger of the industry slipping back into the soft market that marked much of the 1990s. Well-run companies have "a fair amount of redundancy in today's rates," and it's just good business to give some ground to attract business, he said. Property rates, he said, have been firming since 1999.

"There is a fair amount of give in this market, and the industry can still make an underwriting profit," Norstrom said in an interview at the Risk and Insurance Management Society's annual conference in Chicago.

He acknowledged that in the long term, there are no guarantees that history won't repeat itself. "No one has ever accused the insurance business of being the brightest of industries in this country," Norstrom said.

Aon's 2003 U.S. Property Report, based on an informal survey of buyers and sellers, found that:

* Rates are beginning to decline for some U.S. property risks;

* Increased and new capacity in the three principal markets--the United States, London/Continental Europe and Bermuda--is spurring competition and starting to push rates downward, and

* The Terrorism Risk Insurance Act in the United States has drawn a mixed response from insurers and buyers alike.

Brendan Noonan