European response: the European Union's corporate governance standards will impact insurers as investors and as providers of coverage to corporations.

The European Union is riding the wave of corporate governance. The European Commission, the institution responsible for initiating European legislation, consulted throughout the summer on its 24-point action plan called "Modernizing Company Law and Enhancing Corporate Governance in the EU." Also known as the corporate governance "Action Plan," it was released on May 21, 2003. On the same date the commission also announced 10 parallel proposals entitled "Reinforcing the Statutory Audit in the EU." With these developments, the commission has taken its place as a co-leader in international regulatory developments and also used the appeal of corporate governance to push forward the rest of its legislative agenda in the field of company law.

These measures are propelled by a desire to strengthen shareholder rights and third-party protection in public companies as well as to reinstate investors' confidence in the capital markets. Will they affect insurers? To the extent that insurers have stock or debt listed on a European exchange, yes, although generally the impact should be mellower than that which the enactment and implementation of the Sarbanes-Oxley Act has had on U.S.-listed insurers.

However, insurers enter the classic corporate governance debate wearing more than one hat. They hold large investments in other listed companies; many of them also are companies in the business of insuring the directors and officers of listed companies, not to mention the statutory auditors of listed companies. The proposed measures, intended to reform the general institutional and legal framework within which public companies operate, will impact insurers both in their capacity as institutional investors and as providers of protection to other corporate governance players.

The proposals highlight that European and U.S. insurers have multiple exposures to corporate governance reforms at national and international levels. The governance of insurers will be increasingly scrutinized in the future and sector-specific legislative rules are just around the corner in many jurisdictions. Insurers must be aware of and prepare for these regulatory developments.

Interested Insurers

The theory of corporate governance and the importance of adequate governance structures in a public company, a long-time favorite topic of academic debate, is common knowledge to both corporate executives and investors, hammered in by consecutive high profile company failures. The insurance sector is affected on at least three levels by the corporate governance debate:

Insurers are public companies. Most of the large European Union and international insurers are public companies where the standard corporation governance challenges must be faced. In this respect, they have to comply with company, securities and bankruptcy laws, stock-exchange regulations and self-regulatory codes of conduct and guidelines. The bar is constantly being raised, and there is added pressure from institutional investors who start demanding evidence of adequate corporate governance structures in order to continue with their investment.

Insurers are institutional investors. As long-term investors in equity and bonds, insurers are naturally interested in preventing corporate failures and ensuring economic performance. Because of their size, sophistication and resources, they are theoretically able and now widely expected to assume an active monitoring role in the companies in which they invest. Active investing involves making good and sustained use of shareholder and bondholder rights, requiring compliance with the highest corporate governance standards and monitoring compliance with those standards.

Insurers sell coverage to directors and officers, as well as to auditors. The behavior of managers is the original and still most important element that corporate governance mechanisms seek to control. Reforms of corporate governance standards and directors' duties and responsibilities create business opportunities for D&O carriers, who see the market hardening. However, the same reforms may have the effect of increasing the frequency and the severity of claims under the policies.

Insurers also cover the professional liability of auditors, a major corporate governance mechanism that is--and perhaps unjustly--widely perceived and routinely targeted as liable to fail to detect corporate governance breakdowns. The extent and nature of the role that is entrusted to auditors and the assessment of litigation risk are vital for professional liability insurance carriers.

Implications for Insurers

Listed insurers will have to meet increased governance requirements and have to comply with all measures eventually adopted. Increased disclosure, the appointment of independent directors and the creation of board committees are current best practice. Implementation will lead to additional compliance costs for all companies falling below that standard. On the other hand, strengthened shareholder rights and the reform of directors' duties and responsibilities by legislative means carry the risk of exposing the daily running of the company to hampering grudge shareholder inquiries, overcautious management, crippling bad press and frivolous claims.

Looking at the U.S. experience, there is a general consensus among chief executive officers that compliance with Sarbanes-Oxley has increased compliance costs, especially for the smaller listed companies. An indication of the difficulties in structuring the internal governance mechanisms is that consistent with the heightened standards of Sarbanes-Oxley, the Securities and Exchange Commission and the stock exchanges, U.S courts (Delaware Chancery Court in particular) continually raise the bar regarding director standards of duty.

Directors can be personally liable for a breach of the duty of care, and that social and personal relationships between directors can prevent independence.

The proposed facilitation of the exercise of shareholders' rights, especially in cross-border cases, should be welcomed by insurers, although it adds pressure on them to use these rights. Proposals obliging institutional investors to disclose their investment and voting policies reflect best practice, but the assumption that the insurer has the expertise to monitor and participate more actively in the affairs of the company it invests in may be misplaced. Outsourcing monitoring functions to specialized providers is a solution on which many business plans have speculated. But it is uncertain whether increased reliance on outside sources will bring the desired results. As an analogy, credit rating agencies in the United States rallied only after the corporate failures of 1930s. Now they also have come under the spotlight and their regulatory role is being re-examined.

D&O insurance carriers will have specific implications. Collective responsibility for both financial statements and certain nonfinancial information sounds ominous for management boards. The commission also will reflect on the development of a wrongful trading rule, which is currently unknown in many E.U. jurisdictions. The enhanced role and responsibilities of nonexecutives on the board and in the nomination, remuneration and audit committees create additional risks for the individuals who accept such positions.

D&O carriers have benefited from the growing interest of European companies in D&O policies, a soft market in the late 1990s. The last two years have been a different story, even though the losses are nowhere near as terrifying as in the United States. Additional directors' duties might create a more litigious environment, which would lead to a constantly high risk of claims under D&O policies for alleged breach of the said duties. Lack of harmonization in implementing the commission's recommendations into national law also could lead to unpredictability. The assessment of corporate governance risks, especially for carriers that operate at a pan-European level, will be more difficult if the number of claims increases in an uneven manner.

D&O Trends

The introduction of E.U. corporate governance reforms can be expected to continue to influence the following D&O market trends:

* D&O underwriting standards will continue to tighten;

* The D&O application disclosures process will become more important;

* Specific wording, including exclusions for wrongful acts or personal profit, will be more heavily scrutinized; and

* Public company directors will seek greater coverage from their companies and pursue separate coverage, as well.

Specific implications for professional liability carriers include reforming the statutory audit framework The commission's proposals intend to address the concerns expressed with regard to the actual or perceived role of auditors in corporate scandals and collapses, thereby enhancing an integral mechanism of corporate governance. The commission's statutory audit reform is soft-handed and principle-based.

An undesirable consequence, however, may be that the current perception of auditors as the primary watchdogs of corporate behavior will be accentuated, potentially leading to the assertion of even wider duties of care and related litigation. This may affect professional liability carriers, which, together with D&O carriers, need a fair amount of predictability as to frequency, level and success rate of claims. The commission is not expected to give into pressure from auditing firms on the issue of capped or proportionate liability. It has promised, however, to examine the economic impact of auditor's liability regimes at the European level, the results of which may have some impact on all liability lines.

A Look to the Future

The commission proposals are "tailored to European cultural and business traditions" and are mostly based on principles. Reactions have so far been positive, but warn against excessive regulation and rule-based heavy-handed approaches (of which many accuse the United States). Still, the proposals have a long way to go through the E.U. legislative bodies before any concrete measures are finally implemented. Insurers should monitor developments with a view to ensuring that the eventual proposals adequately address their specific concerns. Future legislation should take into account guiding principles such as the following:

* Avoid over-regulation and unwarranted increase in compliance costs;

* Ensure, only to the extent necessary, legal and regulatory certainty through firm harmonization measures across the European Union;

* Avoid placing undue reliance on institutional investors as the sole substitute for good management and director supervision;

* Avoid measures which would encourage the creation of an inefficient, litigious environment;

* Clarify executive and nonexecutive directors' duties within the board and the board committees;

* Avoid placing undue reliance on auditors and actuaries as solely responsible for detection of accounting--and now corporate governance--irregularities.

It is reasonable to assume that the corporate governance debate will not subside in the near future--in fact, the corporate governance of financial institutions in particular has gradually received more international attention. The insurance industry relies heavily on smoothly functioning capital markets and should actively support measures that reinforce confidence in them, but should also be prepared for a more direct confrontation with international legislators as future measures may be addressed directly to them.

Guy Soussan is a partner resident in the Brussels office of LeBoeuf Lamb, Greene & MacRae LLP and heads the firm's E.U. insurance regulatory practice. Alexandros Iatrou is a research associate in the Brussels office.