Falling Markets, Rising Risks.

D&O insurers are trying to protect themselves through price firming and more conservative underwriting. But legal claims and the amount of damages awarded by courts keep rising.

Stock market indices have hit lows not seen in two years. Much of the slide on Wall Street is being caused by U.S. corporations that are increasingly cutting revenue projections and reporting losses instead of profits. This is bad news for directors and officers insurers.

D&O insurers don't face the thousands of individual risks that personal lines writers face. However, the average damages of their claims are in the $10 million range. D&O insurance protects a company's management against claims of mismanagement from employees and shareholders.

It is subject to the whims of both the domestic and global economy, said David McElroy, senior vice president of Hartford Specialty.

Writers of D&O--a $5 billion niche market--are being pulled both ways. On one side are the corporate policyholders, who increasingly view their coverage as a gift certificate to be cashed in. On the other side are plaintiffs attorneys, who have their sights set on multimillion-dollar settlements and jury awards. The instability of the stock market and the pressure from policyholders and attorneys are leading D&O writers to raise rates and approve less broad policy terms. Unlike the last three years, when the stock market was more stable, today's volatile market is seen as fertile ground for future D&O claims. "When stocks drop, the likelihood of litigation increases. It portends a more difficult environment than the last three years," said John Keogh, president and chief operating officer of National Union Fire Insurance Co., a member of American International Group Inc.

Price Hikes

The D&O market is concentrated with the top three insurers--AIG, Chubb Group and Lloyd's--writing about 65% of the business. After years of soft prices, D&O carriers are raising rates 5% to 10% and even higher--40% to 50%--for high-tech companies or those who have pending claims. "It appears that after years of significant price decreases, the D&O market has firmed and in some areas, like publicly held tech, biotech and IPOs, turned sharply upward," said Mark Larsen, a Tillinghast-Towers Perrin consultant and the author of the "2000 Directors and Officers Liability Survey." The average size of a shareholder D&O liability claim continues to set records, rising to $9.6 million from 1999's $8.67 million. Larsen also sees a need for higher rates to restore the line to profitability and says the increases must be two to three years of 20% hikes to do the job.

AIG and Chubb will benefit the most from the hardening D&O and professional liability market, according to a study by Timothy C. Connor II and Todd Bault, research analysts for Sanford C. Bernstein & Co. The D&O line--which includes professional liability and employment practices liability insurance--accounts for 20% of Chubb's net premiums written in 2000, whereas AIG is more diversified, and the D&O coverage comprises 10% of its net premiums written. However, Bault and Connor point out that Chubb has the most to lose in this business, as 100% of its earnings are nonlife and any changes in D&O pricing will impact Chubb three to five times more than any other companies.

D&O underwriters price policies based on market capitalization of public companies and a combination of assets and number of employees of private companies. Market conditions, type of risk, industry and terms of the policy also affect the pricing. Because D&O underwriting is account driven, companies take a different approach when viewing a high-tech company vs. a Fortune 500 company. "Writing IBM's D&O cover is like trying to grasp an elephant. Alternatively, writing a dot-com IPO is quite ephemeral," Connor said.

In addition, more business is moving by price because of the current higher market capitalization on business, and insurers are putting a ceiling on the limits they are willing to write. Since the market capitalization of public companies is used as the basis for damages, insurers are being more selective of the risks they will write. "We're getting a lot of phone calls from former clients looking for coverage saying, 'Where have you been? You know we always loved you,"' said Anthony S. Galban, vice president and underwriting manager for D&O liability insurance for Chubb. In terms of coverage, insurers are not only more selective as to who they will quote, but also less likely to rubber-stamp a laundry list of coverages. "We're looking at everything the client wants more closely, such as exclusions or adding names to coverage. They are looking for tweaks in the coverage, and we know a lot of the tweaks aren't so harmless," Galban said.

Shorter terms also are being offered in D&O coverage. Three-year deals are ancient history, because insurers have discovered that to survive in today's business climate, a business has to adapt quarter to quarter.

D&O insurers also complain that their policyholders are too quick to settle and want them to take on some of the fiscal responsibility to deter them from wanting to use their insurance as a quick settlement vehicle. "The coverage has expanded to the point where the clients have virtually no skin in the game, and when facing a problem, they're often inclined to just pay--often irrespective of actual liability. It's pure dysfunction," Galban said. Currently, Chubb is asking for 10% to 20% coinsurance from its clients and is pushing harder for higher retentions. "We're fighting the fight," Galban said.

Keogh said MG also is requesting levels of coinsurance from policyholders, "so they can be on the same side of the table as we are,"

Costly Reform

As rates and severity of claims rise, D&O insurers are taking a closer look at what effect the Private Securities Litigation Reform Act of 1995 is having on the industry The Reform Act's main intent was to reduce settlement costs and frivolous litigation, but the number of total cases hasn't decreased and the amount of payouts has increased. A securities class-action lawsuit is a case brought pursuant to Federal Rule of Civil Procedure 23 on behalf of a group of people who purchased the securities of a particular company during a set period of time (the class period), according to Stanford University's Securities Class Action Clearinghouse.

The act was passed because litigation was so frenetic in the 1980s and early '09s that the name of one of the plaintiffs attorneys became synonymous with being sued. To be "Lerached" is a reference to William Lerach of the firm Milberg, Weiss, Bershad, Hynes & Lerach LLP, one of the top plaintiffs law firms for securities litigation suits. Currently, the firm lists around 97 recently filed federal securities class actions and boasts recovering $20 billion in aggregate from these types of suits.

Before 1995, corporations were at risk to receive boilerplate lawsuits brought by plaintiffs attorneys on behalf of shareholders who held small portions of the stock. "Plaintiffs law firms used to brag that they could file a complaint in 120 minutes," said Donna Ferrara, vice president of Arthur Gallagher Risk Management Services Inc.

Insurers frankly admit they priced their D&O policies with the idea there would be a drop in securities litigation. "The end result is we didn't expect to be sitting in 2001 and seeing these results in 2001," Keogh said. National Union was not alone in viewing the Reform Act as a way to improve the environment of securities litigation. In anticipation, D&O insurers were more willing to expand terms, and pricing came down.

To right the wrongs, the act introduced fixes such as a heightened pleading standard and forward-looking statements. However, although the number of frivolous cases is down, the plaintiffs bar has adjusted to the new rules of bringing securities class-action cases to court. "The act laid out the ground rules in how to sue," Bault said.

Fewer Lawsuits

Opinions vary on the success of the act. When viewed in the context of getting rid of the nuisance suits, everyone agrees the act accomplished that. "The fringe cases were weeded out. The plaintiffs bar has done its homework; the cases aren't based on newspaper articles anymore," said H. Robert Fiebach, chairman of Cozen & O'Connor's D&O department. However, experts say the act hasn't achieved its goal of reducing the number of suits in total and cutting settlement figures. "Did it cut down suits? Yes, no more 120-minute wonders. But if people thought it would reduce all litigation, they will be disappointed," Ferrara said.

The heightened pleading standard helped to achieve the higher rate of dismissals, but it created an environment for more well-researched cases seeking higher amounts as well. The number of dismissals has increased from 14% before the Reform Act to 25% after the act. The average classaction settlement for all securities cases filed before the Reform Act was $8.5 million. The average settlement for cases filed after the act, up to 1999, was $45.8 million, according to National Economic Research Associates.

The heightened pleading standard forces plaintiffs attorneys to prove that the defendant acted with a "required state of mind." It is the force behind the ironic result of the Reform Act that actually increased the average settlement. Because the act requires a better researched case, the suits that aren't dismissed are stronger, better investigated and seek higher damages. Plaintiffs lawyers now have to show a direct connection that the alleged act was done knowingly. That has led attorneys to look for more concrete examples of wrongdoing instead of basing an allegation on missing an earnings forecast. This need for proof has led plaintiffs attorneys to look for insider trading by members of the corporation. That's another slippery slope to pin a case on, because proving insider trading isn't easy. "It's hard to define insider trading, but like the saying about pornography, you know it when you see it," Ferrara said.

The National Economic Research Association reports that an average of 56% of all class actions contain such allegations. "Once the suits get through, what the plaintiffs bar looks for in damages is a lot more severe," Keogh said. Plaintiffs attorneys turned to forensic accountants and contacted former employees to shore up their cases. "Corporations and insurers underestimated the tenacity of the plaintiffs bar. They didn't turn to family law or lure making [after the Reform Act]. They invested in the process," Ferrara said.

Numbers Game

In order to meet the higher pleading standard, many experts believe the plaintiffs bar has turned to allegations of accounting irregularities. But the accounting industry's increasingly lowered image is helping plaintiffs lawyers make their cases.

Misleading accounting was the pet cause of outgoing Securities and Exchange Commission Chairman Arthur Levitt. On several occasions over the last four years, Levitt took the accounting profession to task for participating in a game of "nods and winks." He said earnings reports "reflect the desires of management rather than the underlying financial reporting of a company." The National Economic Research Association reports accounting irregularities spawn about 50% of all securities class-action suits-a 224% increase since 1995. Companies caught in the accounting irregularity headlights include Rite-Aid, Oxford Health and Cendant. Cendant's $100 million restatement resulted in a $3 billion cash settlement of a securities fraud allegation in 1998.

D & O insurers are well aware of the risks in accounting. "The SEC has made accounting practices an issue and is more critical of corporate America and its accounting cases than ever before. The corporations are under pressure to meet Wall Street expectations and some have taken aggressive approaches to get the numbers This can lead to a problem," Keogh said.

William Lerach of Milberg, Weiss, Bershad, Hynes & Lerach, reported in a paper, "An Alarming Decline in the Quality of Financial Reporting," that the increase in fraudulent accounting can be pinned on the influx of initial public offerings and the change in executive compensation to cash bonuses and stock options based on earnings targets. "It's not hard to see the temptation to manipulate reported results to meet internal targets and investor expectations under these circumstances--especially when the efficient market will savage the stock for the slightest earnings disappointment," Lerach wrote.

To protect their clients against impending D & O claims, insurers claim they're stepping up communication and offering risk-management seminars. AIG is focusing on educating its D & O clients by offering corporate governance and accounting irregularity seminars. "We want our clients to understand what it means and how to communicate when its stock goes down or there is an earnings restatement," Keogh said.

Chubb's Galban likes to offer a personal touch in dealing with policyholders. "I believe in meeting with the customers because the qualities in management set the tone for the company." He also sees a difference between today's management and that of five years ago. "There's a certain giddiness or lightheadedness about what they can accomplish because they have enjoyed years of success. Today's management is less seasoned than five years ago and more ambitious. Whenever there is a boom market, people tend to misbehave."

                        Market Share for Primary
                           D&O Insurers--U.S.
                        The D&O business is very
                         concentrated -- 85% by
                         the top 10 companies.
Rank  Insurer                     Percent
 1    AIG                          32.7
 2    Chubb                        19.1
 3    Lloyd's                      12.5
 4    Aegis                         4.5
 5    Genesis (PRMS)                3.1
 6    Hartford                      3.1
 7    Great American                2.6
 8    Admiral                       2.4
 9    Special Program Management    2.4
10    CNA                           2.3
11    X.L. Insurance                2.0
12    Zurich                        1.8
13    Old Republic                  0.9
14    St. Paul                      0.7
15    Gulf Insurance                0.7
16    Coda                          0.6
17    Royal & SunAlliance           0.4
18    Fidelity & Deposit            0.4
19    United Educators              0.3
20    Fireman's Fund                0.3
21    Clarendon                     0.3
22    TIG Insurance                 0.3
23    Rock River                    0.2
24    General Star                  0.2
25    Cincinnati Insurance          0.2
26    Swiss Re                      0.1
27    Philadelphia Insurance        0.1
28    Travelers                     0.1
29    Legion                        0.0
30    Generali                      0.0
-     Other [*]                     5.7
      Total                       100.0

Policy counts and premium volume are based on a nonrandom sample of 1,878 organizations, including some with quota-share arrangements resulting in addition of "primary policies."

(*.)Represents all carriers with two accounts or fewer, including the following with two accounts: Ace, Federated Rural Electric, Northland, Ohio Hospital Insurance and Shand Morahan.

Source: Tillinghast-Towers Perrin

                      Federal Litigation Box Score
                The higher pleading standard and greater
                     amount of case dismissals have
                 done little to decrease the number of
               securities federal class-action lawsuits.
                      (Dec. 22,1995-April 10,2001)
                       1996  1997  1998  1999  2000  2001  1996-01
Federal class actions   110   179   234   206   195    45      961
Source: Stanford University Securities
class Action clearinghouse

Advice from the Plaintiffs Bar

Melvyn I. Weiss is a founding member of the law firm Milberg, Weiss, Bershad, Hynes & Lerach LLP, which is considered the top practice focused on class-action litigation in the United States. The firm has more than 170 attorneys and offices in six cities, Currently, Milberg, Weiss has about 97 recently filed federal securities class actions and boasts recovering $20 billion in aggregate from these types of suits. Weiss was involved in several cases concerning insurance companies, including Executive Life Insurance Company of America; the Prudential Limited Partnership litigation ($110 million was recovered); New York Life Insurance Policyholder litigation (recovered more than $300 million); and Prudential Life Insurance Policyholder litigation (recovered more than $2 billion).

Directors and officers insurers and corporations were looking to the Private Securities Litigation Reform Act of 1995 to reduce the number of securities class-action lawsuits and their settlement size. But that hasn't happened. In 2000, there were 195 securities class-action lawsuits filed, a 77% increase over the 110 in 1996, according to Stanford University School of Law's Securities Class Action Clearinghouse. Weiss attributes the state of securities class-action lawsuits to the act's heightened pleading standard and said the plaintiffs bar plans to overcome that hurdle. He discussed other ramifications of the act and the current environment for class-action securities lawsuits in a recent interview with Best's Review.

Q: What effect did the Private Securities Litigation Reform Act of 1995 have on the number of class-action securities litigation suits you have filed since 1995? How well has it accomplished its objectives?

The objective of the PSLRA depends on whose perspective you are using. Corporate America wanted it to cut the number of cases. Certain institutional investors wanted to increase the quality of them or the process by which they were run and managed. I would say the number of cases fried has been cut, because there should have been a lot more cases filed, given the amount of fraud and market manipulation that's been going on. So, even though in absolute numbers they are about the same or somewhat larger in number, there are a lot less than would have been brought, given the market conditions, had the PSLRA not been enacted.

[The act] made the pleading standards more difficult. You had to allege the basis for your action with much more detail. Given that victims of this kind of wrongdoing are remote from the wrongs that victimized them, it's very, very difficult to get the kind of detail together that the new act requires. So, that has caused firms like mine to spend a lot more money investigating the cases before we start them. It also gave a safe harbor for forward-looking statements, so companies can get away with a lot more rinky-dink than they had in the past by merely characterizing these statements as forward-looking and putting themselves within the purview of protection that way. Unless you can prove it's a misstatement of a current fact, you can't be sued on it.

Q: The number of cases is slightly decreasing--up from 1996 but down from the 234 cases filed in 1998, according to Stanford University School of Law's Securities Class Action Clearinghouse--but the size of settlements in the cases is rising. What's your take on that fact?

Numbers are decreasing, but it doesn't mean it's less than the number of cases that were fought in 1994. The settlements across the board are significantly higher than they have been prior to the PSLRA, because we're doing a lot more investigations. Since there are a lot more cases being dismissed than before, the ones that survive are by definition the strongest cases. We are making sure that they pay the proper settlement amounts in those cases, because in order for us to survive as contingency lawyers, we have to maintain a revenue stream to attract the best young lawyers to our organization.

We typically litigate the better cases longer, because, under the PSLRA, the defendants, as soon as they make a motion to dismiss the action, have an automatic stay of discovery. That delays the outcome of litigation, so the cases tend to last a lot longer, and we are getting significantly bigger recoveries. In addition, we are finding a lot of these wrongs are monumental in scope, like Cendant and Waste Management. The number of hundred-million-plus settlements has increased substantially and, unfortunately, what I'm finding is that more and more first-line companies are getting involved in wrongdoing. It used to be a lot of the cases were against peripheral companies. Now you're getting big companies like Cendant, Lucent and Xerox being sued with substantial claims of wrongdoing. I think the Wall Street environment--if you miss your targets by even a penny--can be brutally penalizing in terms of the price of your stock and puts a tremendous amount of pressure on management and the people under it to make su re the earnings estimates are met. And they are doing it in a lot of different ways. They are doing it by falsifying transactions, by not writing off bad assets like inventories or accounts receivables, by creating artificial sales and premature recognition of income. The accounting profession, which I have always criticized as being inadequate as the watchdog, has now shrunk into only five firms, and therefore, the competition for clients has decreased. Competition creates, in my view, a greater challenge to do a good job, but when you have very few auditing firms to select from of that size, the companies can't really do quality checks, because most of the time these auditing firms are conflicted because they represent competitors or the like.

Q: Insurers characterize the plaintiffs bar as being "resourceful" and being to find new ways to win cases. How do you respond to that?

Thanks for the compliment. I think it's true. One of the things that Milberg, Weiss set out to do from the beginning--and since I'm a founder, I know it to be true--is to create a litigation force for the victims that is at least comparable to the Wall Street law firms that big corporations can hire. We've succeeded. If you take a look at the makeup of our firm, you'll see that we have lawyers that come from judicial clerkships, that come from top law schools, from big law firms who decided after two or three years...they wanted to come into this end of the practice. So, we built a capability to prosecute these cases with a great professional skill, and we also are aggressive. We didn't decide to stay in a cocoon atmosphere. When you represent victims, you begin to really start feeling their pain, and it spurs you to do better things.

Q: D&O insurers initially cut rates and offered broader coverage to policyholders after the PSLRA passed in hopes that the number of cases and amount of settlements would lessen. Now that the settlements are still high, they are offering one-year contracts, less broad coverage, requests for policyholders to coinsure and higher rates to policyholders. How will this more conservative approach affect prospective lawsuits?

It never has, but it's going to make the prosecution of these cases more difficult, because the other side has already advertised to us that they are going to get tougher in the defense and they are going to bring more cases to trial, which means we are going to have to spend more resources to get the results. So the risk is greater, the cost is greater, and we have to punish the other side for putting our clients through that by getting even bigger recoveries when we succeed. I'm sure we're going to lose some, because that's the risk of litigation, but when we win we have to make sure that they recognize they will have to pay big time.

Q: Do you see the current volatile stock market as fodder for future class-action securities suits?

Yes, because more and more people are becoming dismayed at what they've seen. You're beginning to see people coming forward from within the bowels of the companies who didn't like what was going on. The accountants, who were so compliant for the last six or seven years, are going to feel more pressure to get it right and bring out the cover-ups of the past. When we start a lawsuit now, you can't believe how many people come out of the Internet to come to our Web site or go into the chat rooms. You hear all kinds of conversations that are rather startling.

Q: What advice would you like to give D&O insurers?

The directors have to really get their act together and provide more oversight and not just let the strong-willed CEO get his or her way. The audit committee has to be truly functioning and really skeptical in the way it approaches its job. And I know the institutional environment they work in is difficult, because it becomes sort of collegial and social, and there are a lot of great benefits being there, because you live very well as a director of these companies. The management really has to start setting up a network where people within the organization who feel uncomfortable about what's going on have an outlet to come forward so they can talk about it, so big problems can be avoided. As I said to a group of management people and lawyers in a settlement discussion recently, you know it's not only what you say, but how you say it that creates the environment. You can use a budget as a mere checkpoint to judge performance to do better next time, or you can use a budget as a whip, as a weapon to instruct th e people under you that you better achieve these numbers or else you're in trouble. If you do it the latter way, you are going to get into a lot of trouble.

Q: A recent article in Business Week said plaintiffs lawyers finally have the upper hand in America's courtrooms. Do you agree or disagree, and why?

No way. It totally ignores the political environment that we are in. We are in a very conservative political and judicial environment. Even under the Clinton years, the judges in the federal courts had to be approved by a Senate that was dominated by the Republicans. Corporate America, the Chamber of Commerce and the Republicans have done a very good job of demonizing the plaintiffs bar. There is a lot of bad publicity because of the tobacco fees, and the judges are chopping fees all over the country, making it much more difficult to finance these cases. Many more cases are being dismissed by judges who don't think the pleading standards are being met, because they have an aversion against class actions. Congress is trying to federalize all class actions, or the Republicans are. So, we're in a very tough environment.