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D&O insurance: not buyer friendly.

D&O Insurance: Not Buyer Friendly

Corporate executives face increasing exposure to costly litigation about the quality of their performance. Corporations must protect their key managers from unwarranted personal liability threats. Directors and officers must take note of their exposure and move to cover their flanks.

Since the early 1970s, directors and officers liability coverage has been a fixture in the insurance portfolio of most large corporations. But, while the demand for such insurance has been consistent, the supply of insurance has not been stable. The most severe insurance market contraction occurred between 1984 and 1987.

Another shift in insurance market conditions has taken hold - again, a shift away from a buyer-friendly market. Throughout 1990, increases in premium have been the rule. Trends clearly point to more difficulty for insurance consumers.

How will the insurance market changes impact your company? And what steps can be taken to counteract adverse insurance market movements? These questions will be addressed in the following advisory.

Your Exposure Profile

As is true of any business, the prices charged by insurance companies will ultimately be driven by costs. Analysis of the 852 lawsuits brought against directors and officers of the 1,442 organizations participating in the 1990 Wyatt Directors and Officers Liability Survey shows that the overall frequency of claims is increasing at a compounded annual rate of 10%. Many claims that were of minimal concern in yesterday's benign economic period have, or will, become serious as the business environment deteriorates. Underwriters will continue to adjust by increasing premiums, restricting coverage, and eliminating unprofitable business.

The impact of the insurance market shift will be selective because loss trends vary appreciably by characteristics of the company. For example, while growth in claims has been severe for banks and other highly regulated companies, there has been a leveling off of claims against directors and officers of small and private corporations.

Significant changes have occurred in the types of claims being asserted. The 1987, 1988, and 1989 Wyatt survey participants reported that about one-third of the claims brought by shareholders involved tender offer, merger, or acquisition activity. A reduction in the incidence of merger and acquisition claims was recorded in the 1990 Wyatt survey.

But the decrease has been more than offset by challenges to divestiture decisions, adoption of takeover defense measures, proxy solicitations, and security repurchases. The data support the notion that most of the increase in frequency is due to second-generation M&A claims (i.e., lawsuits from divestitures made necessary by a prior merger) as well as the lingering effect of the surge in corporate debt.

Corporations need to understand D&O liability claim patterns in order to effectively negotiate insurance coverage terms and conditions. A corporation that is not highly leveraged, and does not fit the second-generation M&A claim profile, may have a strong case for an exception from across-the-board premium rate increases that many insurers are seeking to impose today. Analysis of probable claim circumstances is also required to anticipate and respond to underwriting concerns. Too often underwriting decisions are made without the benefit of such information.

D&O liability loss prevention can help decrease the likelihood and/or cost of claims. During the past year, Wyatt has been studying the relationship between claims and such characteristics as number of board members, proportion of independent outside directors, long-term executive compensation plans, and domicile. There is objective proof that certain types of loss prevention will reduce liability risk.

Structuring Your Program

The upper exposure limit of D&O liability is uncertain in our volatile legal environment. Determining the right amount of coverage for your directors and officers must be based on subjective and objective analysis. The objective criteria include actual claim magnitudes and the coverage limit selections of similar companies.

Information is available on about four dozen cases in which the award or settlement exceeded $10 million. Review the fact patterns of these cases in relation to your circumstances. Statistical estimates may be made of the probability that payments will exceed a given level for reasons other than insolvency. Five percent of the closed claims captured in the 1990 survey involved payments in excess of $5 million. About 1% of the closed claims were disposed of for an amount in excess of $20 million.

As is true of claim frequency, claim severity varies by type of claim and the characteristics of the corporation. It is interesting to note in this regard that above a threshold of about $100 million in assets, the magnitude of any given claim is not substantially affected by the size of the corporation. The datum implies that, all other things being equal, coverage limits required by a corporation with $500 million in assets and a corporation with $5 billion in assets are about the same.

On the other hand, such factors as number of shareholders, financial performance, and business activity have a great deal to do with claim magnitude. Statistical analysis of claim relationships by these and other variables is useful in adjusting coverage limits to the circumstances of your company.

Since the advent of the D&O liability insurance crisis in late 1984, the number of coverage exclusions has increased. In deciding which coverage exclusions to accept or reject among insurance proposals, consider how many dollars may be at stake for individual executives and the corporation in the event an excluded claim materializes.

Legislation enacted during the past four years, in most states, expands the power of the corporation to indemnify directors and officers. Increasing use of these statutory provisions has shifted the financial burden, for more claims, from the directors and officers to the corporation. About 67% of the claims captured in the 1990 Wyatt survey were reported to be covered by corporate indemnification, up from 63% in the 1989 survey. A corporation that can comfortably withstand the indemnity loss may determine that the cost of eliminating the exclusion is not worthwhile.

Consider increasing deductibles on the portion of the insurance coverage reimbursing the corporation for indemnities paid on behalf of executives, or eliminating corporate reimbursement coverage altogether. But don't be too quick or accept a small premium concession for a large deductible increase. Like any other decision, the costs and benefits should be quantified.

There is no standard D&O liability insurance policy. Each insurance company uses a unique set of forms that can vary appreciably in coverage. Insurance policy terms and conditions should be carefully reviewed in relation to your circumstances. The time for such review is before a coverage dispute arises.

Examine Your Alternatives

A growing number of companies are using a combination of insurance and other devices to fund possible D&O liability losses. In general, these companies also have sophisticated risk-financing arrangements for such exposures as product liability and worker's compensation. The integration of D&O liability into corporate financing programs is logical since, absent conventional insurance, it is the corporation that pays in most cases. As noted earlier, about 67% of the claims asserted against directors and officers are covered by corporate indemnification. About 75% of the reported claims also target the corporation.

Captives and other vehicles are being used to fund loss exposures up to the D&O liability insurance deductible. Another need being met is protecting directors and officers from claims not covered by commercial insurance due to policy exclusions or other limitations. For example, D&O liability insurance generally does not cover claims made after the policy period, even though the alleged wrongful act may have taken place during the policy period. When properly structured, a risk-financing plan can provide assurance that funds will be available to pay D&O liability claims that may not be known or knowable until many years after the alleged wrongful act.

Today's D&O liability insurance market differs from the early markets in one fundamental respect: Insurance consumers have access to alternatives. Long-term commercial insurance company players are not likely to overreact as they did in the 1984-to-1987 period because many insurance consumers will respond by abandoning the commercial insurance market.

No single action will provide absolute protection. But, a combination of effective use of state exoneration statutes, broad corporate indemnification, loss prevention programs, insurance, and other financing arrangements will eliminate a substantial portion of the risk to directors and officers.

Table : D&O Insurance: Market Share Leaders*
 By Premium By Policy
 Volume Count
AIG 38% 28%
Chubb 19 29
Aegis 14 5
London 8 5
Aetna 5 4
CNA 3 7


*For primary insurance layers Source: The 1990 Wyatt Directors and Officers Liability Survey
COPYRIGHT 1991 Directors and Boards
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

Article Details
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Title Annotation:Chairman's Agenda: Balancing Shareholder Interests; Directors and Officers
Author:Wollner, Kenneth S.
Publication:Directors & Boards
Article Type:column
Date:Mar 22, 1991
Words:1422
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