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Preparing for changes in the D & O insurance market.

Last year will probably be recalled as one of relative stability in the directors' and officers' liability insurance market. However, trends clearly show the beginning of a market adjustment. How will market changes impact companies? How can risk managers counteract these adverse market movements?

As is true in all businesses, the prices charged by insurance companies will ultimately be driven by costs. Analysis of 852 lawsuits brought against directors and officers of 11442 organizations participating in the 1990 Wyatt Directors & Officers Liability Survey shows that the overall frequency of claims is increasing at a compound annual rate of about 10 percent. Many claims that were of minimal concern in yesterday's benign economic period have or will become serious as the business environment continues to deteriorate. Underwriters will continue to make adjustments 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 company profile. 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. Today's insurance market is much more sensitive to such trends than in the past.

Significant changes have occurred in the types of claims. 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. While a reduction in the incidence of merger and acquisition claims was recorded in the 1990 survey, the decrease was 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 merger and acquisition claims, such as divestitures and other restructurings due to prior acquisitions, as well as the lingering effect of the surge in corporate debt.

Corporations need to understand D&O claim patterns 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 increases that many insurers are seeking to impose. Analysis of probable claim circumstances is also required to anticipate and respond to underwriting concerns.

D&O loss prevention can help decrease the likelihood and/or cost of claims. During the past year, Wyatt has been studying the relationship among claims and such characteristics as number of board members, proportion of independent outside directors, long-term compensation plans and corporate domicile. There is proof that certain type of loss prevention will reduce liability risks. For instance, Wyatt survey participants with 25 member boards have been more susceptible to claims against their directors and officer than corporations with 15 member boards.

If the company appears to be vulnerable a particular type of claim, insurance underwriters should be told what actions have been taken to minimize the risk. Communicating loss prevention steps will go a long way in strengthening your position with insurers that are interested in a long-term relationship.

Structuring Your Program

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

In the 1990 survey, 5 percent of claims payments were in excess of $5 million, and about 1 percent were in excess of $20 million. Other sources have disclosed that over the past five years, about three dozen court cases ended with awards or settlements greater than $10 million. A review of available information on the claims payments and case facts should be made to evaluate the probability that a loss will exceed a given level.

As is true of claims frequency, claims severity varies by claim type and corporate characteristics.

The magnitude of claims does not vary substantially for corporations with more than $100 million in assets. All 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 the number of shareholders, financial performance and business activity greatly influence claim magnitude. Statistical analysis of claims relationships using these and other variables are useful in adjusting coverate limits to your company's circumstances. A point of reference used by many companies is the insurance purchasing practices of similar organizations. Both averages and the position of a company relative to its peers should be examined. For illustration, consider a publicly traded durable goods manufacturer with about $1 billion in assets and no after-tax losses during the last five years that is involved in a merger. If this company purchased $35 million in D&O insurance, it would have as much, if not more, coverage than three-quarters of its peers.

Since the advent of the D&O insurance crisis in late 1984, the number of coverage exclusions has increased. In deciding which coverage exclusions to accept or reject, consider how many dollars may be at stake for individual executives and the corporation if an excluded claim materializes. Legislation enacted in most states during the last four years expands the power of the corporation to indemnify directors and officers. Increasing use of these statutes has shifted the financial burden for more claims from the directors and officers to the corporation. The 1990 Wyatt survey showed a slightly more than 10 percent increase in the number of claims covered by corporate indemnification. 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 insurance coverage reimbursing the corporation for indemnities paid on behalf of executives or eliminating corporate reimbursement coverage altogether. However, do not accept a small premium concession for a large deductible increase without quantifying the costs and benefits. Deductibles related to claims not subject to corporate indemnification should be low because the individual directors and officers are responsible for such amounts.

There is no standard D&O insurance policy. Each insurance company uses a unique set of forms which 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.

Examine Your Alternatives

Corporate indemnification, while helpful, is of little value when the corporation becomes insolvent, is prohibited from indemnifying or simply refuses to indemnify as a matter of discretion. As a result, liability insurance is one of the most effective ways to cover D&O losses. However, other mechanisms are available to complement or replace commercial insurance.

Since 1986, strong competition to commercial insurance companies has come from policyholder-formed insurers domiciled in Bermuda, Vermont and elsewhere. Collectively, they write about one-fifth of all D&O premiums. Many of these companies are well capitalized and have loyal policyholders, including in the case of ACE, CODA and X.L. about half of the Fortune 500 companies.

Many states now also sanction the use of such financing arrangements as trusteed or other indemnity funds and captives. Legal and financial experts should evaluate each option in terms of their effectiveness and costs.

A growing number of companies are using a combination of insurance and other devices to fund possible D&O losses. In general, these companies also have sophisticated risk financing arrangements for such exposures as products liability and workers' compensation. The integration of D&O into corporate financing programs is logical because, absent conventional insurance, it is the corporation that pays in most cases. About 78 percent of the reported claims target the corporation as well as the directors and/or officers.

Claims Not Covered

Captives and other vehicles are being used to fund loss exposures up to the D&O insurance deductible. Another need being met is protecting directors and officers against claims not covered by commercial insurance due to policy exclusions or other limitations. For example, D&O 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. Properly structured, a risk financing plan can provide assurance that funds will be available to pay D&O claims that may not be known until many years after the alleged wrongful act.

The general principles that should be applied- in funding a risk financing program are the same for D&O as other casualty exposures. The assets of the plan should be maintained at a level which is prudent in relation to expected losses. Initial contributions should be pointed toward funding the coverage limit within a few years. Adjustments to the fund should be made in line with changes in exposure and claims experience.

Today's D&O insurance market differs from the early markets in one respect: Insurance consumers have access to alternatives. Long-term D&O underwriters are not likely to overreact as they did from 1984 to 1987 because many consumers would respond by abandoning the commercial insurance market. Kenneth S. Wollner, J.D., is a consultant in the Chicago office of The Wyatt Co. This article is based on Wyatt's 1990 Directors & Officers Liability Survey, which was endorsed by the RIMS Research Committee and In which RIMS members participated.
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Title Annotation:directors' and officers' liability insurance
Author:Wollner, Kenneth S.
Publication:Risk Management
Date:Mar 1, 1991
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