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Yesterday's losses predict tomorrow's D&O market.

Yesterday's Losses Predict Tomorrow's D&O Market

Fundamental changes have taken place in the directors and officers liability insurance marketplace during recent years. From late 1984 through 1987, U.S. corporations, on average, witnessed their directors and officers insurance premiums increase more than tenfold. Even more traumatic was the reduction in policy limits and substantive coverage they experienced and the fact that many corporations were unable to obtain any D&O coverage.

Inaccurate assessments of D&O liability exposures was a major reason for the insurance marketplace adjustments. By analyzing claims data, however, risk managers can clearly see the relationship between D&O insurance underwriting and exposure characteristics to avoid such assessment pitfalls. The analysis also can show what risk managers may expect from the commercial insurance market independent of market cycles or other short-term phenomena.

Claim Frequency

As can be seen from D&O surveys by The Wyatt Company starting in 1973, the surge in claims against directors and officers is a long-term trend. In the company's 1978 survey, the 1,759 companies which participated reported 330 claims made against their directors and officers during 1969 through 1977. In the latest survey, which was conducted between June and August 1988, 1,708 respondents reported 759 claims made during 1979 through 1987. Thus, the frequency of claims made against directors and officers of the survey participants has more than doubled from 19 percent in 1978 to 44 percent in 1988.

The rate of increase in D&O claims has varied little. The rise in claim frequency since 1973 has ranged between 8 percent and 15 percent per year. While the growth in claim frequency contributes to instability in D&O loss experience, the relative consistency in the rise of claims detracts from the argument that the sheer number of D&O suits accounts for the insurance crisis. A greater number of losses improves the distribution or "spread of risk," thereby setting the stage for more accurate projection of loss costs. Conventionally, the expectation is for insurers, unrestricted by external regulation, to react to changes in claim frequency by adjusting prices.

Claim Sources

Tracing of the history of D&O insurance supports the view that uncertainty in exposure assessment is due partially to the rapid introduction of new sources of claims.

Although D&O insurance has existed for about 50 years, the coverage remained uncultivated until the late 1960s. Two major developments were the catalysts for the demand for D&O insurance. First, many states, Delaware being the first, enacted statutes that not only authorized the purchase of insurance by corporations, but also permitted the insurance protection to extend beyond the corporation's power to indemnify its directors and officers. Second, several federal court decisions at the time imposed strict and precise rules regarding the relationship between corporate management and the growing number of public shareholders.

By the time D&O insurance became a fixture in corporate risk management, the trend to expand the scope of the federal securities laws was reversed. The most important of these decisions held that scienter--intent to deceive, manipulate or defraud--was required to establish liability under Section 10 (b), the broad anti-fraud provision of the Securities Exchange Act of 1934.

Experts were correct in predicting a wave of claims, but those which have occurred have come from unexpected and disparate sources or involved issues not considered significant when D&O insurance policies were first drafted by underwriters. Applying the broad language of conventional D&O policies added new perils within the insurance policy coverage.

The variety of claims filed against directors and officers shows the rapid pace of innovation in D&O liability. In the 1988 survey, 759 claims were sorted into 42 possible issues grouped for five claimant categories. Claims were reported for all but three of the 42 possible cells, which included 158 claims that could not be categorized.

The results showed that shareholders are the largest source of claims against directors and officers, ranging from a low of 38 percent in the 1982 survey to 47 percent in the 1988 survey (see Table 1). Another example of the uncertainty faced by directors and officers is the shift in sources of claims asserted by parties other than shareholders. Claims by current and former employees increased almost twice as fast as other sources of claims against directors and officers, from 12 percent of the claims reported in the 1976 survey to 21 percent in the 1988 survey. Moreover, employment-related claims are rising at an explosive rate. While the frequency and severity of other third-party claims have increased in absolute terms, the rate of growth for claims brought by current and former employees is higher than other third-party liability claims.

Claimants by type of business also shows the degree of variability in D&O exposure characteristics. Today, shareholder suits are the dominant source of claims against directors and officers of petroleum, manufacturing and merchandising concerns; they account for more than half the number of claims and more than two-thirds of the dollars paid on closed claims. On the other hand, the same businesses reported less than average frequency of claims brought by employees and former employees. Customers represent a major source of claims against directors and officers of financial service organizations, including insurance companies. Customer suits, however, occur relatively infrequently in other industries.

Claim Circumstances

The matter of directors and officers liability depends on the interpretation by the courts of such unprecise terms as "negligence," "good faith," "reasonably believed to be in the best interests of the corporation," "intentional misconduct or recklessness." These are such terms which purport to differentiate standards of permissible conduct. Since content of these terms is influenced by the circumstances of each case, D&O exposures are shaped not only by doctrinal trends in the law but also by dynamic economic and other global forces.

A main cause of the claims explosion against directors and officers is novel circumstances. During the 1980s, merger activity and business failures in certain industries and regions around the country triggered much of the litigation.

From 1979 to 1987, American corporations underwent an unprecedented wave of mergers, acquisitions and divestitures, as new financing techniques left no public corporation too big for a takeover. Such corporate reorganizations present a particularly dangerous development because of inherent conflicts of interest faced by boards of directors. As the Delaware Supreme Court observed in Smith v. Van Gorkom, a highly publicized decision growing out of board approval of a merger proposal: "It is, of course, a fact of corporate life that today when faced with difficult and sensitive issues, directors often are subject to suit irrespective of the decisions they make."

The 1988 survey findings are consistent with the view expressed by the Delaware Supreme Court. About two-thirds of the participants were involved in some type of merger, acquisition or divestiture activity during the prior five years. Of those involved in such transactions, about one out of four reported claims against their directors or officers. Only one out of eight companies not involved in mergers, acquisitions or divestitures reported one or more claims.

Comparing the description of shareholder claims in 1988 with past surveys confirms that the merger boom is a major cause of D&O suits. In the 1988 survey, public offering and financial reporting issues not attendant to a tender offer, acquisition or merger, ranked surprisingly low in terms of percentage of shareholder claims: 14 percent for financial reporting and 5 percent for stock offering. On the other hand, the issue identified by participants in 39 percent of the shareholder claims was tender offer, acquisition or merger activity.

Whereas in past surveys, the frequency of financial reporting and stock offering claims exceeded tender offer, acquisition and merger claims. These findings are all the more remarkable in light of the flurry of public offerings not related to mergers and acquisitions during 1979 to 1987, prompted by the strong stock market and high interest rates for most of this period.

The potential for accumulating losses arising from a common circumstance is another dimension of D&O underwriting, particularly for insurers who apply a "niche" underwriting strategy. An example would be segmentation into the financial services or energy industries. The concentration of business failures among oil companies and financial institutions with a high proportion of energy loans in their portfolios is the largest circumstance giving rise to D&O losses in excess of $10 million.

Claim Severity

Until 1984, the largest D&O paid claim had been slightly more than $13 million. Since that time, at least 25 judgments or settlements in excess of $10 million have been identified, not including defenses costs. Judgments and settlements exceeding $30 million are not uncommon today, and with the return of coverage limits capacity to the D&O insurance market, it may be only a matter of time until underwriters are called upon to pay claims in excess of $100 million.

The cost of the average claim reported in the Wyatt surveys has reached proportions that in other lines of insurance would be described as shock losses. The average total claim cost (third-party indemnity and defense) for all claims reported in the 1988 survey (claims-made in 1979 to 1987, including claims not involving payment to the claimant) is estimated at $1,848,000. The projected average defense cost for reported claims by survey year (untrended) is 1974, $182,000; 1976, $206,000; 1978, $278,000; 1980, $318,000; 1982, $365,000; 1984, $461,000; 1986, $592,000; and 1988, $693,000.

The risk for directors and officers is further magnified by the substantial period of time that typically occurs between the claim and its disposition, either through judgment or settlement. About one-third of the claims reported in the 1988 survey were still open at least three years after the year they were filed. The average time lag from claim until disposition is 5.25 years, and it takes at least seven years before a book of D&O insurance business can be described as substantially mature for loss evaluation purposes.

Thus, with meaningful loss data emerging only after many years, underwriters cannot make timely and accurate adjustments to loss trends. Timely data is necessary to properly respond to rapid changes in D&O exposure characteristics, and its unavailability is the most significant risk inherent in D&O insurance for carriers and purchasers alike.

Role of D&O Insurance

Public corporations are structured to transfer most business risk to security holders, who presumably are in the best position to efficiently distribute risk among capital markets. Directors & officers liability has the effect of shifting the burden of adverse outcomes immediately to professional managers, and in most cases, through application of corporate indemnification to the corporation as well.

D&O insurance is another medium through which exposure to loss can be financed. Insurance companies and brokers promote D&O coverage in large part for the perception that it provides corporations and corporate management with a broad level of comfort. This perception has been reinforced by the policy wordings. Consequently, stage was set for an expansive definition of the role of D&O insurance in corporate risk transfer.

The availability of D&O insurance as a corporate asset or safety net has become prominent in the last few years. Examples of this development are actions taken by Chase Manhattan, Bank of America, Seafirst Corporation and other banks directly against their officers and directors. In the financial services sector, federal regulatory authorities have accessed D&O insurance to recoup FDIC and FSLIC insured losses. More and more of today's D&O litigation focuses on separation of management from the risk-bearing functions of the public corporation. The stake in the litigation is frequently the proceeds of D&O insurance.

The 1988 survey participants reported that two-thirds of the claims made against their directors and officers were covered by insurance. In the 1987 survey, restrictions imposed by underwriters in the amount and scope of coverage were documented. All major D&O insurance underwriters have revised their coverage forms to preclude what they consider abuses of D&O insurance. [Tabular Data Omitted]

Kenneth S. Wollner is a risk management consultant in the Chicago office of The Wyatt Company.
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Title Annotation:directors and officers liability insurance
Author:Wollner, Kenneth S.
Publication:Risk Management
Date:Feb 1, 1989
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