Working with a Net

For many banks, the market for directors and officers liability insurance has entered a period of relative calm: Pricing has leveled off; some banks have even reported premium decreases. Concurrently, insurers are giving back some of the benefits they took away in recent years. But these tranquil waters may be deceiving.

Settlement amounts for securities class-action suits continue to rise; many big banks still face premium hikes; and some insurers and brokers are enduring a rash of investigations and litigation themselves. “You’d better get what you can get while you can,” warns Dan Bailey, an attorney at Bailey Cavalieri in Columbus, Ohio. “Be prepared for some additional pain in the not-too-distant future.”

Bailey is alluding to the fact that while premiums have stabilized and policyholders have found some wiggle room at the bargaining table, these tendencies could be short-lived given the increasing severity of securities action lawsuits that trigger D&O claims. Add to that an insurance industry itself under siege, with issues ranging from alleged price fixing and collusion to securities class actions.

To be sure, some banks have had no respite in price increases. Banks with $1 billion or more in assets paid a median premium of $278,000 in 2004, up from $174,000 the year before, according to a recent survey of 29 banks by the Tillinghast business of Towers Perrin, a New York consulting firm. Those numbers were skewed by the bigger banks, which tend to pay relatively higher premiums because they carry multiple business lines that are more complex and increase the risk of D&O claims. Furthermore, median limits for this group of banks dropped to $15 million, down from $25 million.

The good news is that smaller banks had much more stable premiums in 2004, a mirror of other industries that have seen prices level off or drop. In fact, some banks have seen decreases. Among banks that have not had specific risk issues such as big securities claims or governmental investigations, renewals pricing declined 20%, says Eric Anderson, a managing director at the financial services group of Aon Corp., a Chicago-based insurance broker.

“If you look at ’04, it was a client base looking to get money back,” Anderson says. “Those that had not been sued had a clean record, good corporate governanceu00e2u20ac”they were negotiating hard to get a premium decrease. And, generally, they were successful.”

New entrants into the market have helped stabilize premiums by creating increased capacity. These new players also tend to provide insurance for excess coverageu00e2u20ac”that is, the additional layers needed from other carriers that allows a large company to reach its desired limits.

Watch Your Step

Yet despite the stabilization of rates for many institutions, bank boards still need to be ready for another possible spike in rates and restrictions on coverage. While the number of securities class-action lawsuits filed has declined in recent years, their severity has actually increased. A federal judge in November approved a $2.6 billion settlement of a securities class-action lawsuit by Worldcom investors who claimed they were defrauded by Citigroup. The settlement was the second-largest ever, behind a settlement between Cendant and its investors of $3.5 billion. A $494 million settlement between investors and Bank of America Corp. ranks fourth for all time.

Banks were second only to educational institutions in the number of D&O claims in 2004, with 38% of respondents reporting at least one D&O claim last year, according to Tillinghast. Among its survey of 2,400 companies overall, securities class-action suits were the number-one source of D&O claims for public companies. As a result, financial institutions have not experienced the level of discounts to premiums found in other industries. “They are bucking the trend,” says Elissa Sirovatka, D&O survey program leader at Tillinghast.

Many expect the trend of big settlements to continue. “The premiums have leveled off,” Bailey says, “yet the claim environment does not justify that result at all. The difference between the claim exposure and the pricing seems to be widening. Particularly, the severity of D&O claims seems to be escalating at a dramatic rate. We are not seeing the insurance market following that escalation.”

What may further complicate matters is the spate of litigation looming for insurance companies and brokers themselves. No company seems immune. Marsh & McLennan Cos. is being sued by New York Attorney General Eliot Spitzer, who accuses the world’s largest insurance broker of rigging bids and taking kickbacks. American International Group, the world’s largest insurer, has been accused of colluding with Marsh. AIG is also under investigation by the Justice Department over whether the company violated securities laws when it helped PNC Financial Services Group clean bad loans from its balance sheet. St. Paul Travelers Cos., another insurer, is facing a class-action suit for market practices, as is Aon. Other D&O insurers have been subpoenaed by several states about questionable market practices.

(Sources from companies involved in these investigations or lawsuits declined to comment on them for this article.)
How the troubles facing the insurance industry will affect coverage down the road is anyone’s guess. “It’s a unique twist,” says Craig Collins, a business development manager of the professional liability group at Progressive Corp., a D&O provider based in Mayfield Village, Ohio. “We’re not sure how it is going to play out. It’s something that we just didn’t consider.”

Still, banks in 2004 experienced a softer D&O market than in 2002 and 2003. Over time, the D&O insurance market has gone through cycles ranging from overcapacity and low prices to tight supply and high premiums. Insurers in the 1990s competed for market share, by lowering premiums and adding new features such as entity coverage. This was good news for banks, which saw premiums drop overall for five straight years in the 1990s.

Yet trouble may still lie ahead. Insurance companies collected $12 billion in premiums from 1996 through 2002, according to Bailey, the D&O attorney. During the same period, they paid about $32 billion in claims. The bubble burst when the string of financial scandals hit, including Enron and WorldCom. The aftermath of 9/11 also helped send premiums soaring. And the Sarbanes-Oxley Act, which gave new powers to the Securities and Exchange Commission and introduced criminal penalties such as felonies for securities fraud, contributed to rising prices. Prices rose as much as 50% a year for entire policies and 100% for A-side coverage, the layer of D&O insurance that protects the personal assets of directors and officers.

Insurance companies moved to lower limits, cut provisions, and tinker with wording in contracts to reduce their own risk. That included attempts to restrict severability clauses, provisions that say the facts, knowledge, or conduct of one insured cannot be used to deny coverage for another insured. And for the most part, carriers did away with three-year policies, reducing them to one year. “Banks were almost dictated the terms,” says Lou Ann Layton, global D&O practice leader for New York-based insurance broker Marsh Inc.

The leveling off in 2004 was caused in part because a half-dozen carriers have entered the D&O market over the last two years, according to Bailey. Lured by higher premiums, carriers such as Arch Insurance Group and Allied World Assurance Co. (AWAC) have begun offering D&O insurance, joining more established carriers such as AIG, Chubb, Ace, and Progressive.

Ripple Effect On Coverage

For now, the extra supply means better contracts for banks up-front. D&O insurance is usually structured in three layers. A-side coverage protects directors and officers when the corporation cannot indemnify them. B-side coverage is insurance for the corporation and covers a company’s responsibility to indemnify its directors and officers. C-side, also known as entity coverage, handles claims made directly against the corporation.

Layton notes that insurers have made concessions in areas such as severability and modifications to the language in the conduct exclusions. One big gain for some banks has been getting insurance companies to allow A-side coverage to be nonrescindable. In other words, in the event an application was misrepresented or there was fraud on the part of an officer, a carrier can move to rescind the B- and C-sides of a policy, but not the A-side. That allows the company to help protect the assets of innocent directors and officers.

Like many bigger financial institutions, First Horizon National Corp., a $28 billion bank based in Memphis, Tennessee, purchased at renewal a separate policy of A-side above and beyond its blended layer of A, B, and C. In doing so, First Horizon paid about the same premium for its D&O policy when it was renewed in August, but added a feature that makes the A-side nonrescindable, a clause it previously had to do without. The bottom line: While prices aren’t decreasing overall, some insurers have become more flexible in helping companies protect the personal assets of their board members.

“When it comes to the conduct exclusions such as fraud and personal profit, we have a lot of empathy for individuals who ostensibly would be hung out to dry,” says Tony Galban, senior vice president and product manager at Warren, New Jersey-based Chubb. “We have a lot less empathy of covering the company in these situations.”

Another issue that could affect premiums and coverage in the coming years is a pipeline filled with litigation. With premiums down as much as 50% in the excess layers of coverage, some traditional players see trouble brewing. Newer carriers tend to sell excess coverage to establish themselves before moving into offering the primary layer. “Why excess carriers are giving move discounts is inexplicable,” Galban says.

To be sure, given the recent turmoil in the D&O market and the prospect of more rough seas ahead, board members have done a better job educating themselves on the ins and outs of policy renewals. Still, directors must remain vigilant. Here are some things to consider:

Ask For It.

“These polices are generally quite negotiable,” Bailey says. “If you know what to ask for, you can get it.” Marsh’s Layton adds that insurers work within a certain bandwidth to set the charge for every million dollars of coverage: “At the high end are riskier institutions, and at the low end of that bandwidth are what underwriters perceive as better-run companies than others, and their rates reflect that.”

El Dorado Savings Bank, a $1.4 billion financial institution in Placerville, California, this year paid 14% less for its D&O policy by prepaying for a three-year agreement. While three-year policies are not the norm today, El Dorado has a few things in its favor, among them and foremost: its niche of low-risk residential loans. The bank is also closely held and boasts a seasoned management. Thomas Meuser, president and chief executive officer, has been with the bank for 35 years and its executives’ average tenure is 30 years. “We have a pretty low-risk profile,” Meuser says.

Contract Language.

In general, the wording in the agreement will decide whether a board member ultimately gets covered. “The quality of the coverage is very intricate and has to be airtight, especially when it is regarding the assets of the officers and directors,” Anderson says. “The language in the contracts is crucial as to whether the insurance company will be providing the indemnity or not. It can literally turn on a phrase.”

For large banks that rely on more than one carrier, all too often policyholders focus on language in the agreement with the primary insurer, making the assumption that the agreements with the excess carriers will be the same. That’s not the case. “You need to watch the excess insurers’ policy forms,” Anderson says. “They don’t necessary follow form. Most of the negotiation is spent on the language in the primary agreement. There’s a tendency not to pay attention [to the others].”


Experts warn that buyers of D&O must always make sure a policy has severability. The policy should be “severable” among those covered, meaning a separate policy is issued to each insured person. Carriers, to be sure, want a remedy to cover themselves in case they were lied to in the underwriting process. While only one or two officers may have perpotrated the lie, the other directors and officers are at risk of getting sued. In many cases, insurers are allowing policies to be severable on the A-side but not B- and C-sides.

Conduct Exclusions.

Directors need to carefully look at wording that would trigger conduct exclusions such as fraud, illegal profit, and dishonesty. Can the carrier invoke the exclusion before a judgment in an underlying claim? “In light of the high-profile cases, that’s a big issue right now,” Bailey says. In effect, boards need to make sure the policy will pay defense costs until it is adjudicated. Adds Murphy of First Horizon: “If you want to provide the best protection for your insured, you want the test to be that there would be some adjudication.” Avoid so-called “in-fact” wording. This allows the insurer to negotiate what it will pay if there is alleged fraud or dishonesty, making it harder for a director or officer to collect.

Purchasing Additional Coverage.

Banks may want to consider purchasing a separate layer of A-side coverage, a “tower” in industry parlance, above and beyond a typical ABC plan. Typically it’s the B-side or C-side that get triggered first, which can leave little remaining for the part of the coverageu00e2u20ac”the A-sideu00e2u20ac”intended to protect the assets of directors. “You run the potential of going over the limit,” says Collins of Progressive. The separate A-tower of coverage will have its own separate limit. This strategy also helps directors in case a bank becomes insolvent. While regulators could seize a standard plan as an asset, preventing directors from tapping into it, an A-side-only tower is unambiguously intended for the directors.
Offering additional A-side coverage also makes sense from a competitive standpoint. “It is something that we see our peers doing,” says First Horizon’s Murphy. “Certainly we want to provide the same kind of protection to our board and officers that our peers are doing. We base it on providing the best protection to our officers and board.”

Defense Costs.

Directors also have to decide whether to include wording in their coverage that allows for defense costs for criminal proceedings. This is not a black-and-white issue. “We are seeing more criminal claims against directors and officers,” Bailey says. “Whether you want that or not, reasonable minds will differ. It is good to assure a director that he will be covered in case of criminal claims,” Bailey notes. “But on the other hand, if you have a crook, do all the other directors and officers want their coverage diluted by the crook? Those criminal defense costs can run into some big numbers.”

Quality Of The Carrier.

Policyholders should also look at the track record of their carriers. Since securities class-action suits can drain corporate pockets, buyers need to consider the credit quality of the insurer. Litigation that triggers D&O policies tends to have a long tail, often four to five years. “You want to make sure the carrier is there for the long run,” says Barbara Stafford, director of financial institutions for D&O at St. Paul Travelers, St. Paul, Minnesota. “You might not know how that carrier is going to perform until there is a claim.”

Get Involved.

Above all, be prepared when the D&O policy comes up for renewal, experts warn. “When you are out purchasing your insurance, do your homework,” Baileys says. “There’s a real advantage for companies that make sure they have got sophisticated advisers working for them in this process. The quality of your program is going to directly depend on how smart the people are who are doing the buying. And we are seeing directors themselves become more involved in that process.”

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