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What’s Ahead for the D&O Market

Banks have enjoyed a softer market for director and officers liability insurance recently, however the better times may be fleeting.

After several years of a hard market for D&O insurance purchases following 9/11, banks lately at their annual renewal periods have been delighted to find lower or flat premiums, higher limits, and in some cases more coverage.

That was the case last August for First Horizon National Corp., when it renewed its D&O insurance. The $37 billion bank, headquartered in Memphis, Tennessee, purchases D&O as part of a bundle of insurance coverage, which also includes professional liability, employment practices liability, and fiduciary liability. While the bank declined to discuss amounts, it paid 11% less for its renewal in 2005 versus the previous year.

First Horizon’s carrier, National Union, a division of New York-based American International Group, also allowed it to create a separate limit for A-side coverageu00e2u20ac”the layer of D&O insurance that protects the personal assets of directors and officers. Before the renewal, First Horizon’s A-side coverage was bundled with everything else, sharing the same limit.

“The softer market is what helped us achieve all of that,” says Lisa Murphy, a vice president of corporate insurance at First Horizon. “We are getting more coverage for less money.”

Yet Murphy and other risk managers aren’t kidding themselves. While banks have benefited from a better market, a few signs point to a return to higher premiums later this year. A pipeline of securities class action suitsu00e2u20ac”and perhaps last year’s hurricanesu00e2u20ac”will eventually conspire to drive rates up again and reduce coverage, many predict.

For now, banks have done well at the bargaining table. Average premiums plummeted to $782,000, down from $1.4 million, according to the Tillinghast business of Towers Perrin, a New York consulting firm that tracks D&O coverage across industries. Those numbers might be skewed, since the approximately 30 banks in the survey changes significantly each year. More telling is a glance at eight banks that were in both surveys, says Elissa Sirovatka, D&O survey program leader at Tillinghast.

That group of eight saw their average premiums decline to $985,000 in 2005, down from $996,000 a year earlier. They also had higher average limits, $34 million, up from $30 million.

Yet the data from Tillinghast also points to increasing claims that will eventually send rates upward again. And claims are already on the rise: Tillinghast measured the frequency of claims at banks over a ten-year period, which rose to 0.63 per bank in 2005, up from 0.38 claims per bank in 2004.

That’s more evidence the softer market’s reign may soon end. The lower rates and better coverage was helped by an influx of new entrants in the D&O market as a result of the hard market. Yet now with so much competition, that effect is dwindling, notes Sirovatka. “It’s a paradox to have increases in frequency and falling premiums,” Sirovatka says. “This isn’t going to last a lot longer.”

Banks will also have to contend with more securities fraud suits as a result of frequent restatements of earnings due to the tough operating environment banks face nowadays, adds Vic Stewman, banking sector manager for Chubb Specialty Insurance, a division Chubb Corp., Warren, New Jersey.

And last year’s hurricanes will continue to play themselves out in the coming months. “The wildcard is going to be the effects of the hurricanes in the short-term, both on reinsurers and the companies that rely on reinsurers,” Stewman says.

By mid-year, insurance companies will have a good idea of the fallout with their reinsurers. “That’s when we’ll see what kind of pricing up-ticks the reinsurance community will be giving to their insurance company clients,” says Lou Ann Layton, national D&O practice leader for Marsh Inc., the New York-based insurance broker. “That will have some impact on rates probably in the third and fourth quarter.”

Those increases might be tempered by reinsurers’ healthy capital base: $73 billion for U.S. companies, and $300 billion for global reinsurers, according to the Insurance Information Institute. Insured losses from Hurricanes Katrina, Rita, and Wilma are estimated to range from $52 billion to $79 billion, according to Risk Management Solutions, a catastrophe risk-modeling firm based in Newark, California.

Regardless of what happens to rates and coverages, banks will be better off by preparing well for their renewals, brokers advise. “All banks aren’t created equal,” Layton says. “It is important to get in front of the underwriters because you are able to differentiate your institution.”

So whether it’s corporate governance, compliance, privacy issues, or other risk matters, insurers want to get a good sense at renewal time that the bank is run well. “We are going through the same motions,” Murphy says. “We were already sharing with them the issues that are important to the underwriters. It is reiterating each year what we are doing.”

u00e2u20ac”by Charles Keenan

Top of Mind: What Directors Are Saying About Comp Issues

At the recent gathering of more than 200 bankers and directors at the Bank Director Bank Executive and Board Compensation Conference in Dallas, attendees were polled on issues related to compensation committees and the process for evaluating and benchmarking compensation programs.

When asked who makes the hiring decision when the bank needs to retain an outside executive compensation consultant, the largest group of respondents (47%) said their compensation committee does the hiring while 31% said their management and board make the final decision. Similarly, when asked to whom the consulting firm reports, 51% said the hired firm reports to the compensation committee and 27% said the firm reports to management and the board.

The increase in the complexity of board members’ responsibilities was discussed in several sessions at the conference, and although both experts and directors agree their jobs take more time and are potentially more risky, 62% of directors and executives polled characterized their compensation for serving as a director as “fair.” Sixty-five percent believed it was competitive with institutions of similar sizes.

For the approximate one-third of respondents who did not categorize their bank’s compensation as either fair or competitive, the area they felt needed most attention was meeting fees: 38% said their board’s meeting fee structure needs to be addressed. The bank’s equity program was noted by 25% of those who are not satisfied with their compensation; 18% were dissatisfied with their retainer.

In particular, the responsibility of chairing a board committee has grown in the years since the passage of the Sarbanes-Oxley Act. Although 29% of bank directors polled noted their bank currently offers additional compensation to their committee chairs, 41% do not offer any additional compensation for certain board positions. As an indication that this trend may increase, 50% said they ought to be offering additional compensation to directors in certain positions.

In the wake of several prominent legal cases in 2005 and due to rising pressure from shareholders, establishing control over CEO compensation has become a very hot topic. In light of this, Bank Director asked conference audience members whether they believed U.S. banks are having trouble controlling the size of CEO compensation packages. While 39% said no, another 36% said yes and 25% said they weren’t sure. Of those who felt more control was needed, the area of options and equity packages was specifically noted as the aspect of executive compensation most in need of attention and additional control.

Finally, bankers and directors were polled on whether they believe their board currently has experienced and knowledgeable experts that are needed to serve on the compensation committee. Although more than half said yes, 34% said no. Clearly this is an area boards will need to address in the coming year, especially in light of increased focus by investors and the media on structuring executive and director compensation programs that are equitable.

S-Corps May Be Attractive Targets

When banks achieve the 10-year mark as an S-corporation, they can utilize some favorable tax rules due to the fact that they no longer need to apply the built-in gains tax, potentially making them much more attractive acquisition targets than comparable C-corporation banks, according to analysis released by Grant Thornton LLP. u00c2

“There are 498 S-corporation banks and thrifts that will hit the magic 10-year mark January 1, 2007,” said John Ziegelbauer, Grant Thornton’s managing partner of the financial institutions industry practice. “That’s more than one out of five of the current number of S-corporation banks and thrifts. The year after that, another 408 hit the 10-year mark. In addition, there are over 100 de novo banks and thrifts that made the S-corporation election at organization. Banks and bank holding companies interested in acquiring any of these S-corporations may be able to reach a better deal for both sides due to these favorable tax conditions.”

u00c2 Additional findings of Grant Thornton’s 2005 S-corporation analysis include:

u00c2 A total of 2,237u00e2u20ac”26% of the 8,585 eligible Federal Deposit Insurance Corp.-insured banks and thrifts as of March 31, 2005u00e2u20ac”are currently S-corporations.u00c2 This represents a net increase of 100 S-corporation banks and thrifts over 2004.

The Southwest region has the highest percentage of financial institution S-corporationsu00e2u20ac”39% of banks and 27% of stock-thrifts. Following closely behind are banks in the Midwest with 36%, and stock-thrifts in the Southeast with 21%.

Twenty-one banks and seven stock-thrifts with more than $1 billion in total assets have successfully made the S-corporation conversion.u00c2

“The S-corporation conversion has universal appeal to banks and thrifts across both geographies and asset sizes,” says Dick Soukup, coauthor of the analysis and a financial institutions industry assurance partner with Grant Thornton’s Chicago office. “It will be interesting to see how many S-corporation banks are acquired once their 10-year built-in gains tax recognition period is over.”

Corporate Financial Branding Lags

Among increasing consumer interest in personal financial management, new research from Ipsos Insight shows that less than one-fifth of Americans know about leading financial brands, such as Bank of America, Fidelity, Allstate, Merrill Lynch, Metlife, Prudential Financial, and New York Life. Further, women lag behind their male counterparts: an average of only one in six American women is familiar with major financial services brands, even though women have improved financial independency.

“Overall familiarity with key financial brands is surprisingly low, particularly given the marketing efforts of the big players,” says Doug Cottings, senior vice president of Ipsos Insight’s Financial Services Practice. “With a one-size-fits-all mindset, the financial services industry has yet to really connect with important segments, including women, young consumers, and many middle-income families.”

Other findings in the research show that as Americans age, there is a natural progression of familiarity with financial services brands; older consumers are more conscious of key brands. “Despite the financial services industry’s focus on the baby-boomer market (those born between 1946 and 1964), the survey reveals that most Americans aren’t familiar with the range of financial services brands until after retirement age. “By then, most consumers have made their most important financial decisions,” says Cottings. “There is a real opportunity for the financial community to build brand awareness in the younger market, including the baby-boomers that have yet to retire.”

Income is also a significant factor in determining the familiarity of brands in financial services: customers with household incomes about $100,000 a year have the strongest knowledge of major financial brands. “To sustain long-term growth, the industry should focus on power branding in different demographic and sociographic segments of the population. Despite the fact that most financial companies target the expected audienceu00e2u20ac”which is male, mature, and wealthyu00e2u20ac”companies should see that there is great potential in the younger generations, especially among females who are financially successful, independent, and more conscious of their financial health,” says Cottings. “For financial companies, such opportunity is hard to ignore.”

Section 404 Exemption Would Relieve Community Banks

The Independent Community Bankers of America (ICBA) applauded a government advisory panel’s recommendation to exempt smaller companies from the internal control attestation requirements of the Sarbanes-Oxley Act (SOX) Section 404, which will help community banks better serve local communities. “Reducing the SOX burden enables community banksu00e2u20ac”which supply about a third of small business lending by banks nationwideu00e2u20ac”to further support small business development in their local communities,” says Chris Cole, ICBA regulatory counsel and a former banker.

The Internal Controls Subcommittee of the Securities and Exchange Commission Advisory Committee on Smaller Public Companies recommended exempting companies with market capital of less than $125 million and revenues no greater than $125 million completely from SOX Section 404. In addition, the panel recommended exempting smaller public companies with market capital of between $125 million to $750 million and revenues no greater than $250 million from the internal control attestation requirements of Section 404.

The panel concluded that the Section 404 compliance burden on smaller public companies has a negative effect on their competitiveness and capital-formation ability, which in turn hurts the national economy, Cole notes. The panel also found internal controls over financial reporting are not as effective as other techniques to detect and prevent fraud by senior management.

The advisory panel’s conclusions that smaller companies bear a disproportionate share of the costs of SOX Section 404 are telling. ICBA’s recent survey of Section 404 costs for community banks reveals that the average community bank will spend more than $200,000 and devote over 2,000 internal staff hours to comply with the Section 404u00e2u20ac”taking away resources that they could use to better serve their customers and their communities.

“Smaller companies are already subject to certain corporate governance standards and subjecting them to internal control audits by outside auditors raises the bar far too high for many,” says Cole.

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