Sleep Insurance: How the Market is Affecting Your D&O Coverage

Heritage Community Bank, a de novo commercial bank in Randolph, New Jersey, renewed its directors and officers liability insurance in the third quarter last year without much stress. The bank compared prices among three carriers, all of whom offered premium hikes in the 10% range. Yet Pete Kenney, chief executive of the $74 million bank, is counting his blessings. The bank received its renewal before the financial market meltdown in the fall, when several large banks either failed or were acquired, and before major world stock indexes suffered steep declines. “I wouldn’t want to be going through the renewal process right now,” Kenney says. “It is crazy out there.”

Kenney speaks for most banks in the wake of the financial fallout, which began with the unraveling of subprime mortgage portfolios in mid-2007. As banks struggle in the midst of a recession and rising defaults, they face a much tougher market for insuring their directors and officers against lawsuits. Premiums for D&O insurance have risen fast, while coverage has been narrowed, as insurers look for ways to reduce risk.

“There will be more impacts and aftershocks felt throughout the marketplace,” says Ann Longmore, D&O product leader at New York-based Willis HRH, the North American subsidiary of Willis Group Holdings. “We don’t have any sense we are near the end of the travail which is the credit crisis.”

Since the market meltdown last fall-including the failure or near collapse of several large financial institutions and a steep decline in stock prices-banks are seeing much higher premiums, generally in the 20% to 200% range, according to Willis.

Meanwhile, insurers are reducing the amount they will underwrite, forcing buyers to shop around for more carriers to reach the coverage they want for their directors and officers. The trends have given directors pause, says John Olson, a senior partner at Gibson, Dunn & Crutcher’s Washington, D.C. office. The big question: Under what circumstances will directors be indemnified, or paid for incurred claims?

“Directors are nervous,” Olson says. “I don’t know a board that isn’t asking for an update on what their indemnification provisions are. They want to be sure that someone knowledgeable has reviewed the policy and what the coverage is.”

Banks face a double whammy of sorts, since rockier times will make it almost necessary to raise coverage limits for directors in order to retain or lure them. “If you are sitting on a board today, you are looking for more insurance, not less,” Longmore adds. “The specter of having to tell someone they’ll have less directors and officers coverage right now is a scary prospect.”

Premiums paid by banks are all over the board, depending on a variety of factors, such as whether the company is public, the quality of its loan portfolio, and its overall risk profile. But premiums can easily range from $10,000 to $20,000 for each $1 million in coverage, according to Willis. That said, plain-vanilla, locally owned community banks should still be able to get coverage for less.

Whether a bank has had past securities litigation is also a factor, as is the strength of its capital base and whether the bank is situated in an area hard hit by the mortgage meltdown, such as Florida and California, notes Richard Edsall, vice president and financial institutions D&O product liability manager at Chubb Group of Insurance Cos., an insurance carrier based in Warren, New Jersey. So community banks with strong balance sheets and solid underwriting that are located in low-risk areas might only see increases in the single digits, Edsall says.

The subprime and credit crises have already led to a higher number of securities class-action lawsuits-a big driver of D&O claims. Through Dec.15, 210 lawsuits had been filed against corporations in 2008, compared with 177 for all of 2007 and 119 in 2006, according to the Securities Class Action Clearinghouse, a collaboration between Stanford Law School and Cornerstone Research. While the numbers are far below the peak of 498 in 2001, the trend is moving upward. The financial sector has driven most of the lawsuits, making up 57% of the 110 filings in the first half of 2008, according to the clearinghouse. Most of the financial sector filings were related to the subprime crisis and credit crunch.

Fewer failures than the S&L crisis

On the one hand, the number of bank failures in 2008 pales in comparison to the 747 closings of savings and loans institutions in the late 1980s and early 1990s.

Back then, $1 million of coverage cost about $35,000, estimates Richard Roth, executive vice president and chief operating officer of Ulster Savings Bank, a $644 million thrift in Kingston, New York. The bank renewed its policy in April last year for $18,000, with $5 million in overall coverage. The thrift locked in for a three-year deal, shielding itself from the recent price increases. “I suspect the price is going to go through the roof in the short term,” Roth says.

Yet the financial crisis for banks gathered steam as 2008 progressed, with 25 financial institution failures reported in the second half through Dec. 12, up from just four closings in the first two quarters. Meanwhile, some of the failures have made up for numbers in size, with Washington Mutual, formerly the 13th largest financial institution nationwide, arranged for sale by the government to JPMorgan Chase in September. Meanwhile, the crisis has expanded beyond banking, with the federal government taking control of AIG, a leading provider to financial institutions of D&O insurance.

The upward trend in premiums for banks is opposite that of all companies, which have experienced a softening D&O market in recent years, with excess capacity in the marketplace. Overall, premiums declined an average of 14% in the third quarter of 2007, compared with the same period in 2006, according to a survey of 2,900 companies by Towers Perrin, a consulting firm based in Stamford, Connecticut. During the same time frame, premiums for banks rose 57% among repeat participants, possibly due to subprime credit issues, the study said. “Banks have already had a tough time,” acknowledges Michael Turk, a senior consultant at the firm.

Yet banks also reported a 46% jump in average limits to $25 million, the largest increase among all industries in the survey. About 38% of banks increased limits. “There is a lot of speculation that maybe these guys knew this was coming down the pike,” Turk adds.

Higher losses for insurers might eventually mean higher premiums for all. With D&O claims, equity losses, credit losses, and an active hurricane season in 2008, the insurance industry’s statutory surplus was predicted to drop 15%, a reduction of $80 billion for the year, according to Towers Perrin. The surplus is a measure of the capital cushion held by insurers. More losses could lead to higher premiums across the board in all industries.

The ABCs of D&O

D&O insurance is usually structured in three layers. Side-A coverage protects directors and officers from claims against them for their wrongful acts. Side-A coverage kicks in when a corporation can’t (or won’t) pay for-or indemnify-its directors and officers, a situation that can arise when the company is not permitted by law to do so, chooses not to do so, or cannot do so due to bankruptcy or lack of funds. Side-B coverage is insurance for when the corporation does indemnify its directors and officers. Side-C, also known as entity coverage, handles claims made directly against the corporation.

Over the years, insurers have written Side-A policies profusely, says David Bradford, an executive vice president at Advisen, a consultant based in New York. Their thinking was that while companies might have lawsuits, they weren’t likely to experience bankruptcy at the same time. That scenario has all but changed ever since the failures of some of the largest financial institutions.

While numbers are difficult to quantify, Bradford says carriers have collected perhaps $500 million in Side-A premiums. But losses in this category may top $1.5 billion this year alone, thanks to the multiple failures of mortgage finance companies, banks, and insurance giant AIG.

“D&O insurers never expected to pay many or any losses under these Side-A policies,” Bradford says. “There could be real upheaval in the marketplace as to the cost and the type of coverage that is going to be available to directors going forward because of the losses [insurers] are incurring.”

Less capacity

Insurers are also reducing their limits, forcing financial institutions to shop around with other carriers in order to reach the coverage level they want. “Capacity is really being cut back,” Willis’s Longmore says. “Underwriters today are much more skeptical with the repeated writedowns and assets disappearing overnight from balance sheets. That has gotten everyone a little bit frightened as to future prospects.”

Only the most solid banks can get coverage blocks in the $20 million to $25 million range, Longmore continues. Nevertheless, carriers are still asking for the same premiums despite the lower limits.

Insurers are also looking to shift the way they share coverage. Over the last 15 years they have tended to stack limits horizontally, meaning a claim would burn through the first insurer before dipping into the next.

As a way to reduce costs and limit premium increases, some carriers are leaning toward selling policies the way they did in the early 1990s, which tended to be in a vertical format. With this method, also known as quota share, carriers split the cost of a larger claim. “That is something that could expand, especially as underwriters look at these large exposures,” says Edsall of Chubb.

“Carriers are less likely [to] blow through their entire limit,” Longmore adds. “And it might help us rein in, to some degree, the price increases and detrimental impacts on terms and conditions.”

Buyer beware

Bank directors need to be on the lookout for policy revisions at renewal time. An important one to watch for involves the change-of-control provision, which has gained increased relevance in the wake of bank takeovers. Banks should know what kind of change-of-control triggers are in their policies.

Given the Fed’s efforts to encourage acquisitions, pushing stronger banks to buy weaker ones, a wave of consolidation is likely to occur before the industry emerges from the current crisis, Lou Ann Layton, a managing director at New York-based broker Marsh Inc., notes. Policies generally have a provision that calls for them to expire as a result of an acquisition, but these clauses vary in when and how a policy terminates. That’s all the more important these days, when mergers can happen in a day-or over months. “You want to make sure you have your change-of-control trigger, and that you know what it is and when it goes into effect, so that you are protecting your directors and officers,” Layton says.

Directors also need to be mindful of new exclusions. One recent addition includes investment banking, making any claims related to that area of the business uncovered, according to Longmore. Insurers are also cutting out extras, such as coverage for employees’ legal fees.

Banks also need to pay strict attention to endorsements in their policies. For example, a new carrier might have an endorsement that tries to aggregate any new subprime claims into a previous policy period to reduce its exposure. “You have got to pay strict attention to the endorsements that are put on the policy that basically try to aggregate anything arising out of the subprime by putting it back into the old policy period,” Layton says.

Another possibility being bandied about is the revival of the so-called regulatory exclusion, which came into vogue as a result of the S&L crisis before fading away after the market softened again. Regulatory exclusions absolve the insurer of paying claims in the event of enforcement actions, investigations, and other fallout as a result of government oversight. So far, insurers haven’t brought back the exclusion, but it is still a possibility. “The big unknown here is what impact regulatory intervention will have,” Longmore says.

To keep up with all the changes, directors need to make sure the bank has a good handle on their D&O coverage. “Directors must make sure whoever is responsible for coverage comes before the board and explains how much coverage is needed, and how much use of consultants and brokers is adequate,” says Ron Glancz, a partner at the Washington, D.C. office of Venable LLP. “Make sure the application is 100%.”

Just how much more insurance carriers will seek to reduce their risk when underwriting D&O policies for banks remains to be seen. “We see this [issue as] one we are nowhere near being done with from a standpoint of risk and exposure,” says Edsall. “Banks and brokers should be prepared for this to be an ongoing issue.”