The market for directors and officers liability insurance continues to mirror the broader-based market for bank stocks and the country’s economic prosperity overall. Although new areas of liability continually crop up, and the legal landscape is about as constant as the tide, bank directors and officers generally have more opportunities for coverage than ever before. For that, they are due at least one sigh of relief.
But although times are good and the current tide is high, two areas demand board members’ ongoing attention in the D&O arena. First, bank directors and officers should be mindful of significant trends in D&O liability claims, arising both from shifts in societal concerns as well as changes in case law. In addition, they must be careful to determine which coverages are the most pertinent and spend their premium dollars wisely, given the glut of products currently flooding the marketplace.
Claims and coverages
In general, on the claims side, the resilient stock market continues to buoy the performance of many publicly traded companies, which has meant fewer shocks to shareholders and, consequently, a lower-than-anticipated loss rate for D&O insurers. (More specific claims data will follow later in this article.)
On the coverage demand side, new premium dollars are flowing into the market from first-time buyers of D&O who are going through initial public stock offerings. In addition, 1997 was a record year for mergers, acquisitions, and divestitures, both for financial institutions and commercial companies. This has led to an increase in the placement of both traditional D&O run-off liability programs and more uniquely tailored programs such as a “rolling run-offs” for highly acquisitive companies, each of which has provided considerable additional D&O premium to the marketplace. These factors have acted as a balance to the loss of ongoing premium resulting from those same consolidations. On the coverage supply side, the whole sector of management liability coverages (D&O, E&O, fidelity, fiduciary liability, employment practices liability) has attracted new capacity throughout 1997, both from U.S. and foreign insurers.
The net of these three phenomena has been unabated competition for business among an even-greater number of underwriters than in previous years. This trend of consistent and meaningful rate reductions, which began to intensify in late 1996, seems likely to continue for the foreseeable future, certainly through the end of 1998.
The current D&O market in its entirety, now exceeds $1.25 billion in total capacity (e.g., the total amount theoretically available to a single buyer). It derives this capacity from approximately 70 U.S. and overseas insurance providers. That said, only $600 million of that capacity has been in existence for any length of time and could therefore be considered “seasoned.” This seasoned market is offered by no more than 25 insurers. This could be a meaningful fact if loss ratios were to take a strong turn for the worse, because if history is any predictor, the first sign of problems will mark the disappearance of virtually all “unseasoned” capacity.
The D&O market has been most competitive for companies with the largest capital bases. For such institutions, a wide variety of coverage, pricing, and structural options are available. Only institutions undertaking initial public offerings or those involved in greater-than-normal merger and acquisition activity should be finding the market to be at all difficult to enter.
More and more buyers are benefiting from the placement of multiline policies to expand existing coverage and multiyear arrangements to lock in attractive pricing for five years or longer. Institutions that purchased such programs within the past two years are rolling these contracts over for an additional year or more. (By contrast, risk financing techniques that may utilize preloss funding vehicles such as finite risk, capital markets “liquidity” programs, or even captive insurance company self-insurance programs have not penetrated this arena to any great degree.)
Ongoing and emerging exposures
Defense of ERISA claims is the largest producer of fiduciary liability loss costs. Absent a dramatic deterioration in the economy, and the consequent rash of employee and retiree lawsuits, alleged ERISA violations should remain the most active source of claims for the foreseeable future. That said, the continuing merger and acquisition activity within the banking industry will mean that financial institutions will have to be sensitive to the dangers of benefit plans being combined improperly and the claim problems that can result.
Recent case law imposes more stringent limits on employers seeking to alter or reduce employee benefits, but this case law applies only under very specific conditions. Expectations that case law would change adversely in areas such as managed care or employee investment option education have not, in fact, been realized.
A few areas in particular have an increased potential to give rise to claims this year and thus should be of interest to bank directors and officers. These areas are not limited to, but include securities claims, year 2000 liability, and employment practices liability suits.
Securities claimsu00e2u20ac”Despite the fanfare that surrounded the Private Securities Litigation Reform Act, which went into effect in 1995, this law has in fact had little impact on the frequency of securities actions. This is meaningful because securities actions are generally the most troublesome source of large D&O claims. Nowhere was that more pronounced than with the S&L failures of the late 1980s and early 1990s.
Although there has been a decline in the number of securities suits that might be deemed frivolous, there has been no relief in the filing of more serious suits. Suits alleging improper insider transactions, for example, have produced significant settlements. Figure 1 profiles shareholder actions since 1991 and demonstrates this fact statistically. It’s obviously fair to say “the jury is still out” on whether or not financial institutions directors and officers will derive any meaningful protection from this well-intentioned reform act.
Year 2000 liabilityu00e2u20ac”Another source of potential trouble for directors and officers is the Millenium Bug, or year 2000 (Y2K) risk. In addition to the noncompliant systems-identification and modification issues facing all financial institutions, there are signs that insurance underwriters, and their reinsurers, will soon move to restrict or eliminate reimbursement for losses arising from a Y2K-related system failure. These restrictions are likely to include losses caused not only by the institution’s systems but also by those of their vendors. Bank
regulators’ disclosure requirements will prompt more detailed analyses of the financial impact of system conversion/correction, though gauging the ultimate impact of any institution’s Y2K problem will not be an easy job.
Institutions should not be surprised to be asked to complete lengthy questionnaires from underwriters seeking information to help them evaluate exposures in this area. Likewise, and for similar reasons, underwriters are beginning to ask about exposures arising from the introduction of the European Single Currency (EMU), particularly its potential effect on global institutions and their European banking clients.
Employment practices liabilityu00e2u20ac”Employee-related lawsuits have come of age, particularly in the world of financial institutions. Though several insurers are endorsing EPLI coverage for their directors and officers policies, such coverage is usually not as broad as stand-alone coverage (among other things, libel, slander, mental anguish, and damages incurred by the corporate entity typically are not covered). Thus the limits of coverage that might be available would, of course, have to be shared among any other shareholder suits occurring during the policy period.
Since more specific coverage against such suits is being offered by many of the traditional D&O markets, directors and officers should demand to be informed about the kind and amount of EPL coverage in effect on their behalf. Particular attention should be paid to the provision of punitive damages coverage in those jurisdictions that allow its insurability.
The amount of D&O insurance purchased by corporations is closely tied to both asset size and industry group. Figure 2 shows the total limits of coverage purchased by all financial institutions according to asset size.
As shown in Figure 2, the median limit purchased by
all financial institutions with assets greater than $50 billion was $100 million. In other words, 50% of that asset group purchased more than $100 million in D&O limits. However, banks, as a subset of all types of financial institutions (including insurance companies, mutual funds and others), generally purchase higher limits than most of their financial institution counterparts, due largely to the effect of limits purchased by banks with assets greater than $10 billion. Notably, while average limits purchased by banks greater than $10 billion are higher than their financial institution peer group, average limits purchased by banks with less then $10 billion in total assets are lower than their financial institution peer group. This difference in purchasing patterns between large and smaller banks, especially in comparison to similarly sized nonbanks, is indicative of the business diversity that tends to come with increasing sizeu00e2u20ac”and the increased exposures that accompany it.
Interestingly, as a benchmark of size, total assets is only one of the correlators of limits purchased: in fact, a more accurate predictor of D&O limits purchased by financial institutions turns out to be market capitalization, as shown in Figure 3.
Banks typically accept slightly higher corporate reimbursement deductibles than the overall financial institution peer group. Again, there is a strong correlation between asset size and deductibles, with a notable preference for higher deductibles existing with banks having more than $10 billion in total assets. For banks over $50 billion in total assets, 25% of the deductibles in place were at least at a $5 million per occurrence level.
The database also reveals an interesting fact about the way financial institutions handle D&O coverage allocation between the entity and its officers and directors. With disputes over allocation being the single biggest contention between a D&O carrier and its insured, the vast majority of financial institutions are electing to address up front the issue of covered and uncovered defendants, as well as the percentage of a settlement that will be allocated to each for purposes of reimbursement. Even more notable is the fact that nearly five out of every six financial institutions include coverage for the entity for securities litigation in their D&O programs, a percentage far higher than for commercial concerns.
The database reveals that financial institutions tend to be financial risk trendsetters, whose decisions often result in the adoption of similar solutions by the commercial business classes. For example, in the last two to three years, banks and their peers have been in the forefront of multiyear D&O program purchase, with 36% of financial institutions purchasing their D&O on a multiyear basis. There has also been a trend toward combining other risks within the D&O program. Approximately 22% of financial institutions are now implementing a combined risk approach, wherein D&O exposures may be combined and insured with professional liability exposures, fidelity exposures, fraudulent trading exposures, fiduciary liability exposures, or some combination of those exposures.
These combined exposure programs were originally attractive to banks as they provided a cost-effective means by to purchase professional liability coverage, usually for the first time. This was, of course, important to banks as they began the process of aggressively expanding their mix of fee-based businesses, which brought with it a whole new set of legal liabilities. As the drive for fee income increases, the necessity for professional liability coverage will intensify as well.
Figure 4 displays the distribution of limits and corresponding premiums by asset range for the financial institution peer group. Similarly, Figure 5 shows premium distribution by business class.
Again we see a correlation with asset size and business class, and not surprisingly, there is a significant premium difference between large institutions and their smaller counterparts and between banks and all other financial institutions. Looking at premium solely as a function of asset size, the statistics reveal that 25% of all banks with assets in excess of $50 billion incur annual D&O costs in excess of $3.5 million.
Strategies for the future
For the protection of the institutions’ individual officers and directors, it is imperative that boards develop a solid understanding of the new legal, social, and technological environment in which they operate and its potential impact on the scope of management liability. In this regard, a comprehensive, enterprisewide risk identification and evaluation of management liability exposures would be beneficial to all firms not having done so in the recent past. So many changes are occurring to the size and mix of business activities, and they are happening with such breathtaking speed, that most financial institutions’ officers and directors need frequent briefings to feel completely comfortable with their knowledge of their current exposures.
For the protection of their balance sheets and income statements, institutions should investigate whether they can benefit from any of the many new risk financing, coverage, and structural options available in the marketplace. For example, multiline, and/or multiyear agreements will become generally more available to middle-market customers as a side benefit from underwriters’ favorable experience with larger corporations. The current pricing and availability of such programs for virtually all buyers makes their consideration compelling, as does the accompanying potential for broader coverage(s).
Similarly, rolling out existing multiyear programs for another year or two is well worth consideration, as may be the inclusion of coverage reinstatement provisions.
The good news about the world of directors and officers liability is that the cost and availability of risk transfer coverage is highly advantageous to nearly all financial institutions wishing to protect themselves through the purchase of insurance. The bad news is that the exposures being faced by all but the smallest institutions are growing and changing as fast as the businesses of the institutions, and there is no end in sight.
[Editor’s note] This article is based on statistics derived from the 110 financial institutions captured by the National Economics Research Association (NERA) study and includes observations made by the authors over the past year. The article also sites portions of a J&H Marsh & McLennan benchmarking database.