The Rising Cost of Liability Protection
If it feels like being a bank director nowadays is relatively more risky than, say, serving on the board of the local manufacturing company, youu00e2u20acu2122re right. At least, thatu00e2u20acu2122s what insurers seem to think.
A February report by Aon Financial Services Group, the insurance brokerage, found that while overall rates charged by insurers for directors and officers liability coverage fell 18.99% for the year that ended in December 2007, the tab for insuring directors of banks and securities firms soared by almost the exact same amountu00e2u20ac”18.66%.
Brian Wanat, an Aon managing director, says the increases have only just begun. u00e2u20acu0153Weu00e2u20acu2122re sort of in the fourth inning of a nine-inning game here,u00e2u20ac he says. u00e2u20acu0153We continue to see a lot of scrutiny on banks, and we see D&O carriers trying to push up the rates a bit. Thereu00e2u20acu2122s still a lot to play out.u00e2u20ac
Blame the subprime mortgage-related credit and liquidity crisisu00e2u20ac”and more specifically, the big associated drops in bank market capsu00e2u20ac”for the hikes. Experts predict a potential surge in suits against banks brought by other lenders, insurers, and investors in securities that are backed by mortgage or other types of loans. The primary concern for D&O insurers, however, is shareholder suits, which typically are triggered by big valuation changes.
Wanat says plaintiffsu00e2u20acu2122 attorneys typically u00e2u20acu0153look for companies with huge market-cap drops, along the lines of 30% or more, and then backfill to find a reason to file suit.u00e2u20ac A January analysis by Bear Stearns & Co. insurance analyst David Small found 154 large- and medium-sized financial institutions had lost more than 40% of their market caps in 2007. Small projects a u00e2u20acu0153potential worst-case scenariou00e2u20ac for D&O insurers of up to $9 billion directly related to the subprime crisis.
In recent months, such big-name financial services firms as E-Trade Financial Corp., National City Corp., and Washington Mutual have been sued after sizeable, subprime-related share-price drops.
u00e2u20acu0153If you look at the entire financial services sector, there are a number of companies that have lost tremendous amounts of market cap,u00e2u20ac says Evan Rosenberg, global specialty lines manager with Chubb Specialty Insurance, a provider of D&O coverage. u00e2u20acu0153The unfortunate truth is that thereu00e2u20acu2122s a strong correlation between a companyu00e2u20acu2122s stock dropping by a significant amount in a short period of time and being sued.u00e2u20ac
Board members are usually among the targets in such class-action suitsu00e2u20ac”even if they have fulfilled their duties of care and loyalty, established proper procedures, asked the right questions, and all those other things good board members are supposed to do. Furthermore, successfully fending off a suit doesnu00e2u20acu2122t mean there wonu00e2u20acu2122t be significant defense costs.
In this high-risk environment, directors should review their coverage closely. Insurance underwriters examine such factors as stock performance, management stability, insider trades and share buyback activity, historical claim trends, and even the composition of the shareholder base before setting the premiums.
Lately, underwriters have been stepping up their subprime-related due diligence. u00e2u20acu0153Weu00e2u20acu2122re asking a lot of questions along the lines of, u00e2u20acu02dcWhat steps are you taking to prevent or reduce your risks going forward? Are you changing your portfolio mix?u00e2u20acu2122u00e2u20ac Rosenberg says.
What theyu00e2u20acu2122re finding is no surprise. u00e2u20acu0153Some financial institutions are in terrific shape and wonu00e2u20acu2122t see any significant changes, and some have more problems and will see big rate increases,u00e2u20ac Rosenberg says. u00e2u20acu0153And there are some [companies] out there that, quite honestly, are going to have trouble getting a program in placeu00e2u20ac because the risks are too high.
A well-run bank with no history of claims, a stable shareholder base and management team, and little exposure to potential credit problems could expect premiums of around 1% of coverageu00e2u20ac”say, $100,000 for $10 million of coverage, Wanat says. Those facing greater risks might pay anywhere between 5% and 10% of coverage limits.
In 2006, the average bank surveyed by consulting firm Towers Perrin paid $598,426 for about $30 million in coverageu00e2u20ac”a premium of roughly 2%.
But price alone should not be the determining factor in which coverage to select. In recent years, insurers have begun lumping entity and director and officer coverageu00e2u20ac”forms of insurance that protect the corporation and managementu00e2u20ac”together with D&O insurance. Doing so can lower overall premiums but isnu00e2u20acu2122t necessarily good for directors, Rosenberg says, because u00e2u20acu0153any defense costs you pay for the entity reduces whatu00e2u20acu2122s left over to defend individuals.u00e2u20ac
To that end, smart boards are specifying the purchase of u00e2u20acu0153Side Au00e2u20ac coverage, specifically for individual directors and officers. In 2006, according to Towers Perrin, 26% of banks had such policies. u00e2u20acu0153If directors understood the issues better and were more involved, weu00e2u20acu2122d see more Side A coverage,u00e2u20ac says Michael Turk, a senior consultant for Towers Perrin.
A small but growing number of directors are demanding so-called u00e2u20acu0153independent director liabilityu00e2u20ac coverage, which is similar to Side A, but applies solely to outside board members. u00e2u20acu0153Directors should independently review policies from their own, individual perspective,u00e2u20ac says Alan Rutkin, an insurance litigation partner with Rivkin Radler LLP, a New York law firm.
And always stick with insurers that have strong balance sheets and solid reputations. While shopping around for a better rate might sound nice, remember, the company pays for the insurance and the board runs the company. D&O coverage is a cost of doing business. If your current coverage allows you to sleep at night, it might be better to stand pat, rather than risk some sort of changeover snafu during troubled times. u00e2u20ac”John R. Engen
Board-Shareholder Communication: The Next Governance Frontier
As companies brace for clashes with shareowners over executive pay at 2008 annual meetings, pioneering boards are reducing tensions by opening direct channels of dialogue between directors and investors according to a new policy briefing by the Millstein Center for Corporate Governance and Performance at the Yale School of Management.
The briefing, titled “Talking Governance: Board-Shareowner Communications on Executive Compensation,” finds the following:
u00e2u20acu00a2 Sustained, two-way dialogue between directors and shareowners on executive compensation and other governance topics is, so far, rare in the United States.
u00e2u20acu00a2 There is no insurmountable legal obstacle to board-shareowner dialogue on executive pay or governance. Research shows that Regulation Fair Disclosure (Reg FD), a rule passed by the SEC to prevent selective disclosure of information, is not a barrier to communication between directors and investors on executive pay policies and other governance matters.
u00e2u20acu00a2 Investor and corporate officials identify concrete and significant advantages from board-shareowner communications.
u00e2u20acu00a2 Without processes for open board-shareowner dialogue, public markets may face unnecessary costs and burdens.
The authors of the briefing, Stephen Davis, project director of the Millstein Center, and Stephen Alogna, senior manager of Deloitte & Touche LLP Corporate Governance Services and visiting research fellow at the Center, add, u00e2u20acu0153Hostility between parties can saddle investors and public company boards with burdensome costs and risks, including the possibility of the share price not reflecting the full value potential of the company over time.u00e2u20ac
u00e2u20acu0153The new capital markets virtually demand uncircling the wagons and opening up communications between boards and management with shareholders,u00e2u20ac comments Ira M. Millstein, senior associate dean for corporate governance at Yale. u00e2u20acu0153I see communication between boards and management with shareholders as the alternative to hostile interactions, additional mandated disclosures, or other hurried regulation and litigation.u00e2u20ac
Insurance Brokerages Still Booming
Bank insurance brokerage fee income hovered near record levels in 2007, reaching a total of $4.04 billion, a scant 0.8% lower than the record $4.08 billion attained in 2006, according to the Michael White-Symetra Bank Fee Income Report.
The Bank-FIR report reveals that nearly half the banks (45.7%) in the United States engaged in activities that produced insurance brokerage revenue. Bank insurance brokerage fee income consists of commissions and fees earned by a bank or its subsidiary from insurance product sales and referrals of credit, life, health, property, casualty, and title insurance. It does not include income derived from the sale of annuities.
Citibank reported year-end insurance brokerage fee income of $1.19 billion, putting it in first place. BB&T Co. which has acquired more insurance agencies than any other banking organization, ranked second nationally with $836.9 million in insurance brokerage earnings. Delaware-based FIA Card Services, the former MBNA America Bank, ranked third with $256.6 million in insurance brokerage revenue.
Banks with more than $10 billion in assets continued to have the highest participation (69.7%) in insurance brokerage activities and produced $3.2 billion in insurance fee income in 2007. These large banks accounted for 79.3% of all bank insurance brokerage fee income earned in 2007.
u00e2u20acu0153The leveling of banksu00e2u20acu2122 insurance brokerage fee income in 2007 resulted from several factors: one, a soft market in commercial insurance; two, a tendency to locate new insurance operations within bank holding company subsidiaries rather than bank subsidiaries; three, the conversion of some banks to OTS-regulated thrifts that do not report insurance brokerage income; and four, the removal of any annuity commissions from the insurance total,u00e2u20ac said Michael White, president of the eponymous firm. He said historically, banksu00e2u20acu2122 insurance brokerage revenue has constituted about one-third of the banking industryu00e2u20acu2122s total.