D&O Liability: The Old Ball and Chain

When Bar Harbor Bankshares, the parent of Bar Harbor Banking and Trust, spun off the bank`s trust operations, acquired a local brokerage firm, and set up a separate financial services subsidiary at the start of this year, the bank`s insurance portfolio required substantial modification. The expanded range of investment services the Bar Harbor, Maine institution began offering its customers after the acquisition meant the company was suddenly exposed to significant new areas of liability. Crucial among the new insurance coverages that had to be put in place at the corporate level after the $450 million bank created its subsidiary, BTI Financial Group, were protections for the personal liabilities of its directors and officers. For Lynda Z. Tyson, a member of Bar Harbor`s board since 1994, the updates required by the corporate restructuring presented dramatic evidence that the accelerating pace of change in the business climateu00e2u20ac”from merger-driven consolidation to the new horizons opened by last year`s financial reform legislation and the advent of electronic commerce and online bankingu00e2u20ac”has made liability protection for decision makers a much more complicated issue. “When I joined, it was very important to me to know that the bank carried D&O insurance in amounts that were appropriate to the circumstances,” Tyson says. And she has made sure that the institution has adapted as those circumstances have changedu00e2u20ac”through annual reviews of the personal liability insurance she herself carries as well as occasional evaluations of the bank`s coverage by outside consultants. “We`re just very conservative on this issue.” Dean Read, who came to Bar Harbor Bankshares as president and chief executive shortly after BTI was launched, notes the company relied heavily on its insurance agent in considering what alterations to make in its liability coverage following the corporate restructuring. “We`re a community bank, and we can`t afford, nor do we have the need for, somebody who is an insurance expert,” Read says, adding that in the past, the uncomplicated nature of the bank`s insurance policies meant little attention was required beyond an annual review. But that is changing, especially as Bar Harbor prepares to offer its customers online access to their accounts later this year. “Now, with varying distribution channelsu00e2u20ac”online banking being just one of themu00e2u20ac”and BTI, it`s time for us to assess this insurance issue in greater depth,” Read says. “And we have already had some discussions. We have some insurance people on our various [board] committees, and their recommendation to us was to put this back on our agents.” Increasing concern among Bar Harbor`s directors and management over liability insurance of all kinds, including D&O coverage, reflects an industrywide trend, according our talks with bankers, lawyers, insurance brokers, and underwriters. Banks are pursuing higher coverage limits and are seeking policy endorsements to broaden coverage for activities previously unforeseen or explicitly excluded, even if doing so means additional premium costs. Moreover, amid signs that a nearly decade-long slide in prices paid for D&O liability coverage is coming to an end, banks and corporations of all kinds are signing policies that lock in rates for periods longer than a year, and in some cases, even three years. Michael O`Connell, senior vice president of insurance broker Marsh Inc. and practice leader in its financial services group, confirms that both limits and terms are on the rise across the banking industry. According to a benchmarking study prepared by Marsh that examined D&O liability insurance in a variety of industries as of April 2000, the average coverage limit for all banks was $48.8 million, with an average deductible of $2.1 million. Significantly, the average term has clearly moved past one year, according to the Marsh study. For banks in all asset classes, the average term was 2.33 years, ranging from an average of 2.01 years for banks with less than $1 billion in assets to an average of 2.72 years for those in the $5 billion to $25 billion category (see Figure 1). “We continue to see an increase in average limits, whether we`re talking about banks with less than $1 billion in assets or more than $25 billion,” O`Connell says. “And as far as the average term, if we had done this study five years ago, the average term would not have gone beyond 1.2 years in any class. So this demonstrates that most banking institutions have made the transition from annual policies to a multiyear term, whether they`re smaller or larger.” According to O`Connell and his colleague Donald Bryan, managing director and practice leader for D&O liability at Marsh USA, much of the increase in D&O limits reflects a trend among banks and other corporations to purchase blended or combined lines liability insurance policies. Such policies consolidate D&O liability, bankers professional liability, employment practices liability, and other lines of coverage in a single policy. These blended policies, sometimes referred to as global risk policies, enable banks to obtain higher aggregate coverage limits than would be economically feasible if the policies were purchased separately. Moreover, the cost efficiencies escalate rapidly with multiyear policies. For example, an underwriter might use a multiple of 2.4 times the annual premium payment to set the price of a three-year contract with similar coverage limits leading to a reduction of as much as 20% annually over a three-year period, and the larger the amounts involved, the greater the cost savings. According to Bryan, “cost efficiency is a big driver, so the incentive to take advantage of the efficiencies is greater” for bigger banks. At First National Bank of Anchorage, pricing issues were an important motivation when R. Suzen Shaw, the bank`s vice president and quality systems and risk manager, began evaluating the status of its various liability coverages. Shaw says she noticed signs last year that the market for bank D&O coverage was tightening. “Because of that, we went into the market last year looking for the best D&O product we could find,” she explains. “We put it together with Chubb and we locked in a three-year prepaid program. We managed to get a discount by locking it in for three years.” Dan Bailey, a partner with the Columbus, Ohio law firm of Arter & Hadden, whose practice is focused on D&O liability, says directors should prepare to pay more for liability insurance. “Over the last five to eight years, we`ve enjoyed a fairly soft marketplace for D&O insurance, which means that it has been relatively inexpensive and that coverage has gotten broader even though pricing has eroded,” he notes. “That trend is now stopping, and we`re going to see the pendulum swing in the other direction.” Al Salvatico, a principal with Minneola, New York-based insurance brokerage ARC Excess and Surplus LLC, pointed to the latest three-year results from the London insurance market, which show a cumulative loss ratio of 180%. “If you look at that, you could say it was justification for raising rates,” he says, “and there are a lot of carriers out there who want to raise rates.” A turn toward tighter markets for D&O liability insurance might catch some boards unprepared, Bailey warns. “As this product has been fairly inexpensive and as coverage has broadened, some directors have gotten used to that, and some banks have taken advantage of circumstances to increase their limits,” he says. “The question for them is going to be whether, as the market starts to tighten, they want to continue that level of coverage or start cutting back. It`s a very important decision. “I would caution against cutting back materially, because clearly the loss experience is not being reduced; if anything, it is increasing,” Bailey continues. He notes that while the bulk of liability claims continue to be in businesses other than bankingu00e2u20ac”particularly high technologyu00e2u20ac”there have been recent examples in less volatile businesses like consumer products manufacturing. A number of factors are contributing to pricing pressures. Among them, a perception that D&O liability coverage has been underpriced industrywide relative to the number of claims, which have begun to rise after a several-year period of stability. “Since 1993-94, we have seen a few good years in D&O liability, where we didn`t have much in the way of claims,” Marsh`s Bryan adds. “But now we`re starting to see more claims involving D&O.” Figures compiled by National Economic Research Associates (NERA), a White Plains, New York-based consulting firm, provide clear evidence of an acceleration in one of the most important sources of D&O liability claims: class-action lawsuits against boards and officers, many triggered by shareholders disgruntled over declining stock prices. “The 10-year bull market we have experienced has plumped up market capitalizations to historically high levels,” Marsh`s O`Connell says. “When there is a problem with a company`s performance against that base, the mistakes are magnified. A 5% stock drop in the 1980s meant only a fraction of what it means today.” Higher volatility has meant more unhappy shareholders, and greater activism among shareholders has led to more litigation. According to NERA`s statistics, a total of 231 lawsuits were filed in federal courts against boards of directors and officers in 1999 alone, and 14 of those, or 6%, were against banks. Those one-year numbers are up sharply from the prior three years combined. Some 184 federal lawsuits were filed against boards between 1996 and 1998, with 11 against banks. And the three-year numbers represented a rise from the five years ended in 1995, which saw a total 177 suits filed, including eight that involved banks. There`s no sign that the pace of such litigation has slowed this year. “The claims are there, and the chances are that in a very unsettled and very unpredictable stock market such as we`re seeing now, there will be opportunities for even more,” Salvatico says. Also fueling directors` increasing liability worries is the report presented by the Securities and Exchange Commission`s blue-ribbon panel on how to improve the effectiveness of corporate auditing procedures. The panel`s report, presented in February 1999, effectively codified the responsibilities and expectations of board audit committees. “This has meant some fundamental changes in the liability profile of the audit committee, in the event that changes are later made and financial restatements are required,” Bryan says. “And because the audit committee is part of the board, this is clearly a D&O liability issue.” The focus on board audit committees is doubly important for bankers, according to Barb Stafford, assistant vice president in the financial services segment at Minnesota-based St. Paul Fire and Marine Insurance Co. “There is an expectation of greater attention to accurate accounting and accurate expression of financial standing, so that they cannot be charged with making misleading statements or allowing any misrepresentation,” she says. “That`s a huge concern for directors and officers of any type of company, but especially financial institutions, because the vast majority of shareholder claims involve misrepresentation and accounting issues.” But despite increased attention to these areas, boards cannot afford to lose sight of more traditional liability concerns. Bank directors must be accountable to shareholders, ensure compliance with an array of governmental regulatory regimes, satisfy fiduciary duties toward depositors, and meet the competitive needs of their market. In addition, expansion into nontraditional business lines, such as insurance and investment services adds another risky element to this increasingly complex web of responsibilities. “Each of these constituencies feels, when it has been compromised or suffered some loss, that it is attributable to the action or inaction of directors, that it has a claim against the board,” says Bob Cox, managing director and underwriting manager for financial institutions at Chubb and Son in Warren, New Jersey. In addition to the stock market, Chubb and other liability insurance underwriters say there are other areas in the current business environment that could give rise to exposure for bank boards. Not surprisingly, they start off with traditional bankers` concerns with problem loans and regulatory compliance. The rising economic tide lifted nearly all boats in the 1990s, which may have led to complacency on the part of some bankers about loan quality. “Our general sense,” Cox says, “is that as times stay good, bankers tend to get a little less stringent on loan quality, and, over time, we`re concerned the industry could be caught with some loan problems.” At midyear 2000, regulators became more vocal about warnings of increased rates of noncurrent commercial and industrial loansu00e2u20ac”which posted a 12.3% increase in the first quarter of the year. Many banks have publicly responded by bolstering reserves, but much will depend on how well the ecomony responds. Directors are also under the gun because business expansion opportunities made possible by last year`s Gramm-Leach-Bliley Act has brought with it additional compliance with rules and regulations of the Securities and Exchange Commission and state insurance authorities. Changes in regulations such as these bring with them additional oversight challenges for bank boards, Cox says. Then there are mergers. Directors are at risk for their approval of mergers and acquisitions if shareholders, employees, or customers are dissatisfied. In prominent cases like Bank One/First Chicago and First Union/CoreStates, such troubles have resulted in litigation and even the ouster of some executives. The board must examine the strategic and competitive risks involved when banks acquire or create financial services units. “We`re trying to figure out how to assess the ability of any particular bank to integrate an acquisition of a nonbanking entity or to expand into a business they have no particular experience in,” Chubb`s Cox continued. Another liability weighing down boards today is privacy risk. Protecting the sanctity of customer information demands having appropriate policies approved by the board and the managerial expertise to implement them effectively. Without such policies, banks that try to offer any of the vast array of products like property and casualty insurance and mutual funds to targeted customers will be vulnerable to accusations of having violated those customers` privacy. Privacy has developed into a political hot button in the last several months as a consumer backlash against online marketing techniques has drawn the attention of the Federal Trade Commission and inspired rhetoric from both the Democratic and Republican presidential candidates. “Obviously, the board has to be super-vigilant about the possibility of computer crimes and must make sure management has proper procedures in place to avoid them,” says Ron Glancz, a partner in charge of the financial services practice at the law firm Venable, Baetjer, Howard & Civiletti in Washington, D.C. “I would certainly recommend strongly that banks protect directors from any kind of suit involving invasion of privacy.” Still, no bank that hopes to survive for long can ignore the strategic imperative of the Internet, despite its inherent risks. Even for the smallest bank, the development of online operations is no longer a question of if, but when. These boards bear the responsibility for decisions on how and how fast to move into electronic commerce and what policies regarding security must be in place. “From a D&O perspective, it may seem like you can put your toe in, but from the long-term perspective, you have to get it right,” says Marsh`s Bryan. As the Internet alters fundamental business models, he adds, it will be up to directors to make sure their institutions keep pace: “This will be a key element of exposure going forward, because it`s no longer an issue of whether or not you`re engaging in e-commerce. It`s how well you do it.” For the insurance industry, however, electronic commerce remains a question mark. It is still too soon, according to Cox, to determine how e-commerce will affect D&O liability exposure and what programs underwriters will cobble together to manage those added risks. “The industry is struggling with that, and I think you will see, over the next year, a whole variety of responses by insurers to help banks address that liability exposure,” he says. “We`re rapidly trying to come up with a suite of products that would respond to the whole host of e-commerce exposures. But there are problems. The law is still emerging in this area, so it`s hard to assess the potential liabilities, and it`s hard to assess the damages.” Boards looking to manage the increasing complexity of D&O liability issues should recognize that the quality and terms of coverage vary widely from company to company. “The biggest point for community bankers is to recognize that D&O insurance is, 1) a very important coverage for the bank and, 2) a fairly complex form of insurance that is not well understood in many quarters,” says Arter & Hadden`s Bailey. They should seek a qualified adviser to evaluate, negotiate, and purchase that policy, he advises.Finally, experts say, read the fine print, because no two companies` D&O offerings are alike. Says Salvatico of ARC Excess and Surplus: Insurance is looked upon as a necessary evil. Everyone is cost-conscious, and the tendency is to get the cheapest policy. But that may not be the best policy, and since bank directors are dealing with their own assets, they should be going after the best coverage they can get.