D&O Liability: Protecting the Board

When it’s time to shop for directors and officers liability insurance, buyer beware. Not only do financial institutions need to swallow hefty premium hikes, they face lower coverage limits, higher deductibles, new restrictions, and a tougher application process.

“You have to be very careful you are getting the same coverage,” says William Brown Jr., a principal at WKB Advisory Services, an insurance and risk management consulting firm in New York. “There are new exclusions, and the application process is tighter than before.”

It doesn’t help that banks are considered riskier than companies in other industries. Banks must answer to more regulators as well as comply with myriad federal and state laws. Moreover, D&O claims can come from many different sources. The pinch on D&O policies is also a result of the Sarbanes-Oxley Act, which gave new powers to the Securities and Exchange Commission and introduced criminal penalties such as felonies for securities fraud. Finally, insurers are facing more substantial claims and higher reinsurance costs as a result of financial scandals and fallout from 9/11.

Banks can hedge against the increasing scrutiny by purchasing different levels of D&O insurance. So-called A-side coverage is personal coverage for losses incurred by directors and officers that the corporation cannot indemnify. B-side coverage is insurance for the corporation that covers any of a company’s responsibilities to indemnify its directors and officers. Entity coverage, or C-side, covers claims made directly against the corporation. Carriers have also introduced recently personal director’s insurance, a policy sold to independent directors who serve on several boards.

Whatever a company selects, it will see much higher premiums, which have jumped for the third year in a row. Among U.S. companies last year, prices rose 30% in 2002, following similar hikes in 2001 and 2000, according to a recent survey by Tillinghast-Towers Perrin, a New York consulting firm. Banks themselves have stomached premium increases anywhere from 10% to well over 100%, with large banks getting hit the hardest last year. The inflation likely will continue at least into next year, says Mark Larsen, consultant and D&O survey director at Tillinghast. “Until we see some improvement in the stock market and shareholders believe that good corporate governance has taken hold, we can expect to see this trend continue into 2003, and possibly beyond.”

In the financial industry, the rise means banks will shell out millions of dollars more each year for coverage. In the 1990s, banks generally paid 1% of the so-called rate on line, or $10,000 annually for every $1 million in coverage, according to Willis Management Risk Services, an insurance broker. Today, they are paying anywhere from 3% to 20%. For the same $1 million in coverage, that means $30,000 to $200,000 in annual premiums.

The trouble with D&O insurance has been brewing for a while. Insurers in the 1990s raced to grab market share, lowering premiums and adding new features such as entity coverage. All of this at first glance was good for banks: For five straight years in the late 1990s, premiums fell.

The problem was, the economics weren’t working. Insurance companies collected $12 billion in premiums from 1996 through 2002, says Don Bailey, global practice leader for Willis in New York. During the same period, they paid about $32 billion in claims. “If that trend continues, we will no longer have a market for D&O insurance,” Bailey says. “The correction is very necessary.”

Like it or not, the higher fees and new restrictions were a long time coming in the industry, says Tony Galban, a vice president and D&O underwriting manager at Chubb Corp., the Warren, New Jersey-based insurer. One complicating factor is the rising number of claims, even as carriers look to recoup losses. “We are now digging out of a hole in an environment where people are pouring dirt on us,” Galban says.

Indeed, insurers had begun to feel the pain by 2000, and had started levying increases as a result of a rising flood of claims from many sources. Employees can sue for discrimination, wrongful discharge, and environmental hazards. Customers can file suits for invasion of privacy, loss of data, security breaches, and lending practices. And one of the biggest sources of litigation stems from the jump in shareholder suits against banks and other companies. The average indemnity paid for shareholder claims among the 2,200 companies in the Tillinghast survey increased to $23.35 million in 2002, compared with $17.18 million in 2001 and $9.62 million in 2000.

Meanwhile, the average securities class-action settlement in 2002 was $24 million, up from $6.5 million in 1996, according to Willis. Throughout the 1990s, settlements from securities litigation averaged 5% of the drop in market capitalization, estimates Bailey. Yet now that number is likely to be between 15% and 25%. That means a $1 billion bank that loses 50% of its value in a short period could end up settling for up to $125 million, versus $25 million in the 1990s. Numbers like those are no longer hard to imagine, given Bank of America’s $494 million settlement.

To recoup their costs, insurers are doing everything they can. For the first time in eight years, coverage limits taken by corporations have gone down, according to the Tillinghast survey. In some cases, the lower limits have forced banks to purchase coverage from more carriers to obtain the limits they need. Retentionsu00e2u20ac”or deductiblesu00e2u20ac”are up. Banks with $1 billion in assets or less have seen deductibles jump to a range of $100,000 to $1 million, up from $25,000 two years ago, according to data from Chubb. For banks $1 billion to $5 billion in assets, deductibles have risen to the $1 million to $5 million range, up from $250,000. And for banks with $20 billion or more in assets, deductibles have jumped to the $1 million to $10 million range, up from $500,000.

Meanwhile, three-year policies are a rarity now, brokers say, as insurers demand annual renewals that will allow them to readjust for risk more often. Insurance companies also are requiring coinsurance, ranging from 10% to 40%, arguing that will give banks more incentive to reduce risk.

Directors need to pay careful attention to their contract, particularly to those areas insurers are aggressively trying to whittle down. One such topic is severability, which has become a big issue for directors and officers. Severability means that the facts, knowledge, or conduct of one insured cannot be used to deny coverage for another insured. The policy is “severable” among those covered, meaning a separate policy is issued to each insured person.

Directors should make sure coverage includes severability for both the application and any exclusions, says Lou Ann Layton, global D&O practice leader for Marsh Inc., the New York-based insurance broker. To not have severability means an innocent director and the company will have to negotiate how much they will collect. “Lack of severability in a contract is grounds for considering another insurer and even paying more for it if it comes to that,” she says. “Without severability, you are at a big disadvantage.”

The personal profit and fraud exclusion also needs to be reviewed carefully. Historically, these provisions have had so-called final adjudication wording, which stated that unless a court of law proved the individuals in question committed acts of fraud or dishonesty, the D&O policy had to respond. Insurers are trying to eliminate that wording by insertingu00e2u20ac”in industry parlanceu00e2u20ac””in fact” wording. This allows the insurer to negotiate what it will pay if there is alleged fraud or dishonesty, making it harder for a director or officer to collect.

On the other hand, directors of companies affected by fraud have seen the downside of wording in the fraud exclusion that favors their fellow indicted colleagues. A true crook on the board, innocent until proven guilty, can accelerate exhaustion of policy limits, notes Paul Kim, a managing director at Aon Financial Services Group in New York. “Innocent directors are concerned when policy limits are being utilized to pay for the defense of executives when everyone knows that person actually committed fraud,” Kim says. “The challenge is crafting wording that eliminates coverage for such individuals but maintains coverage for the innocent directors.”

The application has also become a critical part of renewing a D&O policy. During the soft market of the 1990s, insurers often waived the requirement for an application. Now they not only require one, but they are using the application as another way to protect themselves. Any false information can be grounds for cancellation of the policy, and even earnings misstatements can result in an insurer rescinding a policy, depending on the agreement. Banks also have less time to turn applications aroundu00e2u20ac”insurers now typically hand out forms 30 days prior to the renewal date. That allows them to get a risk picture as close as possible to the new contract. And after Sarbanes-Oxley, applications are also getting more scrutiny. “Carriers are asking more questions related to corporate governance, trying to get at conflict-of-interest issues,” Bailey of Willis says.

Directors need to be vigilant about educating themselves to the changes in the policies, says Debra McManigle, a product manager at Burnham Insurance Group in Battle Creek, Michigan. Directors should, at least every two years, get involved with the process of going over their insurance with their agent, she says. “It’s for their own protection.”

Simply put, banks should make sure their own houses are in order. “Based on the high-profile corporate bankruptcies and scandals, banks need to look at the complete set of best practices for corporate governance,” says Larsen of Tillinghast.

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