Can D&O risk be quantified?

Quantifying directors’ and officers’ (D&O) exposures is not only possible, but necessary in the current environment where shareholder lawsuits proliferate, says one analytics company.Advisen Ltd. co-founder David Bradford says insurers must look beyond more traditional tools to new metrics for understanding this risk. “Securities class actions have become a dominating source of (D&O) claims,” he notes, but understanding a public company’s propensity for facing such suits has proven “devilishly difficult” in the past. Underwriters pored over financial statements, review corporate governance procedures, and still produce mixed results in understanding the exposure faced.Commonplace metrics include the Kristi Commercial Credit, TACC score and Z-score matrices (z-scores measure a company’s likelihood of declaring bankruptcy).Advisen recently launched a new “total accruel scores”, which looks at corporate accounting practices and combines them with the more traditional indices to come up with the numerical probability of a company facing one or more securities class action lawsuits. Bradford says attention has to be given to “overly-aggressive” accounting practices to predict shareholder unrest. For example, do companies rely on estimates in their financial statements such as the amount of bad debt write-offs in the coming year, versus more firm numbers such as cash on hand. “With these estimates, companies are either subject to getting them wrong, or then can be manipulated by management.” Bradford hopes new metrics like the total accruel score will not only help to quantify risk, but also lead to better risk control, as brokers communicate to clients about their relative risk and companies learn to benchmark themselves against their peers.