D&O Liability: Clear Skies or Turbulence Ahead?

Current trends in both Canada and the United States indicate 2008 will be the most active year for securities litigation filings since 2002. That development, in combination with the competitiveness of the executive liability insurance markets (outside the financial and real estate industries), give rise to the following questions:

• Are we at a crossroads in the market-cycle, or is the soft market here to stay into 2009 and beyond?

• What are some of the key issues driving today’s dynamic environment for executive liability risks?

• What are some of the trends to come?

THE MARKET

Unlike the last soft market experienced in the late 1990s, in which the quantum of insurance capital was offered by a limited number of admitted insurers in Canada, the current part of the cycle appears to be driven less by a limited few, and more by an increasing proliferation of domestic and foreign-admitted players. The health of the market is driven by the supply and demand of available insurance capital. With the exception of certain financial and real estate risks, capacity, quality of product from credit-worthy insurers and stability of pricing are all prevalent features of the current market cycle. There has been little consolidation in the executive liability industry to date. But with 2009 budgets looming and insurers vying for market share, we are sure to be in for an interesting ride.

The executive liability reinsurance market is not immune from this soft-rate environment. In fact, demand for reinsurance is at its lowest point in years. Only fear related to the increasing odds over time of a mega-natural catastrophe happening, in addition to the effects of the weakening global economy affecting equity valuations in the underwriting sector, might slow down the magnitude of price reductions or firm pricing in the reinsurance markets.

ECONOMIC FACTORS AND THE CREDIT EFFECT

The full impact of the sub-prime mortgage and asset-backed commercial paper (ABCP) market crisis is still not clear. Initial losses to the property and casualty insurance industry were estimated in 2007 to be in the low, single-digit billions of dollars, but now they have increased significantly. It is unlikely the effects of both loss and litigation damages will be known for some time.

Given that financial markets continue to be volatile, and investments form a significant portion of insurers’ profits, instability remains the current theme. Recently, a number of highly-publicized insurers reported staggering quarterly financial losses; others reported solid financial results. The underlying effects of these losses are not yet known.

LITIGATION AND LEGAL TRENDS

The effects of Canada’s new secondary market statutory regime, including Ontario’s Bill 198 and other similar provincial legislation, are starting to take flight. But does this really mean Canada will be susceptible to U. S.-style litigation tactics and trends? Since the new laws have taken effect, approximately nine actions have been filed, with almost 50% of these actions being filed in 2008. Filing rates are expected to increase.

In the United States, the securities filing trends are no different. NERA Economic Consulting recently reported in their 2008 Mid-Year Update that there have already been 139 filings through to June 30, 2008. If that same pace held throughout the rest of the year, it is estimated 280 filings would be brought in 2008. Although the majority of cases filed this year are still considered to be standard cases (containing common financial-and accounting-related allegations), more than half of the cases represent sub-prime, auction-rate securities and options backdating cases. Most of these cases will not go to trial given the obvious incentives to settle; looking at the situation positively, a number will be dismissed. Both average and median settlement amounts appear to be decreasing, although given the magnitude of investor losses in some of the sub-prime related cases, the averages may rise again in the future if these cases are resolved in the plaintiffs’ favour.

Recently a small mining development company launched the first lawsuit against a Canadian credit rating agency, DBRS Ltd., over the seizing of a Cdn$35- billion market for ABCP. Will there be more litigation related to our southern sister crisis?

FUTURE CONSIDERATIONS

So what’s in store for the near-and long-term future of the executive liability marketplace? Typically the market is driven by attritional frequency and severity of loss development. If the credit crisis isn’t going to change behavior, outside of the financial and real estate industries, what will?

Some key issues on which underwriters and constituents in the executive liability industry will be focusing in the future include solvency issues, the effects of climate change and environmental laws, issues concerning executive compensation, global D&O regulatory/tax issues, changing purchasing trends of personal and balance sheet protection, pension issues, recent amendments to Canada’s bankruptcy laws, cyber risk exposures and proposed amendments relating to income trust conversions. Let’s focus on a few very recent developments.

First, the findings earlier this year of OSC Staff Notice 51-716, related to environmental reporting and disclosure of TSX and venture issuers, were alarming. There were many findings based on the 35 reporting issuers reviewed, but some of the key findings included a lack of quantification of the risks and liabilities, as well as the use of too many boilerplate statements. It is clear there will be an increasing importance related to disclosure and transparency requirements regarding environmental related risks, but will the appropriate laws and standards come soon enough for Canadian issuers — i. e. before the litigation?

Second, Canada will soon have its own set of rules concerning executive compensation. The proposed repeal and substitution of Form 51-102F6, Statement of Executive Compensation, is not expected to be brought into effect until the end of 2008. When implemented, it will create increased disclosure and transparency regarding all aspects of compensation, as well as a new Compensation Discussion and Analysis (CD&A) requirement that will provide rationale and detail regarding a company’s compensation practices. This is clearly a step ahead of our environmental disclosure obligations.

Third, in a recent case decided by the Delaware Court of Chancery, Schoon v. Troy Corp., it was held a company had the right to amend its bylaws. This in itself is not surprising, but what’s unique is that this includes the ability to remove the right to provide indemnity to former board members who have not already been named as a party to a lawsuit. This legal development will no doubt have a far-reaching effect, particularly in respect of buying trends for specialized D&O insurance products such as Side A or non-indemnifiable insurance coverages, in addition to the corporate indemnities themselves. Over the past few years, there has been a clear shift in the purchasing priorities of boards both inside and outside of Canada to the protection and insuring of personal assets. This trend is likely to persist.

Fourth, to restore balance and fairness to Canada’s corporate tax regime, the federal Canadian government released draft conversion rules for income trusts on July 14, 2008. The rules are designed effectively to level the tax playing field between income trusts and corporations. It is not yet known when these proposals will be enacted into law; when they are, there may be far-reaching effects on both trustee and D&O liability insurance purchases — particularly given the uncertainty related to whether or not an “acquisition of control” of corporations within the income fund structure occurs on the conversion of the income fund into a corporation.

Finally, recent amendments relating to t he Bankruptcy Insolvency Act (BIA) and Companies Creditors Arrangement Act (CCAA) passed by Parliament in July 2008 now empower the courts upon application to remove directors that are unreasonably impairing the possibility of a viable plan or are likely to act inappropriately. The amendments have been codified to encourage directors to remain on boards during the restructuring by granting a judicial charge to secure a corporate indemnity. The charge may not be granted if the company is able to obtain adequate D&O insurance at a reasonable cost. With bankruptcy filings on the rise, the need for appropriate counsel and advice on the issues and liability protection continues to increase.

In order to maintain stability and sustainability in the marketplace, brokers, insureds and (re)insurers will face divergent pressures in the near future that demand respect for the valuation of quantitative and qualitative D&O insurance capital. Without some restraint, the market may be destined for a crisis. But as long as there continues to be a proliferation of participants driving competition (outside of the unknown impact of the financial credit crisis), there is likely no end in sight to this soft market anytime soon.

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Only fear related to the increasing odds over time of a mega-natural catastrophe happening, or the effects of the weakening global economy on equity valuations, might slow down the magnitude of price reductions in the D&O reinsurance markets.