Oh No… It’s “D&O”

While price strengthening in the North American commercial insurance marketplace had been well underway before 9/11, the terrorist attacks served as a catalyst that rocketed proper coverage prices upward. It was perhaps an unfortunate coincidence that the financial troubles of Enron and Worldcom, and the subsequent corporate governance scandals and shareholder lawsuits that ensued from these highly-public cases, made global headlines at more or less the same time.

Now, the hard line taken by insurers to property and terrorism exposures, through a combination of increased pricing as well as reduced terms of coverage, is being turned on casualty lines. Specifically, directors’ and officers’ (D&O) and errors and omissions (E&O) have carried the brunt of price increases and cover cutbacks.

Joe Hardy, the director of risk management and insurance at Hudson’s Bay Co., admits that D&O coverage had been under-priced before the rate corrections introduced by insurers last year. As a result, corporations are now not only paying for the increased risk perceived to be inherent in the market, but the price backlog from the years of the “soft market”. Hardy compares the steely approach being taken by insurers with D&O to the product liability crises of the mid-1980s when a series of highly-publicized drug product call-backs caused a mass withdrawal of insurance capacity. As such, Karen McWilliam, a risk management consultant, expects the stricture terms and pricing of D&O cover will be one of the “top stories” of 2003.

Are insurers over-reacting to the potential risk within the D&O market? According to insurer feedback from a D&O conference recently held in Toronto (see article on page 24 of this issue for further details), rates in this business within Canada have risen by between 25%-50% over the past year – significantly lower than the tenfold increases that have been common in the U.S. Notably, two U.S.-based insurers disclosed multi-million dollar special reserve charges toward the end of last year relating specifically to D&O claim exposures. AIG, which is one of the largest D&O writers globally, announced an after-tax reserve allocation of US$1.8 billion to boost its liability reserves, with US$450 million of this amount relating specifically to D&O. Udo Nixdorf, senior vice president of Chubb Canada (Chubb was the other major insurer to disclose a significant reserve adjustment for D&O toward the end of last year), believes that, in addition to the current and future risk of D&O exposures facing insurers, there is a past “worldwide claims bubble” of D&O-related cases with a potential cost of about US$7 billion.

The risk associated with D&O lies with increased shareholder activism, regulatory scrutiny and the growingly apparent lack of appropriate corporate governance practices applied by public companies. Insurers feel that corporations and their directors are not taking the risks associated with poor corporate governance seriously enough. However, the greatest concern lies with the jump in shareholder lawsuits and value of case settlements which currently average US$17 million versus the average of US$6 million in 1996. In the past, the majority of D&O cases related to employee dissatisfaction and creditors seeking payment. Today, nearly 50% of D&O cases are shareholder lawsuits, insurers note. The plaintiffs’ bar has found a new “insurance cash cow” in D&O similar to the legal attacks made through asbestos. As a result, the U.S. government introduced the Sarbanes-Oxley Act last year, which places tough financial reporting requirements on publicly traded companies, while several of the major U.S.-based security exchanges have brought in their own more stringent listing requirements. In Canada, the Toronto Stock Exchange introduced new corporate governance guidelines last year, although these requirements are “voluntary” and therefore are largely inadequate in curbing the potential D&O risk factor, according to insurers.

D&O rate increases in Canada over the past year have been in the order of 30% to 300% comments Danielle Carolan, an account manager at Aon Reed Stenhouse Inc. E&O covers have risen by between 35%-100% over the same period, she notes, which is in line with the general price movement on commercial casualty lines. Carolan does not believe that the risk associated with D&O in Canada is as high as the litigation-prone U.S. However, there are two broad factors driving D&O pricing in Canada, she observes, the first being that the market has experienced a dramatic withdrawal of capacity with the majority of the insurers still engaged in the market being U.S.-based, and secondly, many listed Canadian companies also trade on U.S. security exchanges. The sectors most hard hit have been financial services and technology firms, she adds, with the restrictions on coverage and higher pricing applying across the country except for Quebec. “Underwriters are really bearing down, and paying close attention to the corporate governance procedures [applied by companies].”

Is there an end in sight to the tighter market conditions applying to D&O? Carolan does not believe that the “market’s storm” has run its full course, and that corporate insureds will continue to experience difficulty in attaining cover – at least at rates and terms they would be happy with. However, Aon Reed Stenhouse has tapped into the Bermuda and London markets to secure cover for their clients, she notes, which has helped to ease the capacity and pricing problem – at least for now.