The D&O Shakeout

You do not have to look that far to find the insurance effects of the corporate scandal crisis in the U.S. Soaring claims costs and emerging exposures have prompted top directors and officers liability insurers to boost reserves and speak out against runaway litigation.

AIG, one of the largest directors’ and offices’ (D&O) carriers, recently announced it would incur a net after-tax charge of US$1.8 billion for the fourth quarter 2002, stemming from an increase in casualty loss reserves. The company stated that 25% of the reserve increase will apply to D&O liability. In early February, a representative from another major D&O insurer, called for an “Institute for Securities Class Action Defense” to curb “egregious” class action securities lawsuits that have plagued the executive risk marketplace. John Degnan, vice chairman of Chubb, says an industry response is necessary to “confront and reverse a very troubling pattern of abusive, outrageously aggressive and, in some cases, downright dishonest conduct on the part of the plaintiffs’ bar in class action securities litigation.” Shareholder lawsuits currently represent at least 50% of D&O claims.

Figures related to executive risk and shareholder litigation in the U.S. are startling. The well-documented “dot.com meltdown” in early 2000, and the spectacular failures of Enron and Worldcom, represent only the most glaring examples of corporate malfeasance. There is much more. “Enron was the symptom rather than the disease,” comments Jordan Solway, Chubb Insurance Company of Canada’s specialty claims manager. Solway spoke at a conference on executive risk which was recently held in Toronto. “The legacy of Enron is the corporate governance crisis we see today.”

In fact, although the number of class action shareholder lawsuits for fraud related to U.S. federal securities declined in 2002 to 259 actions from a high of 488 in 2001, there are still many concerns (the proliferation of “IPO Allocation” lawsuits accounted for about 65% of the spike in litigation in 2001). Average settlements in recent cases have averaged US$17 million, as opposed to US$6 million in 1996. Paid losses on roughly two dozen D&O claims have exceed the US$100 million mark over the last two years. Enron alone could cost insurers as much as US$500 million.

According to Chubb Canada’s senior vice president Udo Nixdorf, there is also a worldwide “claims bubble” – a backlog of 700 cases with a potential impact of US$7 billion. And that has led to a sharp backlash by insurers. “The result for many corporations in terms of D&O insurance is not just premium increases, but the roll back of terms and conditions that used to be standard in many policies,” says Jack Mazakian, a managing partner at brokerage firm Jones Brown Inc. “Corporate self-retentions have skyrocketed and co-insurance clauses have been re-introduced, often with relative allocation determined purely at the discretion of the insurer.”

The reaction from U.S. legislators to the corporate governance crisis was comprehensive, with the introduction of the Sarbanes-Oxley Act in July 2002. This legislation puts stringent requirements on publicly traded companies for financial reporting, disclosure and board composition. In particular, it contains mandatory guidelines for certification of financial statements in quarterly reports, prohibitions against personal loans to directors and officers, audit committee requirements, timely disclosure of material change, shortened periods for insider reporting and accounting industry oversight and regulation.

It’s not just federal legislation, but individual action on the part of major stock exchanges in the U.S. that has created onerous compliance rules. The NYSE recently introduced new listing requirements that include disclosure of corporate governance guidelines, shareholder rights to vote on all equity compensation plans and new definitions of “independent” directors.

Canadian Exposure

With all this movement south of the border, what is happening in the Canadian marketplace? Most agree that the exposure of directors and officers in Canada is not nearly as high as in the U.S. – the number of shareholder lawsuits in Canada represents less than 10% of that in the U.S. Still, average premium increases for D&O insurance have ranged from 25%-50 % for “clean” risks to much higher multiples for clients with poor claims experience – with no top end in sight, observes Mazakian.

The seeming disconnect between premium and exposure masks a couple of points, though. First, many Canadian insureds are listed on U.S. stock exchanges, especially the NYSE and NASDAQ. These clients must be treated essentially as U.S. entities, with the same risk profile. The second point is that many D&O insurers are U.S.-based and tend to view experience in American terms. And third, and perhaps most importantly, is the belief that developments in Canada will lead to far more scrutiny of corporate governance practices and new exposures.

The regulatory response in Canada has been direct, but not as substantial as the Sarbanes-Oxley Act. The Saucier Report, presented in late 2001, formed the basis for new corporate governance guidelines introduced last year by the Toronto Stock Exchange. Rooted more in disclosure than regulation, the new guidelines require mandatory disclosure of governance practices, outline the role of the board in contributing to strategic direction of the corporation and impose new standards on audit committees.

Critics of the new guidelines have focused on the concept of voluntary disclosure, citing that the rules require no mandatory certification of financial statements by management, no definition of “independent” directors, no authority for hiring or firing auditors and no mandatory code of business conduct and ethics. New legislation in Ontario could toughen up corporate reporting and disclosure practices. Bill-188 proposes amendments to the Ontario Securities Act, which would require the CEO and CFO to certify financial statements, make corporate officers liable to disgorge any profits from improper conduct and grant investors in the secondary market a direct right of action against corporate directors and officers for misrepresentation, without any requirement of reliance. This last point is important, because of the slowly changing Canadian legal environment for shareholder class action lawsuits, especially those related to fraud and misrepresentation. Canadian courts generally have rejected the U.S. “fraud on the market” theory, which holds that shareholders can bring fraud claims based on a stock’s market price fluctuation, even when a plaintiff has not relied on or even read the company statement in dispute. However, we may be seeing a new strain of judicial activism in Canada.

Canadian Stirrings

A recent Quebec Superior Court of Justice decision certified a share-related class action lawsuit against the officers and directors of Jitec Inc. and three brokerage firms – the first time a class action has proceeded on the fraud on the market doctrine. The petitioners allege they suffered damages as a result of manipulation of Jitec’s share price to maintain it at an artificially high level. Crucially, the case marks a clear departure from the principles applied by Ontario courts in the Bre-X case, in which the fraud on the market doctrine was rejected.

In another important legal decision, the Ontario Superior Court of Justice recently set aside a $27 million severance agreement that the board of directors had approved for the Chairman of Repap Enterprise Inc. The court held that the board of directors of Repap approved the employment contract without careful and objective analysis, finding also that the directors’ actions were not protected by the “business judgment” rule. The decision presents a warning to directors that courts are ready to scrutinize board behavior.

Many of these lawsuits are emerging because of an increased shareholder activism in Canada, according to Solway. In fact, the Canadian Coalition for Good Governance was formed last year to monitor corporate governance practices and “align the interests of boards and management with those of the shareholders,” says Claude Lamoureux president of the Ontario Teacher’s Pension Plan. The coalition has the backing of the OTPP and OMERS, representing investors with more than $500 billion in assets under administration.

On top of this, the Globe and Mail released a corporate governance survey last fall of 270 companies in the S&P/TSX index. It found that “Corporate Canada falls short of groundbreaking U.S. requirements that a majority of directors be independent of the company. Further, they fail to meet new standards for fully independent audit, compensation and nominating committees…Many companies do no even meet existing Toronto Stock Exchange guidelines for boards of directors.” Judicial, shareholder and regulatory activism all point to signs that D&O exposures will not diminish in the near future. “The D&O market is gradually evolving in Canada,” notes Nixdorf. “I think you will see claims and lawsuits plateau in the U.S., but they will rise in Canada.”

Cover Cuts

The reaction in the p&c insurance market to D&O exposures is similar to that toward other commercial policies, but with a few wrinkles thrown in because of the unique nature of the executive risk product. There are substantial premium hikes, increases in self-retentions (often up to $1 million), reductions in policy limits and the reintroduction of coinsurance options.

There are also much tougher terms and substantial revisions to standard policy wordings, potentially including rescission of coverage when a company restates earnings, limitations on continuity of coverage, increased exclusions – for bankruptcy, insolvency or employment practices liability – and elimination of coverage extensions, such as coverage for underwriters of an IPO. In many cases, entity coverage, a traditional part of D&O policies that covered the company as a whole, is now only an option and, in some cases, not available at all.

Nixdorf points out that there has been a “changed underwriting dynamic,” in which far more scrutiny is placed on company financial reporting, particularly for firms with frequent restatements and those in certain industries, such as telecommunications and technology. According to the US General Accounting Office, the number of financial restatements due to accounting irregularities increased by 145% between 1997 and 2002.

The underwriting microscope is also tightly focused on corporate board structure, director qualifications, board independence and corporate conduct policies and procedures, says Nixdorf. D&O insurance is written on a “primary/excess” basis, typically with one insurer as the primary carrier and others participating on upper limits. Nixdorf said upper limit coverage used to be cheaper, but since some insurers have been stung with huge claims, that is no longer a reality. In fact, worldwide capacity in general is declining in the D&O marketplace, with depleted reserves for IBNR claims and diminishing capital to support primary and reinsurance writings, he adds.

“It’s clear that some carriers have lost the appetite for D&O insurance,” says Mazakian, noting the withdrawal of Royal & SunAlliance Canada from the executive risk marketplace. “What we have seen is a distinct ‘tiering’ of insurers, in which the top-tier are still accepting risks, the middle-tier is taking a cautious stance and the lower tier is barely holding on.”

Corporate Awareness

With all this insurance activity, is the message of sound corporate governance getting through to today’s boards and directors? That is a question many brokers, insurers and lawyers are still shaking their heads at in this atmosphere of heightened shareholder and regulatory scrutiny. Several sources say they see too many ignoring the risk and rationalizing corporate governance exposures. “We still hear many corporate directors say things like, ‘I’m well-off so why would I need D&O coverage?'” observes Mazakian. “It points to a fundamental misunderstanding of the risks out there.”

Proper risk management and close attention to corporate governance guidelines and procedures may help entities ward off exposures – and huge premium hikes. In fact, sources say there seems to be a leveling off of premium adjustments after the harsh corrections of mid-late 2002. Many predict a gradual stabilizing of D&O premiums by 2004, with some bumps along the way this year. “We are still waiting for underwriters to blink,” Mazakian notes, referring to the tough stance insurers are taking on D&O premiums. “But we haven’t seen too many signs yet.”