D&O Liability Insurance Rates Rise Amid Corporate Scandals: Little Moderation in Costs Is Expected As New Governance Rules Are Welcomed

Even the cleanest American companies are paying through the nose for the sins of their less noble peers. While financial scandals have exploded, technology players have melted down, and shareholder lawsuits have proliferated, all public companies have been hit by a spike in costs of directors and officers (D&O) liability insurance. And experts in the field expect no short-term letup in D&O rate increases at the very time corporations are under intensifying regulatory and investor pressures to not only recruit the best directors but to require them to work harder. Ironically, the new Sarbanes-Oxley law may be a moderating force over the longer term. But not immediately, given the way the act spells out requirements for director actions in areas where boards previously had considerable discretion or wiggle room and thus heightens the probability of shareholder lawsuits for any fumbles that appear to violate the statute. LouAnn Layton, a managing director who heads the D&O practice at insurance broker Marsh & McLennan Cos., says she expects that the new law eventually will provide a “comfort level” for insurers but doesn’t see that happening for a while. Layton and Tony Galvan, the D&O manager at Chubb Corp., one of the two largest marketers of D&O policies, say that although the latest spike, which began in 2001, is almost directly traceable to the recent scandals and collapses, the industry has a long history of pricing volatility. For example, a spike followed the famous Smith vs. Van Gorkum decision in Delaware during the mid-1980s, which led to the now common practice of market checks to determine the highest price available for a publicly held target. But D&O rates started to slip in the mid-1990s. This was unusual because it paralleled a surge in mergers and acquisitions, normally a key source of shareholder litigation. “Our exposure was going up and rates were down so we were digging ourselves into a pretty precipitous hole, which is probably the explanation of why rates now are increasing in such a dramatic fashion,” Galvan says. Thus, the insurance industry already was suffering from D&O underpricing at the very time. Galvan notes that claims were surging, the “severity of claims was accentuating problems,” and companies were willing to settle for huge sums rather than fight and look like the “poster child for defender of bad corporate behavior.” “The plaintiffs know they can demand a hefty sum and probably get it so they can sue for increasingly large sums of money,” Galvan says. Many D&O rate increases were in the triple-digit range in 2001 and 2002 on average and the double-digit range on average in early 2003. Dropping Sarbanes-Oxley into the mix results in a real challenge to public companies. There is an increased need to buy D&O insurance, regardless of the rates, to protect directors from personal losses, especially people like audit committee members who are given special responsibilities under the law. “The companies may have to increase the (coverage) limits for independent directors, especially audit committee members, to retain and attract directors,” Layton says. “A lot of our clients are rethinking their program design and whether they have to increase the limits to attract independent directors.” Galvan states that as a result of the law “there will be almost more exposure in the near term as more companies come clean and we get more litigation out of it.” But he and Layton are more optimistic for the longer run. “I think the reinvigoration of the board’s power will provide a natural check on some of these abuses,” Galvan says. I don’t think it’s a panacea, but I do think the increased muscle of the board is a good thing.” Layton says the hope is that Sarbanes-Oxley results in “policies and procedures at the board level,” which will draw fewer lawsuits. Business ostensibly will be handled in a better manner, including more thorough due diligence and “real-time disclosure” of results in approaching acquisitions and other corporate development actions. “It will be a comfort to know that losses and lawsuits may not be as frequent,” she states. Jonathan Legge, who heads the m&a group in Marsh McLennan’s D&O practice, says that many parts of Sarbanes-Oxley are yet to be completely defined, but a big contribution thus far has been to warn the corporate board “it is not a rubber stamp.” That bodes for more intensive scrutiny of acquisition proposals, he notes. “The boards are taking even minute decisions very seriously,” he says. Legge also thinks that the requirements of the act ultimately will impact decisions made in leverage buyouts and venture capital investments. One possibility for the future, although it is not imminent, is to market D&O insurance much like auto and health care insurance, with a rating system favoring companies that keep their noses clean. In fact, some consultants are already starting to develop these products but are meeting with reluctance from underwriters. “There are all sorts of vendors out there hawking score sheets for corporate governance,” Galvan says, but notes that he doesn’t want to “subcontract that to vendors.” “This is intuitive stuff in many cases. Do they have the right people and the right system? I don’t need to pay someone to tell me that. I can figure it out by opening the proxy.” Layton notes that some “rating agencies” on corporate governance may emerge but that more experience with implementation of Sarbanes-Oxley is needed before anyone can determine what impact they will have. In a “white paper” on the subject, National Union, another large D&O underwriter, warned about the tendency of companies to take out “entity coverage,” which protects the corporation itself in shareholder damage litigation. The insurer, an arm of American International Group, said that the problem is that the entity protection may dilute the coverage available for officers and directors. With entity coverage guarding the corporate treasury, the paper said, there are “reduced corporate incentives to hold down litigation costs and settlements” and qualified director candidates will be turned off. Copyright 2003 Thomson Media Inc. All Rights Reserved.