Amid Fewer Lawsuits, D&O Premiums Fall

Good news for companies footing the bill for liability coverage for corporate officers and directors: Thanks primarily to excess capacity in the insurance market, companies should be able to get more D&O coverage for less money.

Driven by increasing capacity in the insurance market as a whole and by decreasing frequency and severity of losses of class-action lawsuits, D&O premiums have fallen by an average of nearly 30 percent since the end of 2003, according to Advisen, an information service for the commercial insurance industry.

“That means more coverage for less money,” says David Bradford, editor-in-chief at Advisen and author of the briefing, “The D&O Market in 2006.”

Bradford

Barring an unusually severe year for natural catastrophes, Bradford and other experts expect rates to continue to fall in 2007, as policyholders’ surplus continues to accumulate and the number of securities class-action suits filed remains low.

“As prices continue to go down, I suspect underwriters will be more willing to bargain broader coverage for smaller rate increases, so the breadth of coverage should increase as well,” Bradford says.

While the average premium for D&O liability insurance more than doubled from the fourth quarter of 2000 to the fourth quarter of 2003, policyholders’ surplus has been growing since then, putting downward pressure on rate levels. Moreover, the property and casualty industry posted near-record profitability in 2005, despite record-shattering catastrophe losses in 2005 as a result of Hurricanes Katrina, Rita, and Wilma. 2006 then proved to be a very mild year for catastrophic losses, and the subsequent huge profits only fed the glut of policyholders’ surplus.

“As long as policyholders’ surplus continues to grow faster than the overall economy, and barring excessive catastrophic losses, premium rates will continue to fall, and potentially could fall very sharply,” Bradford says.

LaCroix

As they have in prior soft markets, underwriters are likely to succumb to buyer demands to retain business. “Directors and officers should pay less than in the past and be able to acquire broader coverage because terms have loosened as competition has increased,” says Kevin LaCroix, a director at insurance wholesaler Oakbridge Insurance Services and author of a blog on the D&O industry.

REPORT

Below is an excerpt from Advisen's report on the state of the D&O insurance market in 2006.

The number of securities class action suits filed – the principal source of D&O losses for public companies—fell sharply in 2006. The number of U.S. public companies also has fallen slightly over the 2004-2006 period—which is most likely attributable to public companies electing to go private rather than incur the expenses and potential liabilities associated with Sarbanes-Oxley—but the decrease in the number of

public companies does not account for the drop in the number of suits. On an absolute basis, the number of suits fell 49% between 2004 and 2006, and relative to the number of public companies, suits fell 47%.

A number of theories for the decline in securities class action suits have been proposed; one of the more persuasive is that there has been a fundamental change in corporate governance practices and transparency to shareholders, substantially the result of the Sarbanes-Oxley Act. If this is the case, 2006 may mark the beginning of a sustained period of lower securities class action claims frequency (at least until an inflated market inspires a new round of accounting creativity).

The downward trend in the number of suits filed in 2006 is distributed across almost every industry group. This is consistent with the theory that of improved claim frequency is attributable to better governance and heightened transparency throughout the entire public company sector. The only other year since 1996 in which as many industry groups moved in parallel was 1998, when almost every industry saw the number of suits filed increase. While there is still a wide variation in the number of suits by industry group, the gap is closing: the spread between the industry with the least number of suits filed and the industry with the most is at its lowest point in the 1996-2006 period.

Source

Advisen D&O Market Report (Jan. 26, 2007)

So far, some insurers have shifted capacity from very large public companies to small public companies, private companies, and nonprofit entities, keeping rates stable for the largest companies, while rates for smaller companies are falling sharply. Advisen notes that the trend of fewer lawsuits being filed may encourage some insurers to re-allocate capacity to large public companies in 2007.

Class-action lawsuits, which are the principal source of D&O losses for public companies, plunged in 2006; falling 49 percent from 2004 levels. While there are several theories for that decline, the Advisen report credits a “fundamental change in corporate governance practices and transparency to shareholders” thanks to the Sarbanes-Oxley Act. If that’s the case, the report continues, 2006 may mark the beginning of a sustained period of fewer class-action lawsuits, at least until another overheated market comes along and induces a new round of accounting misdeeds.

The decline in suits filed in 2006 is distributed across almost every industry group, which Advisen says is consistent with the theory that better governance is lifting Corporate America overall. The only other recent year where most industry groups moved in tandem, Advisen notes, was the Internet Bubble heyday of 1998—when almost every industry saw the number of suits filed increase.

“I believe SOX is actually doing its job, increasing transparency and implementing improvements in corporate governance practices that are filtering through and contributing to lower number of suits,” Bradford says.

In addition, Advisen reports, early indications show suits filed in recent years will settle for less. While median cash settlements ranked by settlement year were up in 2005 and 2006, many of those cases were filed earlier in the decade when shareholders wanted directors’ scalps; median cash settlements by filing year, however, have been trending downward.

“Reported severity is actually up because mega-cases from the early part of [the] decade [are] being resolved,” LaCroix says, “but on average, severity should start declining once mega cases like Enron, Adelphia, Kmart, WorldCom, and Tyco work their way through the system.”

Still, LaCroix expects certain sectors to see smaller decreases than others. Financial and health-care services in particular might not see the same level of price declines, “since the experience in those areas has been more negative than the industry as a whole,” he says.

What About Backdating?

A number of companies have been targeted in securities class-action suits related to stock option backdating scandals, and more lawsuits are likely to be filed in 2007. The Advisen report, however, says those lawsuits “probably will prove to be more [of] an annoyance than a significant source of losses to D&O underwriters.”

“It does not appear that shareholders have been badly damaged, if damaged at all, by backdated options in most cases,” the briefing says. But, the report adds, the large number of shareholder derivative suits resulting from the scandals could produce significant legal bills for defendants.

Roughly 144 shareholder derivative lawsuits related to options backdating have been filed so far, but such suits don’t typically result in large monetary awards, Bradford says. “It’s making the D&O underwriting community nervous, but so far it seems to be relatively manageable cases and it’s not expected to generate excessive losses,” he says.

LaCroix agrees. “At the current level, backdating-related cases wouldn’t significantly harden the market,” he says. “If claim activity levels increase dramatically, it could impact pricing. The industry is watching it closely.”