Network Firm News

Tuesday, September 17, 2002

AIG's White Paper on the D&O Market: "Understanding Board Member Risk"
Executive Summary
It is a trying time for corporate directors and officers. Corporate scandals have put the actions of executives under greater scrutiny. New corporate governance initiatives, while a positive step in addressing valid concerns of the investing public, have created new liability exposures for directors and officers, some of which may not have been intended. The personal assets of directors and officers are at risk now more than ever. The specter of prison time also looms large. With good reason, talented people are asking themselves whether being a director is worth the risk.

In the current environment, it is critical that directors and officers investigate and understand how their directors and officers liability insurance (D&O) protects or fails to protect them. The findings could surprise them. As the nation’s leading provider of D&O insurance, National Union feels strongly that the industry’s ultimate customer—individual directors and officers—should understand why changes to the D&O insurance policy are needed. Modifications must be made in order to refocus the policy on its original intent: protecting the personal assets of directors and officers. These changes will serve the best interests of directors and officers.

The modifications being made are not only in response to the recent corporate scandals and the increased exposure that directors and officers face. They are being made because the fundamental economics of the D&O insurance industry have been extremely negative ever since the passage of the Private Securities Litigation Reform Act of 1995 (the “Reform Act”).

With this in mind, we thank PricewaterhouseCoopers for their assistance and input, included herein, into some of the underlying causes behind recent securities litigation trends and the reasons these trends have not tracked to pre-Reform Act expectations.

Despite the Reform Act’s good intentions, securities claims soared to record levels of frequency and severity after its passage. The number of companies sued in securities litigation rose nearly 300% from 1996 to 2001.1 Settlement values jumped 150% during the same time period.2 However, given the competitive environment that was created by new entrants to the marketplace, the premiums insurers charged to cover these increasing exposures reduced by more than half. In 2000, the implausible economics of the situation begin to take a visible toll. Two large D&O carriers became insolvent. Since then, several more insurance carriers have been downgraded. Currently, the balance sheets of many D&O insurance carriers are dangerously weakened.

In dozens of recent cases, due to the insolvency of a D&O insurer or a problem inherent in the D&O insurance policy itself, directors and officers have been left without protection for their personal assets. One large D&O insurance company recently went from an A- credit rating to liquidation in 18 months, leaving many insureds with a D&O policy that was not worth the paper it was printed on.

The inclusion of coverage for the corporation in the D&O policy has also had several unforeseen effects, adverse to the interests of directors and officers. First, the inclusion of “entity coverage” has diluted the amount of coverage available for directors and officers. Policy limits intended for individuals are being eroded by the corporation’s own liabilities when a claim occurs. Second, the existence of entity coverage has also reduced corporate incentives to hold down litigation costs and settlements: Corporations no longer have a vested financial interest in mitigating damages—only in settling suits within policy limits.

Since the introduction of entity coverage, settlement amounts, as well as legal expenses, have skyrocketed. Third, in certain instances, such as the corporation’s bankruptcy, directors and officers have found access to their policy proceeds (including funds to pay for their defense) wholly blocked due to the inclusion of entity coverage.

Despite certain well-publicized instances of fraud, the vast majority of directors and officers are innocent and deserve protection. If the D&O industry is unable to protect these individuals, they will not continue to expose themselves to the threat of personal litigation.

And in order for D&O insurance and the D&O insurance market to protect innocent directors and officers, immediate changes must be made:

• Entity coverage, which has diluted the protection available to directors and officers, needs to be regulated. In order for the contract to provide clarity as to what it will and will not cover, the industry needs to adopt a pre-set allocation clause, which articulates how much the D&O policy will pay on behalf of the individuals as opposed to how much the corporation will pay on behalf of its own exposure in securities claims.

• The quality of the insurance companies participating at every level of the D&O program must be sound, lest insured directors and officers be blindsided by a carrier that is financially unable to pay losses when a claim occurs. Directors and officers need to realize that their D&O insurance is not a commodity.

• D&O underwriters must understand the true nature of the risk that they are being asked to assume. The industry will not be able to survive if it is required to pay claims on behalf of policyholders who provide inaccurate or misleading information as part of the underwriting process.

• D&O insurance premiums must be aligned with the current level of securities exposure. For this to occur, premium rates must continue to climb rapidly. By returning the D&O policy to its original focus of protecting the personal assets of directors and officers, these changes will also ensure that the D&O policy provides proper economic incentives for all parties involved in defending securities claims. This will result in a reestablishment of the traditional partnership among the insurer, defense counsel, directors, officers and corporation. Individual directors and officers will be better served when this is achieved.

With recent corporate scandals, and the quick passage of the Corporate Auditing and Accountability Act of 2002 (officially titled, “Sarbanes-Oxley Act of 2002”) in response to these scandals, significant additional exposures have been created for directors and officers.

Because of this, the need for change in the D&O insurance industry has become particularly urgent. The need for knowledgeable, experienced brokers is critical. D&O insurers and brokers must act quickly to enact the changes needed to ensure a stable, enduring D&O insurance market. An in-depth analysis of the issues facing directors and officers in today’s marketplace is attached. We hope that you will find this useful and informative in understanding why, and how, the D&O industry needs to change.

Table of Contents
Executive Summary
I Background: The PSLRA
II Expectations: Post 1995
• Capacity
• Premium Rates
• Coverage
• Entity Coverage
• Multi-Year Contracts
III Reality: Post 1995
• Frequency Rises
• Severity Increases
• Accounting Allegations
IV What Went Wrong?
• Record Rise in Restatements
• Accounting Rules Lag Behind
• Complex Disclosure Requirements
• SEC Activism
• Greater Focus by Plaintiff Firms
• Large Valuations
• Lack of Risk Sharing
V Economics of the D&O Industry
• Failed Economics
• Reinsurance Problems
• Unintended Repercussions of Entity Coverage
VI Corporate Auditing and Accountability Act of 2002
• Securities Litigation Reform
• No Bankruptcy Discharge of Securities Law Liability
• CEO/CFO Certification
• Real Time Disclosure
• Increased Frequency of SEC Review
• Audit Committee Requirements
• Executive Compensation
• Insider Transactions
• Disclosure of Off-Balance Sheet Transactions
VII Solutions for the D&O Industry
• Regulate Entity Coverage
• Price Coverage Properly
• Embrace the Flight to Quality
• Risk Sharing
• Side A Excess Program
• Resurrecting the Partnership
• Consequences of Misleading Information
• Protecting the Innocent
Read more . . .

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