Risk ManagementCredit Risk ManagementFinancial Risk Management
While the threat of subprime mortgage litigation hovers over the financial services industry, potentially hitting insurers that provide directors & officers liability coverage, many companies are finding surprising softness when it comes to time to renew their D&O policies
By Russ Banham
In April, Dan Kugler, Snap-on Inc.’s assistant treasurer and risk manager, renewed the company’s directors and officers liability insurance policy and found the experience a pleasant walk in the park. Despite sobering reports that D&O insurers are potentially on the hook for billions of dollars in losses related to the subprime mortgage market meltdown, Kugler got a free pass.Actually, the renewal was even better than a free pass since Kugler wrung moderately lower premiums from his D&O insurers than he did last year. “I was also able to favorably adjust the coverage conditions and policy language,” says Kugler at the Kenosha, Wis.-headquarters of Snap-on, a maker and distributor of tools and diagnostic equipment with $2.5 billion in annual revenue. “Then again, we have no exposure to subprime.”
There’s the rub. While most classes of business can expect soft conditions in the D&O market to continue this year, companies in the financial institutions sector, real estate development, home building and other businesses even tangentially involved in housing and finance may be in for a beating. D&O premiums for these businesses are up from 15% to 400%, according to insurance broker Marsh Inc. On the bright side, “this isn’t trickling down to affect other companies buying D&O,” says Lou Ann Layton, a Marsh managing director.
Hence, Kugler’s success in getting an excellent deal from his insurers, one providing broad liability protection at high financial limits of coverage provided by the various insurance companies participating in Snap-on’s D&O program, each taking a piece of the pie. The number of insurers helps explain the protracted softness in the D&O market. A decade ago, one was hard pressed to find more than a handful of insurers offering D&O insurance, with market share divvied up by American International Group, Chubb Group, ACE Insurance and Travelers. In the post-Enron environment, losses rattled the companies and their rates skyrocketed. Recognizing opportunity, several new insurers were capitalized offshore in Bermuda to enter the market with lower-priced D&O products. “We got a moderate reduction in premium, on top of what were moderate reductions in previous years,” says Kugler.
So did Cisco Systems Inc., which renewed its D&O program in December. “I was very pleased,” says Leslie Lamb, the San Jose, Calif.-based technology company’s global risk and insurance manager. “I got us a decrease [in premium], which was surprising, given the concerns over subprime. I also got the [more liberal] coverage considerations I sought. As far as my experience, there wasn’t any volatility in the D&O market, though maybe it’s coming down the pike.”
Lamb’s point underscores the uncertainty swirling around D&O insurers and the potential losses they may suffer as a result of the subprime debacle. A glance at the Web site of Stanford Securities Class Action Clearinghouse, which breaks out securities litigation by event, seems to paint a dire picture for the insurers. More than 60 class actions had been filed against a Who’s Who of Companies by shareholders. The lawsuits, for the most part, blame the publicly traded companies for not fully assessing the risk of subprime mortgages or meaningfully disclosing it to shareholders. Bear Stearns, of course, is a defendant on the list, as is Countrywide Financial, Ambac, MBIA, Société Généralé and other companies earning dour headlines of late. Their D&O, E&O [errors and omissions] and fiduciary liability insurers are on the hook for billions of dollars in potential losses—if the class actions succeed in the courtroom, or in the case of fiduciary insurers if claims brought under the Employee Retirement Income Security Act for improper oversight of defined contribution plans prove successful.
How many billions? Lehman Brothers estimates D&O and E&O claims together could cost the insurers between $3 billion and $4 billion. Advisen Ltd., a provider of analytics to the insurance industry, pegs the potential loss at $3.6 billion over two years. Navigant Consulting, on the other hand, estimates more than $8 billion in potential subprime-related D&O losses, while Layton from Marsh acknowledges “between $3 billion and $15 billion in combined D&O, E&O and fiduciary losses, which are the numbers we’re hearing from investment banks,” she says. “Without exception, any financial institution whose stock drops because of an announcement of write downs related to subprime will be sued. If a company has a 401(k) plan with subprime-related investments in them, they’re going to see fiduciary claims. And if a company has lending practices associated with subprime risks, they’re looking at E&O claims. This will be much larger than the D&O litigation coming out of the S&L crisis in the 1980s.”
Layton isn’t alone in this concern. “You really have to go back to the late-1980s and the savings and loan debacle to find a comparable industry-specific kind of meltdown, and this is more severe than that,” says Dan Bailey, a partner at Bailey Cavalieri LLC, a Columbus, Ohio-based law firm that specializes in D&O litigation and has been retained by several insurers in a number of subprime related lawsuits. Bailey provided a glimpse of his likely defense strategy. “We’re filing motions to dismiss based on our contention that there was no misrepresentation—the market knew subprime investments were high risk,” he says. “That’s the very definition of subprime and it explains the higher rates of return. Con-sequently, how can an investor complain because these risks have come home to roost?”
So far no D&O claims have come to trial or been settled, although there have been one or two dismissals, Bailey says. Nevertheless, D&O insurers seem to be taking the threat of major losses in stride. “The four largest D&O insurers [AIG, Chubb, Ace and Travelers] have disclosed in different ways their exposure to loss from subprime, and as of right now it doesn’t indicate a meltdown; nor does one seem imminent,” says Joyce Sharaf, assistant vice president at A.M. Best Co., which rates the financial strength of commercial insurance companies. “Are there going to be losses? Yes. Will they be substantial? Who knows? We’ve seen a concentric circle of litigants develop and widen in recent months, with more than just investment banks and brokerage firms being sued. The question is how wide will it get in succeeding months.”
At this juncture, Sharaf says she “hasn’t seen enough pain to cause me to rethink the ratings [of the insurers].” None of the insurers in the D&O market have “massive financial institutions exposure,” she notes, meaning that losses, if and when they occur, will be spread relatively evenly across the insurers and their reinsurers. Another positive is that financial institutions historically buy limited D&O insurance coverage compared to other sectors of business and industry, she notes.
Aon Financial Services Group, which provides insurance broking and consulting, has a similar take. “It’s still a bit too early to tell how this will play out,” says Brian Wanat, a managing director who heads Aon’s financial institutions practice. “We’re in the fourth inning of a nine-inning game. The estimates for what the [insurance] industry will pay out—and we’ve heard as much as $20 billion—are outrageous. But these policies take six years or so for the settlements to come to fruition. That’s a long way off for the checks to be cut, if they’re cut at all.”