Should Directors and officers of major companies be concerned about the limits of their D&O liability insurance? Only if they are unlucky enough to get named in a class action suit brought by an institutional investor. While the chances of getting hit with a lawsuit are relatively slim–according to March Inc., less than a 1% chance in any given year–when a company does get fingered, it can be devastating. In 2006 alone, there were four billion-dollar-plus D&O settlements and seven cases settling in excess of $500 million. Last year, the average settlement value in D&O lawsuits hit a record $45 million–more than twice the average of all settlements since the passage of the Private Securities Litigation Reform Act of 1995–and so far this year, the trend is continuing with average settlement values hovering around $41 million. What's a company to do?
Well, the answer is not to go out and buy all the insurance you can–especially since there isn't enough insurance capacity to cover potential losses anyway. "D&O claims severity is punishing at unprecedented levels," admits Lance Ewing, vice president of risk management at Harrah's Entertainment Inc., "but that doesn't mean we run to insurance as the answer. You make sure you do the right things internally to be prepared before you turn to insurance as the savior."
Unfortunately, the report card on preparedness among companies, when it comes to risk management, is mixed. It is fair to say that most companies have a better handle on risk than they did five years ago–if only because regulations, such as Sarbanes-Oxley, have forced them to consider it. But only in May, Big Four audit firm PricewaterhouseCoopers LLC noted mounting concerns among internal audit executives about their companies' risk assessments. While more than 80% of respondents to the firm's annual internal audit study reported that they conduct yearly enterprise-wide assessments, only a handful continually updated these assessments. Approximately 64% do little or nothing between the annual assessments, and only 20% consider the annual assessments well integrated enough with each other to make sure no risks are falling through the cracks. In a 2006 survey of corporate directors, the Conference Board found that only 43% reported that their companies had formal practices in place to manage reputational risk–a key factor in falling stock values which, in turn, is a key factor driving most D&O lawsuits.
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But while the state of preparedness may be uncertain, the consequences of a bad call on D&O are unmistakably harsh, with several factors conspiring to kick D&O settlements into the stratosphere. The primary culprit, of course, is the rise in market capitalizations; the larger a stock drop, the larger the potential settlement figure, particularly in cases brought by institutional investors like pension funds, which will accept nothing less than giant settlements. Institutional investors filed more than half (53%) of all securities class actions last year, yet these cases accounted for 94% of total settlement values. And the situation gets far more dire when a company faces both institutional investors and a Securities and Exchange Commission prosecution. "When the two get into the act together, it's really time to gulp," says Carol Zacharias, senior vice president and chief counsel at insurer ACE USA.
D&O cases also take longer to settle than they once did–another factor in the rising values. "Before passage of the 1995 reform act, 61% of cases went away in three years," says Zacharias. "Today, only 44% of cases go away in three years, and 38% of cases take longer than five years to reach settlement. If you're the plaintiff in these suits, you'll be taking the settlement value more seriously in the sixth and seventh years."
Without enough insurance to absorb a D&O settlement, directors and officers who are not indemnified by their companies for potential claims must dig into their own wallets, something Enron Corp.'s and WorldCom Inc.'s former board directors glumly had to do, at a reported $13 million and $18 million, respectively. Last year, Tenet Healthcare Corp.'s ex-CEO Jeffrey C. Barbakow reportedly contributed $1 million of his own money to settle the company's securities class action. Even the $100,000 reportedly paid by Krispy Kreme's ex-CFO in that company's class action settlement gives pause.
But it's not all fear and loathing. Thanks to stricter accounting and stock exchange rules, Sarbanes-Oxley monitoring and a roaring stock market, companies arguably are in better shape to avoid a D&O claim. Indeed, the incline in D&O severity is balanced by a pronounced decline in claims frequency. "When the stock market and the macroeconomic environment are good, you tend not to see a lot of securities litigation," says Lou Ann Layton, managing director at insurance broker Marsh Inc.
There is also good news from the courts: On June 21, the U.S. Supreme Court decision in Tellabs Inc. v. Makor Issues & Rights Ltd. essentially made it tougher to press a class action case alleging securities fraud. A week earlier, the Court also ruled that securities underwriters on Wall Street are generally immune from civil antitrust lawsuits. Both decisions raise the bar for class action lawsuits going forward.
Finally, given the current soft insurance market, D&O insurance costs have been steadily falling, so if you want to buy more insurance, it won't hurt so much. The average price for $1 million in coverage in the first quarter of 2007 was down 12.09% from the same period a year ago. That's helped many companies forced to up their limits as their market caps rise. "We've had a steep increase in our market cap over the last five years, with our stock performing phenomenally well," says Dave Hennes, director of risk management at The Toro Co., a Minneapolis-based landscape products manufacturer, with $1.8 billion in revenues. "As it goes up, I incrementally increase our D&O limits."
Still, Hennes, like Harrah's Ewing, doesn't buy all the insurance available. "I'm told there is about $1 billion in insurance that can be purchased by stacking up all the carriers' limits," he says. "But buying that much insurance isn't cost-effective. The key is prevention and good governance, looking to insurance to reassure directors that if something out of the blue happens, we've got that fallback." Hennes works with his insurance broker to benchmark peer companies to determine how much D&O to buy.
Ewing does the same. "We do risk-based scenarios using tabletop models that describe worst-case situations," he says. "This is ongoing since we're constantly evolving and going into new ventures."
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