Filed Under:Claims, Investigative & Forensics

The Subprime Meltdown

Unprecedented banking and financial company failures and hastily arranged buyouts by regulators to avoid insolvencies have left the financial markets reeling. The Federal Reserve and the Treasury Department formulated bailouts of companies once thought solid. Congress wrangled with the $700 billion rescue package to avert further disaster. Stockholders of once-steady entities such as Washington Mutual, Wachovia, or AIG find investments lost, and some on the brink of retirement discover that their nest eggs have shrunk by 25 percent or more. As the affected masses search for people to blame and assets to tap, suits against directors, officers, accountants, and even loan agents and appraisers continue to mount.

Given the more than $230 billion in write-downs from the subprime mortgage crisis in the first half of 2008, an inevitable barrage of litigation ensued. During the first three months of 2008 alone, 170 subprime-related lawsuits were filed in Federal Court. Nearly half of these suits were filed in New York and California. One half of the lawsuits involved putative class actions by borrowers versus lenders and mortgage brokers alleging (among other things) discriminatory lending practices, improper charges, and inadequate disclosures.

When faced with a D&O claim made against a director or an officer of a Fortune 500, a small privately held firm, or an errors and omissions (E&O) claim against a loan broker, insurers must be prepared to apply policy language and investigate the facts. This can be accomplished by answering simple questions.

Does the Policy Language Limit Coverage?

An insurance company may be defending D&O litigation -- or reimbursing an insured for the defense and potential indemnity payments in litigation -- until there is a final adjudication establishing the application of the dishonesty exclusion.

Many D&O policies also contain language excluding "personal profit." The language usually states that such losses are excluded arising out of the gaining "in fact" of any personal profit or advantage to which the insured is not legally entitled.

What Lies Beneath

An insurer's investigation entails a thorough analysis of the operations of its insured. This begins with a complete review of the underwriting materials from the company and documents from the insurance agent or surplus lines broker that contain all the facts about the insured's operations.

Duty of the Insurer

The insurer needs to respond to a tender from a policyholder in an expeditious manner. Some state-specific claim regulations establish time periods that a carrier must follow when responding to an insured and making an initial coverage determination. Preliminarily, the insurance company's response will depend on whether the policy is a straight reimbursement policy and if the policy contains a "duty-to-defend" provision.

The Power of Exclusion

The impact of a subprime crisis on insurance companies will likely be minimized by the effect of exclusions based on the fraud of the insured -- whether the dishonest-acts exclusion or the personal-profit exclusion applies. Insurers have drafted this language anticipating E&O and D&O claims. However, the need for a final adjudication of the facts to apply the exclusions requires the insurer to be vigilant in its investigation from the onset.

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