Why The Corporate Governance Crisis Didnt Kill The D&O Insurance Market If you thought the crisis in corporate governance was over, think again. After a brief lull during the latter half of 2002, corporate malfeasance is once again making headlines, despite the din of war.
Whats worse is that there is every indication that the well of corporate greed may run much deeper than previously understood, leading to an enormous reservoir of potential plaintiffs in future shareholder class action suits against corporations in every industry and of every size.
Recent revelations are left wanting in shock value only because the American public already holds Corporate America in such low esteem. In fact, a recent Wall Street Journal poll of prospective jurors found that 67 percent believe corporate executives will lie to increase profits. Yet jaded jurors are but one of many indicators that corporate chieftains, risk managers, regulators and law enforcement officials have their work cut out for them in the months and years ahead.
Caught in the middle of the crisis in corporate governance are insurers who, in good faith, sold directors and officers coverage during the late 1990s into 2001, but now find themselves financing an avalanche of litigation and settlements. Loss costs for many D&O insurers are three-to-five times their 2001 premiums.
Meanwhile, insurers offering D&O coverage today must contend with an environment that makes indemnifying officers and directors of corporations riskier than ever. Consider the following risk factors of concern to D&O insurers:
A record 330 corporations filed financial restatements in 2002–an increase of 184 percent since 1996 (see accompanying bar chart).
Nearly 15 percent of public corporations have restated earnings while almost 20 percent have been sued.
The number of big-dollar ($100 million-plus) shareholder class action suits is rising sharply, to 261 last year, up from 110 in 1996a 137 percent hike.
The economy remains weak, leading to a surge in the number and size of company bankruptcy filings and a bumper crop of unhappy shareholders. The value of the top 15 bankruptcies in 2002 was $311.7 billion, nearly double the $157.7 billion recorded in 2001.
Good directors are becoming increasingly difficult to find. Executive recruitment firm Korn/Ferry International reported late last year that 48 percent of board members surveyed had turned down board positions because the risk of being sued was too great.
Insurers have also observed that, contrary to conventional wisdom, the corporate governance crisis is by no means confined to the technology (dot-coms), telecommunications (WorldCom) or energy (Enron) sectors. No industry is immune.
While few will be surprised to hear that 26 percent of restatements filed from 1997 through 2002 originated with computer manufacturing and software firms, the fact that 27 percent of restatements occurred at old-line manufacturing, agricultural and mining concerns is somewhat unexpected. (See accompanying pie chart.) Although some of these restatements were simply corrections of honest errors in financial statements, it is nevertheless clear that greed knows no bounds.
Equally unexpected is the fact that nearly half of all restatements occur at relatively small firmsthose with revenues under $100 million. While skullduggery in the executive suites of big corporations like Enron, WorldCom and Tyco get all the headlines, companies with revenues in excess of $1 billion accounted for just 18 percent of restatements over the past five years.
With corporate malfeasance apparently so widespread, it would seem the insurability of officers and directors is in serious doubt. But with a five-alarm blaze raging in the executive suites of Corporate America, demand for D&O coverage has never been strongerpushing prices up by 20-to-50 percent or more upon renewal. The same executives who are skimping on terrorism coverage in droves are loath to skimp on D&O.
Higher prices are essential, but insurers are also hopeful that recent federal legislation (Sarbanes-Oxley) designed to increase accountability among top corporate officials–coupled with rule changes adopted by the various stock exchanges to enhance board effectiveness, aggressive Securities and Exchange Commission investigations into reporting violations, and crackdowns by state attorneys general on abusive investment banking practices–will produce tangible improvements in corporate governance in the very near future.
While none of these reforms individually represents a "silver bullet," the collective impact is substantive and highly beneficial not only in terms of restoring investor confidence, which is the ultimate intent of such reforms, but also in fostering an environment where D&O insurance remains a viable product.
Necessarily, the crisis in corporate governance has provoked changes in the D&O product itselfchanges that extend well beyond hefty price hikes into much tighter underwriting and, perhaps most exciting of all, product innovation.
Among the most radical shifts in underwriting is the elimination by some insurers of so-called "entity coverage" which protects the corporate entity apart from the individual officers and directors. This type of coverage, which became common only in the last few years, is viewed by many as a magnet for litigation since it is the relatively asset-rich corporation (rather than the individual officer or director) that is protected.
Furthermore, because settlements often dwarf the limits of D&O coverage purchased, it is possible that the entire policy (including coverages specifically intended for indemnification of officers and directors) could be legally construed as an asset of the corporation, rather than individuals. This is especially true today with many defendants in D&O cases now seeking refuge in the bankruptcy courts, where creditors will view recoveries under D&O programs as assets to which they are entitled.
While such an interpretation clearly defeats the fundamental purpose of directors and officers coverage, the interests and objectives of bankruptcy courts (to maximize recovery for parties with financial stakes in the firm) are almost diametrically opposed to the interests of corporate defendants.
The possibility of almost unlimited personal liability exposure is a major reason why quality directors are increasingly difficult to recruit and retain. Aside from joint liability, judicial seizure and inadequate limits, directors also find themselves exposed in the event a D&O policy is rescinded. Rescissions can occur if the insurers decision to underwrite was based on information provided by the applicant that was false (for example, overstated earnings). A complete rescission results in no coverage for any party covered under the D&O program.
To help corporations attract top-notch outside directors, at least one major D&O insurer now offers a specialized policy for outside directors that is neither rescindable nor cancelable (except for non-payment of premium). Some insurers, brokers and independent organizations (such as executive recruitment firms and corporate governance consultants) will also help firms identify potential vulnerabilities in their governance structures and offer advice to reduce the associated risks.
Improbable as it may seem, the D&O market has been "saved" even amid one of the most scandalous episodes in American economic history. Strong demand, higher prices, tighter underwriting, substantive reforms and aggressive prosecutions are all playing a role in maintaining the viability of the D&O insurance market for the years ahead.
Robert Hartwig, Ph.D., is senior vice president and chief economist at the Insurance Information Institute in New York. He can be reached at bobh@iii.org.
Reproduced from National Underwriter Edition, April 7, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.
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