Zeroing In On D&O Price Transparency

Last year, the frequency of D&O claims eased somewhat. While severity, excluding shareholder claims, increased 40 percent, the average payment for shareholder claims dropped 39 percent to $14.2 million in 2003 from $23.4 million a year earlier, according to Tillinghasts 2003 D&O Liability Survey.

A similar result was reported by the Stanfords Law School Securities Class Action Clearinghouse that found the number of securities class action suits declined from 225 in 2002 to 175 in 2003a 22 percent drop.

This recent ebb in frequency and severity, however, provides only a brief respite for insurance buyers, many of whom saw their rates double or even triple less than two years ago. Risk managers, brokers and insurers are keenly aware that todays stability can quickly evaporate with a sudden downturn in the stock market.

Uncertainty about the impact of recent legislation makes the D&O market even more unsettled. The concern is that the increased disclosure required of recent legislation, most notably the Sarbanes-Oxley Act of 2002, could provide plaintiffs lawyers an open book into companies operations and a renewed impetus for another surge in litigation, as plaintiffs lawyers become more familiar with the law.

Legislative Reform Only Short-Lived Relief

For a time, D&O frequency eased after the enactment of the Private Securities Litigation Reform Act of 1995, a law aimed at heading off frivolous shareholders suits by requiring shareholders to own a minimum number of securities among other requirements. The run-up in market capitalization during the mid-1990s and, ironically, the laws mandated increased holdings (requiring that shareholders own a minimum number of securities to have a stake in suits) set the stage for record-setting suits in the late-1990s.

Approximately a dozen securities-related class action lawsuits resulted in settlements or judgments that topped $50 million, with several of these suits exceeding $100 million. These dizzying settlements are a sharp departure from the early 1990s when most securities class actions suits settled for between $10 million and $20 million.

Legislative reform eased litigation for a time, but it has not been a long-term agent of change. Sharp swings in prices and terms and conditions over the past decade are graphic evidence of its shortcomings.

A New Science

Rate-risk parity can best be achieved by underwriting matrixes that are geared to insurance buyers increasingly complex D&O exposures. One of the most promising approaches is the development of statistical models that price security exposures based on a companys market capitalization and the volatility of its stock.

Changes in these two factors have historically been good predicators of claims activity. However, only a few insurers have the technical ability and underwriting expertise to capture the massive amount of historical data and convert it into a meaningful logarithm that bring transparency and predictability to the D&O pricing process.

Using extensive historical securities data, such models can simulate the impact of sudden drops in stock price and estimate the likelihood of a suit, the average plaintiffs recovery and a settlement range. From the models output underwriters can establish a statistically driven baseline rate.

Beyond Models

Statistical models notwithstanding, D&O pricing is not and cannot be an entirely formula-driven process. Of equal importance in the pricing process are qualitative factors underwriters use to adjust the baseline rate, such as complexity of operations product exposures, corporate governance, merger and acquisition activity, and account practices among others.

D&O underwriters are increasingly analyzing financial statements and accounting practices to gauge the financial strength of a company instead of relying on third-party opinions.

Achieving transparency is a two-way process. Because underwriters want to know as much as possible about a companys operations, it is expected that a D&O buyer would be willing to share information about his or her companys operations, accounting and revenue recognition practices and corporate governance.

Precision-Tooling The Buying Process

A statistically-based pricing matrix gives brokers tangible, risk-specific information about pricing to demonstrate the appropriateness of a price. Pricing discussions with risk managers can focus on the specific risk characteristics instead of general market conditions, because a price reflects the specific exposures of an account rather than the risk profile of an industry or sector. This ability to differentiate pricing based on specific risk characteristics not only sheds light on the underwriting process, but also helps to streamline the buying decision.

Possessing specific risk information enables brokers to better assess risk tolerance and discuss coverage needs and risk-sharing methodologies with their clients. Brokers and risk managers now have more objective information upon which to set deductibles, retain risk, or pre-establish the way in which future losses are allocated between the company and the insurer.

For well-run companies that happen to be classified in volatile industries like some technology sectors, a statistically-based model can separate them from riskier competitors and keep their pricing aligned with their lower exposure bases.

A statistical approach also ensures the fairness and adequacy of rates throughout market cycles. As prices rise, which they are sure to do, the use of a statistical model can provide rationality to such changes. Because rates have been set at adequate levels from the onset, an accounts pricing is much less likely to experience sharp changes as the general D&O market tightens. During a soft market, the use of a statistically-based model will add discipline and stability.

The use of a statistically-based model dispels the notion that one price fits all risks and brings a scientific approach to a process loosely considered an art. In the end, these new models will increase pricing transparencysomething that buyers have longed forand can help to solidify relationships between buyer and seller.

Keith Thomas is senior vice president in Zurichs Management Solutions Group where he is responsible for D&O programs for commercial markets.

Reproduced from National Underwriter Edition, October 14, 2004. Copyright 2004 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.