Ah, 2008. The year the housing bubble burst and took everyone from you and your next door neighbor, to the banks, investors and insurance companies down with it. Unsinkable businesses faltered. Some even failed.
Eight years later the world is still in recovery. As the details continue to shake out, the insurance industry is just beginning to make the necessary changes to properly safeguard against the next financial crisis.
One area where drastic changes are being made is Directors & Officers (D&O) professional liability, particularly for financial organizations. D&O insurers continue to get hit hard by the fallout from decisions made by their insureds that contributed to the latest recession.
Here is what happened and what you can expect to see, if you haven't already.
What really happened?
The real estate market was known for decades as a rock-solid investment. If you have ever purchased a home then you know how rigorous the process is: credit check, income validation, maybe even the promise of your firstborn child if you don't pay back the loan.
People didn't buy homes unless they could qualify and pay the mortgage, and people always paid their mortgages. Bundling mortgages into mortgage bonds created an investment vehicle that would guarantee returns. Investors couldn't lose if they bet on the housing market.
As time went by, the market got bigger: a strong economy meant more houses being built. Inventory was high, interest rates were low, and truly qualified buyers were hard to come by. Banks and mortgage brokers had to figure out a way to sell the houses that were being built, so they lowered their standards.
Predatory lending practices, such as stated income loans, became the norm. Less-qualified borrowers began to get loans they shouldn't have gotten, usually with adjustable rate mortgages (ARMs) and the promise that they could refinance before the ballooning payments kicked in. Thus the sub-prime housing market was conceived.
Unable to refinance
Mortgage bonds were suddenly being packed with a handful of AAA mortgage loans and a large amount of sub-prime loans. Wall Street even created a new name for this investment instrument: Collateralized Debt Obligations, or CDOs.
Since the CDOs were still based on the housing market, they were considered a good investment, and the market was hot. What few failed to realize was that when those sub-prime ARMs ballooned, homeowners were going to be unable to refinance or make those substantially higher mortgage payments.
High interest loans and too much inventory on the market meant these homeowners were unable to sell their homes, creating a high percentage of default. Welcome to the recession.
Millions have been paid out by insurance companies under D&O policies. (AP Photo/Paul Sakuma)
You can thank the banking industry
Lawsuits from mortgage holders who lost their shirts in the 2008 financial collapse are still making their way through the courts. Millions have been paid out by mortgage brokers, mortgage companies and banks who backed subprime mortgages.
The awards aren't coming from the banks and mortgage companies. The vast majority are being paid by the insurance companies, and the D&O policies are being hit hard.
As you probably know, insurance companies only make changes for one reason: the lawsuits they lose.
Naturally, D&O policy premiums are increasing, sometimes even skyrocketing. Climbing legal fees and judgment payments are showing up on the loss runs of those financial institutions that are still standing.
That creates higher premiums individually, but insurance companies are also looking at the financial industry as a whole. What they see is far riskier than they originally imagined, and there is certainly a surcharge for higher risk.
Insurance companies mean business
Companies that have been writing D&O insurance for years are changing the way they write financial companies. These changes are being revealed not just in the underwriting process, but also in the policies themselves.
Many policies used to be written to cover all decisions of the board with regard to company operations, but now are being issued with something usually reserved for other types of liability policies: classification limitations. Policies will be written to include only what the insurance company has an appetite for or what the insured includes on the application.
If there are no classification limitations, the insurer may opt to add exclusions to the policy that limit the types of activities they are willing to insure. Whether it's a classification limitation or an exclusion, there may be some gaps in coverage for financial institutions, so keep a close eye on the terms and conditions.
This means war(ranties)
Another big change in policy issuance for D&O has been the inclusion of the insured's signed application as part of the policy forms. This makes the warranty statement at the bottom of every application a legal part of the policy contract.
This changes that warranty from a warning statement during the application process to a part of the policy terms and conditions. It will be interesting to see how this change plays out in court.
As the banking and mortgage industries "correct" themselves after the financial crisis of 2008 (and beyond), so must the insurance industry. Keeping a close eye on the quotes and policies issued over the next few years will mean a healthier bottom line for everyone.
Galen Hayes is president of El Sobrante, California-based Hayes Insurance, a full-service commercial insurance brokerage and risk management firm. Email him at ghayes@hayesbrokers.com. Opinions expressed in this article are his own.
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