D&O Insurance Market Insight

May 2005

This report was created by Advisen, Ltd. and is reprinted in FC&S D&O with permission. For more information about this research report or the publisher please contact Jeffrey M. Cohen  at 212.897.4820 or [email protected]

Executive Summary

After rising sharply in 2001 and 2002, the average premium for a directors and officers (D&O) liability insurance policy peaked at the beginning of 2004 and fell throughout the rest of the year. (Exhibit 1) This decline occurred despite a growing number of ever-larger claims. Headline-grabbing securities class action suits drove the loss experience for insurers of public companies. New securities class action filings increased by 17% over 2003, and the average settlement value skyrocketed.

Almost all sectors of the D&O market saw rates fall in 2004, though the magnitude and timing differed by type and size of company, and industry group. Public companies saw larger decreases in median premium per $1 million of policy limit than non-public companies, and median pricing for large companies (both public and non-public) fell more than for small companies. Among nine industries analyzed, Building & Construction Materials showed the smallest decrease in median premium per $1 million limit, while Telecommunications experienced the greatest.

Overall in 2004, pricing on primary policies fell moderately, lower layer excess pricing was at or slightly above 2003 levels, and upper excess layer pricing plunged. For some high excess layers, 2004 pricing was less than half of 2003 levels.

D&O pricing trends were largely consistent with other commercial property & casualty insurance lines. Though varying in degree and timing, pricing in all major lines of business fell in 2004. Rapidly accumulating policyholder surplus—which translates into insurance capacity—reached record levels in 2004, fueling competition.

Overall, both median retentions and median limits of liability rose slightly in 2004, though the magnitude and direction varied substantially by company size and type. Companies with more than $1 billion in revenues were the most aggressive in increasing the amount of D&O insurance they carried, though sharp increases in average policy limit failed to keep pace with the growth in the average securities class action settlement, the principal source of large claims against these companies.

We estimate accident year 2004 will close with a combined ratio of 101.7% for the D&O line of business, producing approximately a 10% return on allocated surplus. Individual company results will vary significantly. In general, we expect insurers focusing on primary and lower excess layers to outperform insurers of high excess layers.

The study was based on D&O programs for more than 15,000 companies in Advisen's Policy Benchmarking System, and on Advisen's “MASCAD” and Large Loss databases of D&O claims events. Policy information was provided by risk managers and wholesale and retail brokers.

Market Overview: 2000-2004

Market Size and Demographics

Drawn by rapidly growing premium volume (Exhibit 2)—the result of sharply rising rates and steadily increasing demand—the number of insurers offering D&O grew by nearly one-third between 2000 and 2004. AIG and Chubb—long the dominant players in the D&O market—saw their respective market shares chipped away by the swarm of new players. The two giants lost approximately 10% of their combined market share between 2002 and 2004, though still growing rapidly in premiums written. Among the most active new players were the Bermuda “Class of 2002,” including AWAC, AXIS, Arch, and Endurance. Hitting the ground running, their collective market share soared from zero in 2001 to 5% in 2002, rising to nearly 11% by 2004.

Partially offsetting the influx of new capacity, several established insurers reduced or completely stopped writing D&O for strategic reasons or because they ceased doing business altogether. Kemper elected to run off its property & casualty business, selling its D&O renewal rights to AXIS in 2002. Allianz announced in 2003 that it no longer would write D&O on large U.S. companies.

The D&O market for non-public companies (including private companies and non-profit entities) expanded rapidly as board members became increasingly concerned about their exposure to lawsuits. Despite falling rate levels, written premium continued to grow in 2004. Widely perceived as less volatile than public company D&O, and generally requiring far smaller limits of liability, non-public company D&O was written by a large and diverse slice of the property & casualty market, ranging from massive AIG to comparatively tiny specialty companies such as the Nonprofit Insurance Alliance of California. The attractiveness of non-public D&O has led a number of insurers to reallocate capacity from volatile and competitive large public company D&O business. Most notably, Chubb has been “reprofiling” its D&O book towards small and middle market customers, including private companies.

While the non-public segment of the D&O market continued to expand, the explosive 1999-2003 growth of total U.S. D&O premium stalled in 2004 as competition heated up and rates fell. The modest increase in 2004 earned premium was largely attributable to rate increases on business written in 2003 but earned in 2004, and as the result of an expanding economy and heightened demand for the coverage. The introduction of Side A-only individual coverage and other new products also contributed. Written premium led earned premium up the growth curve through 2003, but hit the wall of redundant capacity in 2004, absorbing the full impact of the rate decreases. We estimate 2004 earned premium and written premium both to be approximately $7.4 billion.

Premiums, Losses, Reinsurance, and Results

Premium Trends. Much of the 2000-2003 premium growth was driven by rapidly rising rates. Median D&O premium per $1 million of policy limit grew sharply during 2001 and 2002 and peaked in late 2003/early 2004. By the close of 2004, median premium per $1 million of limits had dropped by over 12%. The general pricing trends were evident in premiums for both public and non-public companies of all size categories, though varying in timing and magnitude. The segment of the market most impacted by rate decreases was high excess layers for large public companies. Pricing on some layers was less than half of 2003 levels, and close to 2001 pricing.

D&O pricing trends were largely consistent with other commercial insurance lines, all of which experienced overall lower rate levels in 2004. D&O pricing peaked later than highly competitive lines such as property and general liability, but was not immune to economic and market forces—principally the rapid accumulation of P&C industry surplus (which translates into risk capacity) in 2003 and 2004— exerting downward pricing pressure. (Exhibit 3)

Loss Reserves. D&O loss reserves in 2004 continued a trend of deterioration begun in 1998. Prior to 1998, reaping the benefits of one of the longest and strongest bull markets in history, when investment income and capital gains more than offset underwriting losses from an equally long and soft pricing market, many insurers were liberal in funding loss reserves, resulting in redundancies. As underwriting losses from under-priced business began to grow, and as capital gains dried up, insurers became far more conservative in their reserve estimates, resulting in deficiencies that have grown deeper with each subsequent year. (Exhibit 4) We estimate D&O loss reserves to be approximately $1.25 billion deficient as of the end of 2004.

Reinsurance. Reinsurers were generally receptive to non-public company and small public company D&O, but capacity for large public company D&O was confined to a small and shrinking number of large players. Among the major direct writing reinsurers, American Re expressed little appetite for large public companies, and GE Re began withdrawing from the public company market in 2004. Crippling reserve deficiencies and resultant rating downgrades hampered large broker market player, Converium.

The demand for high limits of liability combined with capacity available from only a few large companies meant that reinsurers were positioned to influence rates and terms. While high excess layers for large public companies were among the most competitive segments of the market in 2004, anecdotal evidence suggests that reinsurers have begun flexing their muscles and are attempting to slow the freefall. Reinsurance intermediary Guy Carpenter notes that D&O treaty terms are getting more restrictive, with loss limitations such as loss ratio caps and corridors being reintroduced. Carpenter also projects that, unless pricing improves, more reinsurers are likely to withdraw from the market, leading to a capacity crunch.^[1]

Underwriting results and return on surplus. We project accident year 2004 to close with a 78.1% loss ratio, up from a projected 75.5% for 2003. The deterioration in loss ratio is due substantially to rate decreases across virtually all segments of the D&O market during 2004, although the impact of those rate decreases was muted in the earned premium calculation by rate increases on premium written in 2003 but earned in 2004. The projected accident year combined ratio is 101.7%, delivering approximately a 10.1% return on allocated surplus. Individual company results are expected to vary significantly. In general, we expect insurers focusing principally on primary and low excess layers to out-perform insurers of high excess layers.

Upper Excess Layers: The Perfect Storm?

One unavoidable conclusion of our analysis of the D&O market in 2004 is that serious trouble may be brewing in the upper excess layers. These layers are, by nature, the most volatile and difficult to price, and increasingly are being rocked by massive securities class action and other settlements. They also are among the most competitive layers. Layers above $50 million were severely impacted by price competition in 2004, with the highest layers priced less than half of 2003 levels. (Exhibit 5)

Loss reserves of high excess insurers, on average, were less adequate than those of primary and lower excess players. (Exhibit 6) Some high excess insurers may have been overly optimistic about the performance of the business, potentially overstating overall company profitability in published financial statements. They run the risk of having to take large reserve adjustments that, as securities suits against PMA Capital, XL Capital, and Convernium made clear, may trigger shareholder lawsuits alleging that investors were misled about the true financial situation of the company.

To compound the problem, insurers writing high excess layers, on average, are among the financially weakest in the D&O market. The average S&P debt rating drops with each successively higher attachment point category. (Exhibit 7)

The situation will grow worse as rate levels fall and average claims severity increases, as is likely in 2005 and, perhaps, beyond. Upper excess players probably will try to move down the tower to better-priced, less volatile lower excess and primary layers. This will increase competition in the lower layers, but only to the extent that security-conscious buyers will accept lesser-rated insurers on the more exposed portions of their program. The best rated insurers may be able to hold on to market share while still commanding a premium for their security, forcing the lesser rated companies to slash premiums further to attract price-sensitive buyers willing to assume more credit risk. It is probable that some excess insurers will conclude that D&O does not represent a good use of their capital, and withdraw from the line or sharply curtail their writings.

Premiums, Limits, and Retentions

Premiums

Rocked by rapidly escalating securities class action settlements and an unprecedented spike in securities class action suit frequency from IPO-related “laddering” claims, expansive coverage terms, and a decade of rate level erosion, D&O was among the first commercial insurance lines to begin climbing out of one of the most sustained soft markets of all times. Sharp increases in median premium per $1 million of policy limit during 2001 and 2002 peaked in late 2003/early 2004. Rapidly expanding capacity began to take its toll in 2004, with median premiums ultimately dropping by over 12%. General pricing trends were consistent for both public and non-public companies of all size categories, though varying in timing and magnitude. Large public companies, always a favorite target of class action plaintiffs attorneys, and particularly so in the wake of the accounting and governance scandals inaugurated by the collapse of Enron, saw premiums skyrocket beginning in 2000, but also ricochet back with similar velocity when they hit the wall of excess capacity in late 2003.

By Revenue Size. Following three years of strong growth, median premium per $1 million limits fell in 2004, though not consistently across all revenue segments. Companies with more than $1 billion in revenues saw median premium per $1 million limits decline about 17%, while the smallest companies—those with less than $100 million in revenues—experienced a drop of 11%. Midsize companies with revenues between $100 million and $1 billion saw their median premium decrease about 3%. (Exhibit 8)

By Type of Company. Median premium per $1 million of limit more than doubled 2001-2004 for public companies, but underwriters watched those gains erode in 2004. Median premium per $1 million limit for public companies fell about 11%. Non-public company median premium per $1 billion of limit grew far less aggressively during 2001-2004, and also fell approximately 11% in 2004. (Exhibit 9)

By Industry. Nine industries—Banking & Finance, Construction Products & Materials, Computers, Energy, Healthcare, Pharmaceuticals & Biotechnology, Retail, Telecommunications, and Utilities—were analyzed for this study. Premium per $1 million of limits varied widely, with Banking & Finance and Computers at the top with median premium per $1 million of limits of about $18,000, and Utilities at the bottom with a median premium per $1 million of limits of about $6,200. (Exhibit 10)

Every industry experienced a decrease in median premium per $1 million limits between 2003 and 2004, though the decreases varied significantly. Telecommunications had the largest drop at—52% while Construction & Building Materials experienced only a nominal decrease of—.4%. (Exhibit 11)

Telecom and Utilities, the industries enjoying the largest decreases in 2004, also were among the industries subject to the largest rate increases during the 2000-2003 period. Median premium per $1 million limit grew 160% for Telecom and 180% for Utilities.

Limits and Retentions

Retentions grew as rates increased. Companies retained more risk to mitigate the impact of rising insurance costs or as a trade-off for broader coverage, but especially as concerns large companies, higher retentions were also encouraged by underwriters anxious to see insureds with more of a stake in the outcome of a claim. Normalized to revenues, median retentions increased materially between 2001 and 2003, and to a lesser degree between 2003 and 2004. Median limits per $1,000 revenues also grew steadily over this period. Both retentions and limits grew much faster for large companies than for small, but small companies took much higher retentions, and bought much higher limits, relative to their size.

Retentions. After holding steady or falling slightly between 2000 and 2001, median retentions per $1,000 of revenues grew steadily for medium size ($100M—$1B) companies, and sharply for large (>$1B) companies between 2001 and 2004. Small companies (<$100M) saw median retentions per $1,000 in revenues creep up between 2000 and 2003, but decrease slightly in 2004. (Exhibit 12) As compared to revenues, small companies kept retentions four times that of the largest companies in 2004.

Limits. The overall trend from 2000 through 2004 was an increase in limits of liability, though that trend varied significantly by size of company. The median limit per $1,000 of revenues shot up sharply for large companies between 2000 and 2001, took a breather in 2002, and then continued its rapid assent through 2003 and 2004. Small companies saw little change until 2004, when the median limit per $1,000 of revenues suddenly jumped about 12%. Mid-size companies seemed unsure of their limits needs—the median limit increasing rapidly between 2000 and 2002, but then sliding slowly downwards in 2003 and 2004. (Exhibit 13) As compared to revenues, small companies bought more than 10 times the limits of large companies in 2004.

The total limit of liability of D&O programs for large (>$1 billion in revenues) insureds increased rapidly, but the average securities class action settlements grew even faster. (Exhibit 14) Average settlements are pushing ever higher into the D&O program tower, and the limits purchased by many companies are increasingly inadequate to cover, to borrow a term from property underwriting, the “probable maximum loss.”

Claims

Securities Class Action and Related Suits

Securities Class Action Suits. Securities class action suits continued to be the principal source of D&O losses to public companies in 2004. While frequency was close to the 1999-2003 average, the upward trend in severity, as represented by average cash settlements during a year, showed few signs of abating, with 2004 experiencing a record number of settlements in excess of $100 million. In addition, related types of suits, such as shareholder derivative actions and ERISA “tag-along” suits against directors and officers, became increasing sources of concern to underwriters as both frequency and severity grew.

Overall, securities class action filings were up 17% in 2004 as compared to 2003. However, the 233 suits filed in 2004 was not an unusually high number compared to the number of suits filed annually during the1998-2003 period, and well below the record 493 filings in 2001. (Exhibit 15) Excluding “laddering,” mutual fund, and analyst suits, there were 212 “traditional” suits filed in 2004, up from 181 in 2003, but in line with recent trends.

While the number of suits filed was not alarming compared to other recent years, certain other trends were more ominous. The rate of dismissals has been falling, meaning that more suits will be settled. In addition, while the median value of cash settlements has remained fairly constant in recent years, the average value of cash settlements has skyrocketed. (Exhibit 16)

The landscape of securities class action suits is repeatedly destabilized by large-scale but non-recurring events, novel new theories of liability advanced by creative and aggressive plaintiffs' attorneys, and hard-to-detect senior management fraud. These types of suits—the bane of D&O underwriters since they are largely unpredictable—were a prominent part of public company D&O claims activity in 2004.

The broad investigation of the mutual fund industry by state prosecutors and the SEC—sparked by New York Attorney General Eliot Spitzer's 2003 investigation of “market timing” in mutual fund transactions—resulted in twenty suits against mutual funds and their managers in 2004. Eliot Spitzer also was the catalyst for suits against a number of major insurance brokers and insurance companies related to his investigation of broker compensation practices and his suit against Marsh Inc. alleging bid-rigging and other anti-competitive practices. The pharmaceutical industry, which had experienced a flurry of suits against smaller companies in 2002 and 2003 related to allegedly inflated or false claims about the status of drugs under development, found some of its largest players targeted in connection with the withdrawal of popular COX-2 inhibitor products.

Shareholder Derivative Suits. Shareholder derivative suits demanded underwriters' increased attention. Previously little more than an annoyance for D&O underwriters – with monetary settlements typically amounting to little more than plaintiffs' legal costs – they became a greater threat in the aftermath of the Cendant shareholder derivative suit's $54 million monetary settlement. Shareholder derivative suit activity has been sharply increasing, especially since 2001, as is evident by Exhibit 17, which tracks rulings in shareholder derivative suits from 1993 through 2003.^[2]

Institutional shareholder lead plaintiffs. Institutional shareholders—typically the lead plaintiffs in shareholder derivative suits, and increasingly the lead plaintiffs in securities class action suits—proved to be savvy and motivated adversaries, and a new source of headaches for underwriters. Viewing recoveries from securities class action suits as an important part of their total return on investment, institutional investors increasingly leveraged the power granted to them as lead plaintiffs under the Private Securities Litigation Reform Act of 1995 to maximize monetary settlements in those suits, achieving eye-popping settlements in several major cases.^[3]

Management liability “clash.” Derivative action suits contributed to the rise in the frequency and severity of management liability “clash” events, where multiple suits covered by management liability policies are filed as the result of the same underlying occurrence or as the result of the same underlying proximate cause. In addition to triggering coverage under D&O policies, other types of management liability policies written by the same insurer can come into play as ERISA fiduciaries, auditors, investment banks, and attorneys are dragged into the litigation. Some events have resulted in massive combined settlements to date, such as Cendant ($3.9 billion), Worldcom/MCI ($3.7 billion), and Enron ($2.1 billion).

Employment Practices Suits

Harassment, discrimination and wrongful termination. Employment-related suits, and particularly suits alleging harassment, discrimination or wrongful termination, were the leading cause of claims under non-public company D&O policies. The Nonprofits' Insurance Alliance of California, a liability pool for California charitable organizations, reports that 98% of D&O claims are employment related, with wrongful termination being the leading allegation. The Philadelphia Insurance Companies estimate that more than 85% of the D&O claims against the non-profits they insure are employment-related, and Chubb Specialty Insurance, which now largely targets small and mid-size companies (public and private) and non-profit organizations, estimates that around 70% of their D&O claims arise from suits filed by employees.^[4]

Both the number of charges filed annually with the Equal Employment Opportunity Commission (EEOC) and the number of lawsuits filed by the EEOC have held comparatively steady over the past decade, but the number of employment-related settlements has steadily risen in recent years. Using EEOC litigation statistics as a proxy for D&O employment-related suits, after plummeting from its 1992 peak, the number of settlements per year has marched upwards since 1997. (Exhibit 18)

Claim severity also is on the rise. While varying widely from year-to-year, the trend in EEOC settlements is clearly upward. (Exhibit 19)

Jury Verdict Research reports that the median compensatory jury award in employment practice liability cases nearly doubled between 1997 and 2003.^[5] (Exhibit 20)

Employment discrimination class action lawsuits have also become more common, sometimes leading to huge settlements. While many of the largest class action suits, such as the ones against WalMart, State Farm Insurance, and Coca Cola, have been against major corporations that are less likely to have employment practices liability (EPL) insurance coverage within their D&O policies, private companies and non-profit entities, which almost always have EPL included in their D&O coverage, are none the less at risk. Two of the largest settlements—U.S. Information Agency/Voice of America ($508 million), and California Public Employees' Retirement System ($250 million)—were paid by non-public entities.

Underwriting and Underwriting Issues

A challenging line of business to underwrite well under the best of circumstances, directors and officers liability insurance took on new dimensions of underwriting complexity in 2004.

Securities Class Actions and Related Exposures

Sarbanes-Oxley Act. Underwriters attempted to confront the still-speculative underwriting consequences of the Sarbanes-Oxley Act as their insureds struggled to meet the looming deadlines for compliance with Section 404. While the Act may improve corporate governance, heightened disclosure and reporting requirements may make it easier for shareholders and plaintiffs attorneys to spot problems and build well-documented cases. Sarbanes-Oxley also extends the statute of limitations for filing securities class action suits.^[6]

Earnings restatements. Earnings restatements are often a precursor of a securities class action suit, but the correlation between the occurrence of a restatement and the subsequent filing of a securities class action suit grows weaker over time. The number of restatements and the number of securities class action filings were nearly identical in the late 1990s, but the growth rate of restatements has outstripped the growth of securities class action filings in recent years. The number of earnings restatements hit an all-time high in 2004, while the number of traditional securities class action filings held more-or-less steady. (Exhibit 21)

The growing gap between the number of restatements and the number of securities class action filings may not be sustainable. Underwriters are concerned that the rapidly growing number of earnings restatements will inevitably lead to an increase in securities class action filings.

Directors' ERISA liability. A Department of Labor suit filed against Enron retirement plan fiduciaries naming as defendants Enron's board of directors for not properly overseeing the plan blew open the doors for ERISA liability suits against directors. Now frequently filed virtually in tandem with a securities class action suit, the complaints in these class actions contain the same allegations as the securities class action lawsuits, but allege the defendants breached their fiduciary duties under ERISA. It is common for D&O policies to contain an exclusion for claims arising out of the insured's role as an ERISA trustee or similar plan manager, so insureds usually must buy a separate fiduciary liability policy for coverage. However, D&O underwriters needed to assure that the scope of coverage in the D&O and fiduciary liability policies are coordinated, and address the issue of two separate limits of liability being exposed in the same event.

Management liability “clash.” While events triggering coverage under more than one management liability policy are not a new phenomenon, the magnitude of the combined settlements—which now can reach into the billions of dollars—is new. Underwriters were challenged to identify and quantify clash risk factors, and to incorporate them into underwriting and pricing criteria. Ceded reinsurance departments were frustrated to find little reinsurance coverage available for these sorts of events.

Environmental liability disclosure. The SEC has come under pressure from socially responsible investment funds and environmental advocacy groups to improve its enforcement of environmental liability disclosure requirements. The commission has resisted making substantive changes to its procedures or policies, but growing attention to the problem of under-disclosed environmental liabilities may set the stage for an increase in securities class action suits alleging damages arising from inadequate disclosure.^[7]

Private company shareholder suits. While employee suits are the most significant D&O liability exposure for private companies, suits by minority shareholders are on the rise. Such suits frequently allege that the board of directors “conspired” with the majority shareholder by approving an action that benefited the majority shareholder at the expense of the minority shareholders. Underwriters are braced for acceleration in the frequency of these suits, anticipating that the Sarbanes-Oxley Act—with its heightened disclosure and corporate governance standards—becomes the de facto standard for private companies as well.^[8]

Data, Analysis, and Pricing issues

Underwriters were challenged to identify and quantify company-specific factors driving D&O suits, particularly securities class action suits. The process was made all the more difficult by plaintiffs attorneys, lawmakers, regulators, law enforcement agencies, and the media all contributing to continued volatility and unpredictability of the outcomes, especially in upper excess layers.

Underwriters in many companies found themselves “flying blind,” lacking data and tools to properly analyze claims and tie them back to specific underwriting criteria and decisions. Many relied on widely used, but largely untested, benchmarks to identify high-risk companies. All the same, the correlation between pricing and the various metrics used by underwriters to assess risk was moderate to virtually non-existent, suggesting that underwriters either ignored their own risk assessments in their final quotes or that the forces driving market pricing were largely blind to these metrics. (Exhibit 22)

Advisen research found that two factors, company size and year-over-year growth in balance sheet accruals, are among the strongest leading indicators of securities class action suits. In tandem, they are effective in identifying the 5% of all public companies likely to be responsible for 22% of all securities class action suits, and the 25% of all public companies likely to produce 54% of all securities class action suits.^[9] (Exhibit 23) Recent Advisen research also indicates that growth in accruals combined with company size also is a strong leading indicator of the size of a securities class action settlement. While company size, measured by market cap, was one of the factors more highly correlated with pricing, balance sheet accruals was one of the least correlated factors.

Some insurers use sophisticated actuarial models for pricing D&O policies, but much of the market relies on underwriting judgment and a few basic rating tools. This is particularly true for excess layers where pricing methods are based more on heuristics and tradition than on data and actuarial analysis. These “rule of thumb” conventions—based more on market-driven pricing of underlying layers than on an independent assessment of the expected losses to the layer being priced—proved particularly vulnerable to pricing pressures, contributing to plunging rates in high excess layers. No pricing model would have shielded underwriters from overcapacity and competition, but superior pricing tools could have provided more reliable pricing benchmarks from which underwriters could have made better-informed decisions on a risk-by-risk basis, a metric for evaluating the expected performance of the book of business, and a fixed point from which to track pricing trends.

Terms and Conditions

The softening market began to take a toll on policy terms and conditions as well as on rate levels. Underwriters were largely successful in holding on to some hard market coverage “pull backs,” but were under mounting pressure on provisions such as severability, personal conduct exclusions, claims triggers, full entity buy backs for securities claims, and the Failure to Effect and Maintain Insurance exclusion.

Implications for 2005 and Beyond

Property & casualty industry surplus continues to grow, signaling that the current soft market is far from over. However, this soft market is highly unlikely to be a repeat of the cutthroat competition of the 1990s, which was driven by record investment income and capital gains. Although rates have declined in most commercial lines, the overall market is not in a freefall. Underwriters would like to take credit for maintaining a level of discipline, but the more likely explanation is that record surplus does not translate directly into increased capacity when viewed in terms of the underlying exposures it supports. While surplus grew rapidly in 2002-2004, the American economy grew even faster, producing ever-increasing insurance exposure units and demand for insurance. When viewed as a percentage of gross domestic product, 2004 P&C surplus (at 3rd quarter) was at approximately the same level as 2000, and well below the 1998 peak. (Exhibit 24) In addition, the property & casualty industry is still underperforming the S&P 500, keeping pressure on senior management to improve returns.

As prices for all commercial lines continue their slow, steady descent, insurance company senior management will continuously re-evaluate which lines offer the best opportunity to maximize return on capital. D&O—at least primary and low excess D&O—appears to be holding its own relative to other lines at the present, and likely will continue to offer a comparatively favorable opportunity throughout at least 2005. The available evidence suggests that non-public company D&O continues to be profitable despite both increasing frequency and severity of employee suits. In the public company market, the frequency of securities class action suits—the single largest driver of claims in this segment—is holding steady, while the growth in average severity is borne significantly by the higher excess players.

However, 2005 may be the turning point for the upper excess segment of the market. Reinsurers already are restricting coverage for the large corporate D&O market, and threaten to further reduce or withdraw capacity. Highly depressed rates may fall further, even as claims mount. Upper excess insurers may try to move down to the more profitable and predictable lower excess and primary layers, which, at least in theory, will increase competition in those layers. However, security-conscious buyers may not be willing to accept the lower average creditworthiness of the excess players on their highly exposed lower layers, permitting the well-rated companies that now dominate those layers to maintain market share with a significant degree of pricing integrity.

Companies that find upper excess D&O to no longer be an attractive use of capital, but are unable to compete effectively in primary and lower layers, are likely to withdraw from the D&O market. Shrinking capacity will eventually lead to a crisis similar to that of the mid-1980s when large corporations were simply unable to buy limits sufficient to cover their exposures. That capacity crisis led to the formation of Ace and XL, and the launch of Bermuda as a preferred domicile for global commercial insurance companies. The looming capacity crunch could lead to a similar response. A sustained shortage of capacity will eventually force rates up to a point where the upper excess again becomes viable, attracting the remaining players on the primary and lower layers, new D&O underwriting units formed by other commercial lines insurers, and new players. However, the efficiency of the market may be compromised by the on-going investigation by New York Attorney General Eliot Spitzer into broker-ownership in insurers. The investigation, seemingly focused on the Bermuda “Class of 2002,” could have a chilling effect on one of the principal catalysts and sources of capital for new insurer formation, large insurance brokers.

But with or without broker capital, the cycle will begin anew.

     Business Impact: D&O buyers—especially large corporate buyers—are enjoying falling premiums, but should be concerned by the specter of a capacity crunch as reinsurance capacity dries up and weaker players on highly competitive upper excess layers leave the market. Insurers will continue to be plagued by mounting claims severity from shareholder suits, and increasing frequency and severity in employment-related settlements. Senior management of multi-line insurers may conclude that D&O—especially D&O for large corporations—does not provide an attractive use of capital and shift capacity to more promising segments of the D&O market, or to other lines of business.

Copyright Advisen Ltd. 2005. Reprinted with permission.