Should D&O insurers have a loss prevention role?

Why don’t directors and officers insurers insist on corporate governance reform from their insureds as a precondition of coverage, the way property and workers’ compensation insurers condition their coverage on loss prevention measures?

This perennial question is examined in a recent law review article by Connecticut Law Professor Tom Baker and Fordham Law Professor Sean Griffith. In “The Missing Monitor in Corporate Governance: The Directors’ and Officers’ Liability Insurer,” the authors interviewed brokers, underwriters and others, and found that despite obvious incentives, D&O insurers do not affirmatively require or provide loss prevention services. The authors also found that D&O insurers don’t manage the claims under their policies, but they allow their insureds to select counsel and manage their defense, leaving defense expense essentially uncontrolled. Additionally, because most D&O claims settle within the limits of insurance, company management is able to shift to others all of the consequences of their behavior.

The authors conclude that things are structured this way because it suits corporate officials — it provides them with a corporately financed way to protect themselves from liability exposure without behavior constraints. The authors question whether this arrangement serves shareholders’ interests, and whether the existence of D&O insurance creates a moral hazard by insulating corporate management from the consequences of their behavior.

I don’t believe that D&O insurance enables or encourages bad corporate behavior, because of the separate threat of regulatory or prosecutorial action for misconduct. In my experience, most corporate managers want to do the right thing because of the perceived reputational taint of a fraud allegation. Whether insurance might offset litigation expense does not affect corporate officials’ desire to avoid the reputation-damaging allegation in the first place.

The fact that most company officials want to do the right thing suggests that companies would seek D&O insurer-provided loss prevention services. However, in my experience, D&O loss prevention services simply are not part of what many companies expect or want from their D&O insurer. There may be several reasons for this.

• Everybody has to offer the services or nobody can. Corporate insurance buyers want their D&O insurance transaction as brief and as uncomplicated as possible. If there is another carrier offering the same coverage without requiring, or even suggesting, that the company “jump through hoops,” even free services will go unclaimed.
• Even if the services are high quality, they will be undervalued in the marketplace. Many companies regard their D&O insurers with suspicion or even hostility. There are not enough companies who welcome their D&O insurers’ corporate governance views to make the cost of providing the services economically justifiable.
• The D&O pricing environment does not support the pricing premise. Some companies would accept or even welcome loss prevention services in exchange for a discount. But in an environment where 10 competitors are willing to offer the discount without making demands or even suggesting additional effort, it is impossible to show savings.
• Corporate governance loss prevention services are costly to provide. To plausibly offer services that would be valued by corporate management requires the insurer to invest in high-quality personnel. However, top management at many insurance companies, who are drawn from a more mainstream property/casualty insurance background, has little appreciation of the need for this investment. The costs create expense ratio pressure and, indeed, may not be commercially justifiable given the D&O pricing environment.
• The benefits of corporate governance loss prevention are uncertain. A sprinkler system’s purpose and benefits are obvious. The benefits of classic good governance practices are less certain. A company can do everything right and still get sued. Many of the major D&O claims problems in the past several years have come from unexpected problems that good governance would not have prevented.

There may be still other reasons why D&O insurers don’t insist on governance reforms or provide loss prevention services. Yet the bottom line is that they don’t, and it is unlikely that they will anytime soon.

However, I believe that most companies want to do the right thing. I also believe that qualified insurance professionals can and ought to help by offering high-quality loss prevention services.

There is a good case to be made that brokers have a role to play here. Brokers, in contrast to insurers, are in the business of providing consultative services. The many companies that are interested in doing the right thing may well be interested to know the practical steps they can take to reduce their securities litigation exposure and improve their corporate governance. But whether these services will be more welcome from brokers rather than insurers remains to be seen.

Kevin M. LaCroix is an attorney and a director of the OakBridge Insurance Services, Beachwood, Ohio, office. An earlier version of this article appeared on LaCroix’s Internet Web blog, the D&O Diary, http://dandodiary.blogspot.com. The cited law review article can be found at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=946309. E-mail: klacroix@oakbridgeins.com. Phone: 216-378-7817.