D&O experts show little tendency to drink from a glass ‘half full’

February 25, 2007

Things are about as good as they can get right now in the directors and officers liability environment but that doesn’t necessarily comfort D&O brokers and underwriters in this high-profile segment; instead it makes them anxious about what lies ahead.

Things are good in many ways: corporate governance is improved; class action suits are declining; claims are down; the stock market is up; insurer reserves are good.

“Times are, well, they couldn’t possibly get much better in a sense of frequency being down; stock markets are very, very kind to us in general; we’ve got better governance in general,” according to Anthony S. Galban, senior vice president and D&O underwriting manager, Chubb Specialty Insurance.

Galban was among the experts at the recent Professional Liability Underwriting Society’s D&O symposium in New York who was asked to answer whether the D&O marketplace should be viewed as half empty or half full.

Galban’s optimistic assessment was shared by Dan Fortin, senior vice president, CNA.

“Half full or half empty? I’m going with full for a number of reasons. One is that the results in the last few years have been fantastic. By all accounts, I would guess, the loss ratios are 50s or lower. The combined ratios are probably in the 80s. Reserve levels are in good shape, not only at the industry level but also at the T-note level,” offered Fortin

D&O underwriters and brokers are not intoxicated by the good news, which they know won’t last.

“I think that it’s important to remember that if we think of this as the best possible time, we should maintain a guard in the sense that it’s probably not going to get better than it has been in the last year,” commented Galban.

Chicago Bears’ fan Fortin put the market’s current success in perspective. “That’s all fine and good, but that’s the past. To quote a great philosopher, Mike Ditka, ‘The past is for cowards and losers.’ I say that not necessarily because we’re all cowards and losers, but because the past is the past and decisions have been made and we have to lie in our beds. In the last three years, those decisions worked out pretty well. Rates were up. Loss costs — we didn’t expect — but it was a very favorable outcome. Three years ago, if we’d been sitting here, it would’ve been a different story. So, really, it’s about what we’re going to do going forward.”

“I’m going to go out on a limb and suggest that the insurance business works in cycles,” joked a straight-faced Stephen J. Sills, chairman, president and chief executive officer, Darwin Professional Underwriters Inc.

“I think we’re going through a phase right now where, yes, one may suggest that things have been good. But I think we can wait a bit of time, and if the brokers are doing what they’re supposed to do, I’m sure the rates will change, and the profitability will really change, and the other things which we’re not expecting right now that are going to pop up and cause claims.”

Reversal of fortune

A number of trends that could “pop up” and reverse current fortunes, among them the scenario of 10 percent rate cuts for each of the past three years; the matter of claims severity if not frequency on the rise; a continued escalation in attorneys’ fees; the potential relaxation of Sarbanes-Oxley and corporate governance standards; additional stock options backdating cases; heightened scrutiny of executive compensation packages; emboldened stockholders and new disclosure rules; and an overall growing tension between management and directors.

But staring into each of these potential dark holes, these experts do see some light.

More stock options backdating scandals may lie ahead but thus far these cases are not translating into a deluge of D&O claims.

They anticipate that following the recent The Home Depot executive compensation controversy, the media and shareholders will intensify their scrutiny of CEO perks and pay. But, as with stock option backdating cases, this does not necessarily mean trouble ahead for D&O claims officers.

In fact, Darwin’s Sills thinks concerns over lavish executive pay will fade. “I would suggest that the number of companies that actually don’t get something in exchange for outlandish pay packages is relatively few,” he said. “And like many things, it will correct itself. Much of this is overblown.”

Shareholder activism

Some worry, however, that the effects of more intense shareholder scrutiny will be felt beyond compensation.

“Certain shareholder activists have been increasingly flexing their muscles. And with extreme examples on the horizon, such as The Home Depot, we may actually see incompetent directors voted out at upcoming annual meetings,” advised Jennifer J. Fahey, managing director and national practice leader for Aon Corp.’s Directors and Officer Liability Financial services group

Shareholder involvement is also being watched for how it alters the dynamics of corporate boardrooms. “The big issue, in my view, is that we’re shifting from the director-centric governance model to a shareholder-centric governance model,” noted Fortin. “The directors are no longer as much about strategy and advisory as they are about policing and compliance.”

He foresees “potentially unhealthy tension in the boardroom” which may not be in the long-term best interest of shareholders.

D&O underwriters say they will continue to insist upon high standards of corporate governance, even if, as is being discussed in Washington, Sarbanes Oxley requirements are relaxed for some companies.

“I don’t think corporate governance should be a fad, although I’m not sure that there isn’t anything more cyclical in the insurance business than corporate culture,” said Chubb’s Galban. “We go through these phases of correction and remediation, back to, ‘Well, if the stock goes up, who really cares what we do?’

But corporate governance is a complete reflection of culture, and the degree to which a company cares about it, works on it, and endeavors to prove it says a lot about what’s going on at the top and what their values are. So it is useful to know all that stuff.”

Industries under watch

Beyond shareholder activism and corporate governance in general, underwriters and brokers will be keeping their eyes on several industries in particular for potential D&O issues.

Mark Lamendola, vice president, Travelers, noted that technology, health care and biopharmaceutical firms are always high on any D&O watch list. “Those are the ones that would concern us the most … I think it’s inherent in their business, their growth. That’s the way Wall Street views them. There are stock volatility issues and accounting and revenue recognition issues.”

Fortin suggested the financial industry itself bears monitoring. “When you’re handling other people’s money, you get a tendency to attract a lot of scrutiny from a lot of different areas,” he noted.

Lamendola added two other industries to his caution list for the future: homebuilders, given the state of the economy; and utilities, given the challenges of dealing with climate change.

Darwin’s Sills seconded those specific industry concerns while also stressing the view that underwriters have a broader responsibility. “If you look at the biotech, the electronic, tech business — those are things in your first three days of being an underwriter they teach you to be aware of. But what are the things that drive volatility? What are the minor changes that cause major ripples through the financials of those companies that are going to cause shareholders to sue? That’s what we spend a lot of time trying to looking into.”

Pricing trends

D&O professionals are also being kept awake at night by pricing, specifically whether the trend of falling prices of the past three years will continue.

“Obviously, this is the point where we get to make decisions,” said Fortin. “We need to identify the risk-reward relationships. We need to put in place, or practice, the discipline that we talk about. … [D]o do you want to … pursue profit or pursue production?”

“Overall, I think, there is stability and that’s on average. Some clients will see great decreases and some who sat tight, may not, because of where our losses are. So we actually have to think on an individual basis,” offered Heather Fox, senior vice president and chief underwriting officer, AIG/National Union.

For Fortin, a lot will depend on what clients and brokers do. “I think the market will continue to do what it has done over many years. That if you ask people to choose between debt and dishonor, you know what they are going to choose. … If people want to drive it down, the marketplace will follow because I don’t think people typically are comfortable about giving up market share,” he said.

Given the stock options and executive compensation controversies, panelists were prodded into guessing what the “next big thing” to surprise the D&O industry might be; what next year’s panelists will be discussing.

Galban took the bait. “I think it will be in the private equity hedge fund area, where there is a lot of money sloshing around, a lot of money looking to take companies private, buy them. There will be some busted deals, huge breakdown of controls, or all simply unexpected.”

Sills seconded that vote. “I think these funds are playing real rough. I don’t think they care an awful lot about governance and I wouldn’t be at all shocked if I had some big epic disclosure or scandal come out of all this.”

But Fortin demurred: “I have no idea. If I did I wouldn’t be doing this. I’d be a trader or step and move in on it. I don’t know what it is going to be.”

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