Corporate governance, capital drive D&O liability prices down

Changing corporate governance practices and excess capital in the insurance market have made directors’ and officers’ liability premiums drop in recent years, and rate level erosion in almost every line of business will cut into insurer profits in 2007, according to Advisen Ltd.

In its report “The D&O Market in 2006,” Advisen, a provider of analytics, benchmarking and market information to the global commercial insurance industry noted that average D&O premiums have fallen nearly 30 percent since the fourth quarter of 2003. The D&O premium decreases have been far more significant than declines in the overall market, and seemed to pickup steam in the fourth quarter of 2006, when premiums dropped 5.5 percent, the company said.

The falling rates are a result of increasing aggregate capacity and decreasing frequency and severity of losses, the report stated. “Barring any major disruptions in the market in 2007, premiums are likely to plummet further, and risk going into a freefall,” the report stated.

The average premium for D&O liability insurance more than doubled between the fourth quarter of 2000 and the fourth quarter of 2003. That rate of increase is much sharper than for the overall property/casualty insurance market, the company said. The figures reversed course in the first quarter of 2004 and has been falling steadily since.

“Capacity withdrawn from hurricane exposed business and redeployed to other lines and regions, plus new capacity generated by 2006 profits and more than $30 billion in new investments in the industry increased downward pressure on rates in 2006 for business other than hurricane exposed property, including D&O,” the company said.

Some companies have shifted capacity from very large public companies to small public companies, private companies and nonprofit entities, the report said. Consequently, “rates for the largest companies have held comparatively firm, but rates for smaller companies are falling sharply,” the report stated.

“We are now three years into the softening D&O market and can clearly see the extenuating factors that are contributing to a perfect storm for pricing declines,” noted David Bradford, editor-in-chief at Advisen and author of the report. “Since the corporate governance debacles of the early 2000s, shareholder activism and government oversight have created much greater transparency into corporate management. And when you combine that with the current capital environment in the industry, you have pricing conditions that may threaten to free-fall.”

Securities class action suits remain the principal source of D&O losses to public companies, the report indicated. For private company and nonprofit entity D&O, employment-related suits are a leading source of claims. The number of securities class action suits filed in 2006 fell sharply. The number of suits fell 49 percent between 2004 and 2006, and relative to the number of public companies, suits fell 47 percent, the data showed.

Changes in corporate governance practices and transparency to shareholders as a result of the Sarbanes-Oxley Act have likely contributed to the decline, according to Advisen. Some practitioners have pointed to an increase in state shareholder derivative actions as an area of concern for D&O underwriters, but the research indicated that those have historically been far less severe than securities class action suits in their impact. A median cash settlement in 2006 was approximately $3.5 million versus about $10 million in 2002 (adjusted to 2006 dollars).

According to the company, settlement values tend to be a function of both actual damages and company size. However, “settlements represent a smaller portion of damages for larger companies than for smaller companies,” the report said.

Based on Advisen’s data, the trend toward fewer securities class action suits should continue through 2007, which will increase pricing pressure. “If does not appear that shareholders have been badly damaged, if damaged at all, by backdated options in most cases,” the report said. “These suits probably will prove to be more an annoyance than a significant source of losses to D&O underwriters.”

The study further noted that there has been pressure to obtain broader coverage in areas concerning severability and non-rescindability. Yet as rates fall, “underwriters are more likely to trade more expansive coverage for higher premiums, increasing pressure throughout the market to offer broader terms and conditions,” the company said.

In forecasting the future, Advisen predicted risk managers will be encouraged to seek lower retentions in 2007. From 2001 to 2004, retentions increased dramatically because risk managers often decided to assume more risk to offset higher premiums, the report said. Rates began softening between 2004 and 2005, and held stable after that through 2006. For 2007, there likely will be more exposure for insurers in lower, highly vulnerable layers at increasingly deficient rate levels, the company noted.

Rate level erosion in almost every line of business will cut into insurer profits in 2007, but as long as it is not an unusually severe year for natural catastrophes, aggregate policyholders’ surplus nonetheless should continue to accumulate. This will further increase downward pressure on pricing in most lines of business including D&O.

“Barring any major disruptions in the market in 2007, premiums are likely to drop further and the bottom will likely be established by insurer Risk Adjusted Return on Capital models, which place higher return requirements on volatile lines like D&O,” Bradford said. “This kind of visibility into fluid market conditions was unavailable to insurance professionals even just a few years ago. But now we can have greater insight into the past which allows us to better understand the future and be prepared for, rather then react to, those market dynamics.”

The “D&O Market in 2006” is available to Advisen subscribers or prospects through an Advisen representative. Data for the study was based on ADVx, which tracks changes in average premiums paid upon the renewal of commercial lines insurance policies on four lines of business — domestic property, general liability, workers’ compensation and D&O liability — with the composite index weighted by its relative premium volume as reported in A.M.Best’s Aggregates and Averages.

Results of Advisen’s study were discussed at the PLUS D&O Symposium held Jan. 31-Feb. 1, 2007 in New York.

Topics Lawsuits Trends Pricing Trends Market Directors Officers