D&O Premiums Decline for First Time Since 1999; Hard Market to Return by 2006 Predicts Tillinghast

December 7, 2004

Tillinghast’s Directors & Officers (D&O) liability insurance premium index dropped 10 percent from 2003 to 2004, the first decline since 1999, according to the 2004 Directors & Officers Liability Survey, done by the Tillinghast business of Towers Perrin. However, claim susceptibility, frequency and severity are still soaring. Tillinghast’s survey, which included 2,455 participants, is the 27th in a series of studies on D&O liability claims and insurance purchasing patterns and the most in-depth study of its type.

According to this year’s survey, much of the current softening in the D&O market is not due to a reduction in claim activity, but rather can be attributed to the entrance of new capacity. Competition is particularly fierce in excess layers for large public companies, where rates are dropping 10 percent to 15 percent. Despite the softening market, some pockets of hard market conditions remain, particularly in banking, health services, and real estate and construction. Looking at the historical data, it appears that 2003 was a turning point in the market; however, Tillinghast cautions not to expect the trend to continue.

“This soft market for D&O insurance will be shorter and less pronounced due to lower investment returns than in the 1980s when cash flow underwriting was prevalent,” said Jim Swanke, managing principal for the Strategic Risk Financing Practice. “Carriers will likely need to begin increasing rates in the short to medium term in order to maintain their return on equity.”

Capacity increased 11 percent to $1.5 billion in full limits from 2003, and a record number (99 percent) of U.S. participants reported having D&O insurance. Fewer respondents cited “cost” as the main reason for going without coverage (44 percent of participants in 2002 versus 26 percent in 2004). “The survey tells us that coverage is being offered broadly in the market, with decreased premiums, increased limits and enhancements, and fewer exclusions,” said consultant Elissa Sirovatka, who leads Tillinghast’s D&O Liability Survey program. “What’s disturbing is that this is occurring at the same time frequency and settlement costs are still rising.”

Among repeat participants, those who responded to the 2003 and 2004 surveys, claim frequency increased 11 percent from 2003 to 2004 and claim susceptibility increased 6 percent. Average severity for repeat participants increased in three out of five claim classes, including employees/unions/physicians, competitors/suppliers/contractors, and shareholders/investors.

“The continued increase in the average cost to settle D&O claims combined with the significant number of open megaclaims makes a tough case for a sustained soft market. The claim conditions we’re seeing justify premium increases rather than decreases,” Sirovatka said.

Top sources of allegations from shareholder claimants (general breach of fiduciary duty, inadequate/inaccurate disclosure, including financial reporting and stock or other public offering) and employee claimants (discrimination and wrongful employee dismissal or termination) were the same for 2003 and 2004. Surprisingly, though, allegations citing accounting fraud also remained the same at 2 percent.

More than half (56 percent) of claims against 2004 participants are still open, which is up from 37 percent in last year’s survey. “The increase in open claims along with the increasing settlement costs will make it difficult for insurers to get a handle on their reserves for D&O liabilities,” Sirovatka said. “Couple this with premature pricing declines and a softening market, and insurers could be heading toward a D&O reserve shortfall if we don’t start to see more disciplined underwriting and adequate pricing.”

Other highlights of the survey include:

— Some Pockets Still Resist Softening — Premium increases were reported on average for business classes such as banking, durable goods, health services, and real estate and construction, as well as those in respondent size categories of $10 million to $50 million and $5 billion to $10 billion. Increases were far more common for Canadian participants, where 90 percent of respondents reported premium increases over the past five quarters.

— Coverage Broadens For Most — The number of U.S. participants reporting increases in deductibles/retentions in this year’s survey (28 percent) is down drastically from last year (44 percent). Following this trend, 13 percent of participants reported increased coverage enhancements — the highest level since 2001 — and 10 percent reported a decrease in exclusions — the highest level since 1999. Average policy limits increased for most asset classes from 2003 to 2004, except for companies in asset classes $400 million to $1 billion and $1 billion to $2 billion, which saw 8 percent and 13 percent decreases, respectively.

Looking Ahead

Tillinghast doesn’t expect the current soft market for D&O liability insurance to last through 2005 and predicts a return to a hard D&O market by 2006. Tillinghast also anticipates continued upward pressure on frequency and severity of loss.

“The market peaked in 2003, and we feel that this decline in rates was far too premature in terms of premium adequacy,” Sirovatka said. “We expect to see a leveling of capacity moving forward, continued pockets of rate increases and a smaller magnitude of rate decreases as the market digests this ‘too much, too soon’ softening.”

Reinsurance Implications

Experts in the Reinsurance business of Towers Perrin say that reinsurers will be paying close attention to the D&O marketplace in 2005.

“We expect that in 2005, in an effort to limit their loss from any one occurrence, reinsurers will be more cautious in supporting multiple carriers’ D&O programs, which could aggregate loss to the reinsurers as a result of a single large loss scenario such as Enron,” said Michael Hollenbach, Professional Liability Practice Leader. “Furthermore, the effect of Sarbanes-Oxley is yet to be determined; we’re waiting to see whether the increased duties imposed on management will drive additional claims.”

Roland Stollsteimer, Senior Vice President, concurred that 2005 renewals will be a critical test for the D&O market; however, he is cautiously optimistic about some sectors of the business. “Competition and capacity among primary D&O insurers have aggressively gravitated toward the private company and nonprofit sectors.”

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