D&O rates are soaring. What are risk managers doing to make sure their losses are covered?
Directors' and officers' cover is in crisis. The fallout from Enron, pensions shortfalls and other corporate bloopers means that rates have soared 400% or more and for some business sectors, cover is just not available.Risk managers are floundering in their attempts to find a solution to the problem of securing affordable directors' and officers' (D&O) cover. In an effort to address the issue, Airmic - the trade body for risk managers - has formed a task force to investigate ways of reducing the cost of D&O insurance.At the first meeting of the task force earlier this month, the group set out its goals, the first is to find out exactly why companies are facing such hefty hikes in their premiums. "The first objective is to understand what lies behind the increases in D&O premiums", says an Airmic spokesman. "The increases may be justifiable in some cases, but often the reasons are fairly opaque," he adds.Even companies with an exemplary claims record have suddenly found the cost of their D&O cover increasing three or fourfold, say market experts. Figures provided by Marsh show that increases of between 300% and 400% have been the norm this year.Meanwhile, research carried out by Aon showed that the cost of D&O cover for 55 of its corporate customers has more than tripled over the past three years. The survey said the average premium paid per £1m of cover provided increased from £3,025 in 2000 to £10,470 at the end of 2002.So why are companies with squeaky clean claims records being hit by massive rate increases? One explanation is that insurers are increasingly assessing D&O risks in terms of the industry sector in which the insured is involved. "Underwriters are becoming much more scientific in the way in which they assess risk", says Reynolds Porter Chamberlain partner Edward Smerdon. "If the company is in a risky sector, such as financial services or biotech, it is likely to see its premiums go up even if it has a good claims record."Evidence suggests that certain industry sectors frighten off insurers, regardless of the claims record of the insured. Earlier this year, FirstCity revealed it was having "enormous problems" finding D&O cover for its clients in the pharmaceuticals, IT and motor sectors.
Rising premiumsInsurers say another reason why companies are being hit with massive premium increases is that, in the past, D&O cover has been available on the cheap. "D&O insurance has been historically underpriced", says Zurich D&O liability underwriter Chris Hewitt. "In the past four years, there has been a rush of circumstances which have made insurers more conscious of the risks they're running. We have had massive collapses in stock prices with the subsequent damage to company balance sheets as well as problems with pension schemes. Insurers have become much more aware of the liabilities facing directors."One way in which companies hope to reduce their D&O premiums is by negotiating with the insurance industry to establish best practice risk management. And the Airmic task force is inviting input from insurers and brokers on what constitutes best practice. They hope that by implementing best practice, risk managers can negotiate cheaper quotes for D&O cover. "We need to establish whether we can agree best practice guidelines with insurers," says the Airmic spokesman. "For example, we want to know how companies can reduce their exposure to D&O claims."Several attempts have already been made by industry bodies to offer guidance to companies on purchasing D&O cover. Last month, the ABI and Biba, together with the Institute of Chartered Secretaries and Administrators and the City of London Law Society, issued a checklist of major issues that directors and officers should consider when reviewing their D&O requirements.But some leading D&O brokers are sceptical about attempts to draw up D&O checklists. "There is a huge difficulty in drawing up best practice guidelines", says Marsh UK D&O practice head Nick Foord-Kelcey. "Higgs suggested a model policy, but you can't really impose a model policy on insurers as D&O is one of the most complex classes of insurance and most insurers have developed their own unique policies."
Complex analysisMarsh's D&O practice has an internal checklist, consisting of 78 criteria, that it uses to check D&O policies. "Because of the complexity of D&O insurance, attempting to reduce that checklist to 10 or 20 points is wildly optimistic", says Foord-Kelcey. "Some of the attempts by people in the industry to draw up D&O guidelines have been so simplistic they are dangerous". Another suggested solution to the problem of costly D&O cover is the formation of mutual insurance companies. Earlier this year, law firm Herbert Smith touted the idea of mutuals as a way of making up for the shortcomings of the D&O market. But, at present, there are a number of legal barriers to the formation of D&O mutuals. "Current law imposes a lot of obstacles to alternative forms of D&O cover", says Foord-Kelcey. "Section 310 of the Companies Act prohibits a company from indemnifying their directors except when they have been acquitted."Forms of alternative risk transfer such as the use of bank letters of credit, an idea favoured by Airmic, are also likely to face legal complications. "If a court rules that a company is unable to indemnify its directors in a particular instance, providing D&O cover with bank letters of credit, for example, will be illegal," says one D&O insurer.So, where now for the Airmic D&O taskforce? "Airmic's approach should be to lobby for amendments to section 310 of the Companies Act", says Foord-Kelcey. "It's a good time to lobby because Higgs recommended amendments to allow the advancement of defence costs." A D&O broker explains: "The more risk that can be transferred to the company, the more able the company will be to negotiate a better price for its D&O cover as it will have the corporate balance sheet to back it up".Being able to fund defence costs is probably risk managers' best hope of ensuring cheaper D&O cover in future. Section 14 of the Higgs report recommends that companies should be able to indemnify in advance against the cost of court proceedings. Foord-Kelcey says: "I think companies should be lobbying to ensure those recommendations are adopted in the final bill that goes before parliament."
What Higgs says about funding defence costs14.15. The Company Law Review recommended in paragraph 6.3 of the final report that companies should be able to indemnify in advance against the cost of defending proceedings, or of a s727 relief application, provided that the decision was made by the disinterested members of the board on the basis of appropriate legal advice, that the prospects of success were good, and that if the outcome was adverse the director would be bound to reimburse the company. It also recommended that it should be lawful for the company to indemnify a director against a bona fide excess of loss requirement on a liability insurance policy, under which the director is bound to pay the first tranche of any liability.14.16. I support these recommendations. I also suggest the government should go further and provide that a company should be able to indemnify a director in advance against the reasonable cost of defending proceedings from the company itself, without trying to establish in advance the prospects of success of the case. The director would be bound to repay the costs if he lost.