Editor: Greg, please tell us a little about your background.
Flood: I am the Executive Vice President and Chief Operating Officer of National Union, a subsidiary of AIG that provides a large proportion of the D&O insurance in North America. I have been affiliated with AIG for 16 years. I have focused mostly on D&O insurance for the last 25 years.
Editor: Has National Union introduced new insurance products to deal with the liability exposure created by the heightened concerns of outside directors?
Flood: Yes. With respect to securities litigation, the plaintiffs' strategies and the size of the settlements have changed materially in the last nine years. The D&O marketplace, including National Union, offers products to address those changes. Most notably, the market provides a much larger offering of policies that insure just directors and officers. They protect them in some (but not all) of the circumstances where the corporation cannot or will not indemnify their directors' and officers. These policies primarily sit as excess over the traditional D&O policies that cover both the individuals and the corporation for liabilities in securities litigation. The market commonly refers to these policies as A side policies. National Union's most popular policy of this kind is called MAX - Maximum A Side Excess Liability Insurance, which would cover the director or officer if, for example, the company became bankrupt or refused to indemnify due to allegations where no criminal conduct has been established.
We also offer a IDL MAX policy specifically designed to meet the needs of independent directors of publicly traded companies. IDL MAX provides them with protection beyond what is available in a traditional D&O policy. The policy is non-rescindable - it cannot be voided under any circumstances, including when claims arise from the wrongful conduct of others.
Editor: Is it important to get adequate D&O insurance limits?
Flood: Take WorldCom, for example, there the insurance was $100 million and the damages sought by the plaintiffs ran into the billions of dollars. There was no corporate indemnity and outside directors wanted access to the $100 million of insurance as did the officers. The exposure of CEO Ebbers and CFO Sullivan alone could have diluted the insurance benefits available to the directors. In that case, the bankruptcy judge determined who got access to those funds.
How to divide the proceeds is not as much of a problem in the standard median-valued securities litigation case against directors and officers because most companies purchase a sufficient amount of insurance to cover possible claims in such cases. The exposure in median-valued cases (the core cases that exclude the extremely high and low settlements) remains in the $6 million range. Therefore, individual and corporate defendants in the vast majority of median-valued cases are still adequately covered by D&O insurance. However the average case (the average of all cases) is a different story. Around 1996, the average case was only $6 million. Today, the average case is $32 million, but ten figure settlements take place. We had 25 settlements last year between $50 million and a few billion dollars. If you go back ten years, the highest settlement at that time was about $80 million. So there has been extraordinary inflation in the average settlement. This has not only resulted in corporations buying more insurance; but it has also resulted in two dozen or so cases a year being inadequately insured and that figure is rising as case values rise.
If there is insufficient insurance, chances are defendants will need to negotiate over the use of the proceeds of the insurance. We are seeing more time dedicated to such negotiations than ever before. Provisions are sometimes found in policies giving the directors and officers first call on the proceeds or vesting the power to decide how the proceeds are allocated in the CEO. However, if the CEO is fired, the new CEO may be hostile to the former management and give priority to the corporation rather than the former managers.
Within each D&O policy are conduct exclusions that are severable. These exclusions provide that only the person who committed enumerated acts (such as, criminal activities, fraud, self-dealing etc) will lose coverage. Outside directors and officers of the company have a conflicting interest in this exclusion, because outside directors are rarely involved in such acts. Also, the wording of the exclusion is important. If the exclusion is not triggered until after an officer has been sentenced following a final judgment, the extraordinary expenses incurred by the officer may eat up the proceeds thereby reducing the amounts available to the other insureds.
Editor: Should directors be concerned about the possibility of rescission by the insurer?
Flood: As you know, I am not a lawyer and each state has different laws. However, in some of the big industrial states, the insurer must show that the information furnished to the insurer which was the basis of its underwriting decisions to go forward did not adequately disclose what the exposure was. Other states permit rescission only if the insurer can show that underwriting information was provided with a malicious intent to affect the underwriting decision.
Based on the statistics, rescission does not occur frequently in D&O insurance. It is unlikely that an insurance carrier could maintain a meaningful share of the market if it rescinded frequently. Insurance brokers can advise insurance buyers which insurance companies are prone to use rescission arguments in court to defeat the claims of an insured. They can also provide the insurance buyer with information about the insurer's success in handling of a product line, including its record in handling claims, its market share, its time in the product line and its financial condition.
Since 1996, of about 2,000 securities cases filed, only seven or eight have actually gone to judgment. About 20% got dismissed and the rest were settled, primarily with some portion of the settlement paid by insurance company proceeds. Therefore, insurance carriers recognize that if they get a reputation for working productively in the settlement process, they will achieve larger market shares.
Editor: Are severability provisions important?
Flood: Severability means different things to different insurers. Severability is standard in most policy exclusion sections and within most insurance companies' application section. Each insurance company has their own definition of severability. The policies are extensively negotiated and the severability clause wording may be changed as a result. Be careful, misrepresentation in the application process or in annual warranty statements may affect severability. The longer the insured is covered by the same D&O insurance carrier, the less likely it is to require annual warranty statements to be completed. In the vast majority of D&O claims severability in the application process is not an issue. That said, if it is important to you as a buyer, it should be carefully considered at the time of purchase of the insurance. Historically, many more claims are not paid by reason of insurance company insolvency than by limited or no severability in a policy.
Editor: What are the maximum coverage limits?
Flood: If the full capacity of each D&O carrier were tapped, the total coverage theoretically available for one risk would probably be in the $1.5 billion range. However, as a practical matter, the actual limits available are lower since most carriers are selective as to the risks in which they will participate and the segment of the risk they will cover, whether in low attachment or high excess attachment. Therefore, the largest single accumulation of limits I saw in 2004 on any one risk was about $500 million, which included a pyramid of A/B and A side policies. That said, in 2005 a few companies have increased their A side D&O policy capacity, so that the $500 million limit may increase into the $600 million range.
Editor: To what extent are premiums affected by the circumstances of the company?
Flood: D&O insurance underwriters rely heavily in rating a risk on items like the balance in a company's finances, the volatility of the industry in which a company is involved, the trends in the company's P&L statements, the patterns of its stock trading value, the résumés of its directors and officers and any litigation (historical and current). Volatility is particularly important in triggering higher premiums.
Corporate governance is an increasing area of underwriter scrutiny over the last few years. The ratings of the agencies that rate governance have been working their way into underwriting submissions. As those ratings become more seasoned, they will help in evaluating the risk. Until then, underwriters try to judge governance by formal company structure and then separately through evidence in the execution of governance, the latter being somewhat harder to judge.
Editor: Bottom line, what are some important considerations to bear in mind in selecting a D&O carrier?
Flood: Last year 33% of all securities claims settled within 36 months from the negative event date. About 42% settled within 60 months from the negative event date. The Disney/Ovitz securities derivative case is nine years old. Most of the loss payment in any securities litigation case is the settlement. Other than some defense funding, the claim settlement is like a balloon payment on the far end of the timeline these cases follow. So the "tail" on these claims lasts a long time. At the same time we've seen a material increase in the settlement value of the average case.
I suggest that insurance buyers keep two things in mind. (1) Because there is such a long tail on the claim settlement side, each insurer needs to properly estimate the future settlement value of their claims' notices and post the appropriate loss reserves on their P&L. Some mark those claims correctly, some may not. If a carrier finds three or four years down the road that it understated its loss reserves, it may decide to diminish its participation in or withdraw from that product line. (2) When purchasing D&O insurance, the buyer needs to evaluate the visible issues that affect litigation against directors and officers and the costs involved in offering D&O insurance. The buyer should then select a carrier that not only has a good track record in terms of substantial market share and duration in the market, but that has also provided quotes reflecting a rational long term approach based on the visible risk issues.