D&O Insurance Trends Move Toward A New Equilibrium

The directors and officers liability insurance market haschanged dramatically during the past couple of years, and furtherchanges are likely in the near future. This article examines recentD&O insurance pricing, coverage and loss trends, and looks atwhere the D&O insurance market might be headed.

The markedly higher premiums currently facedby many D&O insurance purchasers come in the wake of aprolonged “soft” market of the recent past. During the latter halfof the 1990s, the overall D&O insurance market experiencedsharply falling prices and ever-broadening coverage.

To see the trends in D&O insurance premiums, considerTillinghast-Towers Perrins D&O Premium Index. Established andstandardized at a value of 100 for the average in 1974, the indextracks the experience of U.S. for-profit respondents toTillinghast-Towers Perrins annual Directors and Officers LiabilitySurvey. The D&O Premium Index measures relative D&Oinsurance premium after accounting for important demographics(e.g., ownership, size, etc.), as well as policy limit,entity/reimbursement deductible and other important coveragefeatures.

As the accompanying graph shows, the median and average valuesof the D&O Premium Index fell more than 35 percent betweenmid-1994 and mid-1999 (survey responses are generally submitted inthe third quarter of each year). This general softness in theD&O insurance marketplace was consistent with individualpremium changes during this period, as significant majorities ofcompanies surveyed each year reported either no change or adecrease in their D&O insurance premium.

This same period saw entity coverage for securities claimsbecome commonplace. More than 90 percent of publicly-tradedcompanies responding to the 1999 Directors and Officers LiabilitySurvey reported that their D&O insurance included entitycoverage for securities claims, up from less than 30 percent in1996. As well, coverage broadened for a majority of those surveyedover this period to include claims from employees againstnon-officer defendants and/or the entity itself; such changessignificantly broadened the D&O coverage available to privatecompanies.

While fierce competition raged in the D&O insurance marketin the second half of the 1990s, adverse loss trends weredeveloping.

The volatile U.S. stock market of recent years–notable formergers and acquisitions using stock as currency, financialrestatements and questionable insider activity–has provided ampleopportunity for shareholder lawsuits against directors andofficers. Suits from shareholders have historically been the mostcostly class of D&O claims, and the severe marketcapitalization swings of certain stock market sectors during thisperiod only served to make such claims much more costly.

Other factors have also contributed to an increase in theseverity of D&O claims. Although the Private SecuritiesLitigation Reform Act of 1995 helped to reduce the number ofshareholder suits that might be viewed by many as frivolous orhaving little merit, its effect on the severity of shareholderclaims was quite the opposite.

Shareholder suits which survive a motion for dismissal since1995 are arguably those that have more substance than before, andsuch suits certainly have considerably more time and expenseinvested by the plaintiffs.

Since nearly all D&O claims from shareholders are settledrather than tried to a verdict, settlement discussions followingPSLRA have generally featured plaintiffs with stronger casesdemanding commensurately higher settlement values.

These claim trends combined with the high prevalence of entitycoverage to find D&O insurers paying dramatically higher losscosts than they had envisioned when their policies were sold. Manyinsurers have seen adverse loss ratios and shrinking (or vanishing)profit margins for several years.

As a result, the D&O insurance market firmed overall in2000–and for some segments, it turned sharply.

Premiums increased by about 11 percent on average throughmid-2000 for generally equivalent D&O coverage, according tothe D&O Premium Index.

Since most market segments saw little or no increase throughmid-2000 (as evidenced by the nearly flat median value of theD&O Premium Index), it is clear that those segments that didsee an increase in 2000 saw a substantial one. During this period,technology and biotechnology companies, firms involved in recentIPOs or those exhibiting some degree of financial distress werelikely to see increases of 25 to 50 percent or more in theirD&O insurance premium.

Underwriters also clearly began to exercise caution, with somebecoming quite selective. Multi-year policies began to disappear.These developments were not entirely unexpected, given the premiumand loss trends of previous years.

Further sharp premium increases have occurred since mid-2000, asfalling stock prices eroded insurers investment income whilesimultaneously increasing the exposure of many of their insureds toshareholder suits. While final results for the 2001 Directors andOfficers Liability Survey are not yet available, preliminaryresults indicate that, for the first time in many years, a majorityof insured respondents experienced an increase in premium.

Prior to Sept. 11, 2001, D&O insurers were earnestly seekingadditional real premium increases of 20 to 50 percent, dependingupon market segment, often through a combination of premiumincreases and coverage restrictions. Perhaps the most significantcoverage restriction in 2001 is coinsurance, introduced by someD&O insurers and reintroduced by others. Coinsurance is in mostmeaningful respects similar to the pre-determined allocationoffered as an alternative to entity coverage in the mid-1990s.

Since Sept. 11, D&O insurers have responded to increasingpressure from their reinsurers to return to profitability byseeking even larger premium increases. The terrorist attacks onSept. 11 have had and are expected to have only limited directeffect on the D&O insurance line of business. There are,however, some important indirect effects.

Some reinsurers have suggested that without the events of Sept.11, the most significant topic of discussion between insurers andreinsurers during this renewal season would be the losses in theD&O line.

Certainly Sept. 11 has raised reinsurers awareness regardingprofitable use of their capacity, and even at the current higherD&O insurance premium levels, other lines of insurance mayrepresent more profitable business for many reinsurers.

What then does the future hold for the D&O insurancemarket?

In the near term, probably more of the same: further premiumincreases, stricter underwriting standards, and additionaltightening of coverage terms and conditions.

But it wont go on forever; a new equilibrium will be found, ifonly for a little while.

Further out into the future, prices will stabilize andcompetition between current insurers or from new entrants to theD&O insurance market will mean that the cycle has begunagain.

Mark W. Larsen is a consultant in the Chicago office ofTillinghast-Towers Perrin. He is also the director of the firmsannual D&O Liability Survey.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, December 3, 2001.Copyright 2001 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.

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