While it is difficult to pinpoint when any commercial insurance line starts firming—or softening—there has been widespread speculation among industry commentators that the directors and officers (D&O) insurance market has been steadily hardening for at least a year.
The 2012 “Directors and Officers Liability Survey” by Towers Watson largely confirmed this suspicion. It found that 41% of respondents from private/not-for-profit companies reported an increase in their primary D&O policy premiums, an uptick from 18% in the previous year. Nearly one-third (29%) of those working in public companies saw a similar increase.
While a hardening market can be driven by a number of factors (such as reductions in market capital or underwriting capacity), there are three underlying claim trends that stand out: mergers and acquisition (M&A) litigation, regulatory enforcement and the LIBOR-manipulation scandal.
1. Surging M&A Litigation
For many years, significant D&O exposures were virtually synonymous with a single type of claim: securities class-action lawsuits based on fraud. Over the past few years, however, these suits have been a dwindling portion of all securities litigation activity. Part of the explanation for this phenomenon is the explosion in lawsuits challenging corporate mergers and acquisitions. Such lawsuits are often brought by the shareholders of the acquired company against its officers and directors alleging that they failed to maximize the underlying stock’s price in the transaction.
A February Cornerstone Research report (“Shareholder Litigation Involving Mergers and Acquisitions”) found that 96% of all M&A deals exceeding $500 million were challenged in 2012. By contrast, only 53% of such transactions were challenged in 2007. In short, insurers now have to treat such lawsuits as an near-inevitable consequence of any large M&A transaction.
M&A lawsuits have traditionally been bread-and-butter cases for plaintiffs’ attorneys, as they are relatively easy to file and often resolved quickly via expedited discovery in light of the pending deal. Typically, these cases are resolved through “corporate therapeutics” (such as additional disclosures or safeguards) and relatively modest fee awards for plaintiffs’ attorneys. While they will not usually generate the same enormous recoveries as traditional securities class actions, they do provide steady cash flow for plaintiffs’ attorneys.
As a result, the surge in M&A lawsuits has brought a new dynamic for D&O underwriters: the potential for a large volume of low-severity/high-frequency exposures. Such a scenario flies in the face of how potential D&O claims are traditionally evaluated—as a high-severity/low frequency risk. The consequence is a natural progression towards increased retentions and higher premiums to account for these new challenges.
2. Increased Regulatory Activity
In recent years, there has been a surge in government cases against individuals and corporations for alleged wrongdoing. According to the global economic consulting firm NERA, the Securities and Exchange Commission (SEC) settled 714 enforcement proceedings in 2012, the highest number of such settlements since 2007. The SEC also resolved 537 cases against individuals in the past calendar year, the highest number since 2005 and an increase of 14% over 2011. Settlements based on allegations of insider trading reached record levels, and settlements based on conduct including misrepresentations to customers, misappropriation of funds and market manipulation each increased for the third consecutive year.
Each D&O policy responds to regulatory activity in a different manner. Some insureds specifically bargain for coverage to include informal SEC investigations, whereas other policies may only respond after a subpoena is served on an individual covered by the policy. The earlier claims initiated by regulatory activity are covered under a given D&O policy, the longer the insurer must endure the steady erosion of its policy limits through defense costs until the claim is resolved. As any insurer knows, the costs of defending an insured person against an SEC inquiry or enforcement proceeding can be substantial.
In a similar vein, the FDIC has also continued to green-light the filing of lawsuits against former directors and officers of failed banks. As of mid-April, the FDIC had authorized suits in connection with 109 failed institutions against 888 individuals. Of those 888 people, the FDIC authorized suit against 369 of them during 2012, and another 146 in the first four months of 2013. An April Cornerstone report (“Characteristics of FDIC Lawsuits against Directors and Officers of Failed Financial Institutions”) found that the FDIC filed at least 12 new lawsuits against former directors and officers in the first quarter of 2013, in comparison to 26 lawsuits in all of 2012, and only two in 2010. Simply put, the increase in regulatory actions from government agencies will likely lead to more frequent and costly exposures for D&O insurers—conditions that are not conducive to a soft market.
3. Concerns Over LIBOR Scandal
The London Interbank Offered Rate (LIBOR) is a daily interest rate set by 18 banks in cooperation with the British Banker’s Association (BBA). Every morning, each of the banks submits an offer to the BBA of the rate at which it believes it would have to pay to borrow U.S. dollars from other banks. Thomson Reuters gathers the offers, discards the four highest and four lowest submissions, averages the remaining offers and announces the rate. The process is then repeated for other currencies. (While commonly referred to as a single rate, LIBOR is actually a series of benchmark rates.)
LIBOR is significant for a number of reasons. First, the rate submitted by a bank is a relative measure of its health—a low LIBOR indicates that the bank is able to borrow money cheaply and is financially healthy. LIBOR is also used as a benchmark for other interest rates offered by banks in commercial transactions. Any change in LIBOR could affect hundreds of trillions of dollars in securities and loans in the United States. For example, if you have an adjustable-rate mortgage on your home, there is a decent chance that your variable interest rate is tied to reflect movements in LIBOR of a particular duration. If LIBOR rises, your interest payments will increase.
Concerns about manipulation of LIBOR first surfaced in an April 2008 Wall Street Journal article that indicated that some banks did not want to report the high rates of interest they had been paying to acquire short-term loans, lest they be considered not to have sufficient cash on hand. The scandal exploded in June 2012, when Barclays Bank was slapped with $450 million in fines and penalties from British and U.S. authorities. Barclays admitted that it had actively attempted to manipulate LIBOR in order to increase profits on its own derivative investments between 2005 and 2007 and give the impression that it was not in financial distress in 2008. UBS later agreed to a nearly $1.5 billion settlement with U.S., British and Swiss regulators in late December 2012, and the Royal Bank of Scotland settled with U.S. and British regulators for more than $600 million in February 2013.
Insurers are undoubtedly keeping a wary eye on this scandal to determine the potential for exposure. On one hand, there is reason for optimism, as the large regulatory fines and settlements to date would not be covered by typical D&O insurance policies. Industry commentators have also noted that, at present, many bank D&O programs contain substantial self-insured retentions or contain limited, “Side A-only” coverage. Finally, the initial round of lawsuits filed against the participant banks based on purported antitrust violations would likewise not be covered under traditional D&O policies, which only provide entity coverage for securities claims.
On the other hand, Barclays is currently defending itself against a securities litigation brought by a class of plaintiffs who purchased Barclays-sponsored American Depository Receipts on U.S. securities exchanges from 2007 through 2012. Similar securities lawsuits could follow against other banks, as could shareholder derivative suits.
More recently, in late March 2013, Charles Schwab filed a complaint in California Superior Court against participating banks alleging that their collusive and improper conduct cost Schwab millions of dollars in income. Significantly, part of Schwab’s lawsuit alleges violations of Sections 11, 12 and 15 of the Securities Act of 1933. These allegations may trigger entity coverage under D&O policies for certain banks and could spur similar securities fraud cases by other plaintiffs.
Ultimately, the full extent of the LIBOR scandal has yet to be determined, but the potential for significant losses remains. Insurers will be keeping a close watch on further developments for the foreseeable future.