The credit crunch threatens to bring a rise in directors' and officers' claims. Jane Bernstein investigates whether this threat is becoming a reality and how this is affecting sales of the product.
The credit crunch looks set to spark an increase in demand for directors' and officers' insurance as the threat of insolvencies and the associated risks raise awareness of the very real need for D&O cover. But this begs a number of questions — what impact will increased claims have on the availability and affordability of the product? Are claims costs set to soar in 2010? And will underwriters become increasingly cautious in their approach? Some experts are warning that an economic recovery may in fact bring more challenges for company directors, as they suffer from the fall out of the downturn.
When asked to identify the major risks directors face in a credit crunch, most insurance industry experts point to insolvencies and shareholder litigation. Stuart Hill, a partner with law firm Lovells, asserts: "The biggest risk remains from shareholders. In particular, people are going to be looking at the way in which certain entities have been managed over time. They will take a view on whether the board has done its job properly — particularly in circumstances where there may have been a change of management following difficulties."
Michael Lea, head of D&O liability at Jardine Lloyd Thompson, goes on to explain: "The principle risk is that poor business performance will inevitably lead to increased shareholder activism. Governments will feel the need to increase regulatory scrutiny, in order to be seen to be doing something. The media and the public will be looking for scapegoats, and fat cat directors provide that."
As far as insolvencies are concerned, Richard Highley, a senior partner in the commercial litigation group in Davies Arnold Cooper, points out that when an administrator or liquidator is appointed, their job is specifically to maximise recoveries for the creditors — and the directors are an obvious target when searching for potential sources of recovery.
In addition to insolvencies, another issue which sets alarm bells ringing in the D&O sector currently is redundancies — with small to medium-sized enterprises particularly at risk. "The fall out from a recession will inevitably result in increased redundancies as companies try to weather the storm by making cut backs wherever possible," says Angel Underwriting business development director Gary Green, "However, in their haste to shed jobs and make savings, small and medium-sized businesses, which do not often have a dedicated human resources person in place, are the most likely to fall foul of the stringent employment regulations. Where redundancies are necessary, company directors could find themselves being exposed to the prospect of a wrongful termination or discrimination claim being made against them."
However, despite the undoubted increase in exposure, insurers are beginning to report that the expected avalanche of claims has not taken place yet. Most are finding that there has been an increase in the notification of claims but only a small percentage of those have materialised as actual claims.
One argument is that claims take a long time to filter through, due to long investigation periods. The implication is that once the investigations have run their course, the notifications will eventually turn into real claims — and that these may well be costly. As Mr Lea points out: "There is a relatively long lag between incidence of wrongful acts and accountability. Cases take a long time to bring and work through the system. Most insurer disbursements thus far have been in the form of defence costs or mitigation costs."
This argument appears to be backed up by the fact that exposures directly related to redundancies are turning into actual claims. Daniel Holloway, Ace European Group's UK and Ireland corporate financial lines underwriting manager, draws a clear distinction between claims that are happening now and those that are anticipated: "Where insolvencies are concerned, we are anticipating a rise in claims, while with redundancies, we are actually seeing the increase already." He explains these sorts of claims surface a lot sooner than insolvency related ones.
There is an unsettling sense that the industry is experiencing the calm before the storm. Jonathan Corman, partner in the financial professional risks group at Browne Jacobson, agrees that the influx of claims expected has not yet occurred and believes this might be part of a larger pattern that has seen the recession progressing slowly. "The view is that it's all going very slowly compared with the last recession and this is partly because banks are treading more carefully," he observes. "In some cases because politically there is greater pressure on them to be nicer to people. They are certainly not repossessing as much as they did last time and they are not causing as many insolvencies either."
There is also some concern that a return to economic wellbeing will not immediately stem the flow of insolvencies. Indeed, Nigel Pearson, UK and Ireland underwriting manager for the speciality insurance division at Chubb, says conversations with accountants and insolvency practitioners have indicated that as the credit crunch eases, there will be an increase.
Bottom of the cycle
Mr Highley points out that this has been the case in previous recessionary cycles and observes that in the current credit crunch, the banks are sitting on a variety of bad loans that they do not want to realise yet. He comments: "In the past, we have seen an upturn in claims once we start to come out of the recession. That may be because the banks feel that is the time to maximise their recovery. It could be that at the bottom of the cycle, the asset is worth the least."
Chris Hewitt, partner in the financial risks division at Lockton, believes there is a possibility of more activity as the recession subsides, "as it will be easier to spot the companies that didn't take the appropriate action to safeguard their business".
While Douglas Robare, D&O manager for Zurich global corporate UK, says tighter legislation and regulation — such as the bribery legislation going through the UK currently — may also be storing up trouble for D&O insurers. Mr Robare asserts: "These are not just going to be claims against the organisation but claims brought against the individuals."
However, it is not all bad news for the D&O insurance sector. Despite the greater exposures posed by the credit crunch, most are also reporting increased enquiries and a greater demand for the product — particularly among SMEs. CFC Underwriting launched itself into the D&O for SMEs space recently and business development director Graeme Newman observes: "Whereas pre-credit crunch, a lot of small business owners may have viewed D&O as a luxury or an unnecessary expense, that mindset has definitely changed now."
Angel Underwriting also identifies a growing need for D&O amongst SMEs. Mr Green believes: "Smaller businesses are more vulnerable to claims than larger organisations as they often fail to keep pace with legislative changes that affect their business and will find complying with legislation harder. Why? Because by the nature of small businesses, people tend to have multiple roles and responsibilities, with many of these responsibilities resting on the shoulders of the company owners or senior directors."
But in light of the increased exposure, will insurers be less keen to take on new risks and is the market finally likely to harden? Mr Pearson observes that there have been predictions of rates hardening for some time but they have failed to do so. "This is down to a combination of factors," he observes, pointing out that the past few years have seen a fairly benign claims environment and that there is also a lot of new capacity in the market.
Mr Hewitt reports that while underwriters are certainly increasing their due diligence on clients during the underwriting process, there is an abundance of capacity available, with broad coverage, and there are no signs of attempts to narrow coverage. He adds: "There are a number of new market entrants, and there are more looking to enter the market in the near future. There are no visible signs of premium hikes; conversely we are still seeing that reductions are achievable."
In fact, Mr Newman emphasises that D&O cover for smaller professional firms is particularly competitively priced. He acknowledges the potential for an increase in claims but says this can only be a good thing: "You need to sell a product where you can make a good underwriting profit but where there is still a real need for that policy. Rather than worrying about the claims, it should be viewed as an important driver for the sales of the product."
For Simon Million, UK and Ireland D&O manager for Ace Europe, it is not a question of increased risks but rather different risks. He explains: "We look at things differently during these periods. We are no more cautious than we usually are. You don't change your underwriting stance just because you are going into a recession, but what you look at is the different exposures or risks that a client faces. During the good times, the exposures are related to issues like companies expanding, mergers, acquisitions, takeovers. But in difficult times you are looking at factors such as credit risks, can they service their debts. Risks change."
Capacity and appetite
The continued capacity and appetite in the D&O market is good news for companies but is there a fear that as companies continue to tighten their belts, will they simply be looking for the best deal? Mr Robare observes: "There are adequate levels of capacity in the market but insureds do need to focus on the quality of their insurance."
Mr Lea has some equally sound advice for insureds: "My advice would be — don't throw away sound insurer relationships built up over time in favour of being tempted by cheap deals which may turn out to be unsustainable. We believe that a market correction is inevitable at some point and it will be easier for underwriters to stay with those insureds with which they have a proven history and a sound relationship. A deficient D&O policy may turn out to be completely worthless when it is most needed. To have a willing legal defence team provided by an understanding insurer when the directors are being targeted from all sides is the object of a good D&O policy. Anything else, no matter how cheap, is a false economy."
And this increased awareness brought about by the economic downturn looks set to last. As Mr Newman observes: "The credit crunch has been a huge marketing exercise for D&O insurers. It will stick in people's minds for a long time to come and will leave a legacy."
But while the increased demand is to be welcomed, insurers must also be cautious about the potential for high claims activity. Any increase in demand for a product is to be celebrated, but it is not yet time to bring out the champagne.
Regulatory investigations into individuals
Nathan Willmott, partner in the financial services and markets group with Berwin Leighton Paisner, is a lawyer specialising in defending firms and their senior management in Financial Services Authority investigations. He reports a significant rise in regulatory investigations into individuals. The costs of defending FSA investigations, which can be significant, are normally covered by D&O insurance. Here, Mr Willmott answers some further questions on the issue.
How far is the rise triggered by the credit crunch?
"Whenever the FSA suspects a significant breach may have occurred within regulated financial services firms, it will look to conduct an investigation. These can also be triggered by the firms themselves, proactively notifying issues to the FSA. Historically, the FSA's primary focus was the firms themselves, but now it typically investigates potential breaches by the relevant individuals ('approved persons') in parallel with the investigation into the firm.
"We are seeing an increase in these investigations and a large part of that is as a result of the credit crunch. For example, a number of banks have been investigated for failing to detect overvaluations of investments that they hold. There are also cases in which individuals have been investigated by the FSA for issues that have been revealed by the credit crunch. An example would be self-certification mortgages, where regulated firms have encouraged applicants to act dishonestly when stating their income. Had it not been for the property downturn, issues such as these would not necessarily have been revealed."
Would you foresee insurers trying to restrict cover in response to these increased risks?
"This is an obvious risk for members of senior management of FSA-authorised firms and they are keen to be covered. As a result, rather than cutting back on cover, insurers see it as a way to gain competitive advantage — by making clear those risks are covered."
Why are these regulatory investigations so costly?
"They are often very time-consuming. The regulator will issue very wide, onerous document requests and will require individuals to attend interviews. These can require significant preparation. If it chooses to bring proceedings, it is potentially a very lengthy process — very similar to civil litigation."
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