What to Expect in D&O Pricing

So far, the credit debacle and backdating cases haven’t had an immediate impact on the price of Directors and Officers (D&O) liability insurance. The market has remained soft, despite some high-profile settlements, such as the proposed $117.5 million agreement with shareholders of Mercury Interactive over options backdating.

A report by Bear Stearns issued in September indicates that, in general, prices have fallen by 50 percent since 2002, the height of the last wave of accounting scandals. Towers Perrin has found that insurance prices have dropped 18 percent in 2006 alone.

While companies, and indirectly their boards, are reaping the benefits of a soft market, it won’t last forever in the highly cyclical insurance business. They are likely to suffer a reversal to a much firmer market will follow in the future. History is instructive of this point. By using empirical data, however, a strategy can be developed to stabilize costs over time.

Today’s market is still not as soft as in 1998 when D&O insurance carriers were offering multi-year deals for extremely low pricing. At that time, even high-risk technology companies were able to purchase their first $5 million of insurance coverage for less than $70,000. When these multi-year deals ended in 2001, however, some of these same companies suddenly were being charged upwards of $300,000 for a single year for that same $5 million of coverage.

What goes into the pricing of D&O insurance? There is naturally a relationship between the frequency and severity of the risk that insurance carriers are assuming and the premium companies must pay for their D&O insurance. Less obvious are some of the other factors that also affect the price. These factors include overall market capacity, the availability of reinsurance, an individual carriers’ ability to cross-sell other lines of insurance, investment returns, and each policy holder’s need to maintain continuity of coverage from year to year.

Public company D&O insurance policies are typically designed to respond when directors and officers are sued for wrongful acts related to fulfilling their duties. These policies will also typically respond on the company’s behalf if the suit relates to the company’s securities.

The Class-Action Reaction

For public companies, the most severe risk has historically been the threat of securities class-action lawsuits. When filing rates and the dollar amounts involved for these types of lawsuits are up and the cases being brought involve large dollars, insurance carriers generally increase their prices for D&O coverage. Right now, filing rates are down. In 2002, the plaintiffs’ bar filed 212 securities class-action suits; in 2006 the plaintiffs’ bar filed only 107 securities class-action suits, a decrease of nearly 50 percent. This reduced frequency is the biggest factor contributing to the soft market in D&O insurance.

To be sure, 2006 saw a lot of activity in the D&O liability space associated with stock-option backdating. However, of the approximately 200 public companies that announced that they had issues with stock-options back-dating, only 37 had shareholder class-action lawsuits filed against them. Most of the suits were derivative suits, a type of litigation that historically has not led to settlements as large as those of securities class-action lawsuits. Meanwhile, it appears that the Securities and Exchange Commission (SEC) is only pursuing the most egregious cases. Last month, it dismissed three more cases without taking action.

Supply and demand naturally play an important role in the pricing equation. Public companies always want to purchase D&O insurance, so demand is relatively steady. However, D&O insurance carriers do not always want to take on the risk at the prevailing market price. These carriers may consequently exit the market. When there are fewer insurance carriers willing to write D&O insurance, when supply is down, pricing, of course, goes up.

Also relevant to the capacity issue is the way most D&O insurance programs are formed. Most consist of a combination of a primary layer of insurance offered by one insurance carrier and several more layers of insurance—referred to as “excess layers”—offered by other insurance carriers. Each excess layer responds to a claim only after the underlying layer has been exhausted. Because each successive layer is theoretically more remote from being accessed by the insurance buyer, the pricing for each successive layer of insurance is less than the previous one.