A record number of securities class actions, a foundering stock market and high profile corporate failures are creating a tight US D&O market. Adrian Leonard reports.

Underwriters from across the spectrum have observed frequently of late that despite improvements in rates and conditions in most lines of business, the industry has not yet reached the rock-hard atmosphere characterised by the unavailability of coverage at any price. However, in parts of the professional liability market, particularly in US directors' and officers' (D&O) liability and professional errors and omissions (E&O), cover is extremely stretched.

The UK and Europe, in contrast, have not hardened significantly, although a few lines are beginning to look attractive to some underwriters. Competition for UK solicitors business, for example, is beginning to lose its price war flavour and is moving towards an environment which could be more consistently profitable, attracting the likes of Munich American Risk Partners to the class after withdrawals by several Lloyd's syndicates. However, most of the non-US professional liability market is characterised by continued competitive rating, resulting in capacity withdrawals as prices continue to languish. Yet with uncertainty reigning the world over about the extent to which businesses - particularly US corporations - will be found to be financially responsible for losses suffered by their counterparties, certain professional liability lines are, in the eyes of some, impossible to underwrite.

"The situation for US D&O has been incredibly difficult. There have been some horrendous losses in recent years, and an enormous increase in both severity and frequency of securities class action claims, including distortion from laddering claims [arising from agreements between issuers and investment banks to buy shares at fixed prices at stated times following an IPO]," said Jonathan Fahie, head of specialty practice at the London offices of reinsurance broker Guy Carpenter. "The plaintiffs' bar is very active when there is a movement in stock prices. Because market capitalisations in the US can be so huge, a 10% price move can involve enormous amounts of money if a successful suit is brought."

"D&O has become really interesting," said Matt Fay, chief underwriting officer for professional liabilities at reinsurer Converium US. "The market was fiercely competitive for a number of years. That competition has now let up, but a sea change is taking place in the scrutiny of earnings reports. Corporations are under tremendous pressure from a corporate governance standpoint." That pressure is transferred through D&O cover to insurers and their reinsurers, Mr Fay said. With "massive flame-outs" in the corporate world making the headlines with increasing frequency, and new rules requiring chief executives and financial officers to file sworn statements certifying that their companies' statutory filings are accurate, the potential claims under D&O policies could be much more numerous - and more costly.

Escalating prices
The result is predictable. The combined effect of a long soft market, rising claims and a sudden increase in levels of potential claims is that insurance prices are rising. "Primary rates have gone up tremendously, from 70% to 200% for some risks," Mr Fay said, noting that insurance buyers in sectors such as telecoms will see the larger end of the increase scale. "Entity coverage [D&O insurance which indemnifies corporations, rather than the individual directors and officers who manage them] is becoming more and more difficult to buy. There's been a real crack-down on the primary side."

As is always the case when a line of business hardens to this degree, insurers active in other lines are considering entering the US D&O market, but are doing so very cautiously. "The insurance market is much, much smaller than it was, but we believe there are people in the wings looking at the class, waiting to provide new D&O capacity in the next nine to twelve months," said Guy Carpenter's Mr Fahie. "The London market offers new players an attractive point of entry. A Bermudian insurer, for example, could look at accepting business directly from the US, and would probably be invited to write tranches of $5m, $10m or nothing. But the traditional London subscription market is more attractive for someone who wants to put a toe in gently. They can write smaller lines that they feel comfortable with. They can closely monitor their aggregates in different professions and lines of business."

Those that do enter the line may have to take on D&O without the comfort of a reinsurance backstop, Mr Fahie said. "US D&O has become very difficult to reinsure. Judging by the programmes I was involved with this January, many insurers have chosen to run it on a net basis." He continued: "Reinsurers wanted exorbitant prices. Because of the reduction in capacity, some reinsurers are looking to get involved in the class, although new players are quite rightly nervous of the business. There will, of course, be some who see it as an area of opportunity."

Aggregation caution
While Converium continues as a reinsurer of D&O exposures, it has been cautious about aggregation, and has edged back from the line. "Hundreds of millions [were] out in the market for treaty renewals at 1 July," Mr Fay said. "Last year, with the exception of one longstanding renewal, we declined all of them." Converium also turned down the first treaties that came through the door for the July 2002 renewals, and continued with a cautious approach, although three weeks into July's late renewal Converium US had undertaken at least one D&O treaty. "That one," Mr Fay revealed, "is in a very structured environment. There is built-in downside protection for the reinsurer." Such structures could become increasingly common in D&O liability reinsurance treaties, including loss ratio caps, which effectively limit a reinsurer's participation as a book of business deteriorates, and loss corridor clauses, which require insurers to participate in losses at certain levels.

The measures are necessary. As the US authorities continue the mission to root out unscrupulous business practices designed to enhance corporate earnings (many of which were perfectly acceptable twelve months ago), US D&O insurers and their reinsurers are posting case reserves. Recently Morgan Stanley published a so-called `laundry list' of 28 US companies reporting problems which could result in D&O or E&O claims, ranging from the criminal investigation into the alleged hiding of $3bn in loans at bankrupt telecoms giant Adelphia to the reclassification of $6.4bn of revenues at Xerox.

One company on the Morgan Stanley watch list is the Big Five audit practice KPMG, which signed off the accounts of Xerox and those of Rite Aid, the US pharmacy chain which saw four of its executives indicted in a $1.6bn accounting fraud scandal. While there is no accusation that KPMG has done anything wrong, it is possible that the firm, along with the other major accountants, will face E&O claims relating to their audits of companies where irregularities have been disclosed and shareholders short-changed. Already the Big Five has been reduced to four, after Enron-related scandal destroyed all but the rump of Arthur Andersen.

"The dominance of the major audit practices means that wherever there are accounting irregularities among the Fortune 500, one or the other of them is likely to be called upon to contribute to compensation claims," said the active underwriter of a leading Lloyd's syndicate with a large D&O book. "Given the scale of the economic loss sustained by shareholders as a result of misstatement of various items on balance sheets, there must be some fairly nervous partners in some of the accountancy practices. It is hard to see how the insurance structures available to them could cope with the claims they could face. Similarly, major financial institutions which are identified as participants in alleged inflation of profits can expect their professional liability insurances to be called upon."

Already, the repercussions are being felt in the auditors' insurance arena. All four insure their liabilities through offshore captives, channelling excess audit risk into the reinsurance market for a reported combined premium of $200m. Andersen had a similar captive structure, until its Bermuda insurer traded into insolvency in April. In the aftermath, according to anecdotal reports, rates quoted to the Big Four audit groups were up more than 1,000%. "Large accountants are very difficult to price," said Converium's Mr Fay. "We have found it is difficult to get solid information out of their captives on which to base loss projections. We shy away from them."

In a June 2002 Market Update, Willis Group reported a significant rise in D&O rates. "Prices continue to escalate sharply, with no apparent signs of relief in the near or, for that matter, distant future," Willis wrote. "D&O loss experience is staggering... The number of claims being filed against directors and officers continues to escalate, with the number of securities class actions filed in 2001 reaching an all-time high... Although it appears that the record... will not be reached in 2002, the risk of suit continues to be high. The combination of an increase in media attention, current malaise of the stock market, and continued scrutiny by Congress, all add up to the perfect storm for D&O."

Willis pointed out the irony that new regulations surrounding the responsibilities of corporate officers are likely to increase claims. "The passage of new audit committee rules, the new Securities and Exchange Act Rule 10b-5-1 and Regulation FD (Fair Disclosure), increases the potential for liability," Willis stated. Part of the response of risk carriers has been to slash their exposures. "Today we find a market with plenty of capacity, but a real fear of using it. Insurers used to offering limits of $50m to $100m for a single risk today find their comfort zone in the $10m to $15m level." The attritional primary layer was typically considered to be $5m to $10m; now insurers put the bar up as high as the first $100m for large public companies, Willis reported.

Mr Fay agreed. "Between the US, London and Bermuda there is no shortage of reinsurance capacity," he said. Despite across-the-board primary rate rises, each D&O policy could present reinsurance underwriters with greater risk than it did a year ago. "We are not sure if the average risk in D&O has stayed the same or increased," he said. "We do not believe the level of risk has decreased as rates have increased, because the environment may become the most litigious we have seen yet. Compounding that, losses take several years to develop, so when we analyse a piece of business it is not easy to know how bad the ultimate results will be."

Compounding the problem, he said, was the new vilification of corporate America and the executives who run it. "A year ago, corporate executives were viewed as superheroes. The public perception now is of an old boys' club of scoundrels, hiding things in their balance sheets." In which direction the mood will turn, whether the vilification will escalate and what the impact will be are all, currently, impossible to calculate. "It is a wild card, and that makes it very difficult to measure the effect it will have on your potential losses. Even while primary rates are going tremendously, risk under treaties could be going up as well," said Mr Fay.

The Lloyd's underwriter said the uncertainty is so great that US D&O risk "is impossible to price." He advocated a waiting game for the major risks: "It is going to be very hard to underwrite big corporate D&O or accountants' E&O until it is clear what the consequences of the corporate scandals and the fall in the stock market are for litigation in those classes," he said. "All the business is written on a claims made or losses discovered form, so until we have established what the valuation of the existing claims is likely to be, and how many more will come, it is impossible to price this cover. It doesn't matter if it is the original risk or reinsurance." People were still trying to price the business, he said, but the market was getting tighter by the minute. "At some stage there will be a great opportunity in D&O... but not just yet." For now, the perfect storm continues.

By Adrian Leonard
Adrian Leonard is a freelance insurance journalist and a regular contributor to Global Reinsurance.