Do insurers have a role to play in enhancing corporate governance and promoting "good" corporate behaviour in the post-Enron/Worldcom world? asks Mark Goracy

Insurance underwriters and claims professionals involved in financial lines products, in particular directors' and officers' liability and company reimbursement coverage, generally do not view their jobs as including a broad societal or regulatory duty to promote "good" behaviour on the part of the directors and officers and the companies they are evaluating for insurance or when handling and adjusting losses presented under those coverages. Underwriters are driven by a simple motive - writing profitable business. When other factors intrude on that goal, such as achieving market share, writing accounts as an accommodation or evaluating risks for any other purpose, making a profit becomes more difficult.

Claims professionals recognise the impact that adjusting and handling of claims has on profitability, but are also driven by a focus on achieving the best settlement at the most reasonable price for individual covered losses presented under D&O policies, rather than by attempting to modify the behaviour of their insureds.

The insurer's role

It has been suggested that insurance professionals should use their positions as risk assessors and loss adjusters to encourage appropriate behaviour among company directors and officers by requiring certain information and documentation related to the various statutory reporting requirements from their prospective insured's before risking insuring them, and to attempt to instill "good" corporate behaviour when possible in settling claims. This is of course part of the normal underwriting proposal and application process and is often standard operating procedure. It is less common and perhaps mostly theoretical on the claims side. But some are suggesting that underwriters go further and serve as more proactive gatekeepers due to their unique position in assessing corporations and their directors and officers as prospective insureds. An example for US publicly-traded companies would be to incorporate elements such as Sarbanes-Oxley Section 404 attestations into the process as a requirement to quote.

If we consider underwriters and loss control professionals in other lines of business such as workers' compensation and employers' liability or fire and property, we see that "good" behaviour is regularly rewarded by underwriters and other behaviour is punished with rate increases, coverage restrictions, high deductibles, reduced limits or declinations. One would expect that an employment practices liability underwriter would not consider a risk without an operating gender or race sensitivity programme, nor would one expect a fire underwriter to quote a mattress factory that did not have a working sprinkler system.

Transparency is a good thing and the various reporting and compliance requirements recently visited upon the corporate world are, in the long run, developments which will result in much greater disclosure, accountability and clarity, and will therefore provide investors and others who rely on such information with a better foundation upon which to base decisions. Thus there is no inherent problem in asking financial lines insurance underwriters to impose such requirements of "good" corporate behaviour and governance into their underwriting processes and procedures.

Defining "good" corporate behaviour

We must consider what constitutes "good" corporate behaviour. Is it simply profit, increasing shareholder value or guaranteeing secure lifetime employment? Some of us may recall that in the 1980s it was said that, "greed is good". Do any of us think that view would be favoured today? We regularly read about directors and officers doing bad things to innocent shareholders, employees, pensioners and other corporate stakeholders.

From time to time well respected and serious people speak about what we should do to punish bad behaviour, but rarely do we hear about what "good" behaviour actually is. All too often we are simply informed of what punishment to use which will prevent future incidences of bad behaviour, for example jailing the individual. But this rarely has any impact on the company or remaining board members, if any are left.

More promising is where real change in oversight and control of a corporation is implemented, or board changes and control mechanisms are instituted as a result of a D&O claims settlement, a filed claim or regulatory investigation.

Shareholder activism is not new. We have seen shareholder activist reforms in so-called "green resolutions", or in the divestiture of certain investments. Recently, institutional investors have been particularly prominent in requiring specific governance changes and the list of companies impacted is not short. Often though, such changes are out of a textbook on corporate governance and amount to little more than cosmetic or name changes of a previous operating procedure or board position. But, these changes do sometimes have value and, if regularly explored in the adjustment and settlement of claims, should be measured appropriately with a monetary value.

Most of these situations involve an already negotiated dollar settlement with the company, its directors and officers, and the insurer, after which an agreement to modify or change an existing company policy or board procedure is agreed to. Lead plaintiff class action attorneys in the US typically do not permit the inclusion of such terms in a settlement to impact the amount to be paid.

On the claims side what incentive does a claim professional have to try and incorporate prospectively based behavioural changes on the board or its procedures? This would only serve to complicate the negotiating process. One example involved a bank that restated its financial information resulting in a shareholder lawsuit and subsequent investigation by regulators. The bank has agreed, in a consent order to be overseen by the Federal Deposit Insurance Corporation (FDIC), that it cannot enter into any asset purchase or sale transactions with subsidiaries without the prior consent of the FDIC1. That lawsuit is still pending and it is unclear how these external oversight changes would impact claims handling or have any value in the adjustment. Of course when a company enters bankruptcy it is run by a trustee, which would seem to be the most obvious example of failure to run a successful company. But looking at the American airline industry this seems to simply be another tactic used by companies to enhance their competitive edge.

Exporting the class action

Those same US plaintiff law firms, riding the post Enron and Worldcom wave of dissatisfaction, are taking their message of corporate governance reform via litigation to other countries. Many European countries in particular are beginning to consider class action type mechanisms in response to the outcry against their own homegrown examples of corporate misfeasance, such as Parmalat in Italy. Investor activism is particularly on the rise in the Netherlands fuelled by changes in Dutch and European law, while Hong Kong's financial regulator recently publicly endorsed the idea of US-style class action lawsuits. It will be interesting to see how these efforts play out as corporate law, board structures and the rights of shareholders differ in each country. But whatever the reason driving shareholders and their attorneys to push for changes in corporate governance, it will undoubtedly lead to increased exposure for boards and hopefully, to more appropriate behaviour.

There have been guidelines with suggested behaviours for directors and officers published from time to time, aka best practices for directors and officers. In 1996, the National Association of Corporate Directors Blue Ribbon Commission on Director Professionalism suggested directors adopt a culture of professionalism. In the 1990s, the Cadbury Committee in the UK was another that suggested what director's duties should involve. More recently, in 2004, the American Bar Association published a guidebook on the duties, responsibilities and rights of corporate directors, and of course there is Sarbanes-Oxley with its focus on financial control mechanisms. The US courts have also provided various views on this and have provided a shield to D&Os in the business judgment rule (Aronson v Lewis).

It is difficult to find fault with any of these suggested ways of behaving. The question is - will corporate board changes requiring elections every year or any other settlement term or completion of a statutorily-imposed required form necessarily result in a better, more profitable risk for the underwriter? In general, one would agree that greater transparency and disclosure results in better decision-making and perhaps leads to a more complete assessment by the underwriter of the risk, and attestations such as Section 404 certainly focus the mind as they carry stiff personal penalties for the signatories in the event of a false statement. Settlement terms that require changes to promote "good" behaviour are of course also welcome. But do they (or will they) lead to a more profitable risk?

Where's the incentive

Insurance underwriters read these and in their underwriting and evaluation process make decisions based upon whether a prospective risk will be a good, profitable risk for them and their companies - ie, one that will not have a claim. They are not guardians of the investing public and really have little incentive to encourage "good" corporate behaviour. That is the job of people like attorneys general, the Securities and Exchange Commission, the Financial Services Authority and other regulatory bodies around the world whose primary purpose is to protect the investing public and citizens in general by promoting full and complete disclosure under the mantra that sunshine and light does not hurt anyone.

However, the motivations of such regulatory bodies and insurance underwriters are not precisely the same. Underwriters would typically look at a prospective risk and lean toward the view that those directors and officers were honourable and had the best interests of corporate stakeholders at heart. Absent some countervailing information, claims professionals would think likewise. I suspect that certain regulators would lean towards a different view. Here is a current example.

It has been reported recently in the Wall Street Journal that prosecutors in three US states are pursuing a strategy that places companies in a position of non-cooperation if those companies decide to continue paying the defense costs of their directors and officers who are under indictment. Notwithstanding that they are entitled, under corporate indemnification statutes and most US company by-laws to payment of such defense costs, such a strategy if successful could result in those directors and officers having to reach into their own pockets to pay often crushing defense bills. Insurance underwriters on the other hand would view this as a potential opportunity as those without the ability to seek payment of defense costs from their companies could then seek insurance for such costs from D&O underwriters. In fact, such protection is already available in the market commonly known as "Side A" excess difference in conditions coverage. So, it is evident that what motivates the regulators is not necessarily what motivates D&O underwriters. Would the regulators then ask that D&O underwriters stop offering such insurance protection in order to place additional pressure on the indicted directors and officers?

So, do D&O insurers have a role to play in enhancing corporate governance? Should underwriters include in their proposal and application process a credit for those prospective insureds that can demonstrate, or debit for those who cannot demonstrate, compliance with the various statutory regulations and reporting requirements extant in the jurisdictions in which they write business? Should claims people assign a value in their settlement and adjustment calculations to corporate behavioural changes that would improve corporate governance and lead to "good" behaviour? Theoretically, they should do so. The unfortunate reality of the market is that not all insurers act as one on pricing, terms or conditions, so it would be a brave insurer indeed who took the lead. Compliance or non-compliance with those reporting regimens can be good indicators of the quality of the risk that underwriters are considering and claim settlements that include changes in corporate governance or oversight may arguably lead to "good" behaviour and fewer claims. These are not the primary motivators of insurance professionals but they clearly have an impact and should result in better risks and more profit for all of us in the D&O insurance business.

- Mark Goracy is vice president of claims for ACE Overseas General.


1. Doral Financial Corporation Signs Consent Orders with Banking Regulators, Doral Financial Corporation Press Release, March 17, 2006.