The Subprime D&O Fallout

June Cover Story

The Subprime D&O Fallout
Is the D&O market susceptible to the subprime meltdown?

Sharon Emek sells a lot of directors and officers liability insurance from her office in Manhattan. These days, she’s getting a lot of calls from clients worried about the impact of the subprime mortgage meltdown on the D&O market, which had been a buyer’s market the past five years.

“I tell them if they’re a good firm they’re still going to get a good price,” says Emek, a partner at CBS Coverage Group in New York.

By “good firm,” Emek means a company that is nota defendant in subprime-related litigation or expecting to be. “I do hedge funds, financial institutions and commercial banks and even though carriers are giving them a solid look from an underwriting perspective, they’re still getting decent price decreases or the rate is staying fl at,” Emek says. “Outside the financial institutions sector, D&O premiums continue to fall significantly. It’s still a very soft market.”

Emek’s experience seems to run counter to the recent spate of sobering reports about the collision of the subprime fiasco and D&O insurers. Different studies estimate total D&O losses from subprime-related litigation anywhere from $3 billion to $15 billion. Of course, the industry is just guessing at this point since no lawsuits have come to trial or been settled, although a few have been dismissed. Still, the sheer number of securities class actions—61 at last tally—gives pause. Added to that are commercial contract disputes, bankruptcy-related litigation, employment practices liability claims and other lawsuits arising from the subprime mess.

Navigant Consulting, a global provider of business, regulatory and financial advisory services, cites 278subprime-related cases just last year. That’s more than half the number of savings and loan cases handled by the Resolution Trust Corporation in the 1980s, the firm notes. “The S&L crisis has been a high-watermark in terms of the litigation fallout of a major financial crisis,” says Jeff Nielsen, a Navigant managing director. “The subprime-related cases appear on their way to eclipsing that benchmark.”

Assessing Daily Agent Impact
For independent agents and brokers receiving phone calls from concerned clients, the question is whether or not the subprime meltdown will spill over, causing the D&O, E&O and fiduciary insurance markets to tighten. Since the Enron debacle and the resulting laws like Sarbanes-Oxley, the D&O market initially severely tightened and then, as more insurers entered the fray with lower-priced products, softened considerably in the past five years. Ten years ago, market share was distributed among the top four or five players, including American International Group, ACE, Travelers and Chubb. Today, a typical D&O program will comprise these insurers in a layered policy that also includes representation from Bermuda startups such as Arch, Ironshore, Allied World and Endurance, as well as larger carriers like Hartford and smaller insurers, such as Philadelphia Insurance, which Emek has tapped for several policies. “The competition is fierce and that has contributed to soft pricing and liberal terms and conditions,” she says.

Other agents agree. “The D&O product for both public and private companies is significantly under-priced,” says Mike Gorlin, leader of the corporate liability division at Miami-based Seitlin Insurance. “There are probably 30 markets chasing this business. Ever since prices jumped 300% in the wake of Enron, new players have grasped the opportunity to come into this market without legacy losses and an ability to lure contracts away from the big players with much lower premiums.”

Carriers are salivating over the $9 billion to $10 billion in annual D&O premiums produced in the market. “They’re all looking to get their piece of the pie,” says Peter Taffae, managing director of Executive Perils, a Los Angeles-based national wholesale broker. “To get it, they have to take it away from somebody else. And the way to do that is by driving prices down.”

D&O premiums, on average, are down about 10to 15% this year over last year’s policy renewal, depending on the class of business. Those reductions are on top of similar price declines in previous years. Companies tangentially related to the subprime crisis can expect fl at renewals up to substantial price hikes, anywhere from 15% to 400%, according to Marsh. So far, price increases have been limited to the financial institutions and real estate sectors. But if losses pileup as D&O, E&O and other claims spawned by the subprime mess reach conclusion, it may put halt the current soft market conditions. It all depends on the depth of loss: $3 billion should maintain the status quo; $14 billion or more may not.

Holding Up in Court
But the strength of the allegations in the litigation is in question—and that could significantly change the market picture.

“Historically, about a third of all D&O suits are dismissed,” says David Bradford, executive vice president of Advisen Ltd. “Disclosure is the key issue. If you failed to disclose to investors your subprime vulnerabilities and the investors continued to invest not knowing the company was on the verge of a major write down, that is often the basis for a valid case to go forward.” Citigroup, for example, announced a write down of $18 billion because of its subprime and credit-related losses. Needless to say, the company has been sued.

The first case filed in the wake of the subprime disaster was in fact dismissed. In January, a U.S. District Court in California dismissed a case brought against New Century Financial Corporation, which had been named in a subprime-related securities lawsuit. The judge, however, based his conclusion more on the plaintiff’s less-than adequate presentation of the allegations, rather than their merit. Nevertheless, most observers predict there will be losses.

“Looking at the impact of the subprime situation on D&O insurers, we feel good about our $3.6 billion figure,” Bradford says. “We made some value judgments and estimated that more suits will be dismissed than the typical average. We did that because while the purchase of CDOs (collateralized debt obligations) wasn’t out of the defendants’ control, the swoon in housing prices was.”

Bradford believes overall costs for the defendant companies will top $8 billion, but since the financial institutions sector tends to buy relatively small D&O insurance limits compared to other sectors, the loss to insurers will be less than half. The defendants will have to dig into their own pockets to pay the rest. “That should behoove all companies to consider buying much higher limits,” he says.

Preparing for a Market Shift
For independent agents and brokers discussing the market with customers, observers caution that it is still too early to predict where the D&O, E&O and fiduciary markets are headed. One need only pick up the business section of the daily newspaper to realize that predicting the economy is a dicey game these days. “We’re only partway through an economic crisis in this country; therefore we don’t know whether we will seethe contagion effect to assess the ultimate impact on insurers,” says Robert Hartwig, president and chief economist at the New York-based Insurance Information Institute.

Joyce Sharaf, an assistant vice president in the property-casualty division of A.M. Best, agrees that there is not enough data to predict the impact. “I can tell you that I don’t know of any imminent (insurer) down grades as a result of the subprime crisis’ impact on D&O,” she adds. Will the markets remain soft? Most are betting they will. “I’m still getting 15 to20% decreases on renewals,” Gorlin says. “Has underwriting discipline increased? Yes. If an underwriter sees the word ‘residential construction’ in a policy application or renewal, they may ask to see the company’s financials. Even then I’m getting a flat renewal.”

“There’s still a lot of capacity out there,” says Brian Wanat, head of the financial institutions sector at Aon Financial Services Group. “To the extent companies are shying away from financial institutions, they still need to deploy their capital some where. The laws of supply and demand inure to the benefit of the buyer. This doesn’t mean the market won’t turn—we just don’t know the magical ‘when.’”

Taffae is willing to go out on a limb. “I see the market turning in 18 months, give or take six months,” he predicts. “And it will be a knee-jerk market reaction. It usually takes big D&O claims an average of three to five years to work their way through the system, but I don’t think we will have to wait that long for the dust to settle.”

Until then, agents should advise clients to prepare documentation to tell their story as fully and compellingly as possible to underwriters. “Complete disclosure is of the utmost importance for us to be able to properly understand a company’s D&O risk,” O’Neill from AIG says. “Give us all you can to underwrite the risk and then build a partnership with the client. The fewer questions we have about the financials the better.”

Russ Banham (russ@russbanham.com) is an IA senior contributing writer.


Estimating Carrier Exposure

It is uncertain just how much each carrier is financially susceptible to subprime-related losses. Chubb declined a request to discuss the matter, while American International Group was a bit more forthcoming.

“We’ve received 24 D&O claims in the financial institutions sector as of third quarter 2007,” says Jennifer O’Neill, senior vice president and D&O product manager at AIG Executive Liability. “We’re seeing other stuff roll in, but I cannot comment in detail on what that is right now.”

Bob Hartwig of the Insurance Information Institute says some insurers “may have intentionally avoided some D&O sectors and may have written very little financial institutions business. But, it is also typical with D&O to layer policies with different insurers.” In other words, the full extent of insurer liability is cloudy at best.
—R.B.


Who and How Much?

What companies are feeling the effects of subprime-related lawsuits? Among the companies cited in the 61 securities fraud class action lawsuits are predictable ones like Bear Stearns, AMBAC, MBIA, UBS, Countrywide Financial and Societe Generale, and seemingly less obvious candidates such as McGraw Hill, Moody’s and Swiss Re. The61 companies are being sued for not fully assessing the risk of subprime mortgages or meaningfully disclosing it to shareholders. If the companies lose their day in court, D&O insurers will be tapped for legal defense expenses and the costs of either a settlement or verdict, depending on their individual contract terms, conditions and financial limits. E&O (errors and omissions) liability insurers and fiduciary insurers, the latter in cases where 401(k) plan participants sue plan sponsors over shaky subprime investments in the plans, also may be on the hook financially.

How much they may lose is the perplexing question. Lehman Brothers estimates D&O and E&O claims together could cost insurers between $3 billion and $4 billion. Advisen Ltd., which sells analytical data to insurers, projects a potential loss of $3.6billion for D&O and E&O insurers spread over two years, while Navigant estimates more than $8 billion in subprime-related losses. Marsh, meanwhile, citing investment bank sources, cites loss figures ranging from $3 billion to $14 billion.

The wide discrepancy is based on the broad range of companies brought into the litigation and the threat that this sphere will enlarge to include other unexpected defendants. Defendants so far include mortgage brokers, lenders, appraisers, title companies, homebuilders, underwriting firms, mortgage servicers and issuers, bond insurers, money managers, public accounting firms and others. Robert Hartwig, president and chief economist at the New York-based Insurance Information Institute, calls it the “‘contagion effect,’ where we move beyond the entities already named in litigation,” he says. “If the economic situation were to deteriorate further we may wind up seeing lawsuits outside the sectors already named. Right now it is too early to predict the overall impact.”

Lehman Brothers has a similar concern, one that would double its current estimate of insurer loss. “D&O claims could increase over the next several years(by) perhaps an additional $3 billion to $4 billion if stock prices suffer in a slowing economy with increased bankruptcy activity that could generate significant shareholder lawsuits,” the company stated recently. Says Nielsen about the specter of additional defendants, “This appears to be just the beginning.”

—R.B.