By CYRIL TUOHY, managing editor
Cyril Tuohy: ERISA fiduciary liability keeps you up at night. You mentioned that with the retirement of the baby boomers, a lot of people are retiring. As a result, there's the solvency of plans and the rollbacks of plans and the plaintiffs' bar looking out for the workers on the production line who are being forced to give back when the CEO has lifetime health coverage. It's a plaintiff's dream in front of a jury. There's stress on retirement plans and plaintiffs are going
to say, "Why didn't you tell me to save 15 percent in my 401(k)?" Please expand on those ideas.
Keith Thomas: The concern is that, if you look at the demographics in our country, you have a significant portion, the baby boomers so to speak, that are either starting to retire now or will start to retire in very large numbers in the near term--say in the next three, five and 10 years.
I think what's going to happen is a number of things: One, all kinds of benefits plans are going to be stressed, and you will see a lot of companies paring back their benefits with the understanding that this wave of retirements is coming and what that cost would mean for them going forward.
But just with the basic administration of plans, as large numbers retire, you are going to have a number of issues, we think, around how benefits are calculated for number of years of service. If all the formulas are applied appropriately but there are still numerous errors at a company, does that create class-action potential?
And then there is the financial stress where companies, in particular those that have defined benefit plans, suddenly have a large portion of their workforce going to retire. Whether that stretches the plan and the cash outflows in a kind of dramatic way, that may cause them to revisit what the plan looks like. They may not have foreseen the number of folks retiring or retiring as quickly. If they do buyouts, what does it do to their plan? Which may mean other people who are going to be upset if their benefits are reduced.
So, if I am the employer and see this wave of financial pressure coming, I may change the plan rules or the plan formulas to soften that, and that may cause me a problem. All this, by the way, is totally allowable under ERISA. It just creates potential interest for the plaintiffs' bar. When anyone is having something taken away they tend to view it as an entitlement, although it truly isn't--it is at that company's discretion whether they provide it and to what extent. That is the defined benefit piece.
The second piece is the defined contribution piece. My concern, the way that I referred to it during the panel discussion, is lots of companies have converted to 401(k) or defined contribution-type plans, and there is a lot of discussion going on--should we allow financial advisors to come in an talk about the mix of investments that you should have. I think that companies have gone to great lengths to encourage people to sign up and to contribute to the full extent that they can.
But, I can still see the lawsuit where somebody decides that they are living day to day and are not putting anything away. Suddenly, they realize what they have done and come back and sue the company, saying, "You didn't tell me to save enough." Or, "You didn't tell me I shouldn't be in money markets only, even though I'm very risk averse. While that's true, you created a greater risk long term for me in terms of outliving my savings."
I can see that type of potential. It's similar to the fast-food obesity litigation. You should have told me, you should not have let me buy the hamburger; that type of scenario.
I'm not sure it's happening, but that is the type of thing I talk about with people because, unfortunately, the legal environment at times doesn't account for personal accountability, for one's actions related to retirement and health care. So, there is a potential to have that type of scenario. It wouldn't surprise me. Whether it goes anywhere or not, I don't know.
CT: How do you protect independent directors and officers? Do you do a separate contract under an independent directors liability contract? How do you protect independent directors to keep them completely separate from treasurers and senior management? Is that they way to do it, or is there another way?
KT: One of the things that we're seeing is that there is a tension in the management/ boardroom with two different constituencies, which is what you are hitting on. You have the insiders--the CFO, COO, president and so on--that are running the company day to day.
Then you have board members, some who formerly may have been directly involved, like the CEO and now chairman, but often that may not be the case. So, they are not as intimate with the day-to-day issues at the company, and they have competing interests. We think that they should look at IDL-type of contracts.
They may also want to look at buying separate towers of insurance where it's just for individuals, and that can be for both officers and outside board members. It doesn't have to be an inside person versus outside, so to speak. Again, it depends on who really drives the buying decision.
We often are not behind those discussions, behind that screen, so we're not sure who truly is involved in making the decision. They can also look at how they structure the order of payments on the contract, where it could go to outside directors first, insiders next and the organization last. They can look at different ways to structure their policy--within the same limits, by an IDL contract or two mirror towers, one that is for the entity and the individuals and one that dedicated solely to the individuals.
CT: Now that prices have softened and appear to be continuing to do so, what then is the major issue to deal with? There is a question about climate change or environmental liability and another question about bifurcating contracts and yet another about international coverage. Is there one issue that is more important than all the others now that prices are softening (in terms of keeping in mind from a risk perspective)?
As the marketplaces changes for D&O, in terms of price, what should people look out for?
KT: People have to be careful in looking at price and price trends alone. We are doing a lot of things to make this process much more transparent for buyers as we have been doing for a few years. We will sit down with customers and show them how we generated their price by looking at market cap changes and things like that. We have put tools out on Bloomberg that they can use to analyze this type of risk. There is a better alignment of price to risk, individual company risk versus price to what the market is doing. If the market is down 10 points, but your market cap is up 50 percent and your CFO just left, does that mean you should get a 10 percent decrease?
There needs to be a better alignment between price and risk, and the market is the market. That is what part of the problem has been over time and why there are sharper snap backs in the cycle where people end up seeing 50 percent to 100 percent rate increases. This is because, as an industry, we historically have been pretty good at taking price up and out, just very bad a doing it in the right place. We have invested a lot of time, research and money here at Zurich to get a better understanding of our cost of goods sold.
The other part is there's a false sense of security. We are starting to see that change a little bit in the financial markets when you look at interest rates now. You can't just say, "Well, we have averaged 190 to 200 securities class actions a year, and in the last few years they have been down. Last year there were 112, down from 160 or 170, or about a 40 percent reduction. Everything's great."
Well, that is just one metric. People need to understand that you must take that number and divide it by 0.8 because there are fewer publicly traded companies out there. So, that number goes up to 138 or 140 on a normalized basis. The other thing is that severity is up dramatically in the larger market cap space.
You have to understand that this is a business and there's an economics piece to it. If you aggregate dollars, pool the premium in this space versus losses experienced, you can't justify continuing big rate decreases. While some of those megalosses like Enron and MCI were not fully insured, those were real billion-dollar plus losses for this space--D&O and E&O. People need to be cognizant of that.
I think the other part is that the market has been really good. It may start to see some hiccups now as we're seeing things change. As the economy gets stressed, people get more creative, and when people get creative, problems happen. So, while we may have seen claims come down for a number of reasons and we are also in the sweet spot of an economic cycle and stock market performance, when those things come out of sync, things start to happen and I expect to seen an uptick in claims volume.
CT: That's interesting. One other thing you might want to say something about is the snapping back of the market.
KT: That's when the market cycle changes suddenly, and when it does, it is sort of a tsunami price change as opposed to a ripple or a small wave. That is partly because the market is pushing harder and the price-to-risk isn't anywhere in sync, it's way out of whack, and people historically haven't had metrics against which to measure that. Our business has gotten better, Zurich and the D&O community at large, around trying to build a better line of sight on those issues. But, that is one of the issues you get caught with if you just push price. At some point it snaps and will bounce back pretty severely.
CT: Is the severity of the bounce back increasing or has it always been that way in the past as well?
KT: The last few cycles have been like that. In the mid-80s and 2001-2003, our product line saw significant changes. If you were to do this on the back of the envelope, you should look at the Dow in 1995, what the value was, versus the Dow in 2000. Just look at what your exposure base is and what your pricing probably should have done. That is an optic people can look to and say, "OK, if the stock market goes up dramatically or volatility changes dramatically, then loss severity, loss frequency and damages will go up."
Unfortunately, people haven't tracked back to some sort of metric, but I think people are getting better about this.
The other thing ... is the international component. We are seeing a lot of reform, for lack of a better word, in Europe where in the past you couldn't grant class-action status, whether it's employment or securities matters, you now are seeing similar SOX issues. Japan has one, J-SOX. The U.K. has been going through it.
So, the liability environment has changed, and companies need to make sure their D&O product will respond around the globe and in a compliant fashion. By that I mean, make sure you're paying taxes in countries where you can export coverage--local premium taxes, and you also need to know that, in a country where you can't import coverage from the United States, like Brazil, that you find solutions with local contracts. Zurich has done a lot of work on that--both pieces, the tax compliance for customers as well as the local policy solution where it's needed.
October 1, 2008
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