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In an industry where some of the biggest risks come with the tag "uninsurable," technology risk managers have a lot more on their plate than just finding the best price for insurance.

They have to deal with investor expectations, as well as manage the risks of class-action suits, potentially catastrophic patent challenges, privacy breaches, mergers and acquisitions, and outsourced operations around the world, and also decide which risks to retain and which to transfer.

"Many companies, like eBay, are continuing to embrace enterprise risk management, but understand that they need to adapt it to fit their business needs." Redenbaugh says.

For many technology companies, the biggest single risk is that they may not be able to recover from a failed product launch, which tends to put a different perspective on more mundane exposures. Along with simply surviving, technology companies face intense scrutiny from shareholders and Wall Street.

While the technology industry is focused on tomorrow, investors are focused on today. A one-time loss that brings down a company's headline earnings-per-share number can trigger a sell-off on the stock market. Investors might not care if the loss will be reimbursed by insurance later. They simply react to the bad news in the profit-and-loss statement.

The decision for technology companies, then, is to decide whether to transfer the risk through insurance and still face investor fallout--even though the loss will be reimbursed later--or to cover the losses with cash on hand and avoid the premium payments.

"Insurance products really are there to protect the balance sheet," Redenbaugh says. "While we are sensitive to the balance sheet, we live in a P&L-driven world. Most young technology companies are very focused on P&L and short-term, quarterly, EPS-related results."

IT'S DIFFERENT FOR THE RICH

Technology companies flush with cash, however, have a lot more leeway when it comes to developing creative solutions for risk management.

"Tech companies, especially the larger ones, are tending to build pretty significant cash reserves," says Kevin Hoskinson, director, risk management, at Sun Microsystems Inc., "and so what does $100 million mean when you have $4 (billion) or $5 billion (cash) on your balance sheet?"

Among well-known technology companies, for example, Microsoft Corp. has about $32 billion in cash and short-term investments, database software leader Oracle Corp. has $7.8 billion, eBay has about $3.5 billion and Sun has about $3.4 billion.

"You have a lot of companies that have these huge cash run-ups," eBay's Redenbaugh says. "Why do they keep it there? So they can take risks."

Some of the largest technology companies are looking to use their hefty cash hoards to finance their own risk, whether it be through captives, self-insurance or higher retentions.

"They're driven to finance it themselves because, effectively, the alternative product solutions currently don't give them what they want, what they're measured on, which is P&L performance and stability," Redenbaugh says.

Among the trends is an attraction to higher deductibles, says Thomas Fitzgerald, managing director in Aon's National Technology Group.

"When you gravitate to a higher deductible, you need to think about retained liability and how would you most appropriately and efficiently fund for that liability," Fitzgerald says. "In some circumstances, a captive insurance company may make sense."

For example, Microsoft, which cites the "unavailability or high cost of conventional insurance arrangements" in its regulatory filings, relies on traditional insurance for some liability and property risks, but maintains captive insurance arrangements with a face value of $2 billion for catastrophic and other risks.

PATENT PERILS

One of the areas for which wealthier companies are seeking new ways to manage risk is patent lawsuits and judgments, which can easily run into the hundreds of millions of dollars.

Among recent high-profile cases, BlackBerry maker Research in Motion Ltd. agreed in March 2006 to pay $612.5 million to settle a long-running patent-infringement suit. In August 2006, Apple Inc. said it would pay $100 million to end a patent lawsuit that centered on the user interface for its highly popular iPod music player.

Those are the kind of numbers that give underwriters nightmares.

"Everybody agrees it's one of the biggest risks there are out there," Sun's Hoskinson says. "It's been a long road for the underwriters to try and get their arms around how to provide a product but not expose themselves to catastrophic losses."

For that reason, patent coverage is expensive, significant limits are unavailable, and companies that need it may not be able to obtain it.

"I wouldn't say there's no insurance; it's very limited and onerous," Hoskinson says.

Rates for patent coverage in the current market would come to around 10 percent of the total limit, meaning a company would have to pay $100,000 a year for a $1 million limit, says Michael Lamprecht, national cyberrisk practice leader for Arthur J. Gallagher & Co.

"There's no off-the-shelf patent product that is of reasonable price and provides reasonable protection right now," Lamprecht says.

Some big companies have sought to set up captives to buy patent coverage to cover catastrophic losses above $50 million, where coverage is more reasonable, Lamprecht says.

Smaller software companies, however, are finding themselves being forced under their contracts with large customers to buy expensive patent coverage.

"If their customer didn't specifically make them buy it, they wouldn't buy it," Lamprecht says.

Another issue is the intensive underwriting process for patent coverage, which many companies find too intrusive. In addition, companies may not want to learn about hidden patent issues.

"One of the things that leads to the high patent damages is knowledge of infringement," says Ted Doolittle, a principal at Integro Insurance Brokers in San Francisco. "Most insureds, when they understand what the process entails, they don't want to go through it. They'd rather not know about their potential risks."

The costs of coverage, as well as the risks associated with the underwriting process, lead many companies to manage patent exposures from an operational and legal standpoint.

"We invest in IP (intellectual-property) attorneys, and lots and lots of people are using contracts. We're going to defend our patents very aggressively," Hoskinson says. "It really comes down to a business risk that isn't necessarily something that we can transfer to others."

CLASS ACTIONS

While patent litigation remains a key concern, technology companies are breathing a sigh of relief about a drop in class-action lawsuits.

"Securities class-action claims are down almost 50 percent over the historical norm," says Chuck Shay, managing principal at Integro.

The number of securities-fraud class-action lawsuits filed fell to 110 in 2006--the lowest level since the mid-1990s and to around one-fifth the level of 2001, according to the Stanford Law School Securities Class Action Clearinghouse. That drop reflects a rebound in the stock market and stricter corporate governance regulations such as Sarbanes-Oxley.

"There's less in the way of damages or wrongdoing to point to," Shay says.

At the same time, rates for directors' and officers' coverage are also dropping. "Directors' and officers' liability insurance is deteriorating very rapidly," Aon's Fitzgerald says. "We're seeing reductions in the neighborhood of 10 percent, and I would think that 10 percent would probably be seen again in 2007."

Offered terms are also broadening, with underwriters willing to make concessions. "Coverage is continuing to broaden, but really the contract has been pretty much ripped apart. It's very open right now," Shay says.

Another area where technology companies are enjoying a buyer's market is errors-and-omissions coverage. "There are a lot of carriers out there willing to write the business," Doolittle says. "It's a buyer's market from a lot of different perspectives--price, coverage, availability."

The declines are especially notable for middle-market companies with revenues of less than $500 million, where foreign carriers have been setting up U.S. operations to enter what they see as a very profitable market.

"I'm seeing rates free-fall from where they were just 12 months ago. It's pretty shocking, decreases of 50 percent in some cases at renewal," Lamprecht says. For larger companies, the declines have been limited to around 10 percent to 15 percent, he says.

"There is still a very limited group of people that have the stomach for the very large losses that are associated with very large accounts," Lamprecht adds.

As in the D&O market, companies are also seeing a broadening of terms to include contractual liability, as well as cyberrisk and privacy coverages.

"For the software and Internet companies, people have now come to realize that if you don't have contractual liability coverage built into your E&O programs, you don't have a good E&O program," Lamprecht says.

In the area of privacy, companies have been able to pick up coverage for the costs of notifying customers of a breach of data privacy and providing credit protection afterward, instead of simply covering legal costs.

The cost of notifying customers and offering them some protection from identity theft can add up quickly, when such services can cost more than $30 a customer and where recent breaches have involved hundreds of thousands of people.

"What we found out was providing liability coverage, that is lawsuit protection, for organizations in the event they disclose confidential customer information, wasn't really working. They weren't necessarily getting sued," Lamprecht says.

BREAKING AWAY

The challenge for insurers, then, in dealing with technology companies is to stay ahead of their rapidly evolving risk landscape. To accomplish that, insurers have sought more experts in technology and the associated legal issues.

"They're hiring actual technology people, technology and legal people who really understand the issues," Hoskinson says. "It's not a simple matter of looking at a company--and are they software or hardware--and here's the rate we're going to apply to this. It's really digging into what does this technology offer in terms of services, how does it deal with its customers, looking at the contracts.

"It's really understanding it's a complex arena. You can't lump people into buckets," Hoskinson says.

A basic challenge facing insurers working with technology companies, eBay's Redenbaugh says, is to balance the need to weigh historical results when underwriting with the emerging risks that rapid development in the technology sphere brings.

"The insurance industry is always looking backwards, underwriting historical results. They need to get more skillful at the ability to assess risks going forward and underwriting based on that premise," Redenbaugh says.

"There's a widening gap between what's happening in the technology space and what's happening in the insurance marketplace," Redenbaugh says. "The insurance marketplace is falling consistently farther and farther behind and needs to focus on innovation."

MICHAEL FITZPATRICK lives in New Jersey.

March 1, 2007

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