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By MIKE SCHWANDER, executive vice president, and KEN CAPONE, senior vice president of Lockton's Financial Services practice in Denver

A five-year run of reduced premiums, broad terms and increased capacity in the directors' and officers' market has once again come to a grinding halt, at least for financial institutions. In the immortal words of Yogi Berra, it's "deja vu all over again" for the market.

By this point, a few very large public companies had identified the cycle shift and began buying as much D&O capacity as the marketplace would offer. Unfortunately, by the late 1990s, this trend came to an abrupt end when the technology bubble burst and names like Enron, WorldCom and HealthSouth became headline news.

FINANCIAL FIRMS HIT FIRST

At present, the D&O correction is hitting the broad financial institutions industry particularly hard in a manner reminiscent of the late 1980s. Included in this grouping are banks, thrifts, investment banks, hedge funds, private-equity firms, investment advisors, real estate investment firms and others.

These companies are facing premium increases in the range of 10 percent to 200 percent and even higher. In many instances, they will also face the prospect of reduced capacity (reduction in available limits), an increase in deductibles, a tightening in policy terms or, in the worst case, a complete nonrenewal from their carriers.

Oddly enough, a severe spillover into the commercial D&O market has not happened. But it's clear that the industry is trying to talk itself into a commercial hard market.

As insurers announce their 2008 financial performance, we expect to see results that have fallen from 2007 levels. Increased loss ratios, significant investment portfolio write-downs and reduced investment income made 2008 a tough year for some insurers. The result may be an increasingly imbalanced and uneven marketplace for some time to come.

For the industry as a whole, we see the current environment as the beginning of a struggle between two strategies for insurers: (1) maintaining market share by not overreacting to the financial crisis; or (2) significantly adjusting prices, capacity and terms at the risk of market share.

How did we get here? Our eyes were opened in early 2007 when we received a sneak peek at how precarious the subprime mortgage market was. At that time, we started to see lenders stop making loans, close their doors or file bankruptcy.

Since that time, we've had a chance to experience painfully how pervasive the effects of the subprime mortgage meltdown have been. Corporations we historically believed were rock-solid have been crippled, merged, artificially propped-up, sold or put into bankruptcy--names like Citigroup, AIG, Lehman Brothers, Bear Stearns, Merrill Lynch, Washington Mutual, Countrywide, Fannie Mae and Freddie Mac, to list only a handful of the headline-grabbers. If this wasn't bad enough, we're now experiencing a second wave of financial surprises from the likes of Bernard Madoff, Nicholas Cosmo and Arthur Nadel.

All this financial chaos has resulted in--and will continue to result in--a large amount of D&O litigation. Securities class-action filings in 2007 numbered 176, up from 119 in 2006. In 2008, securities class-action filings grew to 226, according to a joint study by Cornerstone Research and Stanford Law School's Securities Class Action Clearinghouse. It is estimated that at least half of these suits are subprime/credit-related cases. Advisen estimates that losses to directors' and officers' liability insurers during the three calendar years 2007-2009 totaled $5.9 billion.

As we experience an increase in claims activity, D&O underwriters will inherently revert to basic blocking and tackling strategies as they underwrite risk. As renewals approach, executives should anticipate a far more extensive underwriting process, one that will require more of their time and attention in order to secure a favorable result.

IMPACTS AT RENEWAL TIME

Although underwriting methodologies vary by insurance company and surely this is not a complete list of all underwriting factors, there are common underwriting criteria that will be addressed at every renewal.

First, underwriters will perform a detailed financial review of the balance sheet and income statement. They will be analyzing various financial performance measures and calculating company cash flows, liquidity and credit availability.

Secondly, underwriters will be looking at potential weak spots in the business model. The current terminology is "stress testing" for breaking points. For example, if a company is heavily dependent on a few clients for its revenue, underwriters will attempt to "stress test" the financial impact of the loss of a significant customer.

Underwriters also will look closely at the M&A activity of a company and analyze the extent of due diligence performed before such transactions are closed. Market capitalization and stock volatility are always important considerations in underwriting a D&O risk because they tend to drive the ultimate loss calculation.

Finally, underwriters will look at corporate governance issues, which we define very broadly. This would include the process and philosophy behind corporate disclosures; whether a company has a healthy culture within its board of directors and a strong management team; its history of stock sales by insiders; and its accounting policies, internal controls and executive compensation.

PAINFUL PERIODS

History is a great teacher--but many times we ignore its lessons. We know that the D&O product can be very unprofitable in the short term, usually resulting in severe fluctuations in pricing and capacity. These restrictive periods are painful for clients, underwriters and brokers.

But clients can pursue strategies to minimize the effects of these severe swings. (For more information on them, please see the accompanying article on our Web site).

D&O liability programs and the process of creating, negotiating and acquiring them can be time-consuming, confusing and frustrating. As Yogi Berra also pointed out, "If you don't know where you are going, you will wind up somewhere else." If done incorrectly, the "somewhere else" could be a very expensive place.

Developing and executing a well-thought-out plan, with the assistance of experienced brokers who have been through these cycles before, will give companies the best opportunity to ride through the latest cycle of the D&O market.

April 15, 2009

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