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By DAN REYNOLDS, senior editor of Risk & Insurance®.

To hear Peter Taffae tell it, he started to get a hunch a little over a year ago that big changes were coming to companies in the insurance sector. Red flags were beginning to go up around American International Group Inc. and some of the sharper people in finance felt that an economic crisis was coming to some of the nation's most important underwriters.

What Taffae came up with was what he calls the "supercontinuity option." For the price of pennies on the overall D&O premium for the relevant layer, the insured gets the option of switching D&O coverage to a backup carrier if the primary carrier on the insured's first D&O layer suffers a crippling ratings downgrade.

When Taffae first came up with the idea, he recalls that carriers that were willing to step into such a shadow role saw the supercontinuity option as an opportunity to snuggle up to companies with big professional liability risks.

The hope was that the shadow carrier might one day get the business should the insured's primary D&O carrier suffer a significant ratings hit. For the shadow underwriter, this was a foot in the door.

At this time last year, thoughts of A-rated carriers suffering massive downgrades were not so farfetched.

"You know it is a great opportunity," Taffae said. "You're right there waiting, you're building a lot of credibility. If carrier X trips, you're right there."

Last summer, Taffae recalled, he was "begging" five of his best clients to take up his supercontinuity option. The first one to do so was Chris Thorn, the risk manager for Southwest Airlines. Other risk managers have taken up the supercontinuity option and even renewed, according to Taffae, though he declined to name other specific risk managers.

Thorn credited Taffae with the idea for launching the product. "He saw the opportunity. This had never been done before as far as I'm aware, and he pitched the idea and said, 'If I'm able to get this done, is this something you'd be interested in?' And I said, 'By all means, I'll check into it,' " said Thorn.

In Thorn's case, his concerns centered around the primary carrier on his D&O program, AIG, now known as AIU Holdings Inc.

Thorn, like many risk managers responsible for structuring important D&O programs, is loyal to AIU Holdings and feels they are a good insurance company.

At the time, though, Thorn just felt that he needed some assurance that, if AIU Holdings Inc. suffered substantial downgrades, he had another carrier that could come in, regardless of whether he had a claim or not, to pick up a piece of the primary layer of his D&O coverage with roughly the same capacity and at roughly the same price.

"I truly believe that AIG as an insurance company is very strong and has plenty of surplus, they just have problems with their parent, and as long as the insurance company can stay whole, there is nothing wrong with it," Thorn said.

What would have triggered Thorn's supercontinuity contract option would have been a double-notch ratings downgrade for AIU Holdings Inc. In the end, AIU Holdings Inc. only suffered a single-notch downgrade since he signed his option with Taffae. Thorn's supercontinuity option thus hasn't been triggered.

What makes Thorn's particular supercontinuity option worthwhile is that changes in Southwest Airlines' risk profile--a shareholder lawsuit against a director or officer, for example?wouldn't constitute a trigger point under the terms of the agreement. Should Thorn have a claim, that wouldn't void his supercontinuity option. Only a double-notch credit downgrade on the part of Thorn's primary insurer would constitute an event outside of Thorn's control and would trigger the option.

"The whole concept of this was that, if the trigger were outside our risk profile, then that is something that the (backup) insurer would probably accept," Thorn said.

Under the terms of the agreement, the backup carrier that has agreed to step in if AIU suffers a double-notch downgrade also remains anonymous.

"The way our program works, the lead (underwriter in the D&O program) doesn't even see who follows," Thorn said.

Taffae said the confidentiality clause was at the request of the backup carriers. "They don't want to be in the public domain," he said.

PERSONAL ASSETS

The way Taffae sees it, boards of directors are typically very keen to make sure that their D&O coverage is rock solid. Investors might find it unsettling, but Taffae thinks boards and officers consider protecting property and other company assets secondary to protecting their personal assets.

"I don't want to be condescending, but I think if you don't do D&O a lot you might not appreciate the fact that there is a great deal of pressure from the board of directors to not screw up the D&O," Taffae said.

"If a guy screws up the property, it's not a big deal because it's the corporate assets, it's not the personal assets. You can understand it's a lot more important," Taffae said.

Since Taffae hatched his supercontinuity concept more than a year ago, much has happened in the financial services sector.

"THEY'RE IDIOTS"

One of the byproducts of the economic crisis has been that underwriters who previously were eager to bring their carriers into a supercontinuity deal with an insured are now less eager to do so.

Deals involving the supercontinuity option are still getting done, Taffae noted, but underwriters for prospective shadow carriers are showing a hesitancy to shore up the relationship between an insured and a large carrier when the carrier has mishandled their own finances.

"The underwriters feel like, 'Why should I support these guys, they're idiots.' " Taffae said.

Risk managers are still curious about exercising a supercontinuity option because more damage in the financial sector and the rest of the economy may yet unfold, according to Taffae.

Granted, risk managers working for banks or large mutual funds will probably have trouble finding a supercontinuity option for their D&O program, according to Southwest's Thorn, because D&O risks in the financial services sector are not very attractive right now.

Should more credit downgrades affect major carriers, risk managers trying to find a safe harbor for their D&O program might want to avoid the scramble of Fortune 500 risk managers scouring the horizon in search of a healthy D&O carrier, said Taffae.

The moment a major downgrade happens, D&O pricing is going to shoot up even further as demand for D&O coverage outstrips supply further still. "The other underwriters, they weren't born yesterday, it's supply and demand so it's going to go up," Taffae said.

For his part, Thorn said he plans to renew his supercontinuity option this August.

"We would be interested in a renewal of this option," Thorn said. "One, the cost of the option was very inexpensive, and that was due mainly to the fact that our risk is considered a value risk, one that is not a high risk at all, and so this market would love to be the lead. They just know that it's probably not going to happen."

August 1, 2009

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