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By DAN REYNOLDS, senior editor of Risk & Insurance®

Directors' and officers' liability (D&O) insurance coverage for the financial sector has had its share of scares in the past few years. There was the fear that the large-cap bank crisis in 2008 and 2009 would send D&O rates skyrocketing. That happened in the short term, but the insurance impacts from that weren't sustained or systematic, largely due to a taxpayer funded bailout of those firms.

Now, another bogeyman is afoot in the sector, according to our experts, and it stems from the increased regulatory focus that investment and banking companies are under in the aftermath of the Dodd-Frank legislation.

That law greatly widens the window for whistleblowers, who could bring the attentions of the Securities and Exchange Commission to bear on the actions of hedge funds or other financial institutions. Reportedly, a flood of tips is hitting the SEC on the topic of financial malfeasance. Add to that the bounty that whistleblowers and their attorneys stand to reap if they turn the SEC on to a genuine case of malfeasance: between 10 percent and 30 percent of total fines and penalties.

Of key concern for underwriters, according to Rick Maloy Jr., chairman and CEO of Maloy Risk Services Inc., a New York-based brokerage which serves the venture capital and hedge fund industries, are the expert networks employed by hedge fund managers and their potential for leaks, which could lead to accusations of inside trading.

"It has become a standard question of the underwriting process. The insurers want to understand how the fund uses expert networks and what compliance controls are in place when dealing with them. Poor controls can lead to a funds inability to find coverage or have much higher premiums," Maloy said.

An executive with a major carrier said that he too has noticed a substantial change in the regulatory environment.

"There has been this huge pendulum swing, and as a result, the SEC is going to be more aggressive, and because of this shift, they are going to get the funds to do what they feel they need them to do," said Mike Smith, president of executive liability for New York-based Chartis.

The new provisions are also viewed as a potential windfall for the plaintiff's bar, according to Smith. There's no telling how aggressive attorneys for whistleblowers are going to get, he said.

"Nobody knows where this is going." Smith said.

Chartis in March came out with its own product, Investigation Edge, which is focused specifically on the costs of SEC investigations.

Or imagine if the SEC gets deluged with tips from whistleblowers and their attorneys, explained Tony Lendez, a partner and head of the financial reporting disputes and investigations practice for New York-based BDO Consulting. This could create months-long delays until the agency determines whether the tip is legitimate and decides whether to take action. If the whistleblower went to the SEC alone and didn't use a company's internal whistleblower system, that could create real problems for a company that has to restate earnings or do some other accounting statement due to getting blindsided by the SEC's findings.

"This whole whistleblower system encourages people to bypass the company's internal control mechanisms that have been in place," Lendez said.

MITIGATING THE RISK

Yet according to Maloy, underwriters have done a good job of revamping the older policy forms to address the more stringent regulatory environment.

"We have written our own policy form that was the amalgamation of three years of work with the various law firms that dominate the hedge fund industry," Maloy said.

Pricing is still down as a result of the insurer interest in the sector. As Maloy explained it, despite limited claims activity from the downturn of 2008, pricing for management liability coverage still increased "dramatically" out of fear. The higher rates made the market attractive for other insurers to get into the space. In 2008, roughly five or six real players were in the space. Now Maloy counts at least 15 or 16.

"Additionally, you're seeing a lot of pressure from outside directors and investors who want to see that this coverage is in place," Maloy said.

Besides insurance, Lendez said that companies would do well to refine internal reporting controls and give them credibility or create systems to encourage employees to report suspected malfeasances internally if they don't already exist--even if that means creating its own bounty structure to incent employees.

"If it is more readily available and readily known, it does increase the likelihood that there will be more whistleblowers," Lendez said.

March 14, 2011

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