By Katie Kuehner-Hebert
Before the financial crisis, community banks enjoyed a soft market for directors' and officers' insurance, as loan losses, bank failures and lawsuits from shareholders and regulators were relatively low in the go-go years when housing development raged and the economy hummed.
But the soft market changed drastically in 2008 after the subprime meltdown caused residential construction across the country to halt, resulting in heavy losses for community banks that had made a lot of loans to developers.
Carriers became concerned with the rapid rise in bank failures -- 426 since the beginning of 2008 --and the subsequent threats of lawsuits on banks and their principals from shareholders and the Federal Deposit Insurance Corp.
As a result, the terms and conditions of directors' and officers' policies have been substantially restricted for much of the industry and prices have hardened for nearly all.
The good news for community banks is that most can still get the coverage they need if they are willing to explain to carriers just how they have lowered their risk profile so that they'll not only survive, but perhaps even thrive once the economy fully recovers, insurers and brokers said.
"No underwriter wants to insure the proverbial 'burning building,' " said Mark Flippen, a vice presidentat Marsh in New York. "Underwriters want to hear the good story, and even banks with impaired balance sheets, who work closely with their broker and underwriters, can obtain favorable terms at renewal."
For many struggling banks, particularly those with regulatory orders to raise capital, some carriers are not renewing their directors' and officers'insurance. Others that pick up coverage are placing exclusions for prior acts.
Many carriers are also placing exclusions for claims brought by the FDIC after a bank has failed, to recoup the agency's expenses of closing the bank, resolving troubled assets and replenishing the Deposit Insurance Fund that covers bank customers with deposits under $250,000.
Carriers have a legitimate worry that the FDIC could file a lawsuit should a bank fail, said Justin Psaki, Arch Insurance Group's vice president, Executive Assurance Division, Financial Institutions/Financial Services Department in New York.
As of Feb. 14, the FDIC has authorized suits in connection with 49 failed institutions against 427 individuals for directors' and officers' liability with damage claims of at least $7.8 billion, according to the agency's website.
This includes 22 filed directors' and officers' lawsuits (two of which have been dismissed after settlement with the named directors and officers) naming 182 former directors and officers
Considering the statute of limitations is three years from the date of failure or when the FDIC takes over as receiver for the bank, the agency has sufficient time to file lawsuits based on the 140 failures in 2009 and the 157 failures in 2010, Psaki said.
"These were the peak years of bank failures associated with the recent credit crisis and could result in significant insurance payouts in the years to come," he said.
Some insurance carriers have refrained from offering coverage to any bank under a regulatory enforcement action, Psaki said. Other carriers, such as Arch Insurance, seek to differentiate these banks by examining the nature and severity of the enforcement action.
For those banks under a severe cease-and-desist order or prompt corrective action, the insurance available is very limited, he said. The options may be for limits of $3 million or less with restrictive terms, such as prior acts exclusion, regulatory exclusion, major shareholder exclusion, and/or no entity coverage.Alternatively, the scope of regulatory coverage might be subject to a sublimit of coverage or apply only to defense costs, with no indemnity coverage.
John Kerns, managing director at Beecher Carlson in New York, said that his brokerage has been able to find specialty markets that provide directors' and officers' coverage for banks under a regulatory enforcement action. Initially capitalized in Bermuda, these carriers are now starting to deploy capital toward community banks that have "a good story."
"We found some carriers willing to sit down with a bank CEO, who can explain that for the next two years the bank will produce enough core earnings, and while they don't have the level capital that a bank wants, they are not going to fail," Kerns said.
The premiums on these policies don't come cheap. Premiums are now five to 12 times higher than the prior average premium of $10,000 per $1 million in coverage, for a typical community bank before the financial crisis, he said.
IronPro, the New York professional liability and management division of Bermuda-based Ironshore Inc., has provided insurance to a few dozen of those banks that find themselves in that "trying to increase my pulse" stage, said Greg Flood, IronPro's president.
"We're pricing in risk of failure," Flood said.
Some of the new entrants to this marketplace are also unbundling the "A-side" of directors' and officers' coverage, to provide dedicated protection for individual directors and officers, said Michael O'Connell, managing director of Aon Risk Solutions'Financial Institutions Practice in New York.
On bundled policies, fidelity or errors and omissions claims can dilute or eliminate potential directors' and officers' coverage altogether, O'Connell said. But now banks can have the limits they need.
"Our role is not only maintaining and procuring broad breadth of coverage for directors and officers, but also introducing new carriers and giving advice on alternative structures," he said. "We recommend purchasing dedicated limits for the directors and officers -- the A-side of D&O coverage."
Many banks with directors' and officers'renewals under pressure have an "arrow in their quiver,"
an extended reporting period, or ERP, said Christine Wartella, worldwide banking practice leader for ChubbSpecialty Insurance in Warren, N.J.
A bank might have the right under its current D&O policy to purchase an extended reporting period for some period beyond the policy's expiration, typically for another year, Wartella said. If the ERP is elected and purchased by the insured, then the carrier will still have exposure to claims for activities that preceded the expiration date of the final policy term.
However, carriers might instead elect to negotiate a change in terms, such as a reduced limit, a regulatory exclusion or an adjustment to thedeductible, she said.
While conditions for the industry overall are improving in 2012, there are 813 banks still on the FDIC problem bank watch list, and so more than a few banks are still subject to a more difficult directors' and officers' renewal negotiation, Wartella said. Most renewal periods have been shortened from three years to one year.
Banks that can demonstrate that their financials have been restored to sufficient strength -- they now havegood capital ratios, their nonperforming assets have stabilized and their earnings are morepredictable -- may be able to find better conditionsand terms in the marketplace, she said.
"There is a fair amount of competitionout there, and a fair degree of capacity out there in the market, soinsurers have got to offer terms and conditions that are commensurate with the market or they will find it difficult to compete," Wartella said.
For nearly all banks, the underwriting due diligence process has become extremely detailed, with underwriters asking questions that are very similar to those of banking regulators, said Siobhan O'Brien, a managing director at Marsh.
As such, O'Brien and her team will meet with their clients four to five months in advance of renewals to assist them in formulating their insurance risk profiles.
Even healthy banks now have to pay more for their directors' and officers'coverage because of the hit the industry has taken after the financial crisis, said Mark Tomlinson, underwriting director at CNA Financial Corp. in Chicago.
Rates have increased each year since 2008, nearly reversing the effects of the prolonged soft market from 2000 to 2007, when rates dropped practically every time a D&O policy was renewed.
"Now the prices are above what they were in 2000, but the verdict is out on whether or not we are back to where we need to be as an industry, given all the rates we gave back in the early to mid-2000s," Tomlinson said.
Still, the insurance market has become competitive again for well-capitalized banks, particularly on excess layers, said Arch's Psaki. Part of this is due to speculation that many smaller banks will likely sell themselves to larger banks as the costs to comply with new laws and regulations skyrocket and the extended low interest rate environment strains their profitability.
"Insurance underwriters are interested in such opportunities, as the sale of a bank can generate a meaningful one-time additional runoff coverage premium," Psaki said.
However, there has also been an uptick in mergers and acquisitions -related securities class-action lawsuits that allege directors and officers of acquired banks breached their fiduciary duties by accepting inadequate or unfair consideration, he said. These lawsuits were filed in over 80 percent of announced mergers and acquisitions deals in 2011, representing 23 percent of all securities class action lawsuits filed that year.
"While these lawsuits are often settled with enhanced disclosures, the legal expenses incurred to get there are meaningful, particularly to the primary carrier and are beginning to change the way insurance carriers approach quoting the primary layer for community bank D&O in terms of premium and retention," Psaki said.
KATIE KUEHNER-HEBERT is based in San Diego. She has more than two decades of journalism experience and expertise in financial writing
April 13, 2012
Copyright 2012© LRP Publications