In recent years there has been a proliferation of lawsuits and administrative proceedings involving financial institutions. Some involve alleged misconduct of financial institutions, such as the allocation of IPO shares to favorite clients, conflicted research analysts and rapid-fire trading by mutual funds. Others involve activities relating to specific clients such as Enron, Worldcom and Adelphia.
These situations have already resulted in significant settlements and the creation of large reserves by financial institutions for additional liability.
Prior to the Enron debacle it was rare for financial institutions to have large exposure either in securities class actions or administrative proceedings.
The financial institutions were aided by the Supreme Court's decision in 1994 in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, (eliminating aiding and abetting liability in securities cases) and by the heightened pleading standards set forth in the Private Securities Litigation Reform Act of 1995.
However, after the bursting of the Internet bubble, the emergence of the IPO securities cases and the surfacing of Enron's problems, financial institutions find themselves at greater risk of potential liability because:
-Some judges and juries have become more skeptical of defendants in securities cases.
-Some decisions relating to manipulative schemes have eroded the effect of the Central Bank and exposed financial institutions to expanded fraud liability.
-A number of the issuers of securities were not financially capable of meeting securities holders' claims relating to their securities.
-As the effects of the erosion of Glass-Steagall continued to filter through to the structure of financial institutions, commercial banking, investment banking and financial services have become more integrated.
-Administrative agencies and state attorneys general have become more aggressive in prosecuting claims.
-Some pension funds have become active in prosecuting claims.
Last year, in the Worldcom litigation, a settlement was reach that put the personal finances of board members at risk, beyond any directors and officers insurance coverage. That added wrinkle makes board members even more nervous about liability. Just how much financial institutions will ultimately be liable is still unknown, but the insurance industry has begun to react.
INSURERS CLAMP DOWN
Historically, insurance underwriters analyzing directors and officers liability risks related to investment banks, commercial banks, broker-dealers, investment advisers and mutual funds have not had a comprehensive understanding of the financial services industry and its pertinent issues.
Neither has the insurance underwriting community kept pace with the increasing complexity resulting from consolidation and integration of financial institutions.
As a result of the alleged malfeasance by some firms and an aggressive plaintiffs' bar, insurers of directors and officers of financial institutions face a crisis in the form of an unprecedented number of claims and expensive settlements.
This has led to a revolution in the insurance underwriting process. In the past, a brief meeting or phone call with a company's risk manager and insurance broker would be the extent of underwriting analysis
However, this is no longer the case. The insurance industry, generally, has realized that simply attempting to increase premium rates and deductibles will not cure the problems plaguing the financial institutions' D&O insurance market.
Insurers, often with the support of the insurance brokerage community, now require initial meetings with senior executives of the particular financial institution being analyzed. Typical client attendees at underwriting meetings include the chief financial officer, treasurer and general counsel.
Executives, such as the chief compliance officer in the mutual fund industry, or board members such as the chair of the audit committee, may be obligated to meet with the insurer as part of the insurance underwriting process. After the initial meeting, the insurance underwriting team usually requests one or several follow-up meetings or conference calls with members of the financial institution's executive team to discuss any open items and confirm salient information.
In addition to ensuring the attendance of senior financial institution executives at underwriting meetings, brokers are providing insurers with detailed financial information.
The cooperation of the insurance brokerage community is essential to achieving best practices underwriting, and most brokers fulfill their responsibility to provide useful information and client personnel to underwriters.
In addition, it is important for brokers to support reasoned and responsible underwriting and explain its long-term benefits to their clients.
Since the financial statements of financial institutions are very different than those of nonfinancial commercial organizations, some insurance companies have recruited underwriters with special skills to analyze these companies.
To effectively underwrite these kinds of risk, an underwriter needs a strong expertise in accounting, tax, legal, finance and corporate governance.
Certain insurance companies have even used third-party consultants to augment the complicated underwriting process, and this cost is borne by either the insurer or the insured.
CHASING A WORTHY GOAL
In the end, the overall goal of the insurance underwriter is to understand the business of the financial institution seeking insurance and to build a fluid relationship with the senior executives of the organization. Hopefully, there will be contact between the parties throughout the year, creating an atmosphere of cooperation in the event of a claim.
The more rigorous underwriting process, which is in response to recent poor underwriting results, has driven underwriters to be more circumspect with their proposed insurance coverage terms and conditions. At the completion of a thorough underwriting due diligence process, responsible insurance markets often incorporate specific policy language addressing issues identified during the analysis into the D&O insurance proposal.
When the underwriting process is complete all parties should have a detailed understanding of precisely what the policy is intended to cover and not cover.
Additionally, the insured party should be familiar with the insurer's claims staff, taking special note of the experience level and ability to navigate through difficult claims should they arise. Finally, the insured, with the assistance of its broker, should analyze the financial strength (current and future prospects) of the D&O insurer and its ability to pay an insurance loss many years in the future as most D&O losses take years to develop and become final.
Insurers of financial institutions have ultimately responded to the proliferation of lawsuits and administrative proceedings by not only requiring a more detailed analytical approach to the underwriting process, but also by being more prudent and responsible with terms and conditions offered.
As a general practice, multiple year D&O insurance policies are not available in the insurance market, allowing for an annual review of each financial institution.
Errors and omissions coverage for investment banking related activities is generally also no longer offered by the insurance market.
Furthermore, deductibles on insurance policies have increased by as much as five times in response to the financial institutions D&O insurance crisis.
In addition, several insurers that have historically provided D&O coverage to financial institutions have begun to limit the amount of coverage offered to this class of business in an effort to balance their insurance portfolios.
GREGORY A. MARKEL is partner and chairman of the litigation department of Cadwalader, Wickersham & Taft LLP, in the firm's New York office. SCOTT MEYER
is president of the financial institutions group for National Union, an AIG company based in New York.
March 1, 2005
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