Do you see the legal treadmill heating up in 2008, and what does this all mean for the carriers like Chubb, AIG and Ace?
In terms of whether there will be E&O claims, the answer is definitely yes. Whether they will be in 2008 or not remains to be seen. Let me tell you about one lawsuit that did come in in 2007 to say why it may or may not be 2008, it might be further down the road.
There was a lawsuit filed this year, in fact just within the last two or three months against one of the big New York law firms, Cadwalader, Wickersham & Taft, and the lawsuit was brought by the trustee for a pool of commercial property-backed mortgages that had been syndicated and securitized just like many of these subprime mortgages had been.
When the entire transaction was set up, one of premises of the whole transaction was there would be certain tax advantages to the investors, and it ultimately turned out that those tax advantages were not available to the investors. They sued the trustee of the trust and the trustee wound up having to make the investors whole, and now the trustee has sued the lawyers that created the document.
The reason I cite this incident and its relevance to your question is that those documents were created in 1997, and the lawsuit against the lawyer was just filed this year. There will be ramifications. But whether those play out in the short term, the middle term or the long term, I think remains to be seen. There have already been lawsuits filed against accountants, and I'm aware of two where accountants remained as co-defendants in securities class-action lawsuits.
The first is a lawsuit arising out of the bankruptcy of American Home Mortgage Inc., which was a mortgage originator that went bankrupt in August 2007. It had done a secondary offering in April 2007, and in connection with that secondary offering, it published an opinion written for the company by Deloitte.
Deloitte had given American Home a clean audit opinion, and that was included with the prospectus that was issued in connection with the secondary offering. So that when the securities class action was filed later in 2007, the lawsuit included a count against Deloitte.
There was another very recent case. within the last two or three weeks, where defendants are a group of asset managers that run a mutual fund as part of the Morgan Keegan mutual-fund family
The bond fund has lost over 50 percent of its value, and investors have filed a securities fraud lawsuit alleging that the bond fund manager had misrepresented assets in which the bond fund was invested. It was represented as safe, secure, conservative when in fact it was invested in a variety of mortgage-backed investments including collateralized debt obligations, and the investor lawsuit named not only the bond fund managers but also sued PricewaterhouseCoopers, which was the auditor for the fund.
Are these are all E&O related? Or are they D&O related as well?
For the other defendants, they would be D&O, but at least based on what I understand are the allegations against the auditors, they would be E&O. They wouldn't be suing them for their mismanagement, they would be suing them for their practices as accountants and auditors. Beyond the lawyers and the accountants, there have already been a number of lawsuits filed just under the heading of real-estate professionals. The ones that have been sued include real-estate brokers.
One lawsuit I'm aware of is a lawsuit filed down in Florida against a homebuilder and a real-estate broker. The idea was that the homebuilder was building spec homes and the real-estate broker was finding potential home buyers who wanted to buy the homes as investments. What they would do is the investor/purchaser of the home would buy the home and rent it back out to a renter with the intent to buy.
The idea was these investors would be brought homebuyers by this real-estate broker, who would prequalify the home renters, so it was a scheme whereby the homebuilder and the broker were acting together to get investors to buy these homes.
There also have been lawsuits against mortgage brokers. The allegation against the mortgage brokers is that they made misrepresentations to the home buyer or mortgagor who thought they were receiving a mortgage on certain terms and conditions. The allegation is that it was actually different terms and conditions, and those allegations include professional type of claims. There are a number of different types of lawsuits against appraisers, either that they inflated appraisals or that they were involved in some sort of scheme with the mortgage broker or the home origination company.
Pretty much all filed within the past 12 months...
That I'm aware of. They may have been more. Title insurers--that's the whole category of real-estate professionals. Then there's the whole category of investment banking E&O. The allegation there is that these investment bankers put together these mortgage pools and securitized them into these exotic, synthetic investments, and the allegation is that they did it incompetently or that they misrepresented the nature of the investments--that they did not structure it in a way that provided the investment protection that they knew the investors wanted.
There are a number of those type of lawsuits out there already. Some of them actually have taken the form of ERISA-type lawsuits because the investors were acting through their 401(k) or their pension plans, but not all of them.
There are, for example, lawsuits against State Street that packaged investments to a variety of different investors, and the allegation is that they committed certain malpractices or misfeasances in connection with the structure of those investments. So in investment banking E&O, there are a lot of those allegations right now.
I assume that all these investment banks and brokerage companies have E&O insurance or D&O insurance that they've taken out?
They do. Investment banks in recent years have got insurance programs that often combine E&O and D&O under a single form under different coverages, Coverage A, B and C. The very largest investment banks typically carry very big self-insured retentions in to the tens or hundreds of millions of dollars.
So, in effect, could these eventually affect premium rates?
Six months ago, I would have said probably not, even three months ago I would have said that. But I'm coming around on this a little bit. The thing that has really got my attention is something that we really haven't talked about yet ... taking a look at the bond insurers because the bond insurers provide default insurance for many of these investments.
The bond insurers in effect lent their triple-A rating to all of these funds and to municipal bonds as well, and there is some pressure on some of these bond insurers, in particular one called Security Capital Assurance. SCA is under great threat of its own credit write-down, and if that were to happen, many of the investors who hold investments insured by that company would no longer qualify for that rating and would fall outside of their investment guidelines and they would have to sell those investments. And so you could have this cascade effect.
Also, municipal bonds rely on those bond insurance companies for credit enhancements so they can get lower interest rates and also sell their bonds So my concern is it's too early to tell if this is the kind of event that could turn the market, but I'm more concerned about that possibility than I was just a few months ago just in terms of the claims that have come in. There are well over 30 securities class-action lawsuits, which makes this a serious event for the D&O industry, and then you add on the possibility of E&O claims and it starts to become more serious.
The D&O industry and the E&O industry have had a good run for a number of years, so it's not going to turn on a dime. The other thing is that these claims just started coming in late in 2007, so it's unlikely that they've gotten the reserves up to the point where it's going to start affecting their results. Insurers are going to report good results for 2007 calendar year and maybe even the 2007 accident year.
So, it will be 2008 before they start really feeling the effects, and it will be at the end of 2008 before they finally do their year-end analysis before they realize if 2008 is or is not a negative year. So if it has that effect, I think it's going to be a delayed effect. It might be 2009 before we know for sure what the effect is going to be. That said, if these lawsuits continue to come in the way they are coming in, it could make underwriters more cautious.
It's already happening in the financial institutions sector, and they are much more cautious. That should come as no surprise to anyone. But will it have a ripple effect outside of those areas as the wave of lawsuits hits other sectors of the economy? It started with the mortgage originators and then moved on to the investment bankers and the REITs, and it's also hit bond insurers, it's hit the credit rating agencies, it's hit home construction companies.
Will it spread even further? And if it does, you could get the insurers becoming more cautious and becoming a little bit more weary. Will it result in a hard market again? It's too early to make that call, but I think for sure you're not going to see the same rate of deterioration in terms of conditions and pricing because everyone's a little bit weary.
That said, today it remains competitive and there's a lot of capacity out there looking to be put to work. The circumstances that create competition are still there. They haven't changed. Until the losses start hitting that capacity, you're not going to really get the circumstances that really lead to a hard market.
The last time we saw something like this was with Enron and WorldCom?
Yes, and keep in mind that that hit right after the effects of Sept. 11, 2001, so it was a variety of things hitting at the same time. The pricing on D&O had already started to turn. It started to turn in 2000, so it was before Sept. 11 and it was before Enron and WorldCom because the losses were already starting to show up and carriers were already reacting.
But the impact of Sept. 11 and the corporate scandals dramatically increased the pace of that increase. So from late 2000 to mid- to late 2003, pricing was going up, and then somewhere in late 2003, it started to come back down and has really started to come back down gradually and steadily since then. If I were to make a prediction, I would say we would see a level pricing at least for the first part of 2008, and then if there starts to be an acceleration and accumulation of these claims, and in particular if the losses start mounting for the carriers, those are the circumstances that could lead to a market turning the other way. I don't think we're there.
The industry looks like it's going to have a decent year?
Yes, they are going to have a good year. There were no hurricanes and no big natural catastrophes with two weeks left to go. Results are going to be good, so factors that usually lead to the hardening of the market aren't present yet. That doesn't mean they are not accumulating and might not have an impact in 2008, but they are not present yet.
Whereas under Enron it was a D&O issue, this is clearly more a D&O issue?
I don't know if Enron and WorldCom was just a D&O issue. Let's not forget that Arthur Andersen went out of business because of all this. But I think there's potential for there to be a lot of E&O-type claims, and we've already seen some of them with the investment banks and the real-estate professionals claims. I think we're going to see more of that sort of thing so there could be an impact on that from the point of view of the insurers' portfolio. I think they are probably watching that very closely.
Who's on the hook for all this? Chubb, Ace and AIG?
In the end the risk potential is proportionate to the carriers' participation in the marketplace. There are carriers that are more active in the financial institutions sector than others, and so they may feel it first. But I don't think it's just going to be limited to them. Certainly AIG, just because of their market clout. You would expect that they will participate at least in proportion to their market share.
So really it's not just the big players?
There are some players who I can think of that relate to the life sciences or the technology, who at this point you'd think they are less likely to be hit, but if there's a general deterioration in the marketplace, that could affect them. The other thing to keep in mind there was that from mid-2005 to mid-2007 there was a lull in securities class-action lawsuits generally.
But beginning in mid-2007, it's really picked up, and it's returned to sort of historical levels. You might speculate that it's the subprime problem and that's part of what's going on but it's not the only thing that's going on, and the claims are really all over the board; they are not just restricted to subprime related claims.
So really what's going on is that the volatility that's returned to the financial marketplace is creating the circumstances that in the past gave rise to D&O claims. So there's volatility and risk there for all of the carriers, not just the ones who are exposed to financial institutions risk.
So it's actually a nerve-wracking time for carriers because there are a lot of changes that have come into the marketplace in the second half of 2007 that really had kind of been dormant for a couple of years, and that had made it easier for the carriers that were competing on price to feel comfortable with what they were doing. But I think that self-aware carriers are probably going to be taking a close look at their practices just to make sure that their practices are consistent with what they are seeing on the claims side.
Sounds like you could see terms tightening up too?
You could, but the thing I keep coming back to is there's a lot of capacity in the marketplace and whenever there's a lot of capacity that means competition and there's going to be competition especially for the good accounts and as long as that capacity is there. There's nothing constraining capacity right now, and so, if the marketplace becomes more disciplined, it's going to have to be an act of will rather than an act of necessity and that's always a lot harder for the marketplace to do.
CYRIL TUOHY is managing editor of Risk & Insurance®.
January 1, 2008
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