Risk managers covered by policies underwritten by the nation's large professional liability carriers like Chubb, Ace and XL have to wonder whether the wave of professional liability suits flooding the courts are going to have an effect on pricing.
Any way you look at it, the past 12 months have been ugly.
Big firms declaring write-downs in the last half of 2007 included Morgan Stanley, UBS and Washington Mutual. Even reinsurer Swiss Re, the world's largest, was affected as it announced in November a write-down of $1.07 billion.
Financial services giants have spent the better part of last summer and fall explaining to investors how they managed to lose billions of dollars in mortgage-backed investments. Industry titans who weren't able to explain the wave of red ink were dismissed by their boards: Stanley O'Neill, former chief of Merrill Lynch, and Chuck Prince, former CEO of Citigroup, to name just two.
As if the write-downs by the financial services giants weren't enough, a number of mortgage brokers and mortgage-related services companies declared bankruptcy.
In the case of American Home Mortgage Inc., which filed for bankruptcy protection in August, it wasn't just the mortgage company which was on the hook. Deloitte & Touche, the auditing giant, was also named as a defendant in a securities class-action suit after it gave American Home Mortgage a clean bill of health last April in connection with the mortgage company's planned secondary offering.
In another recent lawsuit, this time against the Morgan Keegan family of mutual funds, investors hit the fund company and the fund's auditor PricewaterhouseCoopers for allegedly misrepresenting the asset quality in which one of Morgan Keegan's bond funds was invested.
Perhaps more ominously, a prestigious New York law firm, Cadwalader, Wickersham & Taft, has found itself a defendant in a $70 million malpractice lawsuit brought against it by the issuer of mortgage securities over legal documents drafted by the law firm a decade ago.
Scott A. Schechter, a partner with Kaufman Borgeest & Ryan LLP in New York, says that over the next year or two, claims related to errors-and-omissions coverage are going to keep commercial litigation lawyers busy, and make some of them very rich. "I don't think anybody's saying the sky's falling on the D&O side of things, but E&O's quite a different matter," he says. "It's the great unknown."
If and when the E&O suits do reach the courts, they are going to take a long time to settle because sorting out who knew what when is murky.
Take the following example: Investors sue their advisors on the grounds that they, looking for a safe haven, were unaware their retirement savings were being bundled with a mortgage-backed security. Advisors, however, will turn around and blame ratings houses for assigning investment grade ratings to the security, says Schechter.
"Unlike Enron and WorldCom and those megaclaims scenarios, those were easy to get your arms around because you could figure out what the stockholder lost, what the bondholders lost and what the creditors were seeking in bankruptcy," says Schechter.
Even if the courts find in favor of the defendants and any awarded damages are minimal, with legal fees sometimes running as high as $1,000 an hour, unwinding subprime E&O claims is going to prove to be one expensive proposition.
One estimate pegs professional liability insurance losses connected with the subprime lending mess at $16 billion.
Marsh, citing research by Faten Sabry, a New York-based vice president of National Economic Research Associates Inc., says potential litigation arising out of D&O and E&O liability coverage include the following multitude of counterparties: lender lawsuits against banks; shareholder suits against lenders, accountants, trustees and underwriters; insurer lawsuits against lenders; investor suits against trustees; trustee suits against lenders and underwriters; and individual investor lawsuits.
All this is bad news for commercial insurance buyers, who in the past four years have been living with softening rates fed by healthy competition among professional liability underwriters. Now the underwriters will be under pressure to harden rates, according to insurance and legal experts, or at the very least tighten the terms.
"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," says Kevin LaCroix, director of the Beachwood, Ohio, office of Oak Bridge Insurance Services LLC, a wholesaler of executive liability insurance products.
LaCroix admits it's a "nerve-wracking time" for carriers. The second half of 2007 has jolted the professional liability lines out of a dormant couple of years when carriers were competing on price and felt "comfortable with what they were doing."
"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," says LaCroix, author of the professional liability blog, "The D&O Diary."
The danger of contagion is real, as the wave of lawsuits moves from mortgage originators to national banks and brokerages to real estate investment trusts, to bond insurers, to credit ratings agencies and even to 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?" asks LaCroix. "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."
But, he hastens to add: "We're not there yet."
Rick Bortnick, a partner in the Conshohocken, Pa., office of Cozen O'Connor, also agrees that the plaintiff's bar is bound to be emboldened by the recent settlement of William McGuire, the former CEO of United Health, who announced in December that he would forfeit more than $400 million in stock options and retirement benefits in connection with options backdating.
"The plaintiff's bar sees that as an opportunity to reinvigorate the class-action device, the plaintiff's device," he says.
D&O and E&O writers will start feeling the effects of the subprime scandal at the end of 2008 and even into 2009, adds LaCroix. But between now and then, commercial buyers can expect their underwriters to be a lot more cautious.
The nation's top professional liability insurers--AIG, Ace, Arch, Chubb and XL--are the companies most likely to be involved in defending clients from lawsuits related to the subprime lending scandals, although their exposure is also likely to be proportionate to their participation in the marketplace.
While there's no doubt that the subprime mess has increased the upward pressure on professional liability rates, it's also true that the industry as a whole is in healthy financial shape, coming off a record year in 2006 and another strong year in 2007. There's plenty of capacity in the marketplace and the competition among professional liability carriers remains healthy, says LaCroix.
"Until the losses start hitting that capacity, you're not going to really get the circumstances that really lead to a hard market," he says.
In addition, the insurance industry's own exposure to subprime lending, property/casualty carriers in particular, is very modest, notes A.M. Best & Co. It's important to remember the largest banks and brokerages typically have self-insured retentions that run into the tens of millions of dollars before carriers have to pay an E&O liability claim. And the number of cases litigated over the past few years have raised the standard by which plaintiffs can plead securities laws violations.
A study released in December by Guy Carpenter & Co. showed that E&O risk is unevenly spread out across the country. States with the highest likelihood of E&O litigation include Louisiana, Illinois, Michigan, Tennessee, Alabama, Georgia, Pennsylvania, West Virginia, Connecticut, Rhode Island and Massachusetts, the survey found.
Maine, Vermont, Iowa, North Dakota, South Dakota, Kansas, Oklahoma, Wyoming, Oregon and Arizona were found to have the lowest E&O litigation risk.
CYRIL TUOHY is managing editor of Risk & Insurance®.
January 1, 2008
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