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Should You Buy D&O ASAP?

Rates have dropped, but recent settlements may swing the pendulum in the other direction.

1Dec

Just three years ago, directors'
and officers' (D&O) insurance rates
were so high that Ron Foster, then
CFO for troubled fiber-optics giant JDS
Uniphase, threatened to set up a self-insured
facility with other companies rather
than pay the prices insurance companies
were demanding.


That approach would have tied up millions
of dollars in escrow and led to potential
legal complications, but Foster was willing to
risk those headaches because the rates for
D&O liability coverage "were verging on outrageous."
Indeed, premiums rose an average
33 percent between 2002 and 2003 across all
industries. Foster ultimately got a more reasonable
bill from his insurers, but only after
tough negotiations.


These days the market looks completely
different. Foster, now CFO of semiconductor
test-equipment maker FormFactor, says rates were
down "substantially" when he renewed last May, and
he's not alone. "It's a very good market for buyers of
D&O insurance," says Mike Rice, managing director
for Aon Financial Services. Rates have dropped about
46 percent from their 2003 high and are expected to
fall another 5 to 7 percent this year, according to Aon.
At the same time, many companies are finding it easier to get better terms, so much so that "you can
probably buy as broad a contract today as at any time
in the past 20 years," says Rice.


But how long can these good times last? Prices
have fallen in large part because officers and directors
have faced less fire: the number of annual securities
class-action filings has decreased by more than 40
percent since early 2004. An absence of major scandals
has helped, and the fact that law firm Milberg
Weiss, renowned for its indefatigable efforts in securities
class-action litigation, has been hamstrung by
its own legal problems may not have hurt either. But
cases that have reached settlement have
become more expensive, up from an average
of $28 million in 2004 to $71 million
in 2005, according to PricewaterhouseCoopers's
Securities Litigation study. Add to
that the growing prevalence of claims
related to the backdating of stock options,
and the next renewal season could spell
the end of the buyer's market. As Rice
notes, "The combination of more-frequent
and more-costly suits is what typically
leads to problems," and half that
equation already seems to be in evidence.


No company seems in imminent danger
of surpassing the Enron and WorldCom settlements ($7.2 billion and $6.2
billion, respectively), but plenty of companies
have been hit with outsized claims,
according to the Stanford Law School
Securities Class Action Clearinghouse.
Nortel and AOL Time Warner each faced
settlements totaling about $2.5 billion, for
example, while Royal Ahold was on the
hook for $1 billion. And those large
claims may set the stage for others
because, as Daren McNally, an attorney
with Connell Foley LLP who specializes
in insurance-coverage litigation, notes,
"highly publicized and extraordinarily
large cases threaten to redefine what's
considered an appropriate settlement."



Covering Your "A" Side


Supersize settlements are leading many
companies to load up on so-called Side A
coverage, which covers officers and directors
personally (as when, for example,
bankruptcy or state law prohibits companies
from reimbursing them via Side B
coverage, which applies to the company
itself) and which has become critical as
standard indemnification gets harder to
come by. About 9 percent of directors and
officers received partial or no indemnification
from their companies when charged
in securities-litigation cases, according to
Tillinghast, a division of Towers Perrin,
and another 60 percent said their companies
were undecided. "Side A coverage is
definitely on the rise as individuals become
more concerned about decreasing indemnification
and competing claims for policy
limits," says Carol Zacharias, senior vice
president at insurance company ACE Ltd.


Concerns about protecting the personal
assets of directors and officers are only
likely to grow as suits related to backdating
stock options play out. So far, most claims
(about 80 percent) have been in the form
of derivative lawsuits, in which shareholders
sue officers or directors on behalf of
the company. Since the company is effectively bringing the suit (and reaping any
gains), it is prohibited from indemnifying
officers and possibly from reimbursing
them for legal-defense costs. Side A is the
only type of insurance that covers officers
and directors in such cases.


As demand for Side A coverage
grows — in 2005, companies increased
excess coverage lines, which include Side
A only, by 10 to 11 percent on average,
compared with 2 to 3 percent increases in
primary-coverage limits, according to
Tillinghast — there is concern that insurers
will shift some of the burden back on
the insured. To date, directors and officers
have had to put up their own money in
"only a handful of cases," says McNally,
the best-known being WorldCom and
possibly Enron. "But there is a real risk
going forward that directors and officers
will have to contribute their personal
assets, primarily because the settlements
are getting so large."


Some insurance companies are coming
out with new products to help quell
the fear that there won't be enough coverage
to go around. One option is a new
"enhanced" line of Side A coverage that
offers separate additional limits for directors
only or for officers only should a policy's
standard limit of liability be exhausted.
"This is in response to the increasing
frequency of partial settlements we've
seen," where directors are sued separately
from officers and claims are settled separately,
says ACE Bermuda executive vice
president Patrick Tannock. Directors, he
says, often seem to be able to settle sooner,
"leaving officers holding the bag" when
the policy is shared.


But Aon's Rice says that there are few
breakthrough products coming to market.
Rather, he says, insurers are now trying
to get an edge by offering fully nonrescindable
options, improved severability,
and other options as standard equipment.



The Who and How of Options


Finance executives who want to get more
bang for their premium bucks can take
several useful steps. One, of course, is to
be prepared for a litany of questions about
stock-options granting procedures.
"There's no one-size-fits-all," says ACE's
Zacharias. "We accept that there are different
ways to do it." But "we're asking
companies how they issue options, who
reviews them, and who gets stock options."


Careful attention to
language — and a willingness
to negotiate — can also
work in a company's favor. Peter Fahrenthold, Continental
Airlines's managing
director of risk management,
says that one of the
more contentious areas in
D&O coverage concerns
which party gets to decide
when to cut off coverage to
a particular director or
officer who seems to be
guilty.


While Fahrenthold says
it hasn't been possible to
"write into the contract
that the carrier can't make
the decision," he was able to
change the language to
gain more-favorable terms
for the company. Instead of
relying on so-called dispute
arbitration, where a third
party would decide guilt or
innocence, Continental's
policy rests on a "final adjudication,"
meaning a court
decision or an outright confession of guilt.


FormFactor CFO Foster says that face-to-
face meetings with insurers are a great
way to get favorable policies. He hits the
road every year to meet with all of his
D&O carriers (the only type of insurance
he does this for) because they know that
"the CFO is the one minding the store, so
they want to see the whites of your eyes."


Finally, a CFO can help the cause by
keeping in good stead with big investors.
Securities litigation that involves pension
funds and unions carried an average price
tag three times higher than ones that
lacked those key investors, according to
PwC's study. While companies can't control
who sues them, of course, "it's
become more important than ever to
manage relationships with institutional
investors," says Zacharias.



Alix Nyberg Stuart is senior writer at CFO.



Stating the Case for Federal Oversight


A new approach to insurance regulation may lead to lower rates.


If you're like most finance executives, you don't stay up nights thinking about
the structure of insurance regulation. But a move to create a federal oversight
office, as an option to the patchwork of legislation that property/casualty and
life insurers now face from state regulators, is one development that might be
worth tracking.


Senators John Sununu (R-N.H.) and Tim Johnson (D-S. Dak.) introduced a
bill proposing such a structure into the Senate this past spring, while Rep. Ed Royce
(R-Calif.) followed with a similar one in the House. While few expected the bills to
become law during this session, experts say they lay important groundwork for
needed change.


At the very least, a single regulator could reduce administrative and licensing
costs for national insurers, translating into lower costs for corporate buyers. Proponents
say it could also grease the skids for new products to come to market. "If you
ever loosened up the regulation on insurance, the capital markets might well step
in and offer risk financing-type credit that would be far more valuable and efficient
to corporate buyers," says Felix Kloman, retired principal of Towers Perrin and editor
of Risk Management Reports newsletter.


Workers' compensation, which falls under casualty insurance, could also get
less expensive, particularly for companies that use some type of self-insurance facility.
"There's no question" that state-based regulations drive up costs, says Wayne
Salen, director of risk management for Labor Finders International. The staffing firm
now has five different workers' comp policies with varying administrative requirements
to cover operations in 32 states, using AIG "to avoid the nightmare" of the
paperwork and as a last-resort backstop. If AIG could file at a single point, though,
Salen believes he could save anywhere from 5 to 25 percent off current premiums.


Absent congressional authority, the Treasury is still gathering expertise in
the property/casualty insurance arena. The department has become better-versed
in insurance matters over the past several years, since it is responsible for administering
the Terrorism Risk Insurance Act. And because it's a top issue for groups like
the Risk and Insurance Management Society and property/casualty group American
Insurance Association, efforts to gather more support on Capitol Hill for federal
regulation look likely to push ahead in 2007. — A.N.S.


































































Good Rates, for Now
D&O insurance premiums are at a four-year low.*
YearAverage Premium
2005$260,345
2004296,956
2003486,717
2002309,654
2001229,059
2000187,296
1999221,470
1998286,521
1997349,341
1996$396,845
Source: Tillinghast
*Note that the size and number of companies surveyed year-to-year varies, reducing year-to-year comparability.

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