COVER ME
Anyone searching for D&O coverage will find it more expensive and less inclusive than ever before.
By David M. Katz

Every company in the world seems to be restating earnings these days - from TRI, a Malaysian conglomerae, to Tyco in the US - so naturally Dirk Sodestrom thought Westaff's restatement amounted to hardly anything at all. The CFO of the temporary staffing company based in the US even thought investors might see it as a positive sign. Partly because of tax law changes due to the Bush administration's economic stimulus bill, Westaff should have recorded a US$3.1 million tax benefit in the second quarter. The company made the change at the start of September, restating US$1.7 million net income loss to a US$1.4 million gain in the process. The move was apparently too arcane to merit a press release. Still, it was a restatement, and any time a company issues a restatement these days - positive or negative - there is understandable concern about possible shareholder suits. After all, many CEOs and finance chiefs, including Sodestrom, have begun certifying corporate financial statements under the mandates of the US Sarbanes-Oxley Act, passed by Congress in August 2002.

"The piece of paper that starts out 81/2 by 11 inches becomes three feet by five feet in a court of law," says Doug Hagerman, a corporate lawyer with US-based Foley & Lardner.

Little wonder that CEOs and CFOs - as well as board audit committee members, who are also endowed with new individual responsibilities thanks to Sarbanes-Oxley - are keen on maintaining solid corporate directors' and officers' (D&O) liability insurance coverage. In the current economic climate, however, that coverage is becoming increasingly costlier and skimpier.

In fact, Fortune 500 companies have seen their premiums soar 200 to 400 percent on their most recent policy renewals, according to Lou Ann Layton, a broker with Marsh Ltd insurance. In a recent CFO.com online poll, 27 percent of respondents said their companies either doubled or tripled their D&O premium payouts when they last bought coverage. And while companies in high-risk industries like telecommunications or biotechnology have the most to worry about, Layton says: "This is the worst D&O market in the 21 years I've been in the business."

Bumping Up Deductibles

The current D&O crunch follows more than a year of gradual market hardening. In 2001, for example, premiums for the line rose about 29 percent, according to a survey of 2,130 organizations released by insurance advisory company Tillinghast–Towers Perrin in June 2001. The increases picked up steam late that year as a result of losses to other property/casualty insurance lines stemming from the terrorist attacks. ("I personally think that 9/11 enabled D&O underwriters to jump on the bandwagon" of rate increases, says Layton.) And early last summer, D&O insurers really began to turn up the heat - intensifying their scrutiny of insureds and stepping up price hikes.

But that was only the start. Corporations are now being asked to retain a lot more risk. For instance, a Fortune 500 company with a US$1 million deductible is typically being asked to bump that up to US$5 million to US$10 million, says Layton. Bigger corporations that once retained US$5 million have seen their deductibles soar to US$15 million to US$25 million.

Coverage packages have also become much trickier to assemble, according to the Marsh broker. Wary of assuming too much risk in these scandal-plagued times, an underwriter that previously would insure US$25 million of the US$100 million of the basic D&O coverage typically bought by a large corporation might pick up only US$10 million or US$15 million. To sweeten the deal, the carriers may offer to provide the balance of the US$25 million in less risky excess coverage. But excess insurance provides coverage only once the costs hit a certain (high) level.

That has sent brokers scrambling to still other insurance companies for bits of coverage to keep their clients' primary insurance programs intact, according to Layton. The process tends to add transactional costs into corporate insurance bills and anxiety to risk managers' psyches. A big worry is that uninsured gaps will turn up in a company's insurance program - one reason Jeff Pettegrew, Westaff's vice president of insurance and risk management, characterizes the current D&O coverage as "a basket with leaky holes".

Alarming Takeaways

Keeping coverage intact for extended periods is another struggle. Like most other companies, Westaff has a "claims-made" D&O policy. That means that coverage is triggered only when a claim against the insured is filed - rather than, say, when the accounting problem that spawned the claim occurred. If a claim is filed after the policy year, the company could end up with no coverage. For that reason, extending the life of the policy for at least a year is essential, says the risk manager.

But such "extended tail" coverage comes with a price: for a one-year extension of its claims reporting period, Westaff paid the same premium as it did for its basic coverage to its carrier. In past years, insurers commonly provided extended tail coverage at a discount, typically 75 percent of the base premium, says Pettegrew.

Costly as D&O insurance is, most companies are able to buy some form of it. Still, CFOs need to be alert to a substantial narrowing in the scope of that coverage. "The D&O policy gives very broadly and takes away very specifically," observes David Mair, a vice president of the Risk and Insurance Management Society. After a sweeping statement that coverage is triggered by a "wrongful act," the standard policy excludes coverage if the act is intentional (although the intent must be adjudicated, which rarely happens in practice), and sets out a laundry list of other exclusions. For example, the policies generally exclude coverage for "unentitled personal profit," such as certain bonuses executives at Enron were alleged to have received.

Some alarming takeaways may be on the horizon. For instance, some D&O carriers have been talking about excluding claims involving an earnings restatement, says Joseph Monteleone, vice president and claims counsel for Hartford Financial Products. Relatively unheard of in the US, restatement exclusions are more common in the policies of European-based multinationals with US exposures, he says.

There are also rumblings that carriers might stop offering coverage for the corporate entity itself. An add-on to D&O policies, such "entity" coverage is much in demand because most lawsuits filed against directors and officers also name the corporation. More than 90 percent of US insureds bought entity coverage last year, according to the Tillinghast–Towers Perrin survey.

But both insurers and insureds increasingly see this type of coverage as a magnet for plaintiffs' lawyers. "It creates a large target," says Robert Hartwig, chief economist of the Insurance Information Institute in the US. "Suing the entire corporation is potentially more lucrative for the plaintiffs' bar and plaintiffs than simply going after directors and officers, where the assets are limited.".

Skittish Audit Committees

Still those directors - particularly on the audit committee - are plenty concerned about protecting their assets. After all, Sarbanes-Oxley has given them some hefty new powers, including hiring, firing, and oversight of independent auditors. They must also be up on the critical accounting policies and practices used by the auditor. And since their new authority and knowledge are bound to make them seem more like corporate insiders, they're increasingly likely to be defendants in court.

So besides keeping their coverage intact, senior managers face the added burden of assuring audit committee members that despite the increased risk they face, they will be made whole if they are sued. Many of the tools commonly used to put directors' insurance coverage out of harm's way, however, are getting pricey or tough to find.

For example, "severability" provisions, under which each insured is separately covered, can assure innocent directors of coverage even if others commit fraud. But corporations would do well to buy that protection sooner rather than later. "Many insurers that offer severability are beginning to rethink that," says Hartford's Monteleone. The carriers are shy about covering directors who bear some culpability for falsely stated numbers even though they're not guilty of outright fraud.

Directors who get a D&O perk from one corporation for sitting on the board of another are also at risk. Previously a throw-in on standard policies, such outside directorship liability coverage is becoming scarce, says Marsh's Layton. In the wake of recent high-profile bankruptcies, insurers know that an outside director could well be sitting on the board of a bankrupt company with depleted D&O insurance. In that case, the outside company's insurer might have to pick up the legal bills.

Surprisingly, such concerns have even begun rippling through private companies. Although their D&O risks are milder than those of public companies, private company boards can still be hit with lawsuits, says Rick Betterley, a risk- management consultant in the US, and author of The Private Company Management Liability Market Survey. And their executives can be equally anxious about supplying directors with insurance protection. The president of a private company Betterley advises, for instance, recently asked him "to go to her board of directors and say, 'no matter what happens to the company, we need to make sure that the directors are still protected.'"

David M. Katz (davidkatz@cfo.com) is assistant managing editor at CFO.com