July 2002

The tragic events of September 11, 2001, coupled with the recent Enron, K Mart, Global Crossing, WorldCom, Xerox, Tyco and any other company that has “filed” since we drafted this article, debacles have contributed to an already hardening D&O insurance market (and its related coverages - Errors and Omissions, General Partners Liability, and Employment Practices Liability). Prior to 9/11 double-digit rate increases and contractions in policy terms and conditions were becoming the norm due to the frequency and severity of securities class action claims. We will now see such increases and restrictions for the foreseeable future.

September 11th brought an entirely new philosophy to the insurance market. The idea of a true catastrophe had widened beyond the typical manufacturing/petrochemical or weather/seismic related events. The “standard” markets (Swiss Re, Chubb, Hartford, Royal, Travelers, among others) learned that the large limits they put up were not just “sleep at night” coverage for Insureds - these large limits could actually be pierced and encounter losses.

“You May Already Be a Winner?”

Similar to most cyclical markets, pricing is the first sign that a market is starting to turn. While it is difficult to generalize percentage increases for D&O coverage, very few insureds will be exempt from rate deterioration in 2002, with most seeing a 30% to 50% increase. State regulations require insurers to notify the insureds if the insurer expects premiums to rise or coverage to deteriorate beyond certain thresholds, even if the insurers fully intend to renew coverage. Given the market deterioration, check your mailbox as you may already be a “winner.” It is important to note, however, that these notices are as much a formality as they are an indication of the incumbent insurer’s renewal appetite.

It is difficult to make generalizations about rate increases. For example, companies with recent losses or companies coming off of 3-year policy terms are likely to see much larger increases than accounts with stable stock prices and/or annual terms that may have received rate increases in the prior year. Most D&O insurers (or their reinsurers) no longer offer multi-year programs and therefore the premium savings associated with those have vanished. Additionally, companies who carry excess D&O coverage above the primary layer have been especially hard hit. Excess insurers are commonly charging 70% to 90% of the underlying layer, up from 50% to 60% in recent years. The principle cause for an increase in excess pricing is heightened settlement awards. This trend has unfortunately shown, through recent cases (see examples below), that increased settlements are likely to continue.

 

Company	Amount	Settlement Date
USN Corporation	$44M	August 2001
Sunbeam Corporation	$110M	July 2001
Microstrategy, Inc.	$103M	February 2001
Rite Aid Corporation	$193M	January 2001
3COM	$259M	November 2000
St. John Knits Inc.	$61M	August 2000
Mercury Finance	$71M	June 2000
Cendant Corporation	$3.1B	June 2000

“Your Mileage May Vary”

In addition to rate increases, coverage terms have become as restrictive as at any time in recent memory. The "bells and whistles" that historically were added to coverage contracts are no longer being agreed to without meaningful resistance. The following can summarize the material changes impacting 2002 coverage terms:

• Minimum retentions (deductibles) are increasing. It is not uncommon to see a minimum $100,000 per claim deductible on many risks.
• “Waiver of retention” provisions are being deleted. In the past, many carriers would waive the applicable retention (deductible) under certain circumstances if a claim was dismissed without prejudice or if an insured was found not liable. This enhancement is no longer readily available.
• Discovery options are narrowing. If a policy non-renews or is canceled, the insured has a right to purchase extended reporting period coverage, also referred to as “tail” coverage. Typically, the “discovery” is for a period of 365 days. The “tail” option covers claims that are reported during the 365-day extension for wrongful acts alleged to have been committed prior to the date the “tail” coverage is effective. In the past, insurers would provide this option on a bilateral basis, meaning the either insured or insurer could elect this option if either decided to non-renew or cancel coverage. Insurers are now providing this option on a unilateral basis (in the insurer’s favor) only, eliminating the option for the insured to elect a discovery period in the event of the insured’s decision to non-renew or cancel. Additionally, the cost for this 365-day “tail” is increasing as well. The charge for the coverage is now 100% to 150% of the annual premium, up from 50% to 75%.
• Exclusions related to the failure to effect and maintain insurance are being added. Due to of 9/11/01, this exclusion is showing up again on D&O and D&O - related policies. Two examples:
  • A terrorist act creates a loss of an insured’s property. The terrorist exclusion on the insured’s property insurance policy excludes the claim from coverage. As a result, a claim is brought against the “directors and officers” alleging a failure in their oversight responsibilities to maintain proper insurance. Such a D&O claim would be subject to this exclusion and not be covered.
  • An earthquake has damaged property and the insured does not purchase earthquake coverage. A resulting claim by shareholders against the D’s and O’s would not be out of the question, and due to this exclusion, the D&O policy would more than likely not respond.

“Enron, Kmart, Global Crossing...”

While 9/11 had already served to compound pricing pressures facing the D&O marketplace, specific coverage issues have also arisen as a result of the recent spate of major corporate bankruptcies. The major issue can be illustrated by the current Enron situation. Enron creditors are currently fighting the company’s directors and officers over who is able to tap into $350 million of D&O coverage limits that Enron currently purchases.

In the past, efforts to make D&O insurance an asset controlled (and apportioned) by the bankruptcy courts have been rare. However, the staggering amount of bankruptcies since the “dot-com” collapse, along with harder- to- attain recoveries in bankruptcies have made D&O proceeds a viable target. Conventional thinking had been that D&O insurance proceeds “fly under the radar screen” in bankruptcy cases. No longer. The pension holders and investors (and their attorneys) of Enron who have filed suits against the company and its directors know they will get little (if any) economic consideration from Enron. Instead, plaintiffs’ lawyers hope to recoup the estimated losses of their clients from the $350 million in D&O insurance. Historically, courts have been mixed in their interpretation on whether or not D&O proceeds are the property of the bankruptcy estate. Some have held that these proceeds are not the property of the court, and instead must be made solely available to the directors & officers, not to the corporate corporation; while others have taken a position that policies provide coverage for the entity either prior to or hand-in-hand with the directors and officers.

Presently, both the Enron insurers and creditors are trying to block directors and officers from accessing their D&O proceeds. It is important to note that there were (to Enron) and are (to Equity Risk Partners’ clients) policy forms and wording changes available that would have allowed the directors and officers greater access to the D&O proceeds.

• “Broad Form A-Side” coverage protects the directors and officers only in the absence of any other indemnification. The policy does not provide coverage for the corporate entity.
• “Order-of-payments” provision - provides that coverage first applies to the directors and officers - prior to the corporate entity.

“We Should Have Made That Left Turn At Albuquerque”

The D&O market remains the enigma of the insurance industry. The constant shuffling of entrants and dropouts to the market mirrors the revolving door of a shopping center during the holidays. Of all the insurance contracts that an insured purchases, the D&O contract is likely to be the most complex and the least standardized. For the most part, insureds do not focus on the fine print within workers’ compensation or auto liability policies. A policy from one insurance company is likely to be very similar to a policy from another insurance company. Each D&O policy is a unique, separate, legal agreement between insurer and insured.

How much property insurance should you buy? The answer lies in the value of your property, plant and equipment. How much D&O insurance should you buy? The answer is not as simple. Market cap? That is not the right answer for private companies. Largest LP? That does not work if the State of CT pension fund teams up with the State of MA and alleges breach of contract. What about the potential for alleged wrongful termination from a GP who demands a percentage of all future carry on deals consummated during their tenure? Or worse, deals contemplated during their tenure? How much coverage do you need to retain outside directors? Daddy Warbucks will require higher coverage limits than Daffy Duck.

The important conclusion to draw from the issues listed above is that D&O insurance remains a complex coverage that requires consultation, analysis and review. D&O insurance for private equity firms and their portfolio companies requires a unique blend of deal comprehension and insurance expertise.

Private Equity Perspective

What should private equity firms and their portfolio companies do to mitigate D&O insurance costs during this period of rising costs and contracting terms?

If available, use your portfolio. Although insurance carriers are tightening the reins on the use of portfolio programs, the ability of private equity firms to spread their overall risk of loss among a portfolio of companies remains the single best way to mitigate the volatility of the insurance marketplace. The premium savings associated with portfolio programs has almost vanished completely, however carriers are still offering them as an option in certain cases. We recommend that you continue to inquire about the viability of these programs and determine if they make sense based on cost savings and the sharing of limits concept.

Eliminate the “gray areas.” As a result of their multi-faceted nature, private equity firms routinely face exposures that are covered by several different specialty coverages, but which should be consolidated into a single, comprehensive policy form, specifically:

Directors’ and Officers’ Liability
General Partners’ Liability
Employment Practices Liability
Investment Advisors Errors and Omissions
Management Advisory Errors and Omissions

Use the “bully pulpit.” We recommend that our clients communicate with prospective underwriters whenever possible to communicate a constructive picture of the firm and its portfolio. We have found a direct, positive correlation between these meetings with underwriters and final policy terms and premiums. We believe that the value of a long-term relationship with carriers is underestimated.

“Supersize It.” Your renewal specifications, that is. The information demands being made by underwriters of private equity related insureds resemble the subpoena of documents by the special counsel in the Whitewater investigation. D&O underwriters will require the following information:

• Annual and most recent financial statements for each fund
• Annual and most recent financial statements for each portfolio company
• Most recent quarterly report to LP’s for each fund
• Partnership agreement for each fund
• Purchase/Sale agreement for each portfolio company
• Description of operations for each portfolio company
• Employee count by state for each portfolio company
• Offering memorandum for each fund
• Listing of all pending litigation
• List of LP’s for each fund (some insurers)

The good news is that our clients only have to make one copy of the required information. We have to make a copy for each and every insurance company from whom we are seeking quotes. As a result, we have begun to follow up with clients on a quarterly basis for updated information in an attempt to minimize the disruption during the annual renewal process.

We believe that the changes to the D&O marketplace are not temporary. They are systemic. Like property insurance, the hard market is not due to lack of capacity but, rather, renewed underwriting discipline. As a result, we expect the current hardness to be more resistant to downward pricing pressure than in past cycles.

As any athlete who has practiced their sport can attest, before “hitting the showers” you need to “quit on a good one.” We shall do the same. We believe that we have seen the worst of the increases and contractions. Future renewals should be more moderate in pricing increases and some insureds may see slight reductions from today’s levels.

We look forward to the opportunity to be of service to private equity firms and their portfolio companies. Please feel free to contact Ben Gibb at (925) 459-6808, bgibb@equityriskpartners.com, for further information, questions or comments. We appreciate your consideration and support.