As has been noted previously on The D & O Diary (here), a recent study by Cornerstone Research (here) shows that the number of YTD 2006 securities fraud lawsuit filing is down significantly from a year ago. The decline in lawsuit filings is so significant that it almost begs the question: when is D &O pricing going to go down in response to the declining number of suits?

I know my many friends in the D & O underwriting community are thinking, how much further can rates go down? But the reality is that while current pricing is below 2003 levels, it remains well above 2000-01 levels. So The D &O Diary asks the question: should rates be going down further in response to the declining securities fraud lawsuit filings?

It must be conceded that in the very asking of the question there is an unstated premise that should be examined and not merely assumed – that is, that the current reduced level of securities litigation activity represents a secular and not merely a cyclical trend. For those of us who have lived long enough, there is a certain familiarity to the current circumstances. It was just ten years ago, in 1996, just after the enactment of the Private Securities Litigation Reform Act, that securities lawsuit filings were as low as current levels. (See the chart on the Stanford Clearinghouse website, here.) At that time, several carriers acted in response to the apparently lower level filing rate levels and reduced their D & O rates. That set off a price war that reduced pricing to much lower levels- just as an unprecedented wave of new securities filing began to hit the courts. The ensuing blood bath amongst D & O carriers continues to stain the industry’s balance sheets. So if the D & O industry has any memory at all (and also has enough fortitude to conform its actions to its experience, a highly dubious proposition), carriers will hesitate before reducing pricing based upon the current securities filing levels.

There is yet another unstated premise in the question, which is that D & O claims frequency drives D & O pricing. This one seems like a rather logical presumption, but analysis by David Bradford at Advisen discussed at the recent PLUS D & O West Symposium shows that D & O pricing only loosely correlates with D & O claims experience — the most significant factor in determining D & O pricing is insurers’ general level of policyholder surplus (key slides here and here). As it happens, surplus levels are quite high, and likely to go higher if the current mild hurricane season continues. So D & O pricing may indeed decline further in the short term, but if it does, it will have more to do with the fact that the wind didn’t blow this year than with the fact that securities filings are down.

The carriers’ typical response when confronted with the fact that filings are down is a statement that even if frequency is down, average severity is up. Indeed, the annual surveys by all the major consultants that follow the issue show that average securities fraud lawsuit severity has been rising steadily over the last few years (here). The claims settlements that are contributing to the current high severity levels are the sad remnants from the stock market collapse earlier in this decade. The plaintiffs’ style damages calculations in those cases run into the billions of dollars (or in the case of the Cicso Systems securites case that recently settled for more than $ 90 million, into the hundreds of billions of dollars). The magnitude of the purported shareholder loss in those cases makes most of those cases categorically different from the cases that are filed under post-bubble market conditions. More importantly for pricing purposes, these prior accident year claims loss levels arguably have slight predictive power for the likely losses that will accrue in current and future accident years. Continued reference to the post-collpase cases isn’t just driving the car by looking in the rearview mirror (a predilection to which insurers are particularly susceptible), it is trying to drive the car by reading the newspapers from several years ago.

That said, there are other claims-related factors to which carriers more justifiably might refer when contending against the arguments for further price declines. First, securities lawsuit filing rates may be down, but that does not mean that overall D & O claims activity levels are down. In particular, the number of derivative lawsuits is up. A significant shift has occurred in D & O lawsuit filings, away from securities fraud lawsuits and toward shareholders’ derivative lawsuits. This shift may be seen in the lawsuits relating to options backdating. That is, though relatively few companies with options timing problems have been sued in securities fraud lawsuits (16 at last count), over 75 companies have been sued in derivative lawsuits. (For a running count of options backdating lawsuits, see The D & O Diary’s tally, here) Second, there are a variety of forces beyond just options backdating that are contributing to increased numbers of derivative lawsuits ; as The D & O Diary has noted in prior posts (here and here), activist hedge funds are pursuing litigation as part of their overall strategy, management buy-outs are creating conflicts of interest between management and their companies (see here), private equity funds are seeking disproportionate advantages which gives rise to conflict of interest (refer here), and boardroom turmoil is creating a hostile environment in which accusations of wrongdoing more easily can arise (refer here). All these factors are all contributing to increased numbers of shareholders’ derivative lawsuits. The increased number of derivative lawsuits means increased claims frequency exposure at least for primary insurers, and arguably for excess carriers as well given rising defense fee expense and increased derivative settlement levels in recent months.

In addition, there are a variety of developing threats that also could make it precarious to conclude that the current reduced level of securities lawsuits means that overall D & O risk can be presumed to be below historical levels for all purposes. As The D & O Diary has noted (here and here) increased activity levels under the Foreign Corrupt Practices Act present a worrisome new source of D & O risk. A similar observation might be made about the Sarbanes Oxley whistleblower provisions, the Pension Protections Act of 2006 (which together with new FASB requirements that begin phasing in at the end of this year and that c0uld involve new levels of accounting risk). The unfolding of the options backdating scandal is far from complete. These factors and the ever present threat of a change in legislation or case law, makes it very dicey to predict with confidence that overall D & O risk is and will remain down.

So when it comes to D & O risk, the current case for and against further D & O pricing declines is decidedly mixed, notwithstanding the YTD 2006 decline in securities lawsuit filings. A more definitive claims-based view of the evolving D & O risk will only be possible in the fullness of time. The bottom line for now seems to be that if D & O pricing declines further in the short term, it will more likely reflect overall industry policyholder surplus levels rather than any categorical changes in the D & O risk. That said, if securities fraud lawsuit filing rates continue at current lower levels, carriers will undoubtedly face increased pressure to lower their rates.