Last week, I added a post (here) discussing the March 2, 2008 paper entitled “How the Merits Matter: D&O Insurance and Securities Settlements” (here) by Connecticut Law Professor Tom Baker and Fordham Law Professor Sean Griffith. In response to my invitation, Professor Griffith prepared a reply to my comments, which is as follows:

Before beginning, I’d like to thank Kevin for his careful and thoughtful reading of our paper and for his many kind words and comments. Kevin’s comments have improved all of our papers in this area, and they will surely improve this one. I do, however, have a few remarks to make in response to three comments Kevin made towards the end of his write-up. I’ll address: (1) the impact of disclosure on insurance, (2) the possibility that additional disclosure will increase the incidence of lawsuits against corporate insureds, and (3) the ways in which additional disclosure will make the world a better place.

1.         In his review of our paper, Kevin writes that Baker and I “do not seem to have reviewed the idea of compelled disclosure with anyone in the insurance industry.” Not so. We have indeed run the idea of additional disclosure by folks in the insurance industry. In fact, I well remember one of the first conversations I had on this subject. I was working on an earlier paper (here) that proposed mandatory disclosure of D&O insurance details when I received a voicemail message from one of the broker’s I’d been talking to. He excoriated me on the message, offering a stream of expletives that would have made George Carlin blush. He’d read my draft (or, at least the title) and, I gathered, was rather displeased at the prospect of public disclosure of D&O insurance information. This, I believe, is the general reaction, of folks in the insurance industry to the proposal, although their reactions are typically more calmly expressed.

I am neither surprised nor particularly bothered by this reaction. First, it is hardly surprising that more transparency within a market would make an intermediary’s life more difficult. Intermediaries will worry that their profit margins will be eroded away if their customers can see the price paid by comparable companies. Buyers will insist that brokers get them an equally good deal as a competitor or justify why they can’t. But why is that a bad thing? What’s bad for the broker looks good for the consumer. Moreover, brokers often say that they do more than just price a coverage package. If that’s really true, then there will be a place in the market for them post-disclosure. They’ll still be providing a service that’s not available elsewhere. But if it’s not true, then the broker’s role starts to look like waste, and why wouldn’t we then want to disintermediate the market and, perhaps, let risk managers build their own coverage towers?

Second, moving to the insurer’s perspective, I’m not sure that disclosure would be bad. It might be a problem if the insurer is offering discounts for some clients but not others on the basis of factors that are not risk-related, perhaps because a buyer’s price on their D&O program is tied to the fact that they’re buying a (more expensive) general liability policy from the same insurer. (Some suggested to us that tying arrangements of this sort occur in the D&O market.) If we had a disclosure rule, we can expect buyers to demand the same D&O premiums as all similarly situated companies, which would make it harder to engage in tying arrangements. The only valid basis for an insurer to offer different prices would be differences in risk. Underwriters would be in the position of having to articulate why Company A is a better risk than Company B. This would obviously be good for the buyer, but I suspect in the long term it would be good for the seller too. It would focus underwriters on what matters—risk-assessment—and inhibit their ability to make sales that discriminate on some other basis (like tying). From the insurer’s perspective, that’s probably a good thing because insurance that is sold with better risk assessment up front is less likely to lead to losses down the road than insurance that is sold on some other basis.

Now, I don’t know how any of that would ultimately play out. I’m just skeptical of the gloom-and-doom-for-the-industry story. I suspect that those within the industry who are doing what the industry is supposed to do—assessing risk and tailoring coverage—will survive. Also, to be honest, my concern is not so much with the insurance industry as it is with the corporations buying the insurance. And, frankly, when anyone other than the consumer complains about market reform, that’s usually a sign that market reform is a good idea. Producers and (especially) intermediaries have shown themselves across industries and throughout history to be opposed to reforms that enhance competition. I suspect that this market reform would benefit the consumer in a variety of ways, not just in the bottom line price paid by insureds, but more about that in my response to #3, below.

2.         Second point. Disclosure would be bad for corporate insureds, Kevin suggests, because the additional disclosure will make them “lawsuit targets.” In other words, the incidence of lawsuits will go up if plaintiffs lawyers know more about corporate insureds’ coverage packages.

We here this objection fairly often, but I think it’s easily disproven. Here’s how: First, everybody knows that virtually every public company in the US carries D&O insurance. Second, everybody knows that average settlements are much less than average coverage limits (in spite of the rare high profile above-limits settlement, just look at Tillinghast, Cornerstone, or NERA—average limits far exceed average settlements). Those two things being true, plaintiffs’ lawyers needn’t fret about insurance when they file claims. They can reasonably assume that coverage will be there. Moreover, insurance coverage is one of the first disclosures that the parties must make once they’re in litigation. If, in the rather unlikely event that a corporate defendant is not well covered, the plaintiffs’ lawyer can drop the claim before their sunk costs have gotten too large. Bottom line: currently, plaintiffs’ law firms reasonably assume that most corporate defendants will have sufficient D&O coverage to fund claims, and they file any time they can put together the basic elements of liability. If Tom and I got the disclosure rule we want, true, plaintiffs law firms would know the coverage profile of the corporate defendant, and they’d file any time they could put together the basic elements of liability. In other words, the additional disclosure would not be a boon to the plaintiffs’ bar, and the incidence of suit would be about the same.

3.         Kevin also remarks that although we, as academic researchers, would benefit from additional disclosure (true!), we haven’t really specified how additional disclosure would deter securities violations. 

            First, regarding Tom’s and my self-interest. Yes, if we got the disclosure rule we want, we’d crunch the data in more papers. But, let’s face it, we’re not going to get famous doing this. And Tom and I both have tenure, so we don’t really have career incentives that distort our devotion, putting it somewhat grandly, to truth and justice. We want the additional disclosure because we think it would be good for the world and we write the papers because we think the world ought to know what’s good for it.

            Okay, so why would additional disclosure be good for the world? Or, more concretely, how would it deter securities law violations? 

As we said in the papers about underwriting, disclosure of D&O pricing, limits, and coverage structure would enable financial analysts to use this information as a proxy for downside risk and, on the basis of that proxy, to change their valuation of corporate insureds. With enough people in the market using this information (which one might assume on the basis of the efficient capital markets hypothesis), insurers’ collective assessment of a prospective insured’s risk should have a direct impact on the prospective insured’s share price. And, last step, because managers care about share price, anything that has an effect on it (e.g., wobbly corporate governance structures) is something they’re likely to address. So disclosure of D&O pricing, limits, and coverage structure would improve corporate governance. 

What’s different in this paper is that we think the required disclosures should be broadened. Not only should corporations be made to disclose their limits, pricing, and coverage structure on a regular basis (with each renewal), but also any time a corporation settles a securities claim, they should be required to disclose how the settlement is funded. E.g., What amount comes from insurers? What amount comes from the company? Putting this information together with information about the corporate insured’s coverage package, financial analysts and capital market participants ought to be able, as we say in the paper, to assess “which corporations are likely to have engaged in bad acts and which have not.” In other words, which corporations got stuck settling a nuisance claim and which allowed some form of fraud to occur.

How would analysts be able to draw this conclusion? Consider a settlement well within total limits to which a corporate insured nevertheless contributes a substantial amount. The insured’s contribution in this case might indicate that the insurers were able to cash in their coverage defense for savings off of their full exposure. Granted it might indicate other things as well, but if I were a financial analyst, I’d want to know why did the company pay when it had more limits available. And if the insurers had a strong coverage defense, doesn’t that suggest that there was some merit to the plaintiffs’ claim (i.e., that it was not just a nuisance suit)? And if there was some merit to the plaintiff’s underlying claim, have the problems that led to the claim been fixed or management just back to business as usual, denying all the while that the plaintiffs’ claim had any basis at all. Either way, this information would make me reconsider my valuation of the insured corporation’s shares. Again, with enough people in the market acting on this information, the corporation’s share price ought to be effected. And, because managers care about share price, this creates an incentive for managers to actually avoid the kind of things that lead to fraud claims. In other words, disclosure, in the context of both underwriting and claims, gives the market what it needs to provide deterrence. If the information disclosed is useful to capital market participants (we obviously believe that it would be), they will use it in ways that create natural incentives for managers to mend their ways. In my view, that’s the big payoff of all of our research in this area.

Thanks again to Kevin for his comments and for the lively debate as this project has evolved.

I would like to thank Professor Griffith for taking the time to write a detailed response to my prior post. I hope other readers will post their thoughts, comments and reactions to Professor Griffith’s observations by using the “Comment” feature in this blog’s right-hand column. I look forward to hearing readers’ reactions to Professor Griffith’s observations.