Observers outside the D&O insurance industry frequently comment to me that with all the subprime-related litigation, D&O pricing must be skyrocketing. These observers are often puzzled when I respond that the D&O marketplace remains generally competitive and pricing advantageous to buyers. This same conversation recurs with sufficient frequency that if may be worth exploring in greater depth. It may also be worth considering whether or not current marketplace conditions may be vulnerable to abrupt change.


With respect to the litigation activity, there have indeed been a significant number of subprime and credit crisis-related lawsuits, as detailed further below.



Nevertheless, except with respect to certain marketplace segments (such as the financial services industries), D&O insurers generally have not restricted capacity, reduced coverage or raised prices. As IRMI noted in its September 2008 publication The Risk Report (here, subscription required), it may seem “counterintuitive” but “most companies, particularly those outside the financial sector, continue to enjoy ample capacity and relatively advantageous terms and conditions.”



The most important reason for the competitive marketplace conditions is that historically low securities class action activity levels prevailed during most of the period 2005 through 2007. Insurers’ D&O results for those claim reporting periods undoubtedly appear favorable. At the same time, insurers overall results during that same period were also favorable, due to low levels of catastrophe claims after the hurricane intensive period in 2004 and 2005.



Insurers’ business-writing capabilities are directly proportionate to their “policyholder surplus” (which is, in simple terms, the insurance company financial reporting equivalent to shareholders’ equity). As a result of insurers’ strong results in recent reporting years, property and casualty insurers’ industry-wide policyholder surplus is at or near record levels. The insurers’ business-writing capability is correspondingly high – and so the marketplace for most lines of insurance, including D&O, is competitive.



These are of course exactly the conditions that drive the insurance cycle, as ability to write business translates into an appetite for business, with price as the primary means of competition. Eventually, pricing falls below the risk related requirements, results deteriorate, and, when surpluses and redundancies are exhausted, the marketplace corrects.



The current heightened claim activity level is exactly the kind of circumstance that can lead to deteriorating results, particularly to the extent that there is a mismatch between pricing and the risk exposure. Indeed, IRMI noted in its recent report that if the current litigation wave “produces significant loss payouts, and spreads beyond the financial sector” the current wave could “ultimately affect the larger D&O marketplace.”



The ultimate outcome will of course only be revealed in the fullness of time. But in addition to policyholder surplus levels, there are a variety of other factors that could be mitigating the impact of the current litigation wave on the D&O insurers.



First, insurance may not even be involved in many of the highest profile subprime-related claims. Many of the largest banks, for instance, self-insure for their D&O exposure or only carry so-called Side A coverage for nonindemnifiable loss. At least for those banks that have not gone insolvent, these Side A policies are unlikely to be triggered.



Second, much of the current claims activity may not involve losses to which D&O insurance even applies. For example, the buybacks at the center of the recent high-profile auction rate securities settlements (about which refer here) may not involve insurable losses. To the extent that there are damages paid (for example, if the losses must pay investors’ consequential damages), the losses are likely to be more in the nature of investment bank errors and omissions losses than D&O losses.



Third, although the subprime and credit crisis-related litigation wave has spread, the vast majority of the lawsuits have been concentrated in the financial services sector. There are certain D&O carriers that are more exposed to this space than others, but many other carriers have long shunned this space. As a result many carriers may not be experiencing the current heightened claims activity levels, and the ones bearing the brunt of the activity arguably are larger and more diversified.



Fourth, a certain amount of the litigation wave involves companies domiciled (and, most likely, insured) overseas – for example, UBS, Swiss Re, RBS, RBC, Fimalac, Societe Generale, and so on. Losses related to these claims, which represent a significant portion of the subprime related litigation, may not impact the domestic D&O insurance market.



Fifth, although I have on this blog, and even in this post, referred to the current litigation as a “wave,” one could argue that although the current activity exceeds the claim level of the preceding three years, the current level is not far above historical claims activity levels. I suspect there are senior insurance executives whose D&O unit managers are telling them that current claims activity levels are within expected ranges. (Some of these managers may have different employers three to five years from now.)



Sixth, but perhaps most importantly, most of these claims are only in their earliest stages. Carriers’ case reserves may not yet be fully developed. There is also the danger that aggregate loss reserve picks are skewed by several years of better than average results. Carriers may feel confident they have a handle on this situation and fully understand their ultimate exposure, and their confidence may be warranted. It will of course be years before they know for sure.



Earlier on as the subprime litigation wave was just gaining steam, there were a number of dramatic pronouncements (refer, for example, here) about how large the large the potential loss for the insurance industry from the subprime meltdown could be. It has been awhile since anyone has ventured any similar pronouncements, probably because the sky has not yet fallen. But while prognosticators may have become more circumspect, there remains an abiding danger in the current circumstances.



Despite — or maybe because of — all of the foregoing, the subprime and credit-crisis litigation wave remains highly dangerous for the D&O insurance industry. Among other things, there is the possibility that the most significant danger could be underestimation of its long-run significance.



Thanks to the several readers with whom I have spoken and corresponded on these topics in recent days. And very special thanks to Bob Bregman at IRMI for permission to quote The Risk Report.



Another State Court Subprime Class Action Lawsuit: In an earlier post (here), I noted that as part of the current subprime and credit crisis-related litigation wave, plaintiffs’ lawyers have seemed increasingly interested in filing actions under Section 11 of the Securities Act of 1933 in state court. In the latest example of this phenomenon, on August 26, 2008, a plaintiff filed a purported Section 11 class action lawsuit against National City Corporation and several of its directors and officers in Florida (Palm Beach County) Circuit Court. A copy of the complaint can be found here.



The complaint is brought on behalf of the former shareholders of Fidelity Bankshares who acquired National City stock in connection with National City’s acquisition of Fidelity, which was completed in January 2007. The complaint alleges that the offering documents “concealed billions of dollars of risky construction loans” that National City made to finance residential real estate construction, in Florida and elsewhere.



Among other things, the complaint alleges that the construction loans were plagued by “bad product design” and were susceptible to “the high likelihood of default and extreme loan loss severity.” Many of the loans “featured the worst qualities of subprime” though National City supposedly represented its loans as “prime” and “conforming.” The complaint also alleges that the offering documents misrepresented other aspects of National City’s financial condition, including its “nonperforming assets” and its loan loss reserves.



This new lawsuit is merely the latest lawsuit filed against National City regarding subprime-related issues (refer here and here). In any event, I have added this latest lawsuit to my running tally of subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of this latest complaint, the current tally of subprime and credit crisis-related securities lawsuits now stands at 109, of which 69 have been filed in 2008.



Special thanks to Adam Savett of the Securities Litigation Watch for providing a copy of the National City/Fidelity Bankshares complaint.