As I have noted in prior posts on this site (here, for example) D&O insurers confront a number of underwriting challenges in the current financial environment, including a host of macroeconomic factors that are complicated affairs for their policyholders and that could even lead to claims. In the following guest post, Nessim Mezrahi and Stephen Sigrist take a look at the challenging factors the D&O insurers are facing and consider the implications. Mezrahi is co-founder and CEO and Sigrist is Vice President of Data Science at SAR LLC. A copy of this article previously was published on Law360. I would like to thank the authors for allowing me to publish their article on my site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is the authors’ article.
The slip from record market capitalizations for U.S.-listed companies during the second quarter, compounded by high litigation exposure and potential claim severity of private Rule 10b-5 securities class actions, leaves insurance carriers and issuers facing a post-pandemic economic contraction as corporate America grapples with the arduous institutionalization of environmental, social and governance amid a new Cold War.
During the four-year period between the third quarter of 2018 and the third quarter of 2022, the aggregate market capitalization of U.S.-listed companies increased 26.6%, from $31.6 trillion in the third quarter of 2018 to $40 trillion in the third quarter of 2022 — after peaking at $51.9 trillion in the first quarter of 2022.
Our data and analyses indicate that litigation exposure and potential securities class action severity on 596 consolidated securities claims filed after the third quarter of 2018 that allege violations of the federal securities laws under Section 10(b) and 20(a) of the Securities Exchange Act and U.S. Securities and Exchange Commission Rule 10b-5 promulgated thereunder, also peaked in the first quarter of 2022.
Insurance carriers that place capital at risk to protect issuers and their directors and officers, or D&Os, are more likely to face unfavorable developments in 2023. As U.S. corporate valuations fall from their lofty peaks, insurers face a triple threat comprising sustained settlement losses on bloated inventories of securities class actions and shareholder derivative claims, limited investment income from a low interest rate environment during the COVID-19 pandemic, and a softer D&O market.
Coming into the fourth quarter of 2022, D&Os are operating in a fickle stock market while grappling with heightened global tensions, managing gross economic uncertainty driven by untamable inflation, restructuring supply chains, institutionalizing ESG and managing a gripey work force reluctant to return to their physical office location.
As a result, according to a recent Wachtell Lipton Rosen & Katz client memo, corporations must adapt and adopt fit-for-purpose risk oversight processes to limit the negative impact of known and unknown adverse corporate events that may ignite high-severity securities and corporate governance litigation under a new ESG paradigm.
It is mission critical for the board of directors, with the support of their audit committees and chief compliance officers, to effectively protect both the corporation and its shareholders during declining market capitalizations and a trying and murky period of institutionalizing ESG.
D&O Carriers Face a Triple-Threat Ahead of a Post-Pandemic Economic Contraction
Greater global economic uncertainty and three negative factors constraining the public D&O market raise the likelihood of unfavorable loss reserve developments in 2023 for carriers with elevated securities and shareholder derivative claims on inventory.
First, the 12-month period ending in the third quarter of this year has the highest level of Rule 10b-5 securities class action exposure and potential claim severity in at least four years. Carriers are also wrestling with sustained settlement losses and litigation containment expenses from the increase in litigation frequency booked between 2017 through 2019.
Our cumulative estimate of aggregate market capitalization losses resulting from alleged violations of Rule 10b-5 during the preceding four years amounts to $1.72 trillion on 596 consolidated securities class actions analyzed.
This equates to a record $1.54 trillion in Rule 10b-5 securities class action exposure after excluding $177 billion, or approximately 10.3%, in market capitalization losses that may not translate to shareholder damages because they may not merit inclusion in a certified class of allegedly defrauded investors in accordance with the U.S. Supreme Court’s 2021 decision in Goldman Sachs Group Inc. v. Arkansas Teacher Retirement System.
Between 2018 and the present, the federal judiciary has approved over $20 billion in securities class action settlements in the U.S. That quantum exceeds by $5 billion the total U.S. military aid the new administration has provided to Ukraine in its defense of Russia’s unwarranted aggression.
The magnitude of U.S. securities class action settlements approved during the last half decade is a clear indicator of the pivotal role D&O carriers play in ensuring the effectiveness of the securities class action mechanism in the U.S. capital markets.
Second, the D&O market exhibited a two-year negative emergence of $1.58 billion between 2018 and 2019, followed by a two-year low interest environment during the COVID-19 pandemic that restricted investment income for reinsurers. This dynamic may drive price volatility in treaty reinsurance for cedants.
For example, between the third quarter of 2020 and third quarter of 2022, Moody’s Seasoned Aaa corporate bond yield was 2.98%, and the federal funds rate averaged 0.4%.
Third, coming into the fourth quarter of 2022, the public D&O market is entering a transitional phase after a hardened D&O rate environment over a three-year period that led to a material increase in D&O premium growth. In 2019, 2020 and 2021, there were $7.6 billion, $10.8 billion and $14.6 billion, respectively, in direct premiums written.
Results from the second quarter of 2022 indicate that average D&O premiums declined by 14.7% relative to the first quarter. This top-line decline may lead to unfavorable factors affecting profitability in 2023 for public company D&O carriers with higher-than-average securities and shareholder derivatives claims on inventory.
The softening of the market is occurring simultaneously with the maturation of settlement losses on elevated securities claim inventories, which are driving both allocated and unallocated loss adjustment expenses for D&O carriers. To complicate matters, according to Barron’s, equities and bonds are now both in a rare bear market not seen in over 70 years.
These anomalous market conditions indicate a higher probability of emerging unfavorable loss reserve developments for public company D&O insurers as the U.S. capital markets adjust to a post- pandemic economic contraction under strict global anti-inflationary controls and peak geopolitical risk.
ESG and the Fall From Record Market Capitalizations Present Greater D&O Securities Litigation Risks
The aggregate market capitalization of U.S.-listed companies increased approximately 64% over 15 quarterly periods between the third quarter of 2018 and the first quarter of 2022, and suffered an approximate -23% correction during the six-month period between the first and third quarters of 2022.
The record increase in the market capitalization of U.S.-listed companies during the low-yield era of the COVID-19 pandemic was driven by institutional and retail investors’ access to cheap capital.
The influx of accessible dry powder and overvaluations of initial public offerings, driven by venture capitalists, catalyzed deficiencies in poorly implemented corporate governance mandates that led to Securities Exchange Act claims, many of which were prompted by the materialization of undisclosed corporate and event-driven risks.
While contending with remarkable volatility of a bear market and an impending economic contraction amid a new Cold War, issuers and D&Os face emerging event-driven risks manifested by adverse corporate events effectuated by greater scrutiny of ESG-centric corporate governance mandates by institutional investors, regulators and the federal judiciary.
According to research and analysis by Zurich American Insurance Co., “[t]here are two principal ways in which ESG may result in a D&O lawsuit: (1) event-driven litigation following an ESG-related event, and (2) disclosure-related litigation concerning an ESG topic.”
Under an evolving ESG paradigm, insurers and issuers are well served by identifying, analyzing and tracking adverse corporate events that may trigger high-severity securities and corporate governance litigation, and adopting corporate risk oversight processes that are risk-specific.
For example, do D&Os and newly indoctrinated members of the board know which adverse corporate events that have already materialized could lead to a high-severity securities claim? What data- driven risk oversight processes does the corporation have in place to assess and mitigate the impact of quantifiable securities litigation risk exposures? Are the corporation and D&Os sufficiently covered?
ESG is so all-encompassing that, in the aggregate, the related exposure of potential securities litigation affecting issuers is challenging to estimate until investors and regulators attain consensus on the appropriate disclosure and compliance requirements under a viable regulatory framework.
Different interpretations and implementation mechanics of ESG have recently surfaced as key stakeholders cooperate to develop an effective economic ESG ecosystem that ensures that America’s capital markets remain the gold standard throughout the globe.
Stuart Kirk, the former head of responsible investment and research at HSBC Asset Management, for example, suggests that ESG be split in two:
[M]ost people think of ESG [as] trying to do the right thing with their money. They prefer a company that doesn’t burn coal, eschews nepotism and has diverse senior executives. [There are two] completely different meanings then. One considers E, S, and G as inputs to an investment process, the other as outputs — or goals — to maximise. This conflict leads to myriad misunderstandings.
The murkiness of ESG is already affecting institutional investors, such as BlackRock Inc., with litigation over alleged violations of their fiduciary duties by allegedly violating the sole interest rule under the Employee Retirement Income Security Act by not prioritizing investment returns over feel- good ESG investing.
The lack of universal short-term clarity over the effective institutionalization of ESG for issuers will provide investor plaintiffs and corporate defense counsel with ample room to litigate uncontested issues as both seek to win precedent-setting opinions across the U.S. Court of Appeals for the Federal Circuit.
Since the enactment of the Securities Exchange Act 88 years ago, the U.S. capital markets have not faced such extraordinary volatility affecting the evolution of wealth creation in America, all while we lick our wounds from a devastating global pandemic.
Today, issuers and their insurance partners are tasked with adapting to ESG-centric corporate governance mandates to protect corporate reputations and enhance shareholder returns by adopting fit-for-purpose risk oversight processes in the aftermath of a record-setting stock market and an impending economic contraction amid a new Cold War.
Nessim Mezrahi is co-founder and CEO and Stephen Sigrist is vice president of data science at SAR LLC.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 “Ukraine and the start of a second cold war,” Gideon Rachman, Financial Times — Opinion Geopolitics, June 6, 2022.
 S&P Global Market Intelligence.
 SAR SCA Claims database as of September 30, Our SAR’s claim-specific statistical analyses indicate statistically strong correlation of approximately 95% between Rule 10b-5 SCA exposure and potential claim severity.
 For example, see “Credit Suisse Stock Seesaws on Concerns Over Financial Health,” The Wall Street Journal, October 3, 2022.
 See Pg. 22, Risk Management and the Board of Directors. Wachtell, Litpon, Rosen & Katz, September 2022.
 SAR SCA Claims database as of September 30, 2022.
 See SAR SCA Rule 10b-5 Exposure Reports between 3Q’18 and 3Q’22.
 Jeff Lubitz, Managing Director at ISS Securities Class Action $4.6 billion in SCA settlements in the U.S. have been approved or scheduled for approval in 2022.
 “$2.8 Billion in Additional U.S. Military Assistance for Ukraine and Its Neighbors,” Antony J. Blinken, Secretary of State, September 8, 2022.
 “How to Operate in a Volatile Professional Lines Market; OLCM Results — Past 24 Months,” Professional Liability Underwriting Society, Eastern Chapter Fall Seminar at John’s University, September 15, 2022.
 Moody’s Seasoned Aaa Corporate Bond Yield [DAA], retrieved from FRED, Federal Reserve Bank of St. Louis.
 Board of Governors of the Federal Reserve System (US), Federal Funds Effective Rate [DFF], retrieved from FRED, Federal Reserve Bank of Louis.
 “How to Operate in a Volatile Professional Lines Market; D&O Results — Calendar Year,” Professional Liability Underwriting Society, Eastern Chapter Fall Seminar at John’s University, September 15, 2022.
 “Quarterly D&O Pricing Index,” AON, Second Quarter 2022.
 “Everything Is in a Bear Market. How Bad Can It Get?” The Barron’s Daily, September 27, 2022.
 “Petraeus: ‘Putin is desperate and in an irreversible situation’.” DW News, September 28, 2022, at 0:52.
 S&P Global Market Intelligence.
 “ESG and the new mandate for corporate governance,” Zurich, September 1, 2022.
 “Stuart Kirk: ESG must be split in two,” Stuart Kirk, Financial Times, September 2, 2022.
 “ESG Can’t Square With Fiduciary Duty,” Jed Rubenfeld and William Barr, The Wall Street Journal, September 6, 2022.