Corporate fiascoes shine spotlight on D&O insurance

Northwestern Financial Review, Aug 15-Aug 31, 2002 by Dullum, Justin

[interview: Joe Scepanski]

Q With the spotlight on corporate responsibility, will the cost of director's insurance skyrocket?

Look at it this way-there was an insurance crisis in the mid-1980s. It's not going to get as bad as that. The main reason is there is a lot of capacity out there. There are a lot of insurance companies and a lot of capital available to continue to fund losses. In the 1980s, you saw a lot of companies dropping out-getting out of the business of directors and officers insurance, which forced the prices to go up. Right now that isn't an issue. There is still a lot of insurance out there. You're going to see an increase in the pricing because it got to a point where insurance has been under-priced. They weren't making an underwriting profit and really were relying a lot on their investment portfolios to make up the difference. But with the stock market the way it is, insurance providers are no longer making a profit on that side. So they'll look to getting back to making a profit on underwriting.

Will any other factors drive up price?

A lot of the Enron-related issues alone make that a possibility. When you talk about D&O liability, the starting point for a claim is a lawsuit. All someone might have to say is, "Hey, I lost twenty percent of my retirement fund and I want this made right." You'll then see an increase in litigation as public awareness continues to grow. The other trend is for larger and larger judgments. You're going to see some big judgments come out of the Enron case. That, if anything, will continue to drive up the price.

What else in the D&O insurance world might be affected by corporate scandal?

Insurance companies will look more closely at boards. It's a question of whether the board is qualified. Do they have the right people on that board to make the right decisions and what kind of training is being provided to new board members? Insurance companies will also look at whether you've got an independent board. Sometimes there's an overwhelming personality on a board that drives the whole thing, with all the other members riding along on the coattails. That takes away what a board is supposed to do. If the policies and procedures in a bank boil down to one person, it could end up being a tough deal.

If I'm the president of a $120 million bank, what can I do to help insulate myself from litigation?

Continue to review your internal policies. Make sure they are up to date and that they're being followed. It's easy to get complacent. It's easy to implement rules and then just roll along. But when you start ignoring those things, they build and you get the bigger losses. Community bankers face employment liability problems most frequently. It's the most expensive area for community banks. Typically, the individuals filing suit at a community bank are at a salary scale that will somewhat keep down the judgment size, but it's still a frequency issue. There are lender liability issues as well. As the economy weakens and the bank has to take more actions against its loan customers-foreclosure, for instance, it's going to open up the liability side. Stay close to your loan policy. The more you minimize these problems up front, the more you'll keep down your exposure on the backside.

Do you have any examples of a bank that became complacent?

There are many. For instance, we had a bank that took in a lot of forged checks. The trend these days is to give quicker credit on uncollected funds. A customer came in and set up a new business account. They kept it current and didn't do any large transactions for the first year. All of a sudden, they deposited six or seven large out-of-state cashiers checks. The bank's policy was to provide instant credit on those checks, which all ended up to be fraudulent. The customer withdrew the money before the checks were discovered, took the money and ran. This bank got itself into trouble walking the fine balance between customer service and protecting its own assets. Because of the time lapse between the credit deposit and the checks bouncing, insurance didn't cover the loss. This scenario had a lot of red flags. Don't ignore the obvious.