D&O concerns Featured

7:00pm EDT February 24, 2008

As anyone in the directors’ and officers’ (D&O) liability insurance market will tell you, 2008 is shaping up to be an important year to monitor, as current trends and conditions take form.

Three major areas to keep an eye on are the subprime lending crisis, litigation trends and environmental concerns, according to Jerry G. Kysela, resident managing director of Aon Risk Services Inc.

“While the D&O liability marketplace has been relatively soft for the past several years, underwriters are becoming very nervous about the direct and indirect fallout from these factors,” he says.

Smart Business spoke with Kysela about current D&O concerns and what companies should watch out for in the coming months.

How will the subprime lending crisis affect D&O liability insurance?

Well, the main concern is the direct impact this will have on financial institutions. Besides that, there’s an indirect concern about how this will affect businesses and their ability to grow, expand and invest. Lenders are being more careful with just how much and whom they lend to. D&O carriers will pay specific attention to companies who are reliant upon relatively significant levels of debt to finance business and growth. You have to follow their business plans and see how they’re planning to weather the storm. These strategies need to be discussed with your D&O underwriter. Other areas to watch are corporations who invested in subprime investments, such as mortgage-backed securities. These investments may not be worth near what they were, which will affect portfolios, pensions and retirement investments.

What about litigation trends?

Coming off an eight-year trend of high frequency of securities class action claims against directors and officers, 2005 experienced a 22 percent decrease in the number of claims filed and a 39.5 percent decrease in 2006. 2007 reversed this trend with a 40-plus percent increase in frequency over 2006. Most of the increase in frequency materialized in the second half of 2007. The recent increase in frequency is most likely indicative of the recent stock market volatility as well as the sub-prime lending claims, which plaintiff attorneys began to file near the end of 2007. Further, this increased frequency in securities litigation has not been contained only to the financial services sector, despite the headline risk from the sub-prime crisis. Several independent sources have commented that they expect 2008 to be a robust year for securities class action filings, basically a return to historical average annual filings versus the recent trend experienced in 2005 and 2006.

How about environmental concerns?

In late 2006, the SEC voted to propose interpretive guidance for management to improve Sarbanes-Oxley 404 implementation. The proposed principles-based guidance, issued Dec. 20, 2006, is organized around two important principles. First, management should evaluate the design of the controls that it has implemented to determine whether there is a reasonable possibility that a material misstatement in the financial statements would not be prevented or detected in a timely manner. Second, management should gather and analyze evidence about the operation of the controls being evaluated based on its assessment of the risk associated with those controls.

The proposed rule notes that significant accounting estimates and critical accounting policies — both characteristic of environmental liabilities — present a higher risk of material misstatements and control failures. Thus, in the wake of earlier public financial scandals (Enron, WorldCom, etc.), the SEC increased its focus on accounting practices in order to better regulate corporate disclosures. Now, the SEC seems to have turned its attention on environmental financial disclosures. Corporations and corporate executives should take special note of the heightened attention that the SEC is now giving to these disclosures. We expect further activities and guidelines from the accounting profession, as well, through developments in GAAP (Generally Accepted Accounting Principles) procedures for estimating and developing environmental and sustainability risk exposure reserves.

If these factors are not watched closely, what will the consequences be?

The outcome will be potentially expensive litigation with the management — the directors and officers — of public companies facing allegations of misrepresentation and mismanagement.

So, what’s the resolution to all of this?

The resolution is additional due diligence and the necessary disclosure on the part of pubic companies. From an insurance perspective, now is the time to make sure your corporate directors’ and officers’ liability policies — those that protect corporate and personal assets — are tailored to address potential litigation stemming from environmental exposures.

JERRY G. KYSELA is the resident managing director of Aon Risk Services Inc. Reach him at (216) 623-4150 or Jerry_Kysela@ars.aon.com.