How community banking is changing the directors and officers liability insurance marketplace Featured

8:00pm EDT July 26, 2010

Challenging macro-economic conditions have negatively impacted companies across all sectors since the 2008 financial crisis. However, financial institutions — particularly community banks — have been among the most severely affected, says Chris Smith, senior vice president, Aon Risk Services Inc.

“This environment has directly impacted banks’ earnings power and capital ratios, and it has had a significant direct impact to the directors and officers (D&O) liability insurance marketplace,” says Smith. “Formerly, community banking D&O insurance was available with broad terms, three-year deals and very low premiums. However, the current economic and regulatory environment is changing that, and community bank directors and officers have reason to be wary.”

Smart Business spoke with Smith about how community banking is changing and how it is affecting the directors and officers liability insurance marketplace.

Why is the community banking D&O marketplace changing?

For reasons we are all familiar with, the community banking D&O environment has been very challenging. In 2009, 140 banks failed in the U.S., and 50 banks have failed this year as of April 21. The FDIC list of ‘problem banks’ rose to 702 banks at the end of 2009 (up from 117 at the end of the second quarter 2008), representing approximately one in 11 lenders. These bank failures impacted banks both large and small, as 80 percent of the 140 failed banks in 2009 had less than $1 billion in assets.

The anticipated cost of the bank failures is huge, as the FDIC estimates the cost to its reserve fund at approximately $100 billion per the latest projections. According to Gerard Cassidy, banking analyst at RBC Capital Markets, ‘We still see hundreds of bank failures over this cycle, and we’re not certain when the cycle will end. If you assume that the cycle lasts five years and that bank failures began in late 2007 or early 2008, it will be 2013 before we can say it’s over.’

With that as the background, both community banks and the FDIC are girding for long-term instability and the impact that has had — and will have — on the FDIC’s reserve funds and on the premiums that banks pay to the FDIC to support the insolvency fund.

Why is this impacting D&O insurers?

During the savings-and-loan crisis in the 1980s and early 1990s, more than 1,000 banks failed. Of the financial institution firms that failed between 1985 and 1992, the FDIC initiated claims against the former directors and officers of 24 percent of those institutions. If history is any guide, industry observers expect the FDIC to bring suit against a similarly large percent of failed community banks from the current crisis.

When a bank is closed, the FDIC becomes conservator/receiver, and it often petitions the court to ‘stay’ failed bank litigation as per its rights under the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989. This stay requires that investors’ claims must be satisfied under the administrative claim procedure of FIRREA, and the FDIC decides which claims get to move forward.

Accordingly, the FDIC generally leads the charge to pursue claims against bank directors and officers to recover losses.

In the wave of bank failures from 2008 until now, the FDIC has begun to investigate many failed banks and make prelitigation demands for payment of civil damages against directors and officers. And in some instances, the FDIC has sent its demand for payment of civil damages directly to D&O insurers of the bank in question.

However, the pace of litigation by the FDIC has not yet reached the level that the D&O insurance industry expects it to.

While the FDIC has not yet brought the expected tidal wave of litigation, D&O insurers are still exposed to other sources of litigation. Banks can also be sued by shareholders — see Sterling Financial Corp., New Frontier Bank, and Alpha Bank and Trust for examples — as well as employees. Many of the D&O claims against community banks in this current environment are related to these sources of litigation, with additional FDIC activity expected to come.

How are D&O insurers reacting?

Historically, four D&O insurers wrote the lion’s share of community banking D&O insurance. However, The Big Four are re-evaluating their books of D&O insurance, and many insureds have been forced to consider other insurers, many of which are relatively new writers of community banking D&O insurance. The Big Four are tightening underwriting scrutiny for community banks and demanding higher premiums at most all renewals as well as narrowing coverage terms and conditions at many renewals.

What should community bank directors and officers be concerned about?

The most worrisome coverage exclusion some banks have faced at renewal is a regulatory exclusion, which precludes coverage for actions brought by the FDIC, state regulators and the other alphabet soup of regulatory agencies with bank oversight. Community banking directors and officers must be aware of any regulatory exclusion in their D&O programs and must look to procure coverage including regulatory coverage (i.e., without a regulatory exclusion).

It can be particularly difficult to get carriers to remove a regulatory exclusion for a distressed bank. However, a broker with specific expertise in community banking should be able to find regulatory coverage alternatives.

In the event that a community bank is subject to a memorandum of understanding or other regulatory action, the availability of coverage for regulatory claims is crucial to personal asset protection for the directors and officers.

CHRIS SMITH is the senior vice president for Aon Risk Services Inc. (, a risk management, human capital and reinsurance consulting firm. Reach him at (216) 623-4101 or