Notes on a scandal - workers comp
Much water has passed under the bridge since the start of the ﬁnancial crisis back in 2008, but liabilities continue to surface—the scandal over the London Interbank Offered Rate (Libor) being the latest to emerge. The lasting implications of the crisis remain a very real concern for those writing professional liability coverage for ﬁnancial institutions, with ongoing scandals in the banking sector likely to spill over into the wider ﬁnancial service sector. On non-ﬁnancial books of business, matters are looking rather better with some upward rate movement ﬁnally materialising, but investment returns remain depressed, creating a challenging environment for writers of professional liability.
Professional liability insurers have faced a difﬁcult few years, with the fallout from the ﬁnancial crisis, additional capacity and falling rates coalescing to create a challenging set of circumstances. However, as Matthew Irvine, chief underwriting ofﬁcer at XL Insurance indicated, in all three areas of professional liability— directors and ofﬁcers (D&O), employment practices liability (EPL) and errors and omissions (E&O) insurance—“the margin compression of recent years is beginning to abate”. He said that this was not being driven by any constraint in capacity—adding that he did not foresee a classic hard market emerging as a result of conditions— rather it is “being driven by underwriters realising that the margin erosion that we have seen over several years has meant that we are just not getting the return on capital relative to the exposures faced”. He indicated that each account is of course considered on an individual basis—“on their current rate adequacy, their loss record and changes in exposure”—but it seems that limited returns on the line are ﬁnally prompting an upward correction.
Jim Gray, chief underwriting ofﬁcer—professional liability insurance at Alterra, spoke of a “stabilisation of pricing and a potentially upward turn” on non-ﬁnancial D&O, with ﬁnancial D&O making similar upward movement, but with pricing at more generous levels. Addressing ﬁnancial institutions D&O, Gray said that while commercial banks have always exhibited “much larger buying appetite” than other corporates, capacity has been that much more constrained as the loss performance of ﬁnancial institutions has lagged behind those of the corporate entities. “As a result, pricing has been a little higher on a price-per-million basis, as expectations are that the level of claims will remain high”. Irvine likewise indicated that for ﬁnancial institutions “pricing had increased, driven by the volatility of results, stock prices and what has happened to ﬁnancial institutions since 2008”.
Gray said that two factors were playing into the pricing dynamic. The ﬁrst of these was the fact that “additional capacity coming into the market seems to have stabilised”. Linked to this and playing its part in the rate environment is the “investment return climate, which is affecting the return on equity of most re/insurers, meaning that underwriting pricing has necessarily become more important for earnings”. These factors have outweighed the additional capacity of recent years, he said, with price rises evident in the primary and low loss excess layers of business, with “higher excess layers still exhibiting price reductions as excess capacity there remains plentiful”, although Gray did predict that this would stabilise “as the cycle works its way through”.
Shades of Madoff
The most seismic event of recent years for professional liability was the ﬁnancial crisis of 2008–2009, which continues to have lasting repercussions for the line. The fallout from that period has been protracted and the scandal over Libor—which, according to a professor of ﬁnance at MIT “dwarfs by orders of magnitude any ﬁnancial scam in the history of the markets”—suggests that liabilities emanating from the crisis are not likely to go away any time soon. And neither has shareholders’ desire to recoup losses regarded as being the fault of the ﬁnancial institutions in which they were stakeholders. Some of the losses may well stem from plain bad luck as the shock waves of the crisis affected the earnings of ﬁnancial institutions, said Gray. In other instances malfeasance or misfeasance was involved and exactly which is the case “is still winding its way through the system. Insurers have already paid a signiﬁcant amount in losses” related to the crisis, said Gray, with further sums to come. He predicted that the period would likely “result in an overall industry loss for underwriters involved in the ﬁnancial institutions (FI) business”.
Jeffrey Jabon, senior vice president and head of professional lines at ACE Bermuda, said that the crisis had proved a major issue for the line as “signiﬁcant additional exposure was introduced into the insurance market by virtue of the solvency risk associated with companies’ ﬁnancial difﬁculties”. Legal action against troubled ﬁrms had risen sharply since 2008, he said, with “litigation a function of increased exposure relative to deteriorated credit proﬁle, share-price devaluations and with conditions further complicated by additional regulatory scrutiny”. He added that an initial challenge for plaintiffs was identifying particular issues with an institution in the wake of such a systemic event as the ﬁnancial crisis, but indicated that the ﬁnancial sector can nevertheless expect to face further litigation, with evident implications for D&O as issues speciﬁc to the management and corporate governance of some institutions come to light. He suggested that greater public awareness of corporate misconduct and malpractice has left “blood in the water. And when that happens, it tends to attract sharks”.
"For financial institutions pricing had increased, driven by the volatility of results, stock prices and what has happened to financial institutions since 2008."
Further complicating the issue of FI D&O has been the “number of companies that went bankrupt as a result of the crisis and the number that are now, for all intent of purposes, nationalised”, said Irvine. The nationalisation or part-nationalisation of ﬁnancial institutions signiﬁcantly increased scrutiny—from both shareholders and the regulators—he said, with the crisis helping to usher in regulatory measures such as Dodd-Frank and Basel III, which will create further potential pitfalls for the sector. These developments have in turn “created challenges for insurers as they have sought to understand how they write professional liability coverage with the new regulations in place”. And nationalisation has not meant that potential liabilities have gone away. As Irvine indicated, shareholders that have had their positions wiped out during the ﬁnancial crisis are still pursuing claims against nationalised entities. “Those liabilities live on. Shareholders are still looking to losses associated with the ﬁnancial crisis.”
Jabon suggests that “such behaviour is nothing new”, rather it is a product of the cycle—“when the tide goes out you can see what has been going on below the surface”. Jabon warned that “whenever the stock market depreciates there is the effect of an inverse relationship to increasing shareholder litigation risk.” Gray added that following the crisis and its ensuing scandals the “banks are still sorting out their business strategies and proﬁtability, while underwriters are struggling with expectations of future loss ﬂow and increased regulation—both current and anticipated. It has been one issue after another for the sector”. Libor is just the most recent incarnation and Gray reckonedthat it will apply some upward pressure on rates on FI D&O, as recent upward movement reﬂects the rising level of liabilities. “Insurers are uncertain on what the totality of the loss exposures under that business might be, and reinsurance capacity to support those underwriters is also being constrained as reinsurers look at losses coming through their books from 2008–2009.” Nevertheless, Gray said that with FI D&O usually being a small component of any wider D&O book, those uncomfortable with its potential liabilities could step away from the line, even if pricing has at times been viewed as attractive.
The fallout of the ﬁnancial crisis has also been felt among those service providers that worked with the banks, with accountants ﬁnding themselves perhaps next in the ﬁring line; Gray indicating that the re/ insurance industry had always regarded the “large service providers to the banks as the second liability wave of a D&O catastrophe”. Irvine concurred, adding that typically when a large ﬁnancial institution or corporation collapses, the “bankruptcy team that are put in charge of the estate look very closely at everyone to see if they had an active role in those decision-making processes that ultimately led to the collapse. It is their goal to cast their net as widely as they can in order to recoup losses, regardless of whether lawyers, accountants or experts were directly involved in the failure or not”.
The extent and seriousness of losses associated with the ﬁnancial crisis has meant that accountants and lawyers are being dragged into the maw of liabilities, presenting the industry with signiﬁcant potential exposures. As Irvine made clear “these ﬁnancial institutions are far bigger and more complex than they ever were so, when the shoe drops, the size of the loss is so vast that bank trustees are looking for many more people to fund that loss”. In response to the potential threat posed by the collapse of these ﬁnancial institutions, many service ﬁrms are establishing “substantial war chests” in order to defend any involvement in the troubles of stricken ﬁnancial institutions, said Irvine.
The fallout from FI D&O has also found its way into E&O, as those seeking to recoup losses have begun picking their way through the wording of contracts and business. As Gray explained, those suits that have worked their way through the D&O pool of a ﬁnancial institution often then “set their sights on E&O to make up whatever is left from service providers”. However, despite the expectation that when the “D&O wave went through” that there would be signiﬁcant claims against accounting and law ﬁrms, levels of exposure have proved relatively modest, said Gray. “While we remain concerned about the banking side and are watching our accounting clients closely, we are relatively unconcerned on the lawyers’ side, with pricing in each area reﬂecting their relative risk proﬁle and exposure”.
"With the number of regulatory measures introduced post-2008, clients-- both financial and otherwise-- are facing increasing legal liabilities that they will necessarily have to insure against."
Jabon said that following a systemic event such as the ﬁnancial crisis “a chain of events emerges with a discreet order of operation, as lawyers turn to the supporting actors”. As a result, there is often “trolling on the part of shareholders pursuing associated service providers in the hope of ﬁnancial recourse.” These are often followed by individual suits ﬁled by institutional investors “who may opt out of a class action as they feel they can pursue an individual action that will be more favourable to their objectives. It is almost as if you have a hurricane that spawns a series of tornadoes”, said Jabon. The potential for the E&O threat to multiply is therefore very real.
While there are links between the D&O and E&O market— particularly in the face of claims stemming from the ﬁnancial crisis—Gray indicated that the buying patterns of the two lines is nevertheless markedly different. While D&O is generally driven by price and a company budget for coverage, E&O decisions are far more personally motivated with “placements being made by the principals of these ﬁrms”. This means that the “performance characteristics of the underwriters—stability, capacity and claims performance—are more important on E&O, because the people negotiating with underwriters are those who are going to be personally affected by the performance of the product”. Such a dynamic would suggest that those taking E&O coverage will ﬁnd themselves better insulated from the fallout from the ﬁnancial crisis and possible future liabilities stemming from the next major liability event.
Never again, they said
Signiﬁcant regulatory developments have come on the back of the ﬁnancial crisis—Dodd-Frank, Solvency II, Basel III, to name but a few—and are likely to present further lasting challenges for those writing professional liability. As Gray explained “professional liability, more than almost anything else, is the insuring of the risks posed by legal structures, whether they are regulatory, tort or products liability structures”. And with the number of regulatory measures introduced post-2008, clients—both ﬁnancial and otherwise—are facing increasing legal liabilities that they will necessarily have to insure against. As Irvine indicated, the crisis was something of a “wake-up call” for the regulators, with many of them “accused offalling asleep at the switch”. However, while regulators might have been accused of applying a light touch prior to the crisis, “what you are seeing now is the pendulum of regulation swinging way back the other way—with a lot of regulation, much of it very complex”.
Just how ﬁrms will be affected by a number of these regulatory measures remains unclear, creating additional uncertainty. Irvine highlighted Dodd-Frank as a case in point, with little guidance on its likely ﬁnal implications, although the same can be said of a number of other measures such as Solvency II and Basel III, which continue to be constructed at the behest of governments. This uncertainty is likely to create mis-steps by those ﬁrms responding to such developments, with an evident knock-on effect for re/insurers. Irvine said that while companies might think they are conforming to regulation, reinterpretation of, and changes to, new measures could leave them “liable or in breach of regulation”. He said that the industry needs to watch such developments closely so that re/insurers and clients are “up to speed as regards potential threats”.
Gray concurred, arguing that “good underwriters need to be intensely curious. They need to have an up-to-date view on what is going on in the world, both politically and legally, and a way of understanding the implications”. He added that insurers’ long-term relationships with clients would help them navigate some of these challenges, with close cooperation enabling both parties to acquire a “consistent view of what the real levers of risk might be”.
One eye on the horizon
While the ﬁnancial crisis has created signiﬁcant and ongoing implications for professional liability clients and re/insurers, many of the concerns haven’t gone away, with the economic downturn presenting the sector with a further set of unique challenges. Irvine indicated that for D&O the biggest challenges were directly linked with economic conditions—“the low interest rate environment, the faltering economy, the exposure to a double-dip”—all of which are creating a challenging business environment and increasing the chances of business failures. This will in turn raise the prospect of “further D&O suits directed by shareholders against management”.
A further challenge has been the US government’s “constant search for additional sources of revenue”, said Gray, with international ﬁrms— and their international proﬁts—ﬁnding themselves increasingly in the ﬁring line. Again, ﬁrms ﬁnd themselves treading a ﬁne line between regulatory compliance and retaining international proﬁts, and there are signiﬁcant liabilities associated with Washington’s aggressive approach to US tax jurisdiction.
Finally, companies and re/insurers are having to factor in the increasing size and complexity of business and the deals that are being done, said Irvine. For professional ﬁrms on the E&O side, “if things go wrong, it is either more costly to defend or more expensive to resolve than ever before”. Those that were involved in the 2008–2009 denouement have spent hundreds of millions of dollars defending themselves, Irvine said, and these costs are only likely to rise still further. Despite such concerns however, the pitfalls presented by the constant evolution of business is exactly what professional liability coverage insures against, said Gray. As he summed up: “the job of the underwriter isn’t to eliminate all risk, it is to understand the risks that are coming through and price for them accordingly”. The ﬁnancial crisis certainly created a few of those, and in many cases they continue to rumble on, but events at least served to highlight the beneﬁts of D&O and E&O to those ﬁrms exposed to the fallout.
A changing dynamic
Whereas in the past reinsurers in the professional liability space took an overarching position in the market, nowadays they are applying a more focused approach to their relationships with primary insurers, said Gray. Previously reinsurers would “support as many practitioners as they could in order to even things out and get a market performance”. Now they are increasingly applying “an approach that supports speciﬁc underwriters—those that have a strong underwriting philosophy, a good track record of proﬁtability and who structure reinsurance deals in a way that is consistently fair to reinsurers and helps them control aggregates”. A close relationship brings with it greater understanding of an insurer’s liabilities, said Gray, enabling reinsurers to avoid the prospect of holding “ﬁve or six different spots on the same loss tower. By supporting fewer insurers, reinsurers have a mechanism for controlling the level of exposures they might have to any one loss”.
Such a close approach ties in well with the idea that reinsurers appreciate predictability in their insurance partners, said Gray. “If they adhere to a strategy that can be described, then reinsurers tend to stay with a known quantity.” At the same time, the increasing interconnectivity of business encourages close interaction between cedant and reinsurer. “Reinsurers understand that insurers have relationships with a number of large clients that are beneﬁcial to everybody and through close contact reinsurers can participate and beneﬁt from these long-term relationships.” Personal interaction, as always, is key.