Directors’ & Officers’ Liability Insurance in 2020:
The perfect storm

As “Cyclone COVID” makes its way across the global economic, social and political mainland in 2020, company boards could be forgiven for thinking that it is responsible for the most difficult Directors’ & Officers’ Liability (D&O) insurance market in over a decade.  In fact the storm clouds of the current and chaotic D&O insurance market have been rolling in from the horizon for more than 18 months. These clouds have been compounding with the low pressure system created by class action claims over the last decade.

In this article we unravel the key ingredients of this ‘perfect storm’ that are shaking the foundations of the current D&O insurance market. We also identify how directors and officers (‘officeholders’) can prepare themselves to open their doors and step out into the headwinds to engage with insurers while avoiding the inevitable debris of conditions that are expected to prevail well beyond 2020.

Key ingredients for a perfect storm

It was a buyer’s market (also known as a ‘soft market’) for D&O insurance from 2012 to the end of 2017. Premiums were stagnant and capacity was abundant. Litigation funders were proliferating, litigation rates were increasing and settlements for shareholder class actions were growing by number and quantum.

Insurers rarely made a yearly underwriting profit from their D&O portfolios during this period. The Australian D&O premium pool was being dwarfed by the losses being incurred and paid out and something was going to give.

A perfect storm was brewing.

By mid-2018, tell-tale signs of a ‘hard market’ were becoming evident. Several Insurers withdrew from the market and those remaining began tightening their underwriting guidelines and limiting their appetites. Premiums increased across the board. By the start of 2019 the ‘hard market’ was in full swing and it has continued into 2020.

D&O insurance renewal premiums have become headline media news in the past 6 – 12 months. For companies listed on the ASX, premiums have increased up to five times that of the prior year. With additional Insurers withdrawing from the Australian and London markets it has become much more difficult to source and secure capacity. The renewal process itself can now take up to six months to execute. Massive underwriting delays with numerous additional information requests make navigating this market incredibly challenging.

The key ingredients in this perfect storm include:

• Continued large insured losses.
  The 2019 Banking Royal Commission has played a major role in contributing to the number of new class actions with circa 12 new court proceedings. However, there are many other claims being notified. The most recent trend is the naming of individual officeholders along with the Company in proceedings, putting significant pressure on all sides of the D&O insurance policy.

• Actuarial pressure for more premium.
  Actuaries, rather than underwriters are dictating pricing as Insurers strive to return their long suffering portfolios to profit. This is sometimes referred to as ‘underwriting by committee’. Often rating decisions are based purely on the profitability of the portfolio and without proper regard for the merits of the individual risk.

• Demand for additional underwriting information.
  Insurers are now demanding vast amounts of additional information in order to consider coverage terms. Delays are long and the process is onerous on all involved.

• Reduction of market participation.
  Insurers continue to reassess their exposure to determine whether to reduce or withdraw their participation.

• Reduction of capacity from remaining markets.
  Those insurers that are left writing D&O insurance coverage are reducing their capacity. In 2017 it was possible to secure a $30 – $40 million layer. In 2020 this has dropped to a $10 – $15 million layer from a single insurer, at best.

• New capacity is more expensive than “renewal” capacity.
  New insurers to a program will charge more for their capacity per million of cover, compared to insurers currently on the program. Relationships with incumbent markets are therefore crucial in managing pricing increases.

• Insurers are looking for greater Insured “skin in the game”.
  Minimum deductibles have increased across the board. Whether this is for Side B or Side C (company securities claims) coverage. Insurers are demanding that Insureds have greater retentions even where no claims have been reported previously. This trend is not expected to change in the short term.

• An increase in Directors’ responsibilities.
  Currently there are over 650 individual obligations that officeholders must abide by which stem from:

1. corporate and prudential regulation;
2. environmental protection;
3. work health and safety laws;
4. customs and border protection legislation;
5. national security legislation; and
6. copyright legislation.

This highlights the ever increasing scope for claims to be brought against officeholders for wrongful acts, manifesting in increasing claim numbers for Insurers.

• An increase in community expectations.

Community scrutiny of companies now extends to environmental and sustainability issues. Along with cyber, these are the three new and emerging areas of risk for officeholders.  Being a good corporate citizen now extends to being a good community participant and leading by example in these areas.

Cyclone COVID – the eye of the storm

Considering the key ingredients that created the low pressure system before COVID-19 arrived, the timing of the pandemic could hardly have been worse.

It brought volatility into an otherwise predictable tightening D&O insurance market. Furthermore, the unprecedented global nature of the pandemic and widespread uncertainty of its medium- to long-term economic and social effects introduced a new inconsistency into insurer behaviour.

Insurer concerns

Before the pandemic, D&O insurers were progressively increasing rates and reviewing their exposed capacity (policy limits on each risk), and progressively increasing the deductibles imposed on insureds.

COVID-19 gave rise to insurer anxiety about corporate officeholder risk from additional pressures, such as:

1. Cashflow, short-term debt and capital: For businesses forced to close down or severely restrict their operations (such airlines, tourism, retail, hospitality, universities and fitness), financial reserves have been severely exposed. Insurers are concerned about COVID-19 impact and resilience, and are asking direct questions about:
2. Revenue: Underwriters want to know companies’ forecasts for the next 6-18 months. This includes anticipated closures, re-openings and eligibility for government support. They will also consider whether their industry classifies as an essential service and if they have the ability to reduce overheads.
3. Funding and capital: Underwriters want to know company cashflow reserves and ability to access to funding arrangements to help ‘weather the storm’. Insurers will also want to know that companies can cover short-term-debt obligations, or whether they can get relief from those obligations.

• Contractual obligations: Underwriters are interested in companies’ obligations, both as a customer and a supplier. They will want to know how COVID-19 has impacted their ability to supply and deliver to customers and whether their contracts have any relief clauses if they can’t meet their obligations. They will also want to know whether suppliers necessary to their operations (for materials, goods and services) have been affected.
• Employees and OHS: Businesses with many employees have multiple risk issues to manage. Underwriters want to know:

1. Whether employees are exposed to COVID-19 being transmitted in the workplace – and how this risk is being managed with shifts, social distancing, travel and transport.
2. If changes to staffing pose a risk and whether negotiations with workers and relevant union representatives are taking place. These risks include the management of annual and long service leave, reduced shifts and pay, temporary and longer term lay-offs and redundancies.
3. If there is the risk of employee litigation for unfair treatment in relation to hours, shifts, lay-offs and retrenchments, home schooling support and mental health.

• Shareholder communication: Particularly for public companies, Underwriters are interested in the content and tone of shareholder and market communications, and if it’s in line with their continuous disclosure obligations. (There has been some temporary relief in this area, offered by the CERPO Act. See Section 4 below for more information.)
• Engagement with regulators: For companies with particular obligations for continuous/scheduled engagement with regulators (including APRA, ASIC, EPA, WorkCover), Underwriters are interested in the nature of COVID-19 specific discussions. They are also interested in any operational restrictions imposed by regulators and their effects.
• Business Continuity Plans (BCP): Underwriters want to know:

1. Does the company in question have a BCP, and has it been activated?
2. Has the BCP has been effective?
3. How has COVID-19 impacted specific functions? These include: IT infrastructure; resourcing and available work-from-home arrangements; maintenance of risk and operational functions and controls (e.g. crime control environment – cashflow security, employee fraud and financial vulnerability, external threats).
4. Are the BCP arrangements sustainable? Are the arrangements time limited or indefinite?

• Recovery: Underwriters want to know about social distancing and cleaning procedures to protect and accommodate engagement with customers and the public.

Insurer actions

Depending on the impact of COVID-19 on insured businesses and the available information presented to placate these concerns, D&O insurers are taking a range of remedial measures including (from best to worst):

• Relatively routine renewal with pre-COVID-19 scheduled increases to premium rates.
• Increases in deductibles for more company ‘skin in the game’. A greater contribution by the insured business to any loss so as to clearly lift the D&O policy to a catastrophe-only coverage, well above what the insurers might regard as ‘working losses’.
• Reduction in insurer capacity. Once common $20m policy layer limits are being reduced to $10m and in some cases to $5m. The effect of this on larger, multi-layered D&O programs is to create gaps in the program required to be filled by new insurer capacity, (if available) at ‘hard market’ rates.
• New policy exclusions. Either generally in relation to the pandemic itself (COVID-19 Exclusions), or more specifically in relation to company risks (e.g. Insolvency/Financial Impairment Exclusion), or industry sector risks (Franchise/failure to properly pay staff Exclusions). Royal Commission exclusions for banking and finance, aged care, treatment of people with a disability, natural disasters.
• No new business. Servicing of existing renewal business only, with no ability to write new business to fill the gaps mentioned above.
• Withdrawal from sector. Such as from the financial institutions sector or avoidance of COVID-19 affected travel, tourism, retail and related sectors.
• Withdrawal from class. Complete withdrawal from writing D&O insurance business.

Looking for the good news

Despite all the doom and gloom there have been recent positive developments that are worth considering in relation to corporate and officeholder risk, and the potential for relief for officeholders and their D&O insurers. These initiatives include an inquiry into the class action industry, measures to slow class actions and changes to continuous disclosure obligations.

The Federal Government announced a parliamentary committee inquiry into the class action industry earlier this year which is due to report in December 2020. Importantly however this inquiry focusses more on the profits being made by the litigation funders than the actual way in which class actions are instigated and litigated.

The inquiry won’t specifically target security class actions, but rather it has a more general focus on class actions as a whole, including for example retail and franchise industry actions for underpayment of staff.

May 2020 saw new initiatives announced by the Federal Treasurer Josh Frydenberg that were aimed at increasing regulation, transparency and accountability of litigation funders.

The Treasurer announced the imposition of licensing on litigation funders via the Corporations Act in an attempt to slow Australia’s thriving class action industry and to provide additional protections for companies and company directors, recognising the threefold increase in the number of class action lawsuits over the past decade.

Under the changes, litigation funders will be required to hold an Australian Financial Services Licence, strengthening scrutiny on this sector from the corporate watchdog ASIC. Corporate litigation backers will also have to comply with Australia’s Managed Investment Scheme rules.

Also in May 2020 the Federal Government temporarily amended corporate disclosure obligations (CERPO Act) so that from 26 May 2020 and for six months, companies and their officers would only be legally liable for market statements if there had been knowledge, recklessness or negligence. “In response, companies may hold back from making forecasts of future earnings or other forward-looking estimates, limiting the amount of information available to investors during this period,” said Mr Frydenberg.

Law firm Gilbert and Tobin called the change a positive development:

“We hope that it will provide a basis for future law reform to Australia’s continuous disclosure regime.  Whilst Australia’s continuous disclosure regime is fundamental to the efficiency and integrity of our capital markets, its “no fault” liability position unduly contributes to the unedifying spectacle of competing class action claims in response to disclosure mishaps.  The Government’s measures recognise that many disclosure issues involve difficult judgements made under significant pressure with often limited information) and for that it is to be applauded.”

How might D&O insurers respond to these developments?

Initial response has been broadly positive. We expect the D&O insurance market to wait for clear evidence that these initiatives are having a tangible positive impact of corporate and officeholder exposure, before relaxing their current momentum towards tighter underwriting behaviour.

Unless and until there are measures to either relax the continuous disclosure obligations on Directors or make it more difficult for plaintiff law firms to sue Directors by increasing the burden of proof for these breaches, it is difficult to forecast any improvement. We expect that D&O insurers will be looking for both to occur before offering material relief to current underwriting conditions.

What about Supply and Demand?

The D&O insurance market is exposed to traditional supply-and-demand forces like any other.  The current conditions bear this out with insurer capacity in short supply for the reasons discussed in this paper, creating an environment for rapidly escalating premiums and restrictive coverage terms and conditions.

We expect new capital will return to the insurance market once long suffering investors look to the global financial sector in search of better returns.  As this new and returning capital is deployed this will reintroduce competitive tension to the insurance marketplace.

The question as always is when?

If ever there was a right time for new insurers to enter the D&O market, that time is arguably now given the massive premium increases and diminishing competition. We’re also seeing signs that the government may be willing to embed legislative change that will have a real impact on litigation rates.

In the meantime, general market sentiment suggests that the current D&O insurance market volatility, exacerbated by the anxiety surrounding the economic impact of COVID-19, has quite some time to run.

Navigating this market – what can you do now?  How can Austbrokers Corporate help?

There is nothing ‘normal’ or ‘routine’ about engaging with the D&O insurance market in relation to Directors’ & Officers’ Liability insurance, nor most classes of corporate or commercial insurance more widely.

Here is our shortlist of rules to navigate through the process, with Austbrokers Corporate at the top of your list, naturally:

• Hire a well-established, and well regarded insurance broker such as Austbrokers Corporate to guide you through the process. At Austbrokers Corporate, we tell it as it is.  Check word-of mouth; ask for referees; check websites for industry thought leadership, and alignment with your business goals.
• For D&O and other ‘financial lines’ policies (including Professional Indemnity, Crime, Cyber, Employment Practices, Trustees), engage a subject matter expert. These specialist classes require experience as well as specific expertise to engage those particular insurers with the specific products that are unique to this sector.
• Ensure your broker is skilled in assisting the C Suite educate the Board and/or the Audit and Risk Committee. At Austbrokers Corporate we dedicate a lot of time to the Senior Executives, advising them about the challenges ahead and assisting them in delivering difficult messages to their stakeholders.
• In a tightening market you will need to sell your unique risk to your insurers. With your insurance broker appointed well before your insurance program is due for renewal, expect to be fully supported in this exercise through the following steps:

1. Early planning – We begin our planning process several months before renewal, with a pre-renewal strategy meeting to share understanding of your current business issues, insurance market conditions, budgeting, insurer engagement strategy, information collection, execution and reporting.
2. Options – In a volatile insurance market, options are key. With market capacity shrinking, traditional premium shopping exercises are now a luxury. Whilst we never lose sight of cost, the current focus must first be on pre-existing relationships. Where incumbent insurers are materially restricting cover or withdrawing cooperation for whatever reason/s, marketing to targeted additional insurers will ensure that available options are in play with the right balance of relationship value, coverage scope and cost.
3. On larger programs, gaps will almost certainly appear. In the current environment we work hard to anticipate where those gaps will appear, and we include plans for careful remarketing to provide options for program restructuring to maximise the final outcome.
4. Program design – Where circumstances require significant re-engineering of the program, we plan restructuring options with our clients to provide with/without options and price-and-relationship impact assessment for our clients to consider.
5. Premium payment options – Sometimes the simplest thing we can do for our clients is to support their cashflow. We engage with our premium funding partners to provide options to spread premium payments across the term of the policy to provide such relief.

Outlook for the future of D&O Insurance and the marketplace

The short-to-medium term outlook suggests further pricing increases and capacity retraction will persist both domestically as well as globally across the D&O insurance market, as losses are evident in a wide range of international jurisdictions.

Pricing and retentions will continue to increase as companies determine what limits of cover they should take, weighing up risk, retention and cost. Balance sheets will continue to be tested as companies struggle with the COVID-19 environment while potentially purchasing less insurance and taking more risk to their balance sheet.

As always and whatever the prevailing conditions, Austbrokers Corporate continues to provide critically important expertise to its corporate clients to navigate through the current market conditions in search of the best available tailored solutions.

• Companies need to be prepared.

Future internal resourcing needs to be considered as companies are forced to deal with losses and claims below their rising policy deductibles. Companies will of course require contingency plans to respond to and manage any shareholder class action claim if they forgo their Side C (company securities) coverage.

Sadly, if nothing changes many companies are not going to be able to afford to buy the same level of cover they had previously, even if it is available as before. The knock on effects will include the risk that deeds of indemnity will not be fulfilled, resulting in companies struggling to attract high quality directors.

The road ahead remains uncertain and unpredictable. While claims against officeholders and companies continue at their current rate, escalating premiums will continue but won’t address the underlying problem in the long-term.

Real legislative change in Australia is now required to support a more sustainable Directors’ & Officers Liability insurance market into the future.