WorldCom Scandal Could Cause D&O Rates to Quadruple

OLDWICK, N.J. 06/27/2002 (BestWire)- Directors and officers liability coverage--already hurt by high-profile bankruptcies in the dot-com marketplace and the fall of energy giant Enron--could see further rate hikes in the aftermath of accounting problems at WorldCom Inc.

The news that WorldCom was taking $3.8 billion in value off its books and that the potentially fraudulent misreporting of financial information had resulted in the departure of both the company's chief financial officer and its controller could manifest itself in the quadrupling of D&O premiums, said one insurer.

Rates will be increasing anywhere from two to four times the prior premiums, especially for large customers with capitalization of more than $5 billion, said Joe O'Donnell, managing director of Chubb Corp.'s executive protection business. For the larger companies, depending on exclusions and limits, insurance companies may be asking for as high as 10% to 15% of the coverage as a premium amount--for example, $1.5 million in premium for a $10 million policy, O'Donnell said. Some of these higher premiums will be in volatile industries with high stock movement--such as telecom companies, oil and gas, health care, biotech or high tech--he said.

Underwriters will be going back to basics, O'Donnell said, focusing on "due diligence" in the underwriting process and on the terms and conditions large public companies with substantial market capitalization have added to their policies, O'Donnell said. If underwriters even want to quote the risk, the pricing will go up substantially, limits will be reduced, deductibles will go up and underwriters will ask for larger participation in losses, he said.

WorldCom's nearly $4 billion overstatement of earnings is a major problem for the directors and officers, particularly those on the audit committee, said Terry Cummings, an attorney with Ornstein & Brown in New York. When that is added to the liability problem for the outside accounting firm that put together the financial information, the mix could have a potent effect on an already-stressed D&O market.

Since WorldCom's auditors were from Arthur Andersen, which has exhausted its liability coverage following its involvement in the Enron scandal, the question is whether adequate coverage will be available for a second event such as this, Cummings said. The Andersen partners individually may become liable, and there will be major stockholder suits following the WorldCom situation, even if WorldCom does not die, he said.

Jim Swanke, leader of Tillinghast-Towers Perrin's strategic risk-financing practice, said several companies are facing D&O coverage renewal as of July 1. "A lot of folks are still scrambling for coverage, since the underwriting process has lengthened, and companies are being more cautious," he said. "Some companies are going to find themselves working into July and trying to backdate in order to get some kind of coverage for their companies."

One problem for underwriters is that a lot of the litigation has been coming about as result of fraudulent financial statements--one item that has been a key underwriting tool used to determine and price risk, O'Donnell said. If underwriters can't rely on the integrity of those statements, they'll need to be more invasive and intrusive in accessing information on the directors and officers of the company, he said. They'll need access to the audit committee and notes from audit-committee meetings. If they are unable to get this information, they may add exclusions to the policy, increase the premium or choose not to insure the risk, he said.

"I think insurers are being more cautious," Swanke said. "If a case is borderline and on the edge, the recent situations are going to push it over the edge, and underwriters will reject it. If a company was going to offer 'x' dollars of capacity on a case, the company may now offer half or a quarter what they were going to offer previously. As a consultant for companies trying to renew coverage, this makes it even more difficult, and a lot of companies will not be able to renew their D&O and will still be scrambling for coverage."

D&O is a low-frequency/high-severity type of coverage, which makes predictability difficult from an actuarial standpoint, Swanke said. "The bottom line is that as more and more accounting irregularities appear, the underwriting is becoming more rigorous," he said. "As I sit in meetings, I'm amazed at the level of detail and underwriting the companies are taking their prospective insureds through. I don't think the underwriters are overreacting. Rather, they recognize there have been problems, and they don't want to write the next account that will go belly-up. They're just being very careful."

In addition to the increased scrutiny of the applications as they come, the total capacity of D&O is near all-time highs, Swanke said. Carriers that can write tens of millions of coverage are not writing up to their capacity, but instead are offering lower limits, he said. Now, a company that used two carriers may need five or six to get the same amount of coverage--if they are able to find enough carriers to get the coverage, he said.

In addition to the direct problems with D&O coverage, most insurers buy reinsurance, and the reinsurance market is still reeling from Sept. 11 and the bankruptcies of dot-coms and other companies, Swanke said. Rates have been going up for the reinsurance coverage that is available, and that will drive the price increases in the direct coverages higher as well, he said.

Another concern is that a lot of insurers have set quotas on the amount of new business they are willing to accept because of market conditions, Swanke said. Toward the end of the year, there may be a real capacity crunch with people unable to get additional or renewal coverage, and companies that want to renew need to know they should start earlier, he said.

There is a definite flight to quality, as insureds are moving to companies that have been in the business for some time and are financially strong, O'Donnell said. Some of the fringe players who haven't been in the D&O market as long or have smaller books of business may seek profits in some other area, he said.

(By John Hillman, associate editor, BestWeek: