The federal agency that backstops banks may soon file lawsuits against directors and officers of financial institutions it has taken over, creating a litany of concerns for D&O liability insurers and their policyholders, observers say.

The Federal Deposit Insurance Corp. reportedly has begun sending “demand letters” instructing former executives of banks taken over by the government agency to alert their D&O liability insurers they may have claims. As of the end of July, the FDIC had taken over 69 banks this year after taking over 26 in 2008, according to the agency's Web site. The total cost to the FDIC of the failed banks is about $14.4 billion so far for 2009, compared with about $17.8 billion for 2008.

“We've personally been contacted by a number of law firms that represent the FDIC who we know from other dealings indicating that the FDIC has retained them to go get the money,” said Steve Shappell, managing director of Aon Financial Services Group in New York and Denver. “So this is going to happen.”

Attorneys, brokers and other observers expect the FDIC to file federal lawsuits against former bank directors and officers for breach of fiduciary duty, among other potential claims, which likely would trigger D&O policies. The FDIC also aggressively pushed similar lawsuits during the savings and loan crisis in the late 1980s, the last period of widespread, systematic financial institution failures. The D&O liability insurance market has more capacity and softer prices now than during that period, although prices and terms are firming significantly for financial institutions, brokers say. Mr. Shappell said D&O liability rates in the second quarter rose 4% over the second quarter of 2008, and rose 15% for financial institutions. A survey from London-based broker Willis Group Holdings Ltd. returned similar numbers.

The savings and loan crisis gave rise to the use of regulatory exclusions in D&O policies, which bar claims brought by regulatory agencies from coverage. Although one banking trade group estimates that half to three-quarters of banks' D&O liability policies contain such exclusions, brokers and attorneys say the use of the exclusions dissipated during the recent soft market, though recently insurers have again sought to insert regulatory exclusions. While they have been unsuccessful in most cases, the riskiest financial institutions have been forced to accept them, the observers say.

“We're seeing some insurers being very insistent that they get regulatory exclusions,” said William A. Boeck, a Kansas City-based senior vp and insurance and claims counsel at Lockton Financial Services. “The battle days of regulatory exclusions may be coming back.”

Some legal observers say another battle could loom over the “insured vs. insured” exclusion, which bars coverage for claims by one insured entity against another insured entity, traditionally intended to forestall collusion. The question is whether the FDIC, in stepping into the shoes of an insured bank, is barred by such exclusions from suing directors and officers, who also are insured under the same D&O liability policy.

Kay Wilde, a Chicago-based attorney and consultant in Lovells L.L.P.'s insurance and reinsurance group, said the wording of such exclusions varies widely, but in cases where the policy specifically extends the exclusion to the insured entity's bankruptcy trustee, some courts have found for the insurer.

“When it's the standard, vanilla "insured vs. insured' exclusion and it doesn't have that specificity, then courts tend to not apply that and, in those cases, they find that there is coverage,” she said.

Mr. Shappell said one of the largest concerns of policyholders is that the FDIC will decide “this is a good source of revenue” and file a high volume of suits simultaneously or at the same time as a bevy of suits from other regulators and plaintiffs.

“We're watching very carefully what the FDIC appetite is here to file these claims and litigate these claims because, particularly if the FDIC is going to be looking to hold individuals responsible for the losses of a (financial institution), that's a huge fight,” he said. “People will be fighting for their financial life. Those cases do not come cheaply.”

The size and complexity of cases brought by the FDIC likely would lead to higher defense costs, which already have inflated markedly in recent years, legal observers say. In many cases, observers say defense costs alone can exhaust the primary layer of D&O liability coverage, and begin to impact excess insurers.

“Several years ago it was somewhat safe to assume that defense costs (would) be contained in the primary layer and I don't think you can (assume that) anymore,” Randy Hein, vp and quantitative analytics manager at Chubb Specialty Insurance, said in an Aug. 3 webinar sponsored by Advisen Ltd.

The FDIC may have a different willingness to settle than the typical D&O liability plaintiff, for political or other reasons, Ms. Wilde said.

“I had a client describe it as "This is going to be a nightmare,' because it's just a different dynamic than most claims handlers are used to.”, she said.