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As regulatory probes into corporate stock-option granting practices broaden, the number of executives swept up in the scandal is risingas is the tab directors and officers liability insurers will ultimately face from related litigation.
One factor limiting the financial impact on insurers is that the majority of options-related suits filed so far are shareholder derivative suits, which are usually cheaper to defend and settle than traditional securities class action suits, market experts say. Nevertheless, D&O insurers could still find themselves on the hook for millions in defense costs, the experts note.
And while the D&O market has yet to see changes in prices and terms and conditions stemming from the stock option probes, that could change next year if securities class-action activity picks up pace again, some say.
Federal regulators for months have been investigating whether companies improperly manipulated the date of option grants to maximize executives' profits.
The number of firms probed has jumped from 51 in June to 120 at the end of September, according to The Corporate Library L.L.C., a Portland, Maine-based research group that focuses on corporate governance and compensation.
Investigations into options practices already have led to the departure of top company management, including some prominent insurance industry executives. Most recently, Stephen L. Way, founder and chief executive of HCC Insurance Holdings Inc., stepped down on Nov. 17, following an investigation that uncovered improper stock option granting practices by the company. Last month, UnitedHealth Group Inc. Chief Executive Officer Dr. William W. McGuire said he would leave his post amid allegations of improper options-related practices by the health insurer (BI, Oct. 23).
Option probes have also prompted late filing of financial reports, notices of possible earnings restatements, and for many companies, a rising number of shareholder suits.
Insurers now face a significant "defense cost problem," said Steve Shappell, managing director in Aon Financial Services Group's legal and claims department, a division of Chicago-based Aon Corp. "It's going to be very expensiveÖmillions of dollars will be spent defending these" claims, he said.
Lou Ann Layton, managing director and national D&O practice leader for Marsh Inc. in New York, estimated that the number of options-related shareholder suits has reached approximately 120 derivative suitsthose brought on behalf of the companyand less than 30 securities fraud suits.
Under most D&O policies, Securities and Exchange Commission fines would not be paid, and "if individuals disgorge or pay back money that they received improperly, that money wouldn't be paid back either," according to Ann M. Longmore, a New York-based senior vp and the D&O product leader with the executive risk practice at Willis North America, a unit of Willis Group Holdings Ltd. Settlements and court awards for derivative claims also generally are not indemnifiable under most state laws, Ms. Longmore said.
She noted, though, that under the A-side of a company's standard D&O contract or a standalone A-side contract where there is no traditional D&O program, an insurer may be liable for payouts to settle civil claims against compensation committee members, heads of human resources and employee benefits departments, and other executives in the approval chain who are accused of improper practices and were not forced to disgorge monies, or failed to disclose the alleged practices.
"At the very least, investigating the situations will be very costly in terms of forensic accounting time and talent," Ms. Longmore said.
"If these matters continue and are not settled out quickly, substantial sums could be paid out" by insurers, Ms. Longmore said, with cases involving multiple forensic accounting reviews and defense costs totaling up to $5 million each, she said.
Impact on coverage
D&O insurance policyholders have yet to see changes to policies as a result of the options scandal, but the issue is being monitored carefully by underwriters and market conditions could potentially change within the year.
"We really still don't seeknock on woodunderwriters overreacting to these issues," said Marsh's Ms. Layton.
"We don't see any markets trying to reduce capacity," and going forward to Jan. 1 renewals, even those clients facing derivative suits can generally expect to see favorable terms and conditions, she said.
Earlier this month, American International Group Inc.'s president and chief executive officer, Martin Sullivan, in a conference call with analysts said he expected insurance payouts related to any D&O claims stemming from options-related lawsuits to be "manageable" for the insurer, though it is an issue they "continue to monitor carefully."
"I don't think we are going to see a lot of recisionsÖthe current policy language has evolved nicely over the past few years to provide protection against the policies being voided or rescinded," Aon's Mr. Shappell said. Underwriters, though, are "asking very, very tough questions" about options granting practices, he said.
Carl Pursiano, senior vp at Liberty International Underwriters in New York, said among the issues the insurer will consider at renewals is the way a company manages itself, such as ensuring timely financial filings with regulators, and "whether or not the company is currently being investigated by the SEC, the DOJ, the FBI, or plaintiffs firms" or if the company "has been under scrutiny by the media as well."
"I don't think in and of itself the stock options scandal is going to move the needle much on the pricing of D&O," said Mr. Pursiano.
But, that's "against a backdrop" of reduced securities litigation filings overall, Mr. Pursiano noted.
The Stanford Law School Securities Class Action Clearinghouse of Palo Alto, Calif.in cooperation with Cornerstone Research of Bostonearlier this year estimated a 36% drop in the historical average of securities fraud class-action lawsuits, from an average of 194 filings between 1996 and 2005 down to an estimated 123 filings for 2006 (BI, July 31).
"If the number reverts back to the mean, and then you throw in the stock option claims, which seem to be continuing, we could see a bit of moderate firming for the pricing of D&O," Mr. Pursiano said.
"We're probably about halfway through the emergence of the litigation associated with stock options," and "we are going to see more cases filed particularly between now and the first half of next year," Mr. Pursiano predicted.
What will make insurers particularly uncomfortable is if when those claims trickle in, there is also a reversion back to higher numbers of securities suits filed in the coming year"that will have an impact on pricing" in 2007, he said.