Market Conditions. D&O Market Stable Amid Adverse Claims Trends. Phil Norton, Ph.D.

Transcription

1 D&O Market Stable Amid Adverse Claims Trends Phil Norton, Ph.D. As we look to forecast the state of the D&O marketplace in 218, a close examination of 217 events and trends is critical. The D&O market in 217 was best described as a market in flux. The underlying tension in the D&O marketplace was palpable. The numbers of claims increased dramatically, but pricing remained competitive for many risks and flat for most, as suggested by Graph 1. Traditional primary carriers recorded significant losses and began to attempt price increases, though they generally settled for no change in premium at renewal. Newer D&O market entrants were intent on disrupting long-term relationships. Excess capacity remained plentiful and was a softer market than primary. The IPO market, in general, saw a substantial hardening, with limited carriers interested in primary. Percentage Change Graph 1: D&O Market Price Movements 1Q11-2 3Q11 1Q12 3Q12 1Q13 3Q13 1Q14 3Q14 1Q15 3Q15 1Q16 3Q16 1Q17 3Q17 D&O Market Change - Source: CIAB For 218 we anticipate a continuation of these conditions as exemplified in Graph 2, with market tensions increasing but results changing little. On renewal, we expect to see many primary carriers pushing for increases, with excess carriers often reducing their premiums to compensate, resulting in a redistribution of premium dollars. How a client s renewal premium will compare to previous years will depend in large part on what types of reductions they have seen over the past several years. Don t be surprised if some primary carriers target increases toward 1% if their claims experience continues to develop poorly. Graph 2: D&O Renewal Price Changes is why we feel a stable market will extend throughout 218 despite record claims frequency. Specifically, we are seeing more federal mergers and acquisitions claims, more non-u.s. collective actions and more claims brought by emerging plaintiffs attorney firms. All three of these D&O claims categories are being dismissed at higher-thanaverage rates and, when they do settle, they are doing so for claim costs far below the historical average severity. A potential theory is that the emerging firms (analyzed further below) take on cases more prone to dismissal and bring such cases against smaller defendant companies on average. We have reviewed hundreds of claims and agree with this initial assessment. The quality of recent D&O coverage has been excellent, and we do not expect that to change in 218. There have been huge coverage innovations since mid-21 and coverage is continuing to expand into early 218, with the most positive developments, including stacking of derivative demand investigation limits, books and records demand coverage and some positive clarifications regarding M&A-related claims handling. Be advised that some leading carriers are questioning further expansion of the D&O policy language and even signaling the need for significant price increases in 218. While we do not see that materializing anytime soon, it would be prudent to aggressively seek policy enhancements that may have been missed previously. D&O CLAIMS FREQUENCY AT RECORD LEVELS Some of the claim trends seem quite dramatic, but the mitigating factors are also extensive. The most talked about claim trend involves the increase in frequency of Securities Class Actions (SCAs) as displayed in Graph 3. Our claim count for 217 represents the highest annual frequency realized in the last 15 years. The shape of things to come may look alarming, but there is more to the story. Specifically, the increased frequency is caused from three different sources already noted above: (1) M&A activity; (2) non-u.s. class actions; and, to a much lesser extent, (3) emerging law firms. The emerging law firms impact in regards to severity, as their D&O claims have so far cost less on average. As to frequency, emerging firms are indeed a substantially larger component of total claims, but mostly because they are taking market share from the established firms. We can no longer talk about plaintiff firm consolidation as we did several years ago when 1 firms brought over 9% of the D&O securities class actions. Down 1-1% Flat Up 1-1% Up 1-2% Graph 3: Securities Class Action Filings Cornerstone Research 413 Source: CIAB database 217 Q3 In contrast to headlines on D&O claim frequency, we actually project mostly good news, namely a major shift in the underlying mix of recent D&O claims, which will translate into less costly claims. That

2 Graph 4 alerts us to two notable underlying trends that have affected frequency. One is the dramatic impact of cases such as Trulia, which have pulled the frequency of M&A Objection claims away from state courts into federal court. The other trend is Class Action filings outside the U.S., which are also up significantly. This is largely due to the development of laws outside the U.S. allowing for class or collective actions, as well as an increase in the plaintiff s bar s expertise and willingness to sue non-u.s. companies. Non-U.S. class actions are also included in Graph 3 and represent an increasing proportion of the non-m&a claims. And combined, these two trends represent an increase of more than class actions from 212 to 217. Dropping claims from 217 in Graph 3 would certainly make that year look like a pretty typical result over the last 16 years worth of data shown Graph 4: Trends in SCA Filings Cornerstone Research Federal M&A Filings Non-U.S. Class Action Filings D&O CLAIM SEVERITY REMAINS HEIGHTENED Mega claims (originally defined as D&O claim settlements worth in excess of $1M) first emerged with significant frequency in At that time we tracked the 5 most expensive D&O claims over the 8-year period of and ultimately created the first entry on Graph 5 (the $95M average shown above 6). Each data point in Graph 5 is a rolling average of the eight year period ending in the Last Settlement Year as shown on the horizontal axis. For example, the next data point ($14M in last settlement year 7) shows claim #5 for the 8-year period ending in 7, or 7, and so forth. Note that 217 appears to be a departure from previous steady increases. This may be good news for carriers if it also means claim costs in general may be trending flat or downward. Frankly, with so many M&A and non-u.s. claims in the mix, we are certain that average D&O claim costs are decreasing simply because [if for no other reason] the M&A and non-u.s. claims are settling for significantly less money than our historical averages. We track the 5th largest claim as a way of identifying trend without distortion from the largest claims which are clearly outliers. And for the first time since this graph s inception, we calculate the 5th largest claim to come in where it was in the prior year s analysis, at $225M. This suggests Mega Claim activity may be leveling off. 5th Largest Claim ($M) - Last 8 years Graph 5: D&O Mega Claims Costs Stable? Settlement Year Advisen & Gallagher data For a look at some of the claims we reviewed while analyzing D&O settlement patterns, consider the chart on Large D&O Settlements next. Large D&O Settlements COMPANY VALUE TYPE UBS Securities $445 million SCA Bank of America $335 million SCA Puda Coal $228 million SCA Willis Towers Watson $211 million M&A Salix Pharmaceuticals $21 million SCA BP Plc (ADRs) $175 million SCA Clovis Oncology $142 million SCA comscore $11 million SCA Halliburton (2 & 4) $1 million SCA J. C. Penney $98 million SCA PG&E Corp. $9 million Derivative Dole Food Company $74 million SCA Rayonier $73 million SCA Community Health Systems $6 million Derivative Please note that although 217 is the final settlement year for all of the claims in the chart, many of these claims were filed 3 to 5 years earlier (or perhaps much earlier for outliers such as Halliburton). And others that may look like repeats from a prior year are merely being reclassified when the announced, tentative or pending settlement from a prior year drags into the next year before finally closing out. Of particular interest on this list may be the two derivative action settlements, namely PG&E and Community Health. This represents a continuation of a trend first seen about 5 years ago of derivative action settlements in excess of $5M. Virtually unheard of previously, this push for greater settlement amounts underscores the value of Side-A D&O limits.

3 According to the extensive D&O database at Advisen, derivative actions represent about 1% of all D&O claims. However, based on its broad definition of D&O claims, which includes Capital Regulatory actions such as SEC enforcement actions, Advisen counts more than 1,5 claims in a year. This means 15 derivative actions are expected with at least two being expensive ones. Also noteworthy is that Advisen has previously quoted the average severity for recent derivative actions as about $25 million. KLAUSNER AND HEGLAND One of the more interesting D&O claims trends was identified by Michael Klausner and Jason Hegland, with results posted on Kevin LaCroix s D&O Diary blog site in late 217. The identified D&O claims trend has to do with what the authors refer to as emerging plaintiff firms. Klausner, a Stanford law professor, and Hegland, Executive Director of Stanford Securities Litigation Analytics, have ties to the Stanford Securities Clearinghouse database. They did a 1-year study that compared activity between emerging law firms and established law firms. The established firms were top 1 plaintiff attorneys in terms of volume of cases and success with at least 5 of the top 1 largest securities class action settlements (SCAs). The remaining group which they classified as emerging law firms, grew from 6% of all SCAs filed in 8 to fully 43% of all SCAs filed in 215. And the behavior of the two groups is decidedly different. See Graph 6 for details on the percentage volume of claims. Note that the emerging plaintiff attorney firms are generally firms with non-d&o experience that have more recently brought D&O cases, and not simply spin-offs from established firms. Percentage of Filings 5% 4% 3% 2% 1% % Graph 6: Emerging Firms as Lead Plaintiff Counsel 6% 6% 6% 15% 22% 2% 2% Filing Year Source: Klausner and Hegland study Surveys that we at Gallagher have conducted with our carriers and a panel at the November 217 Professional Liability Underwriting Society conference, which included both an established plaintiff attorney and an emerging plaintiff attorney, reached similar conclusions, which are summarized as follows and supported by the Klausner Hegland study. 29% 34% 43% We are seeing more missed earnings, product-based and operations-oriented claims from the emerging firms versus the established plaintiff firms, at a rate of almost 2 to 1, and such cases may be harder to prove. Recent dismissal rates have been approximately 5% and we forecast that they will continue to increase (as they were only 38% in 8); this greater dismissal rate should come from the weaker cases that are included in the increased frequency. We see that the mix of cases that the emerging firms are bringing are indeed more likely to be dismissed with a 1% differential; for example, cases brought by emerging firms in were dismissed 58% of the time versus 48% for established firms. Klausner and Hegland also show in their article that the settlement timing is different for emerging versus established plaintiff attorney firms. For example, emerging firms are more likely to settle in early stages of the claim process. Roughly 67% of the time, established firms do not settle until after the motion to dismiss has been denied, versus 55% of the time for emerging firms. In our opinion this also affects settlement values. The median settlement sizes for cases handled by established firms are more than triple the size of those cases handled by emerging firms. Given that emerging firms target relatively smaller companies, this difference becomes less dramatic; still, Klausner and Hegland state, When we hold market cap and stock drop constant, settlements in cases filed by emerging firms are still smaller than settlements by established firms. Indeed, we find it fascinating that according to Klausner and Hegland, emerging firms bring cases against companies that have an average market cap of only $1.6B [versus $11.5B for established firms]; the medians are $362M and $1.59B, respectively. It is fair to conclude that the upper middle market is more at risk than ever. NOTABLE CLAIMS To flavor claims impacting the environment surrounding our D&O marketplace, we selected a handful of claims that delineate a few very important points: The existence of ADRs does subject the company to U.S. law and thus D&O claim severity consistent with U.S. law, recent derivative actions continue to have the ability to be quite costly, and claims triggered in part by stock price drops are here to stay, though perhaps associated with smaller percentage stock drops compared to historical averages.

4 BP p.l.c In May 21, a case was filed on behalf of purchasers of the BP American Depositary Receipts (ADRs) against BP and several directors and officers for alleged violations of Section 2(a) of the Securities Act, as well as the classic Rule 1b-5 from Section 1(b) of the Securities Exchange Act. The event that ultimately triggered the claim was a fire on a rig just one month prior to the litigation filing. Apparently BP failed to properly assess how much crude oil was leaking as a result of the fire, which had caused a safety valve to fail. Estimates of 5, barrels a day became 5, barrels. But on May 21, 21, BP told a house panel that the spill was releasing 1, barrels daily into the Gulf. BP s stock price was $56.4 just prior to the fire and $41.86 on May 24. Defendants are liable for making false statements or failing to disclose adverse facts, including misrepresentations as to the safety of BP s operations. BP agreed to settle the resulting consolidated class action in June 216, and it was preliminarily approved by the court in November 216. Final approval was granted in February 217. This is an excellent example of how trading ADRs subjects non-u.s. corporations to U.S. law and can lead to typical (and expensive) D&O claims. This class action cost $175 million, excluding defense costs. Community Health Systems, Inc. Allegations were made that individual defendants steered patients into medically unnecessary inpatient admissions versus outpatient treatments. As a result, the defendants caused the company to overbill, exposing the company to substantial fines and liability. In September 211, the Court consolidated the derivative actions and appointed Robbins Geller as Lead Counsel for the plaintiffs. After successful mediation, a Stipulation of Settlement was made in 216 and approved in 217. The $6M claim settlement included $2M for the fee and expenses amount. Classic Cases: Salix Pharmaceuticals; Rayonier Inc.; J. C. Penney Company, Inc. These three cases each followed a basic formula: blame a large stock price drop on executive communications (inadequate or inaccurate) and demand shareholders be made whole for their financial losses. What is interesting about these three cases is the diversity in size of the stock price drops. Specifically, Salix stock dropped 34% on the basis of deteriorating demand for Xifaxan and other drugs; Rayonier fell 15% on heavy volume after a press release announcing a restatement of prior financial statements; and J. C. Penney was off 13% for the day on the news they would be taking on additional debt to finance operations. Settlements were made for $21M, $73M and $97.5M, respectively. One should reflect on this and note that two companies felt it best to settle claims based on stock drops of only 15% or less. In the past, many plaintiffs would not even bring a lawsuit unless proposed damages were closer to 2% of market cap. D&O Coverage Quality Coverage has expanded substantially over the last several years to the significant benefit of our clients. Graph 7 shows a history of D&O coverage quality. Developed initially for Risk Management magazine in 1996, the index measures the average value of the D&O policy from the leading D&O carriers and compares off the shelf policies to fully endorsed ones. Thus, the red portion of the graph represents coverage gaps that can be closed by negotiation. Coverage Score Graph 7: Norton-Bastian D&O Policy Coverage Quality Index As an example, here is a list of 1 negotiable items that have become popular, especially over the last few years. The most recent increase in the index is driven from improved sublimits and excess form flexibility as well as from several nominal, though positive, changes in the primary policy language. Coverage for Plaintiff Attorney Fees Nominal Defendant coverage for Securities Claims Event Study coverage Typical Coverage Obtained Only one exclusion applies to Side-A (conduct) No time limitation on reporting of claims unless prejudiced M&A Coverage for alleged aiding and abetting Asset protection from enforcement units Notice given and accepted Books and Records demand coverage Greater sublimits especially on Derivative Demand Investigations Year Potential Coverage Enhancements 17GGB32845A

5 SUMMARY There are a few important takeaways from our forecast of 218 D&O Market Conditions. They include: Pricing levels should remain flat or see just small increases, on average, with publicly-traded clients differentiated by financial condition, claim history, industry, size and carrier relationships. Primary negotiations may be tougher for all but the cleanest accounts and even those will depend on the recent history of price decreases and the current cost in terms of rate per million. Market competitiveness as represented by the record number of carriers writing D&O (capacity) will be felt most often in the excess layers, with the exceptions including turnaround situations or mispriced accounts. Claim frequency will continue at record or near record levels, but with large and mega class action D&O claims brought by established firms remaining stable at about claims annually. Medium severity claims brought by emerging plaintiff attorney firms will continue to grow. The trend for significant numbers of federal M&A claims and non- U.S. securities actions will continue. The dismissal rates will remain very high, approaching or perhaps exceeding 6% as a whole, as we see a substantial number of weaker D&O cases in the mix. D&O Coverage quality will remain very high, though we foresee some market resistance to further expansion. The structure of programs will continue to see Side-A only cover take approximately 3% of the program, though the difference in conditions advantages have shrunk substantially as traditional D&O primary forms have broadened coverage dramatically since 21. As the greater use of Side-A to essentially fund entity claims continues through derivative action settlements, we believe having dedicated Side-A only limits as part of your D&O program structure is as important as ever. About the Author: Phil Norton, Ph.D. is a Vice Chairman for the Midwest Region, and a Managing Director in Gallagher s. This practice focuses on providing insurance and risk management solutions related to executive and management liability issues. For further information, please contact Dr. Norton at Phil_Norton@ajg.com or , or visit Important Note: This paper is not intended to offer legal advice. Any descriptions of insurance provided herein are not intended as interpretations of coverage. An actual insurance policy must be consulted for full coverage details.