Insurer Insolvency Can Sting D&O Writers

When an insurance company fails, the company's directors and officers insurers are among those who feel the pain.

Like most companies, insurers buy D&O liability insurance to protect their directors and officers from being sued. The D&O coverage is likely to pay for defense costs, as well as any settlements that arise from lawsuits.

"Typically, the normal policyholder doesn't sue," said Karen Kutger, vice president of Professional Risk Solutions, a Somerset, N.J.-based broker that specializes in D&O and errors & omissions coverage. When a company becomes insolvent, policyholders are given 30 days notice to find a new policy. If the policyholder didn't make a claim on the policy, there's no reason to sue. "You can make a claim with the guaranty fund for the unearned premiums, but if you don't have a claim, there really isn't anything to sue for," she said.

The directors and officers of failed insurance companies can face substantial liability from shareholder lawsuits if the company was public. That liability can include civil lawsuits filed by regulators and governmental authorities, and even criminal charges.

In the case of Reliance Insurance Co., the largest insolvency to date, the Pennsylvania Insurance Department was able to reach an $85 million settlement in a lawsuit against Reliance's former directors and officers.

Reliance's D&O insurers -- including Lloyd's underwriters, Greenwich Insurance Co. and Clarendon Insurance Co. -- could have had combined limits of up to $125 million, which would have been a big help to Reliance's policyholders and creditors.

However, defense costs were quickly eroding the limits away. At the time the settlement had been reached, $27 million had already been spent on legal costs associated with defending the directors and officers, according to the court decision, filed in February 2005.

"You can spend millions just defending [directors and officers], especially in a bankruptcy situation when everyone is trying to point the finger," Kutger said.

Ironically, Reliance itself was also a D&O writer, so any of Reliance's former policyholders with claims might find themselves looking to get payment from the states' guaranty systems -- most of which cap claims at $300,000, and may often refuse payments to entities with a net worth greater than $25 million.

Steve Shappell, managing director of legal and claims practice for Aon Risk Service, said the broker spends a lot of time with clients talking about an insurer's financial security.

"A D&O claim today can take three or four years to resolve. You have to predict the strength of insurance companies three and four years from now, when they'd actually be writing the checks to pay the defense costs. It's a challenge," Shappell said.

With that in mind, many D&O buyers build a program with several different D&O carriers to spread the risk of any one company failing.

The issue of insurance company solvency is of such concern among Aon's clients that the world's largest insurance broker created a new coverage to protect them from an insurer failing, Shappell said.

On average, companies spread their D&O risk among five different carriers, he said. Aon offers a policy provided by a sixth underwriter, who agrees to drop down and take on the risk if any of the original five carriers become insolvent.

"D&O insurance is so important, we cannot have individuals having to pay with their own money because an insurance company failed due to insolvency," Shappell said.

Kutger suggested the D&O contracts could be written so that if one of the carriers became insolvent, the other carriers on the program could cover any shortfall.

"All excess carriers should be able to drop down to the primary level should anything happen to anyone in that program," Kutger said.

An insolvent insurance company's D&O insurers might face a double whammy. In addition to covering the costs associated with protecting the directors and officers of a failed insurance company, like all insurers, they may be assessed a portion of their premiums to help the guaranty funds cover the failed company's claims.

(By Meg Green, senior associate editor, BestWeek: [email protected])