Three years of dramatic D&O insurance price increases have ended for most San Diego public companies. In fact, many companies are enjoying significant price decreases. In the second quarter of 2003, the following trend was visible: Fortune 500 pricing continues to increase substantially; Fortune 2000 is flat or modestly increasing; mid-cap is decreasing modestly; and small to micro-cap pricing is decreasing significantly. Obviously, this does not apply to distressed situations.

John Niedernhofer

Two positive outcomes emerged from the price increases over the last three years. The first is a proliferation of alternative D&O coverage types. Second, high D&O premiums increased policyholder due diligence, which typically created a more sophisticated D&O buyer. Adding to this, many well-documented D&O coverage problems emerged from the recent corporate scandals. Companies realize the cost of D&O insurance is meaningless without a thorough understanding of the coverage quality. D&O coverage is only as good as the claim it pays.

Insurers responded to the parade of corporate scandals and unprofitability of D&O with narrowed coverage, much of it subtle. More alarming is the increased willingness to challenge claims, and even to rescind coverage when most needed. This has increased interest in alternative D&O coverage.

Reviewing alternative D&O coverage requires historical context. Whether due to insolvency, the nature of the claim or because the corporation itself brings the claim (e.g. shareholder derivative claims), many claims against directors and officers cannot be indemnified by the corporation. Directors and officers liability insurance was created to fill this void.

However, as is no secret, actuaries and underwriters were mistaken. Securities claims dramatically increased in both frequency and severity. Recognition of the problem coincided in 2000 and 2001 with nasty equity markets, which forced change for D&O insurers. Change comes in two forms: pricing and coverage. Increasing premiums was relatively successful for insurers, because of uniform unprofitability. Successfully narrowing coverage is a different story.

Despite consensus that reduction or elimination of entity coverage for D&O insurance is necessary, insurers that have taken the initiative have been immediately punished with lost market share and have backed off. Insurers have found it much easier to offer an alternative coverage product and let the buyer choose, rather than try to scale back coverage.

The decision to eliminate entity coverage is difficult for the buyer, because the amount of balance sheet protection given up outweighs the amount of premium reduction. However, there are a growing number of reasons to focus on more than pure economics.

While each corporate situation must be evaluated on its own for appropriate coverage structure, one coverage type in particular is gaining rapid interest (and law firm recommendations) -- Side A DIC coverage is offered by a half dozen insurers in one fashion or another. It is typically structured as an excess layer, and offers benefits over conventional D&O in each of the following contexts:

* A separate and broader insuring agreement flows only to the benefit of covered directors and officers, so that if there is a coverage problem under the conventional coverage program, there is then a separate coverage potentially available.

* Because there is a separate insuring agreement benefiting only specified directors and officers, this neutralizes the ability of a bankruptcy estate attempt to freeze the policy.

* It can be structured to drop down to (for covered individuals) a layer in the underlying conventional insurance program that was filled by an insurer that has become insolvent.

* It can be non-rescindable.

* The Sarbanes-Oxley Act enhances personal liability of key executives. The true implications will not be known for years. Further, Section 404 compliance -- attesting to adequacy of internal controls -- will bring its own exposure, and few organizations have begun to implement, let alone attained compliance.

* There is an increase of (non-indemnifiable) shareholder derivative claims piggybacking on traditional federal class action securities litigation.

* Stephen Cutler, in charge of enforcement at the Securities and Exchange Commission, declared a new initiative to increase scrutiny and pursuit of independent directors who fail to pursue misconduct.

On a separate note, private company D&O pricing continues to increase moderately because of deteriorating trends in employment. Most private company D&O coverage includes broad employment practices liability coverage; these claims comprise about half the losses. Because California leads the nation in creating new employee rights and remedies, employment practices coverage for California-centric employers is very unprofitable for most insurers, and therefore premiums continue to rise.

There was a recent alarming decision in New York, which held directors and officers of a privately owned company to the same fiduciary duties as for a public company. In this case, after an organization filed for bankruptcy, creditors targeted corporate officers and directors, alleging they had a fiduciary duty to the corporation to ensure solvency. The judge agreed, and found the officers and directors personally liable to the creditors. Most disconcerting about this decision is that the independent directors did not in any way personally benefit, but were held liable nonetheless.

In conclusion, D&O pricing for public companies has stabilized, except for the larger organizations. There is growing interest in alternative D&O coverage designed to protect only the assets of directors and officers. Of alternative coverage, Side A DIC is gaining widest acceptance for most situations. Private company D&O pricing continues to deteriorate, and there may be a higher liability standard developing for private company directors and officers.

Niedernhofer, JD, is a senior account executive in Barney & Barney's Executive Risk Practice. For information, call (858) 587-7144 or e-mail john@barneyandbarney.com.