Liability insurance a growing concern for energy company directors, officers

Oct. 13, 2003
Liability insurance a growing concern for energy company directors, officers New governance issues and criminal penalties under the Sarbanes-Oxley Act are increasing the need for liability insurance among corporate directors and officers at a time when business scandals are driving up costs and reducing coverage of such policies.

New governance issues and criminal penalties under the Sarbanes-Oxley Act are increasing the need for liability insurance among corporate directors and officers at a time when business scandals are driving up costs and reducing coverage of such policies.

And the risk profile for oil and gas companies is growing.

"It used to be that when an executive was wrong, he just got fired. Now he's also likely to get sued," said Judith McElya, vice-president, financial services, at McGriff, Seibels & Williams of Texas Inc., a Houston-based insurance broker.

Liability issues

Liability insurance for a company's directors and officers, known as a "D&O" policy, insures them against personal liability for "a wrongful act," which is "very broadly defined as an act, error, or omission" resulting in some form of loss, explained McElya, a D&O specialist. "It insures against all perils that they can create, and then it excludes certain areas—the No. 1 being, right now, fraudulent conduct," she said. "In any securities claim, you're likely to have fraud alleged."

Until recently, the insurance industry considered oil and gas companies to be a safe bet for D&O coverage. Prior to the Enron Corp. accounting fraud scandal, said McElya, there was only one class-action lawsuit filed against an oil and gas company for a securities violation—a 1999 case involving a rogue oil trader at Plains All American Pipeline LP.

In the 1990s when the D&O market was "very soft," insurance companies began "looking at industries that had been relatively risk-free, and oil and gas was one of them," McElya said. "We started seeing $25-50 million participation in one D&O program from one carrier, which is an enormous aggregation of risk. But nobody really worried about it, because it was oil and gas."

D&O brokers, she said, "could get [policies] down to extremely inexpensive rates. We wrote 2 or 3-year policies that precluded [underwriters] from being able to do any kind of price, contract, or terms correction midterm." Those multiyear policies began expiring in 2002. "We're renewing for 2004 now, and there are no more multiyear contracts," McElya said.

For companies now seeking D&O insurance, she noted, "It's not a matter of price like before. It's a matter of 'Do I get coverage?' Everyone is paying multiples of what they paid previously, just in order for the carriers to outrun the claims that have been put on the books in the last 3 years."

Expensive coverage

"Customers are paying 80-90% of what they previously would have paid for corporate reimbursement coverage simply to protect unindemnifiable claims, which are a minute portion of what we have seen historically. It may be a bad economic choice, but board members are going to demand it, so economics takes second chair to the issue of having a policy dedicated to protecting the individual's assets," said McElya.

The market "may not be overpriced, because the pricing is definitely reflective of the claims that have occurred in the last 3 years, but it is a significant markup from what insureds have been paying," she said. "What we've seeing now are companies, at the behest of director-candidates, having to buy more D&O insurance at much higher rates. Whereas they may have been buying $10-15 million of D&O, they're now buying $45-50 million."

Lawsuits against energy industry officials also have impacted insurance companies. "In 1995, the three biggest players in oil and gas D&O were Lloyd's of London, American International Group, [and] the Chubb Group of Insurance Cos.," McElya said. Today, Lloyd's of London is "pretty much not writing D&O for oil and gas companies anymore," she said. "AIG took a substantial write-down in the first part of this year, most of which was attributable to D&O. Chubb took two write-downs last year. We're talking billions of dollars here."

Meanwhile, the market has been augmented by "an entire crop of post-[Sept. 11, 2001] carriers that are essentially recapitalized with no 'long-tailed,' or legacy, claims for asbestos or D&O liabilities. They're coming in at the top of the market and are writing on a go-forward basis," said McElya. However, the new companies "are simply not behemoths like an AIG or Chubb."

Coverage reduced

Overall, most insurance companies "have significantly reduced their capacity—in other words, the top limits on any given risk. They're being much more selective in the way that they underwrite policies," McElya said.

Moreover, she said insurance companies have become "very intolerant of any restatements; so if you restate your publicly filed disclosures, you're likely to put your D&O coverage at risk. The argument will be, on the carrier side, that a restatement constitutes an admission that the information originally given underwriters was materially flawed. And if it was materially flawed, the underwriter has the right to void the contract. Insurance companies—some of them—are saying a restatement is the very same thing, because the financials are materially off or they wouldn't have to be restated."

D&O typically provides "two or three coverage grants, depending on what policy you're looking at," McElya said. "The first coverage grant, which we call Side A, is for unindemnifiable claims against individuals. Historically, very few claims qualified as unindemnifiable."

D&O "pays first dollar to individuals in those [Side A] claims," said McElya. However, she said, "The vast majority of D&O claims are under what we call Side B," by which the corporation is reimbursed for indemnification of its directors and officers under its bylaws. A third coverage, Side C, "is coverage for the corporation itself against securities claims," McElya said. Developed in the soft market of the late 1990s, Side C "took care of a couple of problems that the old A-B contracts had—most notably allocation."

For example, she said, a company carrying a $10 million Side B policy and facing a possible $10 million loss from a lawsuit against its directors and the firm itself might erroneously assume it was fully insured. However, McElya said, "The insurance underwriters might determine a 40% responsibility on the part of the directors and pay only $4 million of the $10 million judgment, leaving the company on the hook for the remaining $6 million."

Under Side C, "a company could get its directors and officers out of the suit and not lose the insurance for itself," said McElya. "Then we ran into Enron and realized this coverage presented new issues, especially when an insured goes bankrupt."

Because Enron carried A, B, and C coverage when it sought bankruptcy protection, its primary D&O carrier wouldn't pay legal fees for the company's directors and officers without first obtaining permission from the bankruptcy court, since corporate assets were frozen pending court approval of a reorganization plan.

In Enron's case, McElya said, "The judge initially concluded that the C segment made Enron's D&O policy a part of the corporate estate but allowed it to pay the individuals' legal fees. We dodged that one. But the legal community said, 'If adding the entity coverage is going to allow the D&O contract to be pulled into the bankruptcy estate, then maybe we don't want it.'"

The insurance industry is now selling Side A coverage "as a sort of panacea, whereas we previously sold A, B, and C and covered everything. We'll sell you A, B, and maybe C and then put a little extra A on top, in case the A-B gets blown away by a bad guy, the good guys still have the top layer," McElya said.

Moreover, she said, "There is no deductible on Side A, while there are usually significant deductibles under B and C. There is an argument that, because of more favorable fraud language and severability, the good guys are better protected under Side A than if they are lumped in with everybody under the more stringent fraud and severability provisions in an A-B or A-B-C contract."