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Alexandra Cain, moderator, Listed@ ASX: What are some of the factors that have created difficult conditions in the D&O insurance market? 

Eden Fletcher, director, financial services group, Aon Risk Solutions: A few factors have led to a challenging D&O marketplace. The way policies are constructed and how they have evolved over time is one. These policies were originally designed to protect the interests of individual directors and officers. Originally, the only coverage afforded to companies was in respect of their indemnification obligations to directors and officers. But, as claims’ experience evolved, insurers had to deal with the issue of allocating covered versus uncovered loss under a D&O policy, in circumstances where the company was also named in litigation. So D&O policies were ultimately expanded to include class action coverage for the company. What we have seen in Australia is the vast majority of class actions are brought against companies rather than individual directors and officers. 

We have also seen a material increase in plaintiff law firms focusing on class actions and very active litigation funders in this space. Commentary suggest this heightens the prospect of more speculative claims, which is very problematic in an environment where very few of these matters proceed to final judgement. 

Finally, until about four years ago, the D&O insurance marketplace was awash with insurer capacity and the level of insurer competition had a material impact on mitigating pricing increases. What we have seen in recent years is a contraction of global D&O capacity and very significant pricing increases as insurers look to remediate their portfolios. So, in the context of cumulative securities class action settlements, which are in excess of $2 billion, the historical annual D&O premium pool of circa $250 million to $300 million was unsustainable. We have seen that premium pool grow to close to $1 billion in 2021. 

Rehana Box, partner, Ashurst: The previously very competitive market in Australia led to policies including broad coverage terms. So, as well as low pricing, the cover offered was broader than in other markets and increased year-on-year until around 2016. Now, the market has hardened and the days of cheap, broad cover have ended. 

Moira Saville, partner, KWM: As you say, insurers extended cover to companies through Side C policies. Experience has shown that’s where the vast majority of expensive claims have been, with average class action settlements now more than $40 million. This has clearly had an impact on the market.

Listed@ASX: Is this a peculiarly Australian situation? 

Rehana: Yes and no, but it’s been exacerbated in Australia for various reasons, particularly because of the low premiums in this market. D&O premiums have risen in many markets and, to some extent, we’re following trends that happened earlier in other markets where corporates have had to consider whether to continue with Side C (securities cover) and, sometimes, also Side B (company reimbursement) because of the cost of cover. 

Moira: The litigation environment is the other big contributor. Class actions are prevalent in the US and Canada, but in terms of the Australian experience, the arrival of litigation funders in 2006 has driven the number of securities class actions here. Funders could realise significant returns investing in class actions here. You can see from the number of funders here it’s been successful business for them and has driven the rise in class actions. 

Some features of our legislative environment are different to other jurisdictions. Our continuous disclosure laws are stricter than in the US and the UK. It’s also easier to start a class action here than in the US or Canada. You don’t have certification requirements and there’s a low regulatory burden on the funders. That’s changed more recently, but since 2006, those things provided a facilitative environment for securities class actions. 

Moira Saville, partner, KWM
 

“You can see from the number of funders here it’s been successful business for them and has driven the rise in class actions.”

Listed@ASX: You talk about the legislative environment changing more recently. Can you provide some colour around that? 

Moira: COVID-related changes to continuous disclosure provisions, which have now been made permanent, have had an effect. They provide some relief for companies’ forward-looking statements, although statements are still subject to the same tests. Now, there’s also a knowledge, recklessness or negligence test for continuous disclosure breaches, which we didn’t have before. That’s an important change. Regulation for litigation funders also came in last year. I don’t know if you can draw a causative line, but we have the lowest number of securities class actions in the past year than we’ve had for a long time. 

Rehana: Amendments to the Corporations Act in relation to continuous disclosure obligations were very welcome, but they haven’t completely taken away the risks that exist for directors and companies in respect of continuous disclosure. There is still a requirement under the act and under the listing rules for ASX companies to disclose information to the market a reasonable person would consider relevant to a shareholder in relation to the market price for the company’s stock. Those obligations are not subject to the requirement to prove intent or negligence. So, there is still a significant risk of actions for failure to disclose. This may mean insurers will view the recent changes as not being as significant as some may have hoped in reducing Side C risk. 

Eden: It’s worth pointing out there has been a lower threshold for bringing securities claims in Australia compared to other jurisdictions such as the US. Australia has become the most likely jurisdiction outside the US in which companies may face significant class action litigation. The Australian insurance market has suffered an over-concentration to some local issues, such as securities class action claims, explored by the Financial Services Royal Commission. So going back to the question about whether the Australian environment is unique - a lack of risk diversification in insurance portfolios has impacted their profitability. 

Rehana: One of our Australian corporate clients, which now operates globally, recently sought to effect D&O insurance out of the US and London markets without successfully being able to place its full limit. It was telling and disheartening to see that out of about 30 London market insurers, at least half said they weren’t interested in quoting because it included Australian risk. 
 

Listed@ASX: What’s happening with prospectus insurance as it relates to D&O insurance? 

Eden: Prospectus liability insurance is a product designed to accommodate exposures associated with a public offering, which aligns with the statute of limitation. It allows exposure associated with the raising to be ring fenced under a standalone policy rather than incorporated within a company’s annual D&O insurance program. As capacity in the insurance marketplace has become more constrained as premium levels have risen, we have seen an increase in the number of organisations looking to include cover for raisings under their D&O insurance program rather than pursuing standalone prospectus liability cover. 

We have also come across a number of recently-listed organisations that have forgone cover for the prospectus document and associated investor roadshows entirely as a means of containing cost. This represents a very real exposure, certainly in the first couple of years of being listed, because any litigation is very likely to link back to representations made within that prospectus document. So a word of caution: organisations need to be mindful of that exposure and ensure it’s appropriately addressed, either under the D&O insurance policy or a prospectus liability insurance policy. 

Rehana: Be mindful where you insure IPO risk under an annual corporate D&O policy as there are downsides. It may be more cost effective, but you lose a dedicated limit for IPO-related claims. These will also affect the claims experience under the annual program, which may erode the cost savings of a separate IPO policy. Typically, IPO policies are placed for seven years on a non-cancellable basis. Most claims emerge in the first couple of years post IPO. Nevertheless, it is comforting to have a seven-year policy with a dedicated limit. There is also the risk future policies expressly exclude IPO-related risks, particularly where there is a change of insurer. An incoming insurer may impose a ‘retroactive date’ of the date they come on risk. This would mean claims based on events before that date, such as an earlier IPO, would not be covered. A change in control of the company, for example where it becomes part of a larger group, will usually lead to a change in insurers. Insurers are also changing more regularly in the current hard market as insureds struggle to find cover. 
 

Listed@ASX: Where are we at with litigation funders? 

Moira: The majority of securities class actions in the last 15 years have been funded by litigation funders. Almost all of securities class actions settle. It’s a pretty good risk for a litigation funder in terms of their investment. 

In the Victorian Supreme Court, as a result of legislation, lawyers have the ability to bring class actions in that court and apply to get group cost orders, which is like a contingency fee awarded by the court. The first application was unsuccessful but another application is pending. So that may well change things because we’ll probably see more lawyers funding class actions. 

One reason that legislation was introduced was to provide competition to the litigation funding market. Whether that happens remains to be seen. We might also see litigation funders set up law firms. 

Eden Fletcher, director, financial services group, Aon Risk Solutions  
 

“Certainly, securities class action litigation has been primarily focused on the ASX 200.”

Listed@ASX: Is the biggest risk for companies with a big market capitalisation, deep pockets and good insurance? What is the risk to smaller companies? 

Moira: With some exceptions, the funders or plaintiff lawyers don’t want to commit to a class action that’s going to bring a company down, although there are some exceptions where companies have gone under as a result of, or at least shortly after, a class action has been commenced. But they still want well-capitalised companies. They know the company has D&O insurance, but what they don’t know is whether there is Side C cover, which covers the company. But there’s an expectation most of the very largest public companies have significant Side C cover. 

Eden: Certainly, securities class action litigation has been primarily focused on the ASX 200. When we look at Aon’s portfolio, about 30 per cent of the ASX 200 either never purchased Side C or have made a conscious decision to remove Side C from their D&O insurance program. Over the last 18 to 24 months, there’s been a very dramatic change in buying patterns. 

Listed@ASX: What are some disclosure practices companies could follow to minimise the risk of class action and what actions can they take to positively impact their ability to obtain insurance cover? 

Rehana: Good disclosure practices are key. In relation to improving the chances of obtaining and keeping insurance, strong relationships with insurers is vital. It’s never been more important for listed businesses to build long-term relationships with their insurers. And part of that is gaining the insurers’ trust and listed businesses demonstrating they have good practices and procedures - in particular around disclosure and ESG - which are hot issues that may lead to actions by shareholders or others. It’s really important to have good procedures you can present to insurers in renewal meetings. This will give them confidence if something goes wrong, it’s not going to be the result of poor general practices. Demonstrate to insurers you’re well-managed, everyone understands their duties and it’s company culture to comply with the law and listing rules. 

Eden: D&O insurers are ultimately underwriting the culture of the organisation. So, listed companies need to give insurers the best opportunity to understand their organisation. The presentations companies provide to insurers continue to be really valuable. They do, however, need to be carefully planned, noting organisations are competing for insurer capital. We’re frequently augmenting presentation attendees to include CEOs and heads of audit and risk committees and looking for them to provide tangible evidence around culture and how the organisation complies with its continuous disclosure obligations. 

Rehana: The days of insurers just accepting statements in renewal proposals and presentations is over. They want to see proof you’re actually doing what you say you’re doing and they will probe the position put to them by listed businesses. It’s about trust between the insurer, the company and its management and board. Insurers need to get to know the business and its culture; they need to be confident there is a culture of compliance within the company. Listed companies should be ready for these discussions. 

 

Listed@ASX: How do they test that? 

Rehana: They may ask for information on disclosure practices, governance procedures and the form and regularity of reviews. They will be interested in the results of reviews, what’s been actioned and what hasn’t been actioned and why. These questions were not being asked five years ago but they are now. The quality and experience of the board is increasingly important. 

Listed@ASX: If you are an exemplary company in terms of continuous disclosure, is that going to affect your D&O premium versus a company that can’t show that the same level of disclosure? 

Eden: The short answer is yes, however it goes much further than simply driving better pricing outcomes. The insurance market is such that underwriters are very prepared to walk away from organisations whose risk profile, in their opinion, doesn’t fit their risk appetite. This places greater importance on how organisations showcase and highlight their approach to governance, risk management and compliance. 

 

Listed@ASX: What are some exclusions insurers might put in if they’re not comfortable with a company’s actions? 

Eden: In the current environment, corporate insolvencies are a big concern for insurers, which is naturally aligned with the pandemic and global economic downturn. We’re seeing significant focus by insurers on capital raisings. During the pandemic, a lot of organisations have been raising capital and many insurers are incorporating stricter policy provisions to ensure they have the opportunity to effectively underwrite those raisings. The rationale and requirement for an organisation raising capital is being heavily scrutinised by underwriters. 

 

Listed@ASX: How else has COVID affected this landscape? 

Eden: New working dynamics are also relevant. We’ve been working from home, there has been a significant increase in mental health-related issues and many organisations have sought to downsize staff during the pandemic. This heightens potential for employment practices related claims. We’re also looking at how newer exposures like mandatory vaccinations in the workplace are playing out in other jurisdictions and how that might flow through to D&O litigation in the Australian context. 

Rehana: Maintaining the organisation’s culture, especially with new hires, when everyone is working remotely is an identified risk issue. It’s very easy in a virtual meeting to present one way, but you really don’t get the chance to get to know people working remotely. Training, building trust and the bringing new hires into your way of doing things is much harder when you’re working remotely. Staff retention is another challenge. There’s not as much ‘stickiness’ when people haven’t formed strong relationships with their working colleagues. It’s one of the things that keeps people at a company. When you don’t have that, there’s more chance of people moving on, which also impacts the business’s risk profile. When you lose people, you often lose corporate knowledge and you have replacement risks. Those things can affect D&O risk. 
 

Listed@ASX: How do Sides C and B cover work together in the current context? 

Rehana: Side A directors and officers cover is, or should be, the prime focus of a D&O policy. Sides B and C are there to protect the company. Some insureds are either dropping or reducing their Side C coverage due to cost. Some companies are going further and looking at dropping Side B cover and simply having the truest form of D&O, Side A only, to protect directors and officers where they’re not indemnified by the company because the company cannot indemnify them at law or is financially unable to meet its obligation to indemnify. One of the issues is removing Side C is often not rewarded by insurers with a commensurate reduction in premium. That’s something that needs to be dealt with by the industry because quite often you’re seeing a substantial reduction in the coverage and yet the reduction premium is only 20 per cent or 30 per cent, when really there’s quite a low level of risk transfer to insurers. This does raise the issue of value for money for insureds. 

“One of the issues is removing Side C is often not rewarded by insurers with a commensurate reduction in premium.”

Eden: Rehana makes a good point around the rightsizing of policy limits. There is a clear structural shift in the D&O market taking place and it is important to recognise many organisations did use savings that were generated during soft market conditions to purchase additional limits. The current market represents an opportunity to revisit the appropriateness of the D&O program structure relative to an organisation’s own risk appetite. Benchmarking continues to play a key role and we’re spending a considerable amount of time with boards to interrogate historical purchasing decisions relative to what peers are doing in the current environment. We’re working with clients to help them better understand the links between enterprise risk and D&O causation, and analytics are playing a much more meaningful role. From an Aon perspective we’re taking historical securities class action claim data and overlaying this with client-specific metrics such as market cap, stock volatility, share register, liquidity position, industry, regulatory environment and the increasing costs of defending litigation to create meaningful loss modelling. This is helping our clients better understand how big their D&O loss exposure might be in addition to better informing risk retention strategies. So there’s a lot more science going into the way organisations are procuring D&O coverage. 

Rehana: The differences between Side B and Side C are to protect the company and its balance sheet. Sides B and C can also be dealt with in other ways for instance through co-insurance and captives. These are alternatives clients are actively looking at, given the cost to renew each year has become so significant. D&O is no longer an easy purchase. Companies are looking at the purchase much more critically and considering whether it’s delivering value for money and whether there are better ways of managing the risk. 

Rehana Box, partner, Ashurst   
 

“D&O is no longer an easy purchase. Companies are looking at the purchase much more critically and considering whether it’s delivering value for money.”

Listed@ASX: How would captives work in this situation? 

Rehana: A captive insurer is an insurer owned by the company group. Due to section 199A of the Corporations Act a captive can’t insure Side A risks, because a company, or its related entities, can’t indemnify or release its own directors and officers from liability owed to the company. That’s one of the main purposes of D&O insurance, so D&O insurance will always be needed. However, Side B and C risk can be managed in a captive company or a captive cell. 

There needs to be an analysis of whether a captive is tax- and cost- effective. But in many cases, given the pricing of D&O insurance, a captive has become an attractive option. You can put other risks into that captive; it doesn’t have to be just D&O. There is the benefit that you can put more risks into a captive than the commercial market will insure from time to time. You can use that as a way to directly access reinsurance markets, which might provide some benefits in respect to pricing or getting further cover. But note also that unless some risk is transferred out of captive via reinsurance, it may be treated as transfer pricing under OECD rules.

You can also use a captive as a way of managing the higher deductibles that are now being required by insurers of D&O policies, particularly Side C, which is typically subject to a deductible of at least $1 million. The benefit of a captive is that if you have a good claims experience, there will be profit to repatriate back to the company at some point. Or, the captive can pay for risk management services or other legitimate purposes for which the captive funds can be deployed. But if claims experience is not good, the company must be prepared to put more capital into the captive.

Listed@ASX: So where to from here and how is the market going to perform in the future in terms of price stability and supply? We talked about there being plenty of capacity years ago, and that’s all changed. So what does the future look like? 

Eden: Over the course of the year, there have been some positive developments in the risk landscape with amendments to the continuous disclosure laws. Following material profitability concerns, there has been considerable growth in the Australian D&O premium pool. I would go as far to argue it’s reaching sustainable levels, relative to the overarching, albeit evolving, claims environment. Most insurers have implemented remediation strategies and we’re starting to see signs of local underwriters effectively being vested with greater authority, which is a positive development. After several years of contracting D&O capacity, new insurance markets with no legacy claims’ portfolios are starting to emerge. From our perspective, this represents a distinct opportunity to disrupt the current market cycle. So I’d say we’re cautiously optimistic. 

Moira: We shouldn’t forget we’ve had a couple of good decisions for defendants in securities class actions in the past two years. The appetite of defendants and insurers to run cases to trial might increase, too. So that may well also change the future environment, which could be a good thing.

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