Avoiding the Pitfalls of Multi-year D&O Policies

Multi-year policies have historically been problematic in the Directors and Officers (D&O) insurance market. Multi-year D&O policies are generally written on either a two-year, and to a lesser extent, a three-year policy term. The multi-year D&O policy is based on a “guaranteed premium” threshold that is endorsed onto a policy versus a “guaranteed rate” metric that is typically used in primary general liability policies.Typically, the policies can either be structured with one single shared aggregate limit of liability that covers the entire policy period, or there can be an aggregate limit of liability for the policy that can be reinstated annually over the course of the policy. The premium for the policies can be either pre-paid or collected on some form of an installment basis.There are several forms of multi-year D&O policies that exist in the marketplace today, including run-off, transactional liability, and wind-down polices, etc. For the purposes of this blog post, we are referring to a traditional multi-year D&O policy versus policies issued for specific business situations or regulatory requirements.During the 1990’s, the re/insurance D&O industry on the whole started to support the use of multi-year policies across their entire portfolios. These portfolios included small not-for-profit (NFP) organizations, private entities as well as large global public companies. At the time, the D&O market was in a soft market cycle, plagued by over capacity and reduced rate levels. The introduction of multi-year policies into this market environment exposed several additional drags on the profitability of the segment, such as:

• A reduction in annual renewable risks – The more multi-year D&O policies that were written each year, the less “renewable and new” business there was for each carrier to write. Ultimately, this created intense competition when any new and/or renewable business came to the market. Pricing levels were therefore further eroded given the market dynamics.
•  Multiple layers of crediting – This included multi-line coverage premium credits, credits for prepaid policies, and credits for single aggregate limit vs. re-instatable limits on newly introduced integrated policies for D&O/E&O/EPLI/Fiduciary/Crime, and other lines.
• An inability to re-underwrite based on material changes in the risk operation – Most of the multi-year D&O policies lacked an endorsement that had a “Change in Conditions” or “Cancelation provisions” for either the insured or the insurer.

The increase in the number of D&O markets in the late 1990’s created a classic oversupply of capacity. Coupled with several other macroeconomic factors, it created a “perfect storm” that resulted in extremely unprofitable results for the D&O re/insurance industry. The presence of multi-year policies in the D&O market at the same time reduced insurers’ ability to adjust pricing/terms to combat the increase in losses, leading to a prolonged period of negative results.Against this historical background, there are several important considerations to be made when determining whether to utilize a multi-year D&O policy:

Potential advantages:

• Stabilized pricing parameters – These policies provide insureds with consistent pricing thresholds across the multi-year D&O policy period, and in some cases, increased cost predictability across both the hard and soft insurance market cycle. This benefit is extremely helpful to smaller insureds (i.e., NFP risks) by allowing them to adequately plan and budget for expense/premium items in a long-term strategic planning process.
• Expense reduction/enhanced efficiency – By writing multi-year policies, insurance companies would save the time and expense associated with annually re-underwriting risks. The reduction in frictional costs allows both parties to potentially share in some of the annual savings over the course of the extended policy term.
• Consistent terms/conditions/retention levels – In addition to more consistent terms, the insured benefits from continuity of coverage. This enables the insured to avoid potential gaps in coverage in policy forms when switching carriers annually, and allows insureds with stable operations and predictable loss history to achieve the best possible terms across a longer period.

Potential pitfalls:

• Inability to re-underwrite a risk – Conceivably, there can be major changes in the underlying risk characteristics and/or loss emergence for both an insured and an insurance company in a 12 month timeframe. These changes could have a major impact on the future profitability of the account or the claims paying ability of a carrier.
• Locking in rate/price/capital at inadequate levels – Annual reviews of claim frequency and severity, loss trends, or major systemic events may expose inadequate current rates. This may require an increased capital allocation in order to support their underpriced business from prior years at the expense of allocating capital to segments with higher expected profit margins.
• Counter Cyclical Phenomenon – At times, the demand and request for multi-year policies is inversely correlated between insureds and insurance companies. For instance, when the perception is that forecasted pricing levels will further deteriorate in the future, insureds are less inclined to agree to a multi-year policy. Conversely, insurance companies may be less inclined to lock in lower premiums on a multi-year deal if they project future rate increases in the segment.

The D&O industry today has taken a more selective approach to writing multi-year policies, preferring to write multi-year policies on an individual risk basis versus an overall portfolio basis. Current market feedback suggests that carriers and brokers alike have focused the use of multi-year policies on lower hazard classes and risks with small, consistent exposure bases.  Only time will tell if the continued issuance of multi-year D&O policies contributes to a downturn in the profitability of the segment as was the case in the late 1990’s, or if the lessons of the past have been co-opted into current practices, leading to an increased level of stability in the D&O market.

To contact the author of this article, Bob Oates, click here.