Viewpoint: D&O Market Conundrum — Softening Rates With Rising Claims Severity

Executive Summary: An uncertain economic landscape leading to a rise in claims, decreasing rates, and proposed US Securities and Exchange Commission regulations on environmental, social and governance disclosures (ESG) are just some of the challenges facing directors and officers liability insurance. AmTrust EXEC claims team members Dan Beatty and Erin Zimmerman look at key issues and trends in the sector.

The current D&O market is out of balance with insurers facing a soft underwriting landscape just as the volume and severity of claims are rising. This was one of the main questions discussed by delegates and panelists at the annual Professional Liability Underwriting Society’s D&O symposium we attended in New York, but nobody had a definitive answer. However, we believe that market conditions will force a correction of this imbalance between low rates and increased claims.

Competition from new market entrants, who have increased capacity and been able to undercut some of the legacy carriers burdened with a claims history, has driven down rates and premiums over the last year. But an economic downturn caused by the pandemic, stock market volatility, soaring inflation, rising interest rates, supply chain disruptions, and labor shortages, may put these new carriers under pressure.

A down economy presents serious challenges not only to businesses and organizations, but also to D&O insurers who anticipate a potential increase in management liability claims. This increased claim activity likely will be driven by difficulties—particularly for private companies—in accessing capital markets because of rising interest rates or in raising funds through public offerings in a down market. The uncertain economic outlook has led to additional concerns in the liability insurance sector about financial instability and bankruptcy-related claims, as evidenced by the recent bank failures in the U.S.

Correction Anticipated

However, we anticipate a correction of the imbalanced D&O market when over-capacity is no longer an issue as players exit the arena and rates plunge below breakeven, leading to a necessary hardening of the market.

Into this uncertain climate comes another pressing concern for the D&O market, which has insurance companies of all sizes and longevity scrambling to find solutions: the proposed Securities and Exchange Commission (SEC) regulations concerning environmental, social and governance (ESG) disclosures.

The regulations about companies having to disclose their ESG policies and records have been proposed but not yet been implemented. The SEC proposals originally had a target deadline of October 2022 for final rules, but that has been pushed back with an expectation that 2023 will see the rules finalized and implementation process started.

If, and as it’s increasingly likely, when they are implemented, they will not only affect businesses which must comply with the disclosure regulations, but everyone in the D&O insurance sector.

The new disclosure rules will require listed companies to disclose risks that are “reasonably likely to have a material impact on their business, results of operations, or financial condition,” and also “disclose information about its direct greenhouse gas (GHG) emissions (Scope 1) and indirect emissions from purchased electricity or other forms of energy (Scope 2),” as well as certain types of GHG emissions “from upstream and downstream activities in its value chain (Scope 3).”

In our view, D&O insurers should be most concerned about the proposed regulations relating to disclosures about not only a company’s own greenhouse gas emissions but also those from upstream and downstream activities, as well as having to disclose how climate-related risks will have a material impact on business and the company’s financials. How are companies in a supply chain supposed to capture relevant data if they don’t already have procedures to do so in place? They will need to figure out an infrastructure and take responsibility for their own disclosures and for accurately sourcing up and downstream information.

Logistical Challenge

The new regulations propose a logistical challenge – and a new one. This will be the first time some companies will be capturing and disclosing information about their ESG policies and others in their supply chain. If their reports are inaccurate, share prices may go up or down and lawsuits may ensue relating to misrepresentations of disclosures. At AmTrust, we regularly deal with claims against companies accused of material misrepresentations or omissions in their disclosures, and the proposed ESG disclosure regulations will present new risks for D&O insurers. There is a great deal of room for error, which will be a source for claims and risk, particularly if companies try to cut corners relating to the disclosure regulations.

The SEC enforcement program will have a significant impact on companies as it includes new disclosure requirements related to SEC Rule 10b5 -1 trading plans, operational as of February 2023. They include cooling off periods delaying the first trades after a plan is adopted or amended; limitations on the number of Rule 10b5-1 plans an insider may have and on single-trade arrangements; and new required disclosures by issuers about Rule 10b5-1 plans, insider trading policies and option grant practices.)

There are concerns in the D&O market that the new ESG disclosures are overly broad, adding additional costs for compliance and exposure to increased SEC investigations and securities claims. As well as climate risk, the new disclosures focus on cybersecurity, and on business combination transactions involving shell companies, such as special purpose acquisition companies (SPACs), and private operating companies. If the proposals are implemented, there would be tougher, more detailed rules for cybersecurity disclosure, including deeper company reports on cyberattacks and regular filings on cyber risk management, governance, and strategy. Companies would need to report breaches within four days.

SPACs would also come under tighter disclosure rules aimed at ensuring the same protections offered to investors in traditional initial public offerings. The new rules would require deeper disclosure about tie-ups between SPACs and private operating companies and tighten requirements on performance projections by SPACs and the companies they target for purchase. SPACs would also need to provide more information about their composition, conflicts of interest and sources of dilution.

Proponents of the new SEC disclosure rules, including investors, advocate that they are both essential in combating climate change and in preventing corporate greenwashing. There is already a backlash against ESG policies in some red states with companies pulling funds from ESG initiatives. If these proposed regulations are implemented, they may eventually end up before the U.S. Supreme Court, where they could face additional hurdles based on the court’s current makeup.

In December 2022, Vanguard Group, the world’s biggest fund manager, announced it was pulling out of an investment industry initiative to tackle climate change. The move followed pressure from Republican politicians over their use of ESG factors in managing and selecting assets and securities. More recently, Munich Re and Zurich Insurance have exited the Net-Zero Insurance Alliance, a sub-unit of the larger Glasgow Financial Alliance for Net Zero, citing exposure to legal risks.

While the proposed regulations may expose companies to the risk of lawsuits, most firms will not want to appear uncaring about climate change by not supporting the disclosure of their ESG policies in the name of transparency. Any pushback against the new disclosure regulations is more likely to come from politicians and climate change lobbyists and interest groups.

Additional Entity Coverage

One way companies should look to protect themselves to ensure they are not caught out by these new disclosure requirements is to purchase additional entity coverage for SEC inquiries, which are not generally covered under standard D&O forms. The company must bear the cost of an SEC fact-finding inquiry. Standard D&O insurance typically only covers an investigation, which is triggered by a subpoena or a Wells Notice – a letter sent out by the securities regulator giving notice of the charges it intends to bring and affording the respondent the opportunity to submit a written statement to the ultimate decision maker.

Developments in securities class action litigation and their impact on the liability environment for publicly traded companies present a severe risk for D&O insurers in a changing risk environment. There is an overlap with the proposed ESG disclosure regulations and securities class actions, as plaintiffs’ firms move beyond cases based solely on financial metrics to cases involving a failure of internal controls, such as ESG policies.

We believe that the ESG regulations reflect the need for the SEC to provide some transparency for investors’ concern for climate-related risks.

Since ESG disclosures are judgmental disclosures, there is more room for error. When we move away from financial metrics, there is less certainty and as a result, we should be prepared for plenty of scrutiny on ESG disclosures as we move forward.