My friend and UCLA colleague Andrew Verstein has had a busy summer. Over at CLS, he has posted a summary of his new article “Changing Guards: Improving Corporate Governance with D&O Insurer Rotations,” available here.
I explain that a pernicious mixture of agency costs and relational contracting is largely responsible. When corporations buy D&O insurance, it is the directors and officers who decide what to buy. These managers prefer policies without extensive loss-mitigating interventions that would constrain their freedom and expose them to criticism. Insurers would hesitate to offer such risky policies, but managers implicitly promise to cover any extra losses with lucrative future business. Renewal rates approach 100 percent.[2] These renewals occur despite increasing premiums. Global D&O premiums may be around $15 billion,[3] with U.S. premiums expected to perhaps double in the upcoming year.[4]Dependable renewals at higher rates allow insurers to recoup any losses and thus make them comfortable tolerating, rather than preventing, losses today; shareholders and society bear the cost of ever rising governance risk.
A solution is implicit in the diagnosis: Force corporations to rotate D&O insurers every few years. Mandatory rotation would impose a final round on an otherwise indefinite insurance relationship. Theory predicts that it would stir both participants to action. If insurers know that they are going to lose a client soon, they will realize that there is no chance to recoup losses in the future and will seek to control their risks now. If executives know that insurers are going to demand and enforce risk-mitigation, they will know there is no benefit to paying extra for insurance from passive insurers and will seek to control their costs now. Both sides will seek benefits over a shorter period. That will help control governance risks that could harm shareholders and other stakeholders.
Do read the whole thing.
[2] See, e.g. Aon, Quarterly D&O Pricing Index – Fourth Quarter and Full Year 2018, 9 (2018), https://www.aon.com/getmedia/20bfac85-dce6-4902-91cb-c61265abcd7e/2018-Q4-DO-Pricing-Index.aspx (95.7 percent annual retention).
[3] https://www.insurancethoughtleadership.com/5-do-mega-trends-for-2020/.
[4] https://www.wsj.com/articles/companies-are-paying-a-lot-more-to-insure-their-directors-and-officers-11592731801 (Reporting that the cost of D&O insurance has gone up between 44% and 104%).
