This is part two a five-part D&O series.
Directors and Officers (D&O) risks and related costs are far beyond the costs of D&O insurance premiums and reimbursed legal defense and settlement costs. These costs include internal legal costs, incident/claims response, research and documentation, settlements below insurance deductibles or retentions, settlements outside insurance coverages (exclusions) or policy limits, and internal costs of training, education, and controls. Other costs and impacts to brand value, image and reputation cannot be insured. All can affect the career prospects of officers and directors.
Most companies and organizations do not track these hidden D&O costs, track them very poorly, or only account for them in internal budgets and operations. In most companies we have reviewed, the full spectrum and level of D&O costs are not understood. Yet, these “Hidden Costs” are rising far faster than D&O policy premiums, reimbursements, and external legal bills combined. They are typically many times the tracked costs of D&O insurance and the external legal costs companies do track. While this might not have been a major issue for the D&O environment of even a few years ago, it is a major gap in today’s D&O world and likely to be critical in the immediate future. Companies must enhance their understanding of D&O’s “Hidden Costs” so they can fully address the threats they face and proactively manage their D&O risks and exposures.
Today’s D&O environment is very different and getting worse quickly
Historically, D&O risks were heavily centered around financial reporting, SEC filings and shareholder communications, with some additional risks from Employment Practices Liability. These risks were well understood with clearly defined regulations, standards and practices. Rules were clear. Prudent practices and controls were well defined. Internal and external audits could be used to ensure compliance. Unsurprisingly, D&O risks were rather low, insurance and defense costs were moderate, directors and officers were reasonably well protected, and non-financial threats were low. That was yesterday.
Today’s D&O Environment has more diverse sources of risk. Threats are less clear and rapidly evolving. Many non-financial threats are emerging. Few “safe harbor” conduct standards have been established. Laws, regulations and conduct standards are changing. Statute of limitations on past actions are being extended and some are even being removed. Directors, officers, and companies/organizations are an increasing target for regulators, plaintiff bar lawyers, special interest groups and social activists. It's a whole new world, and a much more threatening one for companies and their insurers. Consider:
· D&O legal filings have increased over 100% in the last 2 years
· New D&O risks are emerging, including:
- Cyber threats
- Mergers and Acquisition objections
- Newer, less defined regulatory requirements and agency initiatives
- Environmental, Sustainability and Governance (ESG) activists
- Boycott threats and company responses
- Social Media activity, both real and fictious
- External party injuries – customers, suppliers, competitors, and communities
· Average settlement costs have risen from $8.5 million to over $13.8 million
· D&O insurance rates have increased 20% to 50% annually with some increasing 100%
· Deductibles and self-insured retentions have increased on average by 200% to 500%
· Coverage limits have declined almost 50%
Yet despite the significant increases in D&O insurance premiums and reductions in coverages, most D&O insurance carriers currently are still not profitable. A number of carriers have exited the market. Further, no new insurance carriers have entered the D&O market in the last 3 years despite this sharply rising insurance revenue environment. Likely because insurance reimbursements are rising even faster and future claims are far from understood.
This rapid hardening and increasingly costly insurance environment is even more troubling since the US has been in a very benign D&O environment for financially driven claims. Company value loss has historically been the leading driver of D&O claims and suits (though that appears to be changing now). Since valuations in most industries have been increasing rather steadily for the last five plus years, the number of value loss driven D&O claims has declined. Yet, overall D&O suits and claims have increased sharpy over the last three years. As companies move into a more financially challenged environment, financially driven D&O litigation appears likely to return to more historic levels. This will further exacerbate D&O threats and risks, and further raise D&O costs. The future D&O world looks likely to be even more risky for companies/organizations, directors and officers.
Why are there “Hidden Costs” of D&O?
The majority of D&O costs are not just in the cost of insurance or even outside legal bills. Many are “hidden” in the operating and legal budgets of the company. And non-reimbursed settlement costs are seldom allocated to risk drivers, particularly those below policy deductibles and retentions. Costs incurred internally to support legal defense efforts, conduct forensic research, investigate incidents, document internal policies, processes, practices and actions, and respond to external data requests are generally not tracked. Most companies have little visibility into these very real growing costs, or the costs incurred from the time and focus lost by officers in supporting defense efforts. With increasing retentions and deductibles in D&O policies, these “Hidden Costs” are growing substantially faster than D&O insurance premiums without an end in sight.
The issues with tracking and understanding the total costs of D&O (and other major risk areas like P&C, Employment Practices, etc.) are analogous to the “Cost of Quality” movement during the 1970’s. Most companies back then did not fully understand their true cost of quality. As a result, they under invested in improving quality and were not addressing the root causes of quality defects and process problems.
Companies today face a similar problem. They do not understand the true costs of D&O incidents and circumstances and underappreciate the size and growth of these costs. As a result, they are not effectively focusing on the root causes of D&O claims and how to minimize both the frequency of incidents and their severity. Virtually all are accepting poor D&O outcomes by default and are not proactively moving to address these significant and growing costs and threats.
As one healthcare CFO recently stated:
“We were very surprised by the significantly higher overall costs we were incurring in defending ourselves and responding to external threats and actions once we began allocating our internal expenses into the major risk areas like D&O, P&C and Employee Practices Liability (EPL). Given the growth in our D&O premiums and recent settlements, we knew it was a lot, but we were stunned at the overall level of costs we were incurring beyond what we were tracking. It has sharpened our focus and urgency on what to do about it.”
Further, just like the very real, but non-apparent, quality problems companies discovered when they began assessing the true cost of quality (like lost brand value, poor product image and low customer satisfaction), few companies today understand the true cost of D&O risks beyond accounting costs. The losses companies, directors and officers incur from D&O events often negatively impact company and individual image, brand value, and reputations. The costs of D&O, as we will see, is far beyond just the accounting systems ability to measure. These non-accounting costs cannot be insured or recovered.
Hidden Costs of D&O - what’s below the “awareness waterline” matters
Companies generally know the direct costs of D&O – insurance premiums, case-by-case defense costs, and settlements. While some do not integrate and track these costs to specific risk areas like D&O, developing a view of these costs by area is a straightforward process. Unfortunately, identifying, tracking and allocating the “Hidden Costs” companies actually incur is much more difficult and seldom done. As a result, executives have only a surface level understanding of their true costs of D&O. Yet these costs are generally most of the cost of D&O risks. This lack of perspective prevents companies from making the best decisions about protecting themselves and their officers and directors, and how to mitigate their risks and costs effectively and proactively. One private company CEO succinctly stated it:
“If you can’t measure it, you can’t manage it. It manages you.”
So, what are the “Hidden Costs” of D&O?
While companies generally recognize and track external legal defense and support costs, internal legal defense costs are often bundled into budget accounts and not allocated against the key drivers of these costs like D&O incidents and circumstances. They are generally thought of as a cost of doing business rather than a large and growing expense that needs to be actively tracked and managed.
The president of a midsized manufacturer put it:
“We knew our internal legal costs were growing fast, but the key drivers were our need to respond to the D&O threats and claims. We were very surprised by how large our D&O internal costs were and how fast they are growing. It looks like they will get far worse before they get better. We need to figure out how to focus and address on the drivers of D&O risks.”
Internal costs of D&O response, research, case documentation and depositions are increasing even faster than internal legal costs.
The EVP of a large service business stated:
“While our legal costs and insurance premiums are increasing a lot, they are small compared to our internal costs to support internal and external responses to D&O claims. I am not really sure we have a full picture of that all these costs are yet.”
Controls and compliance assurance costs are also increasing as financial disclosures, regulatory filings and government regulations grow in volume, complexity, and scope. Yet, gaps and failures in any of these areas can trigger the need for D&O responses. The costs companies expend on controls and compliance to prevent D&O circumstances are seldom segregated from other risk areas (P&C, EPL, etc.) again preventing companies from seeing the true costs of D&O risks.
Settlements below insurance deductibles and retentions or above insurance limits are sometimes allocated into the total cost picture of D&O risk, but not often.
A Chief Legal Counsel said:
“We tend to view legal defense, settlements and support efforts on a case-by-case basis. We have not looked at our costs in total across risk areas. Sounds like we should. We know the costs we see are rising rapidly, but we suspect related costs are rising even faster. We need to get a handle on the overall picture and see what we can do to reduce our overall D&O expense.”
Cost of officer, employee and board training and education is another hidden cost of D&O risk. While these costs likely generate a good return in terms of reducing some incidents, they are a very significant cost and require the involvement of very talented resources to be effective.
A VP of Risk and Internal audit stated:
“We know what we spend in internal and external auditing is very cost effective as well as being critical to the company’s performance, image, reputation and risk minimization. We do not know just how important they are by risk category, how large they are, how they are growing, or if we need to spend more or less. We need better insights on risk drivers and risk costs, and how they are and are likely to change. We need to develop better tools and approaches and that starts with understanding our risk costs, particularly in the D&O area.”
Costs of required policy exclusions are another cost not well understood until it is too late and too costly. And it is never tracked as part of true D&O costs.
A P&C insurance broker shared:
“It is easy to hold down the cost of D&O insurance for a while to retain clients and satisfy an insurance purchaser drive to control costs, particularly if they are not an experienced insurance buyer. You simply increase exclusions to keep premiums steady. But it is often a poor solution that catches up to customers later and drives major costs. But these potential and likely costs are uncertain and in the future. As a result, some buyers are willing to discount these risks to control premium expense growth. I wonder if senior executives and board members see and understand the risk tradeoffs being made and how they expose them to increased risks over time. We would rather discuss tradeoffs and get it right even at the expense of customer churn. But it is a tough call sometimes, and a dramatic impact if companies get it wrong.”
The non-financial impacts to officers’ and directors’ personal brand, public image and reputation threats have become much greater and more severe. They cannot be insured yet can have major impacts on individuals’ careers and willingness of board candidates to serve. Most officers who serve as outside directors on other companies’ boards do not have a full appreciation of the risks they run as outside directors and the impacts these risks could have on their future career prospects should a major D&O circumstance occur.
A recently promoted CEO stated:
“When I was a young CFO, I was very excited and honored with the offer to join my first outside board. While I enjoyed it, I was a bit unaware of the financial and non-financial risks I was running. I never even read or got a detailed understanding the D&O policy protecting me. I just accepted assurances from the head of risk that we had appropriate D&O coverage and that the indemnification letter they provide fully covered me. After I left that board, they had a major class action suit against the directors. Fortunately, the company did extend indemnification to my former colleagues where there were policy gaps. But I wonder had I been involved with that suit and the publicity surrounding it, if I would have succeeded to the top job here”
Companies are experiencing a significant loss of qualified board members over the last few years. While some of this turnover is driven by needing different talent and perspectives on the board, a significant amount of this churn is from board members choosing to leave their board positions. Much of this unwanted churn on boards is driven by board members unwillingness to expose themselves and their families to the increasing D&O risk threats. This churn has real costs beyond the loss of experience and perspectives, it creates significant recruiting costs, education needs, and board efficiency loss. Further, the cost of board and officer recruiting is increasing and candidates’ willingness to serve is also becoming a problem.
A service company board chairman said:
“We recently offered a board position to three candidate none of which were willing to serve. Search firms tell us candidates are becoming increasingly concerned about D&O risks and that closing candidates is getting harder with more refusals. We did finally fill the board seat with a good candidate, but it took far longer, required more discussions, and consumed lots of management and board time. I had a similar experience with another board in the consumer products industry, but it was just not as long a process and only two candidates were unwilling to serve. D&O risk perceptions are becoming an increasing problem in board recruiting”
Keep on keeping on and hoping for the best is not the solution
In a recent survey, over 70% of respondents said they were very concerned about the increasing D&O risks their company’s face. They are also concerned with the current and future impacts on directors and officers. Also, over 90% indicated they were experiencing much higher threats and costs and expected this situation to get worse. Not one respondent believed they fully understood the true cost of D&O risks, or how they are likely to change. The same survey found almost all respondents were unsure of what to do to identify the true costs of D&O, or how best to address and manage the growing threats and risks.
Unsurprisingly, many companies are increasing their internal audit activities, expanding controls and compliance efforts, issuing written internal and public statements, and trying to react to threats as they occur. Few are researching and addressing new and emerging sources of threats. Fewer are developing and deploying new tools, processes and practices to reduce risk frequency and limit severity. Very few are researching and preparing for non-traditional threat areas like enhanced M&A scrutiny, cyber based class action suits, climate change challenges, ESG activist suits, social media risks and external stakeholders claims. These new and emerging sources of risk now make up much of the current and likely future litigation landscape that are driving increased D&O costs and liabilities.
In summary, companies are generally doubling down on the traditional risk management and practices they understand from the past. While not necessarily the wrong thing to do, this alone will not solve the current, new, and emerging D&O risks companies, directors, and officers face. A more targeted, proactive solution is needed. It starts with identifying the true cost of D&O risks, identifying the drivers of risk, focusing on risks that can be controlled and preparing for and responding to risks that cannot be controlled.
Next month’s article will focus on the growth of D&O sources of risk, how they are evolving and what to do about them.