Insurance companies try to detect and reduce risk. Health insurers encourage preventative care, fire insurers insist on functioning sprinklers, police insurers investigate alleged misconduct and drop departments that tolerate excessive force, and Hollywood insurers flag risky scenes as requiring stunt doubles. These efforts make sense – it is the insurer’s money on the line if the client makes a claim – and they tend to benefit society.

Unfortunately, something is different about D&O insurance, which protects directors and officers from suits by shareholders alleging self-dealing or mismanagement. As Professors Tom Baker and Sean Griffith concluded from extensive interviews, “D&O insurers do almost nothing to monitor the public corporations they insure, and D&O insurers do not condition the sale of insurance on compliance with loss prevention requirements in any systematic way.”[1] Without active loss prevention, D&O insurance contributes to moral hazard. Executives know they face little risk of loss from bad management, because they can usually rely on the insurer’s money to settle any claims involving it. While some scholars have hoped that D&O insurers could act as gatekeepers, D&O insurance may actually weaken corporate governance.

Why has D&O insurance developed this way? And can anything be done to fix it? In a new article, 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.

Mandatory rotation is far less extreme than banning D&O insurance altogether. It rewards insurers that improve corporate governance just as health, fire, police, and casting insurers profit when they can encourage clients to act more prudently. It is also a solution that has been used elsewhere. America reduces capture of audit partners, politicians, and diplomats by limiting how long they can serve in a particular engagement, office, or country.

D&O insurance has always been controversial. By design, it insulates executives from liability for self-dealing and careless oversight, essentially deadening the power of litigation to discourage bad management at America’s largest businesses. It also attracts meritless lawsuits: Plaintiffs and their lawyers know that even weak cases may earn a settlement, since defendant executives get to spend insurers’ money to avoid stressful litigation. Part of the problem is excessive loyalty between insurers and their clients. But being a successful gatekeeper means that you protect the corporation rather than just its managers. That message is best sent by a periodic changing of the guard.

ENDNOTES

[1] Tom Baker & Sean Griffith, The Missing Monitor In Corporate Governance: The Directors’ & Officers’ Liability Insurer, 95 Geo. L.J. 1808 (2007).

[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%).

This post comes to us from Professor Andrew Verstein at UCLA School of Law. It is based on his recent article, “Changing Guards: Improving Corporate Governance with D&O Insurer Rotations,” available here.