Specialty Podcast: Cyber Insurance Market Trends and D&O Dynamics

Intro (00:00):
You are listening to the Alliant Specialty Podcast, dedicated to insurance and risk management solutions and trends shaping the market today.

Steve Shappell (00:09):
Good afternoon. Thanks everybody for listening to this month's podcast, following the publication of the claims and legal monthly newsletter, Executive Liability Insights. This month I have David Finz here with me, and we've got a couple of different areas we want to talk about. But we're going to lead off with David talking about cyber spring, David.

David Finz (00:29):
Thanks, Steve. Thanks for having me on. So, Fitch Ratings had recently announced their annual report on the state of the cyber insurance market. They indicated that underwriters are anticipating favorable premium growth and underwriting results through the rest of this year. They also expect that pricing increases will continue to moderate; that's sort of a mealy-mouthed way of saying that the push for rate has begun to run out of steam. And this is thanks to several positive developments in the market rate increases have decelerated. In the fourth quarter of 2022, we saw a 15% increase over the year prior. Now that may sound pretty substantial, but it's a vast improvement over the 34% increase that we had seen in Q4 of 2021 looking back year over year. So, you can see that things are really beginning to calm down. Fitch also estimates that the total direct written premiums for cyber were up by over 50% in 2022, clocking in at $7.2 billion.

Now that's a combination of things, right? Fitch notes that the spike in total premiums was fueled not just by rate increases, but actually by more awareness of the cyber threat on the part of businesses which boosts the demand for coverage. So, it's not just a matter of people paying more for the coverage, it's also a function of more businesses buying cyber insurance. So, this has led to improved loss ratios for the underwriters because now they've gotten more savvy about the criteria to qualify for the coverage to be considered insurable. And along with the increased demand, this has helped them stabilize their books. So, for standalone cyber coverage, the loss ratios, which is what the underwriters look at to determine profitability, dropped from 68% in 2021 to 43% in 2022. Now, to that number, you have to add in their expenses and that is a combination of factors.

It's their own overhead, it's their reinsurance treaties, it's commissioned to the brokers, and you typically are going to want to look at about probably 30% - 35% on top of that figure. So, the magic number is the underwriters really want to keep it below 65%, even ideally 60% to keep this line of business profitable. And seeing that the loss ratio dropped to 43%, even when you add in the expenses is good news. It's quite a turnaround for a risk that some of the pundits were considering to be on the verge of becoming uninsurable. Now why is that? Why are we seeing such an improvement in the loss ratios for the cyber underwriters? The war in Ukraine has certainly played a part in that because what it's done is sidelined some of the bad actors that are basically firing at each other instead of targets in the west.

But there's other reasons too. As I mentioned before, the underwriters are becoming much more scrutinizing in their assessment of risk, and they've expanded the types of controls that they're looking for businesses to evidence in order to qualify for the coverage. And all of this is helping to incentivize businesses to adapt better security, and that only can help on all fronts, right? Not only does it help businesses manage risk better, but it also ensures that this product will be around for years to come because it's written in a way now that is going to be sustainable. So, what that means for our clients is that they need to adjust to these stricter underwriting guidelines. And we've encouraged that because we want to see our clients better manage risk. But at the same time, because of the improved loss ratios, there's going to be a push on the part of brokers like ourselves to resist any further attempt by the underwriters to narrow the scope of coverage.

They've rolled out a lot of exclusions and limitations in the form of sub-limit and co-insurance. So this is the time to revisit some of those and say, listen, we've stepped up, we have educated our clients, we've educated ourselves, we have done what we can to help present a better risk portfolio to you as the underwriters, and we expect our clients to share in that reward given the fact that we are seeing improved loss ratios in the market. So, we want the coverage to be sustainable, but we also want it to remain relevant.

Steve Shappell (04:47):
Yeah, great points, David, right? It is that time and evolution of insurance where the ability to distinguish matters and it should be rewarded. It's a great piece. Thank you so much.

David Finz (04:58):
So, Steve, obviously there's been a lot going on in the world of D&O as well. I'd like to ask you about a recent decision that touches upon the interplay between two issues that I know our claim staff is very laser focused on: rescission and severability.

Steve Shappell (05:13):
Yeah, this is an issue and a fight that I have been engaged in for literally decades, right? There is a time when the leading D&O insurer underwriter policy was silent on the issue of rescission and severability. We've come a long way from there, and this is a big deal, right? Rescission is a concept in insurance, in contract, but particularly insurance that is around and impactful on many lines of insurance. The basic premise is if you make representations to procure insurance and they're material representations and they're false, and the insurer relied upon that, the insurer has this mechanism called rescission ab initio, which would mean the policy would be deemed void from its inception as if it never existed. This is a battle that we'll fight forever. It'll be the constant friction of the quality of information provided to insurers to procure insurance.

What is really interesting, as you noted with regard to D&O, D&O is an interesting scenario because you have a whole bunch of individual insureds who are covered by that policy and have certain knowledge and made certain representations that impact the quality of the underwriting and the insurance. And the challenge in D&O is you also likewise have a lot of exposures to directors and officers that are not indemnifiable. And that's what makes this a big deal; how do we address, how do we protect innocent insureds when the claim comes in and it's based upon misrepresentations, including as serious as fraud. 10B-5 security class actions are premised on fraud and it's "the mental state to commit fraud." And so how do you deal with that? And so, this case that we lead the newsletter with is a good reminder of the importance of talking about this issue.

And there's a whole bunch of different ways to do it. One of the ways insurers in the marketplace a number of years ago said, you know what, we want to be out of the business of rescinding insurance. It doesn't sell well, brokers get very angry, it's harmful to relationships. And what they've done is insert a representation exclusion into the policy in exchange for policy not being rescindable. The challenge with that is you're inserting an exclusion into the policy, which is triggered based on mere allegation, which can be problematic. So, if a complaint alleges false financials, absolute fraud, you arguably lose all your insurance for that claim based on the allegation. So, the critical point being here reminds us that we've got to address the issue of representations we make for procurement insurance, and we have to anticipate and address what happens when a representation is false.

It is material to the risk. How do we protect innocent insureds, and severability and non-imputation and a representation exclusion come into play here? So, one of the key takeaways from this case is have the conversation, right? One size doesn't fit all. Somebody might really prefer to have a policy that's not rescindable and a representation exclusion. My personal philosophy is I love good old-fashioned severability, good old fashioned non-imputation. And if the insurance company wants to rescind the policy as to a certain individual insured, fair enough, go at it. But we can't have that happening. We don't want representation exclusions triggered in a situation like a bankruptcy where an insurer might otherwise be limited in their ability to rescind a policy, which is now an asset of the bankruptcy estate. So, kind of reliving some of my nightmares from the last 20 years where this 10 years ago, this was a big deal.

But the key takeaway here is make sure that you're asking about this, and you have a really good understanding of, do you have representation exclusion in your policy, and as a result, a non-rescindable policy? Or do you have good old-fashioned severability, non-amputation? And how does it interplay? Well with that, David and I want to thank everybody for taking the time to listen to this podcast. And I think both of these topics really reinforce the importance of working with Alliant, a more rewarding way to manage your risk, and would encourage you to reach out to David, me or your Alliant broker with any further questions.