Specialty Podcast: Life Sciences Observations on Buyers’ Restructuring Programs and Carriers’ Pumping The Brakes

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

Rich Leavitt (00:08):
Welcome back to the Alliant Specialty Podcast. My name is Rich Leavitt and I'm an Alliant Life Sciences leader. I'm joined today by Steve Shappell, Alliant Claims and Legal, as well as Andrew Sousa from Alliant Management and Liability to discuss our observations from the recently concluded annual RIMS conference, which brought together risk managers and key decision makers from carriers and brokers. Many of the D&O buyers with whom we met are contemplating restructuring their programs with a decided emphasis on maintaining less balance sheet protection via traditional insurance. On the other side of the equation, carrier D&O product leaders were signaling a slowing, if not end of the relatively soft market conditions of the prior 18 months. Our team will explore these two developments and how they might impact decision making at both the buyer and board level. Steve and Andrew, I was more than a bit surprised by the number of buyers giving strong consideration to buying less insurance from the traditional D&O market, especially on the balance sheet protection front. My surprise is driven by the fact that most buyers and boards maintained their limits and program structures throughout the hard market. Steve, let's start with you. Is there a case to be made for limit reduction in a balance sheet focused program restructuring based on loss and claim trends?

Steve Shappell (01:31):
So, no, Rich. I think the positive news is last year we had a drop in the frequency of shareholder class action litigation against this industry, right? This life science industry. And this year, I think the trend continues to be a downward trend. We have 11 of the 92 shareholder class actions filed so far this year in that industry. But what we haven't seen is a basis for reducing limits. I mean the severity remains very, very high. And in fact, the dismissal rate ticked down last year and the year before that. We had dismissal rates in this industry in the 60% five years ago; last year it had ticked down dramatically. So, dismissal rate is ticked down and severity has absolutely unequivocally not ticked down. So, we still have the same severity and the cost of defending this. Just with a straight face, I went to insureds companies this week and got approval for defense counsel at over $2,000 an hour for a rate. So, it's real expensive to litigate - severity and settlements - there's no indication that would support reducing balance sheet protection. If you are looking at the data as a basis to justify reducing your balance sheet protection.

Rich Leavitt (02:47):
So, it's not exactly a gray area for you, then?

Steve Shappell (02:50):
No, this is not a gray area. I love that the frequency’s down, but the severity and the cost does not support reducing insurance.

Rich Leavitt (03:00):
Thanks Steve. Andrew, you talked to buyers and boards on a daily basis. What do you think is driving this discussion? Is it primarily budgetary? Is it buyers just being fed up with the vagaries of the insurance cycle? Is it a belief that they've been overbuying?

Andrew Sousa (03:16):
Yeah, so I'm going to unpack this in two parts because I've seen it really go both ways from a buyer's perspective. If you go back to '19 and '20 when the market was really challenging for new issuers or IPO companies when they were facing million-dollar premiums and sky-high retentions, we actually saw a lot of companies purchase less limit than a traditional company with a similar risk profile would purchase. As we've approached a softening market and companies have started to see significant premium reductions, in many cases they are redeploying some of that capital towards additional limits, towards additional balance sheet protection that may put them more in line with peers or historical loss modeling. And then if you look at the other end of the scope, I think it's factors like just general risk management philosophy. The company really doesn't put that much value in insurance. The company has an extremely strong balance sheet, they may not see value in balance sheet protection through D&O coverage. And there's some other new avenues like captives that we'll discuss a bit later that have been introduced that could kind of change a buying appetite. One thing I will say from a life science perspective, it's important to consider what D&O insurance does from a balance sheet perspective. Many life science companies have limited cash and the cash that they do have is earmarked towards things like clinical trials or research and development. If you're hit with a costly securities claim, it could make hitting your long-term goals really challenging.

Rich Leavitt (04:47):
Thanks, Andrew. And that's a very good point. There's certainly a lot of concern in the life sciences sector right now. The equity markets are not open quite the way they were. So, cash is I think increasingly important to more and more life sciences companies. Picking up on the conversation, one of the examples that we discussed at RIMS was a scenario in which company X has maintained a $200 million D&O program. First hundred is ABC, on top of that is a S100 million side A. Company X is looking at a decision to drop the entity coverage. So, get rid of C and move to just AB. How might this impact decisions on both program structures and overall limits? Can a case be made to reduce overall limits from $200 million to $150 million?

Steve Shappell (05:41):
Let me kick it off, because I've spent a career battling some of the issues that this notion would present. If you eliminate entity cover and you only buy AB and you buy less insurance, what does that mean? I have countless experience of that scenario. I've done this a long time and I can go back to some of the Safeway decisions where there was no "entity cover" and we end up litigating with the insurance companies and fighting with the insurance companies over a proper allocation then. So fair enough that the entity's not covered. But the entity's liability really is that of the directors and officers. And so how do you get a proper allocation? What's that policy language going to look like? Are we going to accept inferior language? Insurance companies have successfully inserted in these policies this relative legal and financial exposure standard, which was rejected by courts 20 years ago.

What standard would we use? So, we would have a lot of friction in those claims. It's just not easy, flip a switch. I'll use it in the most egregious example: cooking the books. If you're cooking the books, that's an act by a CFO, right? That's specific conduct. And we see the liability of the CFO is glaring for cooking the books. Well, how much of that should be, would be, allocated to the entity versus that of the directors and officers. So that's the first challenge is how do you do that, right? It's sounds great. We'll take that exposure. I'd rather see a higher retention if there's going to be skin in the game and see what benefits you get from that as opposed to, you know, probably a high retention, plus you're going to have a legal battle over allocation of the liability of the directors and officers versus that of the entity based on this, I think slightly favored standard to the insurer of relative legal and financial exposure. And then my other comment is that, if you go back from $200 to $150 and then you ultimately cite, you want to add that 50 back because we really do need it, it's hard to do it. You can't add that $50 million coverage back with a simple request. You lose some continuity, and you have issues of warranty and prior acts issues. So that's my take on this is, while I love the opportunity for full employment to fight these allocation issues, it creates a lot of uncertainty.

Andrew Sousa (08:11):
Yeah, and you took the words right out of my mouth, Steve. My major concern with going to a structure like this would be the problems you'd face with allocations. But I guess hypothetically you could make an argument that you could purchase less limits since you're not sharing coverage with the entity. But again, I think there could be issues elsewhere.

Steve Shappell (08:30):
Agreed. And then once the litigation hits, I can tell you our shareholders are correctly going to push really hard for a greater amount of allocation to that of the directors and officers, who made the decisions that hurt the firm. Especially when you have a shareholder derivative suit pending at the same time trying to hold the directors responsible for harming the company. The allocation becomes really challenging and ultimately, based on my experience in my career, we'd be looking for a hundred percent of the allocation to be that of the directors and officers, and covered under the B component of the ensuring agreements.

Rich Leavitt (09:08):
And Steve, just when you thought allocation was gone. Talk a little bit about the premium differential that one might expect from a full-sided program with entity coverage versus just AB.

Steve Shappell (09:21):
I think one of the issues we're going to have is, are insurers going to just say, okay, we'll give you a 15% discount, 20%, because we get a 10 or 50% discount for going from BC to just A. It's not a great discount but it's a discount. So, we'll get another 10%, but I'm not sure insurers are going to be excited to give much of a discount when all they know is, here's a guarantee that Shappell is going to come chase me for a hundred percent allocation. So why would I give a discount when we know the entity's going to be named and we know Shappell's going to say it's all covered under the AB, right? Because that's the proper allocation. A company can't operate separate and distinct from director's officers. So, A, I'm not sure carriers are going to be very excited about doing it and leaving it silent.

And if we go to predetermined allocation, and I'm a pretty big fan of predetermined allocation because I think it has some benefits, I think the savvy underwriter is going to say, you don't get a discount because as Shappell pointed out, you're maintaining entity coverage. We're just agreeing a hundred percent allocated to B. And so, you don't get a discount. And in fact, as you've argued, in some ways you have greater coverage, and there's less ramifications. There's less risk of losing your insurance in a bankruptcy. There's less ability to allocate coverage for a really bad actor to the entity and exclude that. So, the market will struggle with pricing a discount and whether they would even do it.

Rich Leavitt (10:55):
Well, that's when London thrives when they're the only option. All right, one final topic on the buyer's side before we discuss the carrier's perspective. Can we have a brief discussion about the use of captives for D&O? My take is that funding some aspect of balance sheet protection within an existing captive makes sense for many companies. I know that the recent affirmation that non-identifiable side A can legally be included in captives has spurred some discussion about even greater transference of D&O to captives. Steve and Andrew, what are your thoughts on captives for D&O?

Andrew Sousa (11:29):
The only time I've seen it has been in the London market, where the market was just super challenging. There was no capacity, and they just pretty much did it because they could; they were the only option.

Steve Shappell (11:45):
The recent move by states to make it clear that you can insure non indemnified loss in a captive, I think helps on the derivative exposure. And so, I think, check the box that's an improvement. But, to the extent that you're a company with public securities, I think there's sufficient amount of law out there and if every S1 you look at, every public filing, every IPO, including secondary offerings, every time you go to the capital market, and you raise funds, and you file an S1 or its equivalent, there's a statement in that document that the SEC will not let you indemnify for a violation of the 33 Act. So that's the collision there; it's a great solution for some of the derivative exposure. But you know, one of the things we talked a lot about today is the federal shareholder class action exposure, particularly 33 exposure.

It doesn't address that; Delaware can say as much as they want that you can put that in a captive, but the SEC and federal courts are going to look hard at that and say, no, no, no, no, you can't indemnify, and you can't do indirectly what you can't do directly. And so, you can't use the corporate funds that you stick in a captive to indemnify something that under the 33 Act and the SEC says you cannot. So, I think there remains a substantial gap in indemnification on the federal side that needs to be addressed in addition to issues like bankruptcy. That makes me very nervous to have your insurance in a captive, which I know some people will say it's bankrupt remote as a director. I'm not buying that. And I think there would be some serious concern, and I don't want to be the test case for whether a D&O policy in a captive is in fact bankrupt remote.

Rich Leavitt (13:35):
Yeah. And I think for the kind of the small middle market space, it really doesn't make a lot of sense to explore captive. There's cost associated with funding, administrating and maintaining the captive that make it cost prohibitive.

Steve Shappell (13:50):
Yeah. And the other comment I'd make when you look at the Delaware statute, it mandates that that captive have pretty inadequate conduct exclusions in the captive language where you can lose your coverage with certain behaviors. We get far superior language than that, which is required under the Delaware statute to protect directors and officers, who we know will be accused of fraud and self-dealing. That's the nature of the allegations. So, I would also suggest that an A side policy off the shelf has superior protection to a director and officer, than that which will be permitted under a captive.

Rich Leavitt (14:31):
Thank you. It's just that there has been so much discussion around it. I think now that the market's changing; fewer buyers are actively exploring the captive option. But I know for a while during the throes of the hard market that everything was on the table.

Steve Shappell (14:47):
Yeah. The issue will be back Rich, to your point. The market pendulum swings, when it's hard again, we'll have clients exploring this when we see 50%, 60%, 100% increases in premium.

Rich Leavitt (14:58):
Which is a great segue onto the next topic. Let's talk a little bit about the supply siders at RIMS, especially in light of potentially further decreases in demand overall for D&O, whether that's a slowdown in IPOs or just fewer public companies and people perhaps not buying as much. Steve, it seems as if every conversation I had with carriers at RIMS followed the almost exact same playbook: derivative settlements are impacting our results, severity is greater than buyers realize and after a brief holiday, frequency is back with a vengeance. And I know you touched upon this a little bit earlier on, but can you help us sort through this narrative?

Steve Shappell (15:38):
Yeah, I think the fact that the rates are dropping reflects that the insurers, the capital in the marketplace, don't believe their own narrative. While we have derivative claims, and I track it religiously, the number of significant derivative settlements pales in comparison to the shareholder class action litigation and settlements. We get them and we point to them and there's not even a handful of years which are substantial. But again, the market knows how to price these large severity claims because we've been doing it for decades in shareholder class action litigation, and derivatives is a variation of that shareholder litigation. And while it's non-indemnifiable and it allows us to, arguably, access a greater portion of the tower, the frequency of massive derivative settlements is not driving a concerning severity in the marketplace. And frequency and severity - frequency’s down in shareholder litigation and severity is incredibly remained relatively flat with modest increases. So, it's certainly not going down, but it's not skyrocketing.

Rich Leavitt (16:53):
Andrew, as we know, there's often a lag between what the D&O product leaders message in the media and in large meetings like RIMS and what D&O underwriters are messaging to insureds. What are you hearing from underwriters to buyers during one-on-one? How are they preparing buyers for upcoming renewals?

Andrew Sousa (17:13):
Well, I think D&O underwriters are still taking an aggressive approach on most life sciences business. The primary market is still somewhat limited, but there are more players than there were a few years ago and there's a large group of markets competing for excess and side A capacity. I think the market will remain relatively competitive through Q3 and we may start to see some pullback as we move to the later part of '23 and '24 as we come towards the second and third renewals of the soft market cycle. And that's the message that we are getting from the insurance community as well.

Rich Leavitt (17:52):
Good. I'm glad that both of you are continuing to send a strong message to our life sciences clients that things continue to look good on the D&O front. Well thank you both for this edition of life sciences D&O under the microscope. See you next month.