Magazine article Risk Management

For All the Wrong Reasons, D&O Claims Should Diminish

Magazine article Risk Management

For All the Wrong Reasons, D&O Claims Should Diminish

Article excerpt

Every risk manager whose company carries a significant amount of insurance is concerned that one of its insurers could become insolvent and unable to pay claims. An insurance failure may seriously endanger an insured company's ability to defend or settle claims brought against it. Even with assistance from other sources such as guaranty funds, the risk manager will typically be confronted with a shortfall between the insurance purchased and the claim the insured pays out.

In an effort to reduce the short-fall, state regulators, rehabilitators or liquidators and insured policyholders frequently accuse the failed insurer's officers and directors of mismanagement. But fewer of these accusations and attendant lawsuits will likely be brought in the future. This anticipated decline is both good news and bad news for the risk manager. The bad news is that the bringing of such claims may now cause the loss of what is usually the largest asset in the estate of a failed insurer: its reinsurance. The good news is that a decline in directors, and officers, (D&O) suits will reduce litigation on which risk managers must expend significant time and resources.

Risk managers may want to believe that a decline in D&O suits would be due to the fact that directors and officers are performing their duties in an irreproachable fashion, which in turn should decrease the likelihood of insolvency. But recent developments in the law that signal a decrease in such suits have more to do with the potential adverse effect of D&O litigation on the insolvency process, than with the exemplary behavior of directors and officers.

In any insurance insolvency, the state regulator is responsible for guiding the insolvent insurer through its conservatorship to liquidation or rehabilitation. Therefore, he or she must marshal the assets of the insurer. These assets frequently include claims against the directors and officers, which trigger a source of recovery through the D&O liability insurance policy. Recent case law, however, indicates that such suits may very likely eliminate the regulator's ability to collect the failed insurer's reinsurance, which is its largest asset.

Some Troublesome Signs

The first sign of trouble came in 1989, when the liquidator of the insurer Union Indemnity brought suit against Union Indemnity's directors and officers, maintaining fraud or, at a minimum, had been negligent in the performance of their duties. In a separate action, the liquidator also sued the company's reinsurers for nonpayment of their reinsurance obligations; in that case, as in many others, the refusal by reinsurers to pay their obligations was a tactic used to force a favorable commutation in return for a quick but discounted cash payment. Indeed, because the reinsurers will not have a continuing commercial relationship with the now-defunct cedent, under such circumstances business-oriented resolution is most unlikely.

In this instance, the reinsurers struck gold. They were successful in claiming that the fraud by the company's officers and directors nullified their reinsurance obligations. The trial court held that the allegations of fraud by the liquidator against the officers and directors of Union Indemnity essentially admitted that such fraud had occurred, and therefore was sufficient on its own to permit reinsurers to escape their coverage responsibilities. The appellate court affirmed, but required the reinsurers to return the premiums they had accepted from Union Indemnity. As a result of this devastating and unexpected ruling, there was less money available to the Union Indemnity estate and, indirectly, to its policyholders, who would have otherwise benefitted from the reinsurance coverage.

A decision by a trial court in California held to the contrary. In Garamendi vs. Abeille-Paix Reassurances, et al., the Mission Insurance Company's reinsurers alleged that the company's directors and officers had committed fraud. …

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