Underwriters are responsible for setting the pricing and conditions of D&O policies. By understanding the factors they take into account while doing so, you can ensure that you’re putting your best foot forward when securing terms.
Despite a trend of increasing litigation over the past few years, underwriting practices have been refined to ensure that D&O programmes remain profitable for insurers. Outlined below are some of the aspects considered in the underwriting process.
Ownership structure
The ownership structure of an organisation provides a broad indication of its D&O risk exposure. Its corporate structure, whether it be a public or private company, or non-profit organisation, provides an underwriter with an insight into the type of stakeholders management are accountable to, and therefore, the nature of claims it may receive.
Of all organisation types, publicly listed companies present the highest degree of risk, as its share price movements are carefully monitored by investors and management are subject to onerous compliance obligations. While private companies and non-profit organisations also face many of the same exposures, they are generally considered lower risk by comparison.
Nature of business and experience
An organisation’s business activities often indicate the temperament of its potential claimants. Underwriters look at organisations from a wide range of professions and through the experience gained by analysing claims data across industry sectors, develop preconceived ideas on where the risks lay.
However, it is not only the type of industry which contributes to an organisation’s risk profile, but also its relative experience in that sector. For example, an organisation that has been operating successfully for many years in a high-risk industry such as mining or financial services, would be considered lower risk than a start-up company in the same sector.
In this spirit, underwriters tend to look favourably on organisations that focus on one core business activity rather than being spread thinly across many different services. Additionally, they may be adverse to insuring companies with overly complex business models, especially where management are light on experience.
Financial condition
Annual reports and other supporting documents provide an underwriter with the information required to make judgements on an organisation’s financial health. The analysis of balance sheets, profit and loss statements, and cash flow statements, can help them to understand how money flows throughout the business.
To make sense of it all, an underwriter will begin comparing ‘apples with apples’, by benchmarking an organisation’s key financial ratios against other firms with similar characteristics. There are many that may be used, however, four of the most common include:
- Current ratio: compares an organisation’s assets and liabilities to measure its ability to pay its debts
- Debt-to-equity ratio: displays the proportion of shareholder equity and debt used to fund an organisation’s assets
- Interest cover ratio: determines how easily an organisation can pay the interest on its outstanding debts
- Profit margin: compares net profit against overall revenue to express an organisation’s operating profitability
By doing this, an underwriter can make an informed decision regarding the likelihood of claims arising from financial impairment, i.e. insolvency and bankruptcy. From an underwriter’s perspective, the ideal D&O applicant is an organisation with a robust balance sheet, operating in an industry with a positive economic outlook.
Quality of management
Underwriters will carefully review the qualifications and experience of key executives to determine the quality of an organisation’s leadership team.
To aid this analysis, many publicly listed companies elect to provide underwriters with detailed professional profiles of all key executives. Private and non-profit organisations, on the other hand, may be exempt from providing this information, especially if they have been operating successfully for many years.
Through this process, underwriters can begin to quickly determine whether management have adequate knowledge and capability to successfully perform their duties.
Important! Underwriters may take a conservative stance when considering executives with high public profiles or history with troubled organisations.
Mergers and acquisitions
Mergers and acquisitions (M&A), the process of buying, selling, dividing, and combining organisations, creates unique risk exposures for directors and officers. M&A activity is considered to be relatively high risk, as there are often many stakeholders involved, each with varying interests. By carefully reviewing the details of a specific transaction, an underwriter can analyse its merits and therefore ascertain the possibility of a claim or circumstance arising in its aftermath.
The size and nature of a merger or acquisition has an influence on the likelihood of claims; generally speaking, the larger the transaction, the larger the drama when things don’t turn out as expected. Additionally, stakeholders’ interests are relevant. Stakeholders in a hostile takeover, for instance, are inherently more adversarial, and therefore, litigation is more likely, than say, a friendly takeover.
When offering coverage for M&A activity, underwriters’ may impose certain conditions such as placing a retroactive exclusion, imposing a sub-limit, charging a higher premium, or even declining coverage altogether.
International risks
The existence of international operations is a very important consideration for underwriters. Generally speaking, an organisation with a portion of its annual revenue generated overseas, poses a greater risk than a similar sized organisation operating 100% domestically.
This is particularly the case when an organisation has established local subsidiaries in foreign locations. The increased risks accompanying international operations is largely due to an organisation’s obligation to comply with the rules and regulations of each jurisdiction separately.
The ongoing maintenance of these operations places a huge administrative burden on directors and officers, and in practice, can to be incredibly onerous and susceptible to error; potentially exposing the leadership team and the organisation itself to claims.
Claims history
Reviewing an organisation’s claims history is an obvious and essential component of the underwriting process. Insurance companies by their nature look to acquire profitable accounts, and as a result, seek organisations with a relatively clean claims history.
By analysing previous claims and circumstances, underwriters will attempt to weed out bad risks before offering coverage. From an underwriting point of view, a history of frequent or severe claims is undesirable and organisations are often declined D&O coverage on this basis.
When evaluating an organisation’s claims history, an underwriter will request a complete summary of each incident, as well as the value (or estimated value) of the losses incurred. This information should be disclosed not only when first acquiring coverage, but also during each policy renewal thereafter.
An organisation’s claims history is generally measured in terms of a ‘claims ratio’, which quickly and easily displays the profitability their D&O account. The claims ratio is calculated by dividing the value of claims paid out to a policyholder by the total premiums received by an insurer.
Conclusion
Underwriters are a key decision maker in the D&O insurance acquisition process. They set the pricing and conditions of coverage and take into a range of factors, not only related to an organisation’s management but also the organisation itself. By understanding their considerations in this process, you can better prepare your application to in order to secure a positive result.
