For many UK commercial insurance buyers, a recent renewal of their company directors’ and officers’ liability (D&O) policy will have been a traumatic experience.
Prices have been driven by market hardening from 2019, following years of inadequate rates for risks being run. Since then, buyers’ horror stories have included triple digit percentage rate rises, doubling of deductibles, lowered limits, the adding of exclusions and tightening terms.
Then news came on 18 March that the UK government had launched a consultation, open until July, on wide-ranging reforms to modernise the country’s corporate governance and audit regime.
“The market is already hard, so it’s hard to see how it could get harder. It’s difficult in certain sectors to get renewal on any terms, so the market is extraordinarily challenged already,” says Francis Kean, a partner in McGill and Partners’ financial lines team.
The government’s changes, “Restoring trust in audit and corporate governance: proposals on reforms”, would make directors, rather than boards, personally responsible for the accuracy of company financial statements through the sign-off of internal controls and risk management.
The proposals also include non-executive directors, traditionally treated more softly than senior management. Instead, they - like their executive colleagues - will be responsible for certifying the material accuracy of financial statements and the effectiveness of internal controls, along US Sarbanes-Oxley regulatory lines.
The rule changes would represent an overhaul of the UK’s audit regime, replacing the current Financial Reporting Council (FRC) with a more powerful Audit Reporting and Governance Authority (ARGA). One the one hand, this might be seen to reduce the likelihood of D&O claims by tightening supervision of auditors, reducing the risk of fraud and instances of corporate failures. However, the picture is more complex than that.
“If this is achieved, pressure on professional indemnity lines will be reduced as fewer claims will made against auditors,” says Clive O’Connell, partner and head of (re)insurance at McCarthy Denning. “At the same time, fewer failures should also reduce the scope for D&O claims.”
However, he adds: “That said, the government is seeking to add to the potential liability of directors which increases the scope for claims to be made against them and increases their need for insurance.”
The broader economic picture also suggests plenty of failures will occur.
“New regulation has increased the exposure and risk for directors, post-Covid, when insolvency is much more likely,” says Sara Ager, CEO of consultancy GreenKite Associates. “This may be good for the market but less good for companies, with a likelihood of more and higher value claims, suggesting that the hard market trend is likely to continue for some time.”
She also notes that the relationship between auditors and company directors is not all one-way traffic.
“Much of the information that auditors rely upon comes from the directors themselves, and so if the details are faulty or incomplete, it is likely to end up with a misleading audit report or set of outcomes,” Ager adds.
Kean expects more proceedings against directors.
“The big coverage question that will apply in investigations to establish liability, is at what point is the D&O policy triggered?” he asks.
“We cannot assume that when ARGA launches an investigation that you’re immediately entitled to coverage. If you get a letter requiring you to attend an interview most D&O policies will cover the cost, but you may want legal advice before that point. And if I’m a fellow director and not yet had a letter, it’s useful to get advice, but perhaps I’m not able to get it.
“If the regulator asks you in for a cosy fireside chat, you might not be covered under the D&O policy. The sensible thing to do is accept the invitation, and be seen to cooperate, rather than wait for a formal summons,” Kean adds.
Sleeping on duty
The unwinding since 2018 of construction and facilities management firm Carillion has been the trigger for recent government action. While the FRC only has jurisdiction over people with an accounting qualification, ARGA’s proposed jurisdiction would extend to a much broader, board-level constituency, including CEOs, chairs, chief financial officers and audit committee chairs at private as well as public FTSE-350 businesses.
New regulatory powers and increased likelihood of investigations will increase the burden on D&O policies already under pressure from litigation and the existing regulatory landscape.
“It is important to note that, unlike a legal claim, if there were a suspected breach of a regulation, the regulator will be permitted to launch an investigation, which is in itself costly, time-consuming and disruptive for the company and its firm,” says Ager.
“This regulatory burden would also sit above any regulatory burden already faced by directors, who work within professions and industries who already have their own regulator, rules and standards,” she adds.
The UK government is proposing that ARGA receive supervisory powers akin to those of the Australian Securities and Investments Commission (ASIC), Kean suggests.
He points to the 2007 civil action ASIC brought against the directors of Centro, a property company, which the regulator won in 2011, and for which Centro’s D&O insurance paid out.
The case alleged that non-executive as well as executive directors failed in their duty in relation to approval of financial statements by not checking the company auditor’s figures.
“The non-execs defended themselves by saying they weren’t experts or accountants and relied on auditors and advisors, as well as the executive directors. The court decided this was not enough, and that all directors had a basic requirement of financial literacy,” says Kean.
When ARGA gets up and running, will it generate a reputation similar to ASIC for generating that kind of claim? Centro’s directors were not accused of dishonesty, after all, but of being asleep on watch.
As Kean notes: “Australia is regarded as one of the most hostile environments for D&O liability in the world after the US, and there are parallels between Australia’s regime and the proposed new UK regime.”
Sustained pressure
For now, shorter-term considerations - not least, the insurance market supply and demand dynamics - will continue to drive D&O pricing for several renewals to come, rather than the next wave of regulation, however transformative it proves to be.
“Capacity in this area is already tight. Issues will arise as companies look to increase cover. These issues could manifest themselves in increased rates or in a refusal to renew,” O’Connell says.
It will be some time before the government’s white paper reaches the statute book to affect D&O coverages, although sources agree it will be a hardening price influence when it drops.
“It’s a question of bandwidth,” says Kean. “I wouldn’t disagree [about its eventual effect on pricing], but I’m not expecting the white paper will have a radical effect on the market any time soon. There are much bigger forces at play in the market now than are going to be swayed by this regulation.”
But the writing is on the wall for companies and directors lacking risk awareness or accounting acumen. “I suspect it is likely to be just another reason why the potential for personal liabilities for directors under the UK regime is higher than it has ever been, justifying premium rises,” Kean concludes.
