D&O must navigate a ‘new normal of turbulence’

Insurers expect a rise in management liability claims and the advent of new risk as more businesses incorporate AI, says Sandra Soares, managing director and head of Bermuda Professional Liability at Markel.

“A down economy presents serious challenges, not only to businesses and organisations, but also to directors and officers (D&O) insurers who expect an increase in management liability claims.” This is the view of Sandra Soares, managing director and head of Bermuda Professional Liability at Markel, as she discusses challenges and opportunities in today’s D&O insurance market.

“A more fragile economic environment and persistently high inflation add significant risks to the D&O market, particularly if we see more bank failures, businesses insolvencies or a sharp equity market downturn,” she says.

“Insurers are operating in a very interesting economic environment,” she says, adding that it is an environment “with a lot of mixed signals.”

For example, gross domestic product in the US is strong and the country has record low unemployment, although that is starting to rise. There is high inflation, which Soares says has hurt consumers, but spending is still strong. Interest rates have risen rapidly, and no one knows when they’re going to start coming down; also, it’s unclear whether the US will go into recession next year or avoid it.

“The shocks that have shaken the global economy in recent years have introduced a ‘new normal’ of turbulence, which is driven in some cases by political fragmentation between countries.

“The global economic outlook remains uncertain amid these continued effects and multiple shocks, such as the COVID-19 pandemic, the continuing invasion of Ukraine by Russia, the surge in inflation, increased volatility in the stock market, and significant tightening of monetary policy.”

Soares says that rising interest rates in a post-pandemic economy have “not been seen before.”

As interest rates increased to combat inflation, the cost of financing and the risk of financial insolvency also rose, which has led to several high-profile bankruptcies.

Such uncertainty and its downward pressure on economic growth affect the ability of businesses to invest in the future and to plan accordingly.

In the D&O market, insureds are facing an unprecedented confluence of factors that may lead to an increase in claim frequency and severity counts over the next few years, says Soares.

Increasing potential for litigation

Regulatory and compliance scrutiny is growing, and with that so is the potential for further litigation, Soares says. This is particularly pertinent for climate risks, employment practices and cyber risks,

The costs of managing a regulatory investigation, defending a class action lawsuit or even remediating a cyber attack are increasing. Cyber incidents alone could lead to investigations and more lawsuits.

Soares says lawsuits have already been filed against companies that have suffered a data breach, and this kind of activity is becoming more common.

“Companies are facing litigation from regulatory bodies, their customers and clients, and even their business partners. It’s important to utilise all the tools—which includes insurance—in the company’s risk mitigation toolkit to address this exposure.”

Social inflation is another factor contributing to the rise in claims costs and management liability cases.

“We see social inflation as particularly disruptive for liability insurance because it’s difficult to measure and predict, and it can disproportionately affect the longest-tail lines,” she explains.

“Specifically with long-tail lines, any changes in trends can have a leverage impact, impacting new business as well as prior year loss reserves.

“The degree of claim severity due to mostly the social inflation factors is, quite frankly, unsustainable.”

Based on current trends, the impact of social inflation outweighs the benefits of higher interest rates on long-tail investment income, Soares states, as she urges liability insurers to keep their focus on underwriting discipline.

Rapid growth of AI

Artificial intelligence (AI) continues to be a big talking point across the world, and Soares acknowledges that it’s a very exciting time as businesses talk about incorporating it into their operations.

But of course such developments come with risk. She says that the industry must understand that AI integration can pose challenges for directors and officers and their liabilities.

For example, a company’s directors and officers must ensure that the company’s use of AI complies with all relevant laws and regulations across all of its locations. The use of AI may raise legal and regulatory issues such as data privacy and discrimination.

“From a risk management approach, it’s important to understand that AI systems may present some new risks, such as cybersecurity threats and the risk of algorithmic errors.

“If a company fails to implement and control adequate security measures, a hacking attack could occur causing financial loss and damage to the company’s reputation, which could result in lawsuits, or investigations, targeting the directors and officers.”

The ethics around the use of AI are another crucial area to think about, raising questions around fairness, transparency, and accountability.

Soares says that directors and officers must ensure that the company’s use of AI aligns with their ethical standards and the company’s values. And from a balance sheet perspective, there’s financial responsibility too.

“The cost of acquiring and maintaining AI systems can be substantial, especially in the early phases. Management teams must ensure that the company’s investment in AI is sound and that it’s aligned with their financial goals,” she says.

All these risks underscore the importance of careful planning and effective risk management for AI technology companies as well as businesses that have adopted AI. Soares advises business leaders to seek customised coverage to avoid potential legal and financial consequences.

Key role for carriers

Soares is clear that insurers have a central role to play in helping customers in the D&O market cope with today’s growing challenges.

It’s very important for carriers to understand their insureds’ businesses, identify specific risks, and ask questions about what the company is doing to manage them, she says.

This includes understanding insureds’ risk management methods, their approach to enterprise risk controls, and a company’s overall corporate risk culture.

“Key questions are: How do they identify risks? How do they analyse them? How are they prioritised? Does the company decide on the solution? And how frequently are they monitored?” she says.

“You can overlay that on different things, like when new technology comes out, because generally their approach in the past will be their approach in the future. If they have a good risk process, they usually will apply that going forward.

“It’s also important to take a deeper dive into the company’s performance, including its financial position. So ask: What is the business? Can it withstand a changing financial environment? They may be doing well now, but what levers, if pulled, would pivot that or change their business substantially?”

A comprehensive understanding of how the management is structured is key, and what the claim activity is for that specific insured and the overall industry, she adds.

“Strong financials, an experienced management team and a robust, diverse board are key to D&O risk management,” she says.

For their part, insureds should look for a number of attributes that show a carrier will be a reliable long-term partner, Soares argues. In a long-tailed business like D&O, these attributes include strong ratings and underwriting discipline, along with a world-class claims team that handles difficult claims in a challenging environment with social inflation. It’s also important that carriers demonstrate a clear understanding of the insured’s business and a history of working with clients to provide relevant solutions for what they are facing.

Soares is an advocate for companies having a strong relationship with their insurer. For Markel, regular in-person meetings support this, while also providing underwriters with a tremendous amount of direct insight into the insured.

“Not only do you hear the story first-hand, but you get a deep understanding of the culture at the company. And that’s vital in the underwriting process,” she concludes.

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