Musk is right in flagging insurance costs to protect directors from litigation

Elon Musk was on to something when he complained that the cost of insurance to protect company directors and officers from shareholder litigation has become out of control. The impulsive Tesla boss may be an unlikely spokesperson for the unfairness of these spiralling fees, but they reveal something about this age of corporate misadventure and trigger-happy lawyers. It is bad for shareholders, companies and insurers alike. 

When executives are sued, the payouts can be steep. Take the recent €270m settlement between Volkswagen and its directors’ and officers’ insurers over former executives’ alleged mishandling of Dieselgate. (1)

In the US, Wells Fargo & Co’s D&O insurers agreed to fork out $240m in 2019 over the bank’s fake customer accounts scandal.

Securities law is becoming an enormous catchall. It is no longer just accounting issues that bosses have to worry about. It is cybersecurity breaches, data privacy lapses, environmental calamities and sexual impropriety too. Social media is another potential minefield: Musk and Tesla’s board was sued earlier this year over his tweets.

For years insurers underpriced D&O policies, which cover negligence but not criminal behaviour by executives. They have incurred losses as the frequency and severity of claims has soared. It is no wonder they have been hiking their rates. The average D&O premium paid by US listed companies has risen 56% in the past year, according to broker Aon. UK company D&O rates jumped 130% in 2020 to levels last seen after Enron’s collapse, according to another insurance broker, Marsh. Rates for FTSE-100 companies have almost quadrupled, it said. 

Emerging sectors such as cannabis, cryptocurrency and blank-check companies are having particular difficulties finding adequate coverage because insurers have less visibility on what the potential risks might be.

Several special purpose acquisition company (Spac) mergers involving electric-vehicle companies have already sparked shareholder lawsuits, including at Canoo, Nikola and Lordstown Motors. The US Securities and Exchange Commission has emboldened disgruntled shareholders by raising doubts about whether the very optimistic financial projections Spac executives tout enjoy legal protection.

Insurers are also getting pickier about who they cover and by how much. Sometimes they push back: Chubb is sparring with the former CEO of Wirecard over who should pick up his legal bills after the German fintech’s collapse.

Large companies are generally able to swallow these costs, albeit reluctantly.(2) However, smaller businesses might have no choice but to accept lower coverage limits or a higher deductible, potentially hindering their ability to attract talented directors and stifling the good kind of corporate risk-taking. Some firms may even decide that becoming a public company just is not worth the hassle.

Few boards are willing to go without D&O coverage altogether, something Warren Buffett famously insisted on at Berkshire Hathawa to make directors more wary of “messing up”. Fortunately, some firms have found innovative workarounds to this insurance headache. 

Musk’s surprising response was to offer to insure fellow board members himself before backtracking after proxy advisers objected due to the potential for conflicts of interest. The chair of medical technology company Pulse Biosciences did something similar. 

A better option might be to create a captive insurer, an in-house insurance subsidiary that underwrites the company’s D&O risk. Canadian cannabis company Hexo set aside C$30m to do so in a move it estimates will save up to C$15m in yearly premiums. 

More competition

Rocketing D&O premiums are also the result of the sheer volume and expense of the securities litigation companies are getting hit with nowadays, some of which is meritless. Such complaints remain elevated compared to historic levels even though the number of new US class action cases fell by a fifth last year, partly due to there being fewer contested M&A deals during the pandemic. Wider availability of litigation finance has helped fuel more lawsuits and some top corporate lawyers now charge more than $1,800 per hour. 

There may be some relief in sight as higher premiums lure more competition. But companies hoping for outright price cuts may be disappointed unless policymakers do more to rein in spurious lawsuits. Boards can help too by improving corporate governance.

There will always be tension between shareholders’ important right to seek legal redress and ensuring companies don’t spend all their time in court. Soaring D&O premiums indicate that balance is increasingly out of kilter. Only the lawyers can be content.

(1) In this instance, Volkswagen was the one making a claim on its D&O policy. The payout was in relation to former executives’ crisis response management, not the emissions manipulation.

(2) Costs vary a lot according to the size of the company, what is insured and where it is listed. FTSE-100 companies pay an average of £21,000 per million of cover, compared with £45,000 per million in the US, according to Marsh.

• Chris Bryant is a Bloomberg Opinion columnist covering industrial companies. He previously worked for the Financial Times.

Bloomberg Opinion. More stories like this are available on bloomberg.com/opinion