It’s the insurers, not class actions, driving D&O liability insurance premiums

This article was published by Lawyerly on 29 July 2021.

Brick by brick, the claim that funded class actions are the primary driver of rising directors’ liability insurance premiums is being dismantled. Even more precarious is the claim that the Commonwealth Government’s continuous disclosure reforms are the answer and will result in enormous savings for Australian business. 

For the big business lobby, the rising cost of directors and officers (D&O) liability insurance has been one of the more prominent arguments for stricter regulation of class actions and litigation funding.

The argument goes that an ‘explosion’ in ‘opportunistic’ shareholder class actions against Australian companies is driving some insurance companies out of the market and prompting others, in a less competitive environment, to raise premiums. This, in turn, is said to be causing a significant increase in compliance burdens on companies. Faced with exorbitant premiums and/or substantial excesses, some companies have chosen not to cover their directors and executives. All of this has been enough to make companies risk adverse and would-be directors question their appetite to sit on ASX boards, reducing the already shallow pool of non-executive directors in this country.

Unfortunately, like so many of the arguments put forward by the business lobby and its US backers, this one is based on deliberate misinformation.

Yes, D&O insurance premiums have been rising for a number of years, very steeply on occasion. But the class action environment is just one factor behind this increase. In fact, it is becoming clear that it is more of an excuse proffered by insurers than the primary reason for rising premiums.

Let’s start with the supposed root cause. It is now well established that there has been no ‘explosion’ in shareholder class actions. In fact, the number of shareholder class actions is falling even as D&O premiums have continued to rise. Top tier law firms, Allens and King & Wood Mallesons (KWM), and leading class action academic, Professor Vince Morabito, all published analysis recently that provide empirical evidence of a substantial decline in the number of shareholder class actions. For example, KWM’s analysis^[1] showed a decrease in shareholder class actions filed from approximately 23 in 2017/18 to 7 up to May in 2020/21.^[2] This analysis was broadly in line^[3] with Professor Morabito’s empirical data .

It has also been established that there is no such thing as an ‘opportunistic’ class action. As part of its inquiry into the Treasury Laws Amendment (2021 Measures No.1) Bill – which houses the Government’s proposed continuous disclosure reforms – the Senate Economics References Committee asked Treasury and the Attorney-General’s Department to identify a single example of an ‘opportunistic’ class action. They could not.^[4]

The truth is that class actions are very expensive and very complex to run. They are not launched frivolously; they are launched only after careful consideration and when there is clear evidence of negligence or wrongdoing. In any event, the courts simply do not tolerate being misused by unscrupulous lawyers and vexatious litigants.

Secondly, the rising cost of D&O insurance is a global phenomenon, with premiums also rising at double-digit rates in many countries^[5], including those that do not share Australia’s well-established class action system. There, as here in Australia, the risks faced by company boards, which are reflected in insurance premiums, continue to multiply and go far beyond the threat of legal action by their own shareholders.

As Angelo Aspris from the University of Sydney and Sean Foley from Macquarie University told the Senate Economics References Committee, the “risks currently being borne by shareholders are far more diverse and extreme than at any point in history”. “Consider cybersecurity risk, pandemic risk, climate risk, and more generally environmental, social, and governance risks,” they said in a submission. “Many of these risks were unheard of several years ago, and where risks like [this] used to fall into ethical investments, [they are] now well understood to have important financial implications for all corporate entities.”^[6]

Rising D&O premiums in Australia have, not surprisingly, matched the clear evidence of corporate wrongdoing exposed in recent years, including the findings of the Hayne Royal Commission, AUSTRAC’s action against the banks and the systematic underpayment of vulnerable workers by some of the nation’s biggest companies.

As I have said previously, the simplest way to keep your insurance premiums down – and avoid class actions – is to obey the law.

Thirdly, the link between the volume of shareholder class actions and D&O premiums is weak – and getting weaker.

In its latest D&O Insurance Market Insights report, Aon Australia says “insurers continue to point the finger at securities class action activity as a key driver for premium and capacity re-alignment”. However, this is hard to reconcile with clear evidence that in the same three-year period during which the number of shareholder class actions declined by one third, D&O premiums more than doubled.

In fact, many in the market acknowledge that a large factor in the increase is a correction to years of chronic under-pricing by insurers.

Aon, which puts the current Australian D&O premium pool at more than $800 million, says the “substantial premium re-alignment secured by the D&O insurance market over the past three renewal cycles, and in particular the most recent renewal cycle, has placed the insurance market in a more sustainable position”. While further price pressure is expected this year, and there remains uncertainty about the economic impact of the COVID-19 pandemic, Aon is optimistic the pace of premium increases will start to slow.

Aon calls out recent changes that may further reduce the number of class actions, including temporary, COVID-related continuous disclosure relief and Government reforms that require litigation funders to hold an Australian Financial Services Licence and for funded class actions to be registered under the Managed Investment Scheme regime – reforms Omni Bridgeway supported. “While these developments … largely provide a steppingstone to a more balanced environment for directors and officers, insurers will be cautious in response, seeking clear and sustained evidence over the medium term of a reduction in securities class action activity,” Aon says.

Even if that proves to be the case, and insurers judge there is a reduction in D&O risk, there is no guarantee they will pass on any savings. Marsh & McLennan says it anticipated a stabilisation of class action numbers during 2020 to address premium price increases but that, instead, prices continued to rise^[7].

The Commonwealth Government, however, is optimistic its continuous disclosure reforms – under which companies and their officers would only be liable in civil penalty proceedings for breaches where they acted with ‘knowledge, recklessness or negligence’ – will reduce the number of shareholder class actions and, as a result, drive down compliance and D&O costs.

Treasury puts a figure on the savings in D&O premiums of $912.5 million a year. The Senate Economics References Committee was not convinced, saying in its final report: “Treasury was unable to provide any concrete evidence in support of this estimate … Moreover … the Insurance Council of Australia submitted on behalf of the insurance industry that the measures … 'will quite likely have no discernible effect' on D&O insurance premiums, either in the short to medium or medium to long terms.”

(The Coalition Senators on the Committee released a dissenting report, which did not specifically address the issue of D&O insurance but argued the bill should be passed unamended at the earliest opportunity.)

Despite all the bluster about the impact of shareholder class actions on companies’ D&O premiums and the associated need to water down Australia’s successful continuous disclosure regime, only the insurance industry can explain to boards why prices continue to rise as the risk of shareholder class actions continues to fall.

As Ian Matheson, the chief executive officer of the Australasian Investor Relations Association, told the Committee: “For those companies who have robust disclosure processes, there must be something else that's driving those increases in premiums … members are saying to us that there just doesn't seem to be any rationale for why that is occurring, because they feel that they've done all they can to ensure that, to the greatest extent possible, they've got the policies and processes in place to ensure that all new material information is disclosed to the stock exchange as and when required.”

That’s what exercises boards – and that’s what we really need to know.