Stock Option Timing Scandal to be Felt in D&O Insurance

If investors think they’re safe from the scandal involving the suspicious timing of executive stock option grants, they may want to consider this: Even if they aren’t invested in companies caught up in that mess, it could still cost them big.

That’s because this controversy could lead to big changes across corporate America in the policies for directors’ and officers’ insurance, which is used to shield top executives and board members from personal losses for the decisions that they make while on the job.

Not only are rates expected to rise, but insurers could also be more restrictive in the coverage they offer or what they pay out in claims. Who will get stuck with the tab for such changes? Shareholders at public companies all around, of course.

D&O insurance, which is renewed annually and is paid for by the company, is already expensive. Companies with market capitalization of more than $10 billion paid an average premium of $4.3 million for D&O insurance in 2005, according to Towers Perrin’s Tillinghast consulting division.

Since the insurance typically reimburses the company or its top officials for expenses such as legal costs or regulatory fines, a plethora of future claims could be on the horizon because of the option-timing controversy.

More than 50 companies — from industry bellwethers like Apple Computer Inc. and Home Depot Inc. to many smaller technology companies — are facing questions about whether they manipulated the timing of options grants to boost their value to the recipients and properly disclosed what resulted in outsized and potentially illegal profits for many executives. Shareholders have already started filing lawsuits, some naming board members or corporate officers for their alleged breach of fiduciary duties.

All this is sure to be spooking the insurance industry, which paid out hundreds of millions of dollars in D&O claims following the business scandals in the early part of the decade that led to the collapse of some big names in corporate America. Insurers paid $35 million alone in D&O insurance to cover claims of the former board members of WorldCom, the former telecommunications company that imploded in an $11 billion accounting fraud in 2002.

D&O rates surged nearly 72 percent from 2001 to 2003, and then started to retreat, falling 10 percent in 2004 and 9 percent last year, according to Tillinghast.

But the decline in rates may be short-lived. Companies that have acknowledged some link to the controversy could find it “difficult to obtain renewal terms at palatable rates and may be forced to accept potentially restrictive terms,” said Kevin M. LaCroix, who advises clients on D&O liability issues at OakBridge Insurance Services in Beachwood, Ohio.

And others, even if they have no connection to the scandal, could face higher rates as the insurance industry tries to cover itself in the face of increased risk. Already, insurers are asking businesses questions about whether they have any exposure to option-grant timing, especially in industries like technology where options have been more prevalent as an employee compensation and retention tool.

Some liken this scandal’s potential effect on the business world to what Hurricane Katrina did to insurance rates for anyone living near a coastline, regardless of location.

“Prices will go up, and coverage will go down,” said R. Mark Keenan, a partner at the law firm Anderson Kill & Olick who specializes in insurance coverage. “The insurance industry is going to use this as an excuse to dramatically increase premiums.”

The policy shift could already be happening, especially at companies with July 1 renewal dates, said Elissa Sirovatka, who heads Tillinghast’s D&O survey, which included 2,645 U.S. and 49 Canadian companies.

That means the aftereffect of this scandal is already being felt even before most companies have determined if they have done anything wrong. While timing the issuance of stock option grants may be wrong if it is done to maximize executive payouts, it isn’t yet known what securities laws could have been violated or what role top corporate officials played in these alleged schemes.

“This issue hits a lot of people the wrong way,” said Robert P. Hartwig, chief economist at the Insurance Information Institute. “But this practice might not be considered strictly illegal.”

Regardless, shareholders will see these costs rising, eating away at profit margins all over corporate America — except, of course, if they are invested in an insurance company.

Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org