Directors' and Officers' Liability insurance (D&O) is central to creating a well-managed organization. Any public company will have a difficult time recruiting a board and staffing the company's management team if the very roof over their heads were the cost if a claim were to occur.

Since 2001, the Directors & Officers Insurance market has experienced radical changes. Those of us old enough to remember use the oil shocks of the late 1970s as a benchmark for market pricing run amok. Prices for this essential commodity increased 150 percent from 1978 to 1980. The D&O market actually beat that record by increasing 150 percent from 2001 to 2002.

The market has retreated from the overheated highs of 2003, and there has been a bumpy downward drift. Looking at prices from the third quarter of 2006, companies, on average, are paying 41 percent more than they did just five years ago.

D&O Liability Insurance Price Trends

At Aon, we make a systematic effort to track pricing trends. We do this by harnessing our proprietary database of insurance policy data. Each year, we add close to 10,000 D&O policies to our database.

Insurance contracts are typically repriced every year. The chart first chart below shows quarterly price changes in renewal pricing Q3 2002 and Q3 2006, and the average price change for all D&O renewals occurring in a quarter. For example, an "average" company having a policy renewal (repricing) in the third quarter of 2006 would have experienced a 5 percent reduction in its premium cost.1 This chart does not directly provide an indication of relative cost of D&O coverage over time.

The price for $1 million of D&O coverage has changed considerably. The second chart below shows how the Quarterly Price Index from Q4 2001 through Q2 2006 has changed. The market peaked in the second quarter of 2003, went through a period of recovery, and finally settled into one-and-a-half years of stability. The last quarter of 2005 must be put into context.

The pause in the downward pricing trend in this period may be the result of general uncertainty about insurance company profitability in the aftermath of Hurricanes Katrina, Wilma and Rita in 2005. This became clearer when insurers reported record profits for 2005. Once concerns about the financial impact were answered, the market returned to its pre-hurricane state. Prices are still high by historical measures. It is too early to tell if the market is returning to the pricing stability of 2005 and 2004 or if a new round of price decreases will occur.

D&O claims certainly have an impact on pricing. Claims are becoming less frequent, but more severe. Revelations of corporate stock-option timing have created concern that we are in for a new round of corporate scandals and high-profile D&O cases.

We believe that some of the hand-wringing is unwarranted. Any ability to backdate options has ended with the implementation of Sarbanes-Oxley,2 and it is likely that any cases of improper backdating have come to light. There is considerable uncertainty about the impact of options' "spring-loading" activity.

Because of the nature of the alleged activities, insurers may employ a range of coverage exclusions. In our opinion, the impact for D&O insurers will be relatively minor, but the uncertainty may create a current drag on future price decreases.

Key Market Players

American International Group (AIG) is the single most influential player in the market at the time of this writing. To appreciate AIG's role, it is important to understand that D&O programs are written on a layered basis. This involves the placement of a primary layer, and one or more excess placements to pay for claims that exceed the policy limits of the primary. Primary insurers establish the contract terms and pricing. Excess participants establish their price using the primary premium as a guide.

In the five years beginning in 2001, AIG underwrote 51 percent of the total volume of primary insurance premium. Its nearest competitor is the Chubb Group of Companies (Chubb), which underwrote 14 percent of the total primary premium over the same period.