D&O series - Evolving risks in the boardroom: A new era of D&O liability - Part 1

Part 1: Anticipating corporate failure: enhancing D&O risk assessment with Moody's EDF-X Early Warning System

The intersection of bankruptcy and directors and officers (D&O) insurance has long been a critical point of attention for underwriters, marking bankruptcy as an important risk indicator demanding meticulous assessment.

The global financial crisis shed light on this intricate relationship, as highlighted by Oakbridge. In its 2009 article “Corporate Defaults, Bankruptcies, and D&O Claims” the firm notes the potential for a surge in corporate defaults and bankruptcies due to deteriorating economic conditions, which could precipitate a deluge of lawsuits and claims against directors and officers from creditors and shareholders aiming to recoup losses. DLA Piper echoed these risks in the same year, observing that disappointing recoveries in many bankruptcy cases lead creditors to target the "deep pockets" of a bankrupt company's directors and officers. It highlighted that these D&O suits often allege negligence in corporate oversight, aiming primarily at accessing the company’s D&O insurance policy proceeds — frequently one of the debtor's last substantial assets.

In Insurance Business, Travelers Europe gathers evidence to demonstrate how these risks materialized into higher D&O claims:

"Over time it’s become clear that economic downturns lead to higher directors and officers (D&O) claims. A study from Marsh found that the firm received an average of 200-300 D&O claims in the UK from 2005-2007. Once the 2008 global financial crisis set in, claims notifications increased 75% to around 500 in 2008, peaking above 1,600 in 2012. Claims followed a similar path in the US. The insurance data provider Advisen found that D&O claims totaled about 1,000 in 2006 and then doubled at their peak in 2011. If we look back at the years following the global financial crisis, bankruptcy was one of the biggest sources of D&O claims."

In 2016, AIG conducted a review of more than 300 D&O claims from across the United Kingdom and Europe on which it had significant reserve activity from September 2008 to March 2016 — and almost 25% of those claims were bankruptcy related.

More recently, Willis Towers Watson's "Insolvency Risk on the Rise — Global Directors’ and Officers’ Survey 2024" highlights that insolvency-related claims continue to be a significant source of actions against directors across various jurisdictions. The firm notes an uptick in the risk of such claims as insolvencies have surged, with economic hardships increasing the likelihood of fraudulent or wrongful actions, further amplifying risks for directors and officers under insolvency legislation alongside potential disqualification proceedings and compensation orders. The 2024 D&O survey reveals a significant shift in the perceptions of risk associated with insolvency, bankruptcy, and financial distress. Specifically, the proportion of survey respondents who deem these issues as very or extremely important has surged, more than doubling from 28% in 2021 to 59% in 2024. This data underscores a growing concern among respondents regarding these financial risks over this period.

This trend persists into the present, with Willis Towers Watson's "Insurance Marketplace Realities 2025 — Directors and Officers Liability” report from October 2024 revealing a notable 46% increase in Chapter 11 bankruptcy filings over the year ending June 30, 2024. The report underscores the potential for securities litigation related to the adequacy and accuracy of public companies’ risk disclosures, especially regarding how macroeconomic factors impact them. Deficient disclosures can significantly heighten D&O exposures, illustrating the evolving landscape of risk that underwriters must navigate in assessing D&O insurance.

Highlighting the severity of the situation, the Cornerstone Research mid-year report for 2024, “Trends in Large Corporate Bankruptcy and Financial Distress," reveals a startling increase in US bankruptcy filings. In the first half of 2024 alone, filings were nearly 50% higher than the historical semiannual average observed from 2005-2023. This surge in bankruptcies is not just a statistical anomaly but a trend that insurers must carefully consider since it is likely to translate into more D&O claims.

Given this backdrop of escalating financial distress, predictive tools like Moody's EDF-X™ become even more critical in helping mitigate D&O insurance risks. By helping insurers discern and address the complex risks associated with such uncertain economic conditions, EDF-X offers a pathway to more informed underwriting decisions. The rest of this article, using a case study from Spain, examines the effectiveness of Moody's EDF-X Early Warning System (EWS) in providing this foresight, allowing insurers to proactively identify corporate bankruptcy risk well in advance.

Spain is experiencing a notable rise in bankruptcy declarations, contrasting with the relative stability seen in other European Union countries. This trend underscores increasing credit risks, particularly for small- and medium-sized enterprises (SMEs). Moody’s analysis includes 451,550 medium and small Spanish private companies and reveals that 16% of these SMEs were considered high or severe credit risks as of September 1, 2024 [1]. The construction and real estate development, consumer nondurables, and business products and services sectors, which make up 64% of the total companies assessed, account for 67% of the high- and severe-risk flags. Moody's EDF-X has demonstrated remarkable accuracy in identifying potential bankruptcies, with 82% of analyzed companies flagged at least three months prior to their bankruptcy and 57% identified a year in advance.

These insights allow insurers to refine underwriting processes and adjust premiums to better match the risk levels of companies in more vulnerable sectors. This is particularly important for SMEs, where financial stability can fluctuate significantly. The predictive analytics from EDF-X also helps insurers discern risk trends within specific sectors, advising a more cautious approach in riskier industries. The wave of bankruptcies in the Spanish market underscores the importance of predictive analytics in strengthening insurers' capabilities to preempt financial distress.

Utilizing Moody's EDF-X offers exceptional value in helping insurers make informed decisions when underwriting in sectors perceived as severe or high risk. Its predictive insights into potential bankruptcy buildups can significantly alter an insurer's approach. While some insurers might opt to withdraw from writing policies in such a volatile sector, those leveraging EDF-X gain a strategic advantage. By identifying organizations deemed to be at an acceptable level of risk over the forthcoming year, insurers can confidently underwrite policies for these entities. This capability not only positions them to secure profitable business but also allows them to capitalize on opportunities that competitors may overlook due to perceived risks. Thus, EDF-X empowers insurers to discern and pursue viable ventures within sectors that others may hastily abandon.

Ultimately, Moody's EDF-X equips casualty insurers with predictive tools to assess the risk of corporate bankruptcies ahead of the competition. By strategically using EDF-X's Early Warning System, insurers can improve their underwriting precision, reduce potential losses, seek new opportunities, and fortify their defenses against unforeseen financial distress.
 

References and footnotes:

[1] Companies with fewer than 250 employees and less than $55 million in revenue. It excludes companies in the finance and insurance sectors