Tag Archives: gaap

Modernizing Insurance Accounting — Finally!

Modernization of insurance accounting is finally here. The FASB issued its final guidance on enhanced disclosures for short duration contracts in May 2015 and published an exposure draft in September 2016 on targeted improvements to the accounting for long-duration contracts.

After literally decades of deliberations, the IASB has completed its most recent exposure draft and plans to issue a final comprehensive accounting standard in the first half of 2017. Moreover, additional changes in the statutory accounting for most life insurance contracts are coming into effect; a company can elect to have Principles Based Reserving (PBR) effective on new business as early as Jan. 1, 2017. Companies have three years to prepare for PBR, with all new business issued in 2020 required to be valued using PBR.

The impact of these regulatory changes is likely to be significant to financial reporting, operations and the business overall. Instead of approaching accounting modernization as a compliance exercise, companies instead should view the changes holistically, with an understanding that there will be impacts to systems, processes, profit profiles, capital, pricing and risk. Planning effectively and building a case for change can create efficiencies and enhanced capabilities that benefit the business more broadly.

Financial reporting modernization will affect the entire organization, not just the finance and actuarial functions. Operations and systems; risk management; product development, marketing and distribution; and even HR will need to change.

FASB’s Targeted Changes

In May 2015, the FASB issued Accounting Standards Update (ASU) 2015-09, Disclosures about Short-Duration Contracts.

Rather than changing the existing recognition and measurement guidance in U.S. GAAP for short-duration contracts, the FASB responded to views from financial statement users by requiring enhanced disclosures for the liability for unpaid claims and claims adjustment expenses. The disclosures include annual disaggregated incurred and paid claims development tables that need not exceed ten years, claims counts and incurred but not reported claim liabilities for each accident year included within the incurred claim development tables, and interim (as well as year-end) roll forwards of claim liabilities.

The enhanced disclosures will be effective for public business entities for annual reporting periods beginning after Dec. 15, 2015 (i.e., 2016 for calendar year end entities) and interim reporting periods thereafter. The new disclosures may require the accumulation and reporting of new and different groupings of claims data by insurers from what is currently captured for U.S. statutory and other reporting purposes. Public companies are currently preparing now by making changes to existing processes and systems and performing dry runs of their processes to produce these disclosures. Non-public business entities will have a one-year deferral to allow additional time for preparation.

See also: Who Is Innovating in Financial Services?  

In September 2016, the FASB issued a proposed ASU on targeted improvements to the accounting for long-duration contracts. Proposed revisions include requiring the updating of cash flow assumptions and use of a high-quality fixed-income discount rate that maximizes the use of market observable inputs in calculating various insurance liabilities, simplifying the deferred acquisition costs amortization model and requiring certain insurance guarantees with capital market risk to be reported at fair value. The FASB also proposed enhanced disclosures, which include disaggregated roll forwards of certain asset and liability balances, additional information about risk management and significant estimates, input, judgments and assumptions used to measure various liabilities and to amortize deferred acquisition costs (“DAC”). No effective date was proposed, and transition approaches were provided with the recognition that full retrospective application may be impracticable.

IASB to issue a new comprehensive standard

The IASB’s journey to a final, comprehensive insurance contracts standard is nearly complete. After reviewing feedback from field testing by selected companies in targeted areas, the IASB completed its deliberations in November 2016.

The IASB staff is proceeding with drafting IFRS 17 (previously referred to as IFRS 4 Phase II) with a proposed effective date of Jan. 1, 2021. Three measurement models are provided for in the standard: 1) Building Block Approach (“BBA”); 2) Premium Allocation Approach (“PAA”); and 3) the Variable Fee Approach (“VFA”).

The default model for all insurance contracts is the BBA and is based on a discounted cash flow model with a risk adjustment and deferral of up-front profits through the Contractual Service Margin (CSM). This is a current value model in which changes in the initial building blocks are treated in different ways in the P&L. Changes in the cash flows and risk adjustment related to future services are recognized by adjusting the CSM, whereas those related to past and current services flow to the P&L. The CSM amortization pattern is based on the passage of time and drives the profit recognition profile. The effect of changes in discount rates can either be recognized in other comprehensive income (OCI) or P&L.

The IASB has also allowed for the use of the PAA for qualifying short-term contracts, or those typically written by property and casualty insurers. This approach is similar to an unearned premium accounting for unexpired risks with certain differences such as deferred acquisition costs offsetting the liability for remaining coverage rather than being reflected as an asset. The claims liability, or liability for incurred claims, is measured using the BBA without a CSM.

Discounting of this liability for incurred claims would be required, except where a practical expedient applies for contracts in which claims are settled in one year or less from the incurred date. Similar to the BBA model, the effect of changes in discount rates can either be recognized in other comprehensive income (“OCI”) or the P&L.

The VFA is intended to be applied to qualifying participating contracts. This model was subject to extensive deliberations, considering the prevalence of such features in business issued by European insurers. This model recognizes a linkage of the insurer’s liability to underlying items where the policyholders are paid a substantial share of the returns, and a substantial proportion of the cash flows vary with underlying items. The VFA is the BBA model but with notable differences in treatment including the changes in the insurer’s share of assets being recognized in the CSM, accretion of interest on CSM at current rates, and P&L movements in liabilities mirroring the treatment on underlying assets with differences in OCI, if such an option is elected.

The income statement will be transformed significantly. Rather than being based on premium due or received, insurance contract revenue will be derived based on expected benefits and expenses, allocation of DAC and release of the CSM and risk adjustment. The insurance contracts standard also requires substantial disclosures, including disaggregated roll forwards of certain insurance contract assets and liability balances.

Forming a holistic strategy and plan to address accounting changes will promote effective compliance, reduce cost and disruption, and increase operational efficiency, as well as help insurers create more timely, relevant, and reliable management information.

Statutory accounting: The move to principles-based reserving

The recently adopted Principles-Based Reserving (“PBR”) is a major shift in the calculation of statutory life insurance policy reserves and will have far-reaching business implications. The former formulaic approach to determining policy reserves is being replaced by an approach that more closely reflects the risks of products. Adoption is permitted as early as 2017 with a three-year transition window. Management must indicate to their regulator if they plan on adopting PBR before 2020.

PBR’s primary objective is to have reserves that properly reflect the financial risks, benefits and guarantees associated with policies and also reflect a company’s own experience for assumptions such as mortality, lapses and expenses. The reserves would also be determined assessing the impact under a variety of future economic scenarios.

PBR reserves can require as many as three different calculations based on the risk profile of the products and supporting assets. Companies will hold the highest of the reserve using a formula-based net premium reserve and two principle-based reserves – a Stochastic Reserve (SR) based on many scenarios and a Deterministic Reserve (DR) based on a single baseline scenario. The assumptions underlying principles-based reserves will be updated for changes in the economic environment, for changes in company experience and for changes in margins to reflect the changing nature of the risks. A provision called the “Exclusion Tests” allows companies the option of not calculating the stochastic or deterministic reserves if the appropriate exclusion test is passed. Reserves under PBR may increase or decrease depending on the risks inherent in the products.

PBR requirements call for explicit governance over the processes for experience studies, model inputs and outputs and model development, changes and validation. In addition, regulators will be looking to perform a more holistic review of the reserves. Therefore, and as we noted in the 2015 edition of this publication, it is critical that:

  • The PBR reserve process is auditable, including the setting of margins and assumptions, performing exclusion tests, sensitivity testing, computation of the reserves and disclosures;
  • Controls and governance are in place and documented, including assumption oversight, model validation and model risk controls; and
  • Experience studies are conducted with appropriate frequency and a structure for sharing results with regulators is developed.

PBR will introduce volatility to life statutory reserving, causing additional volatility in statutory earnings. Planning functions will be stressed to be able to forecast the impact of PBR over their planning horizons because three different reserve calculations will need to be forecast.

There is no “one size fits all” approach to addressing the FASB’s and IASB’s changes. Each company will likely be starting from a different place and may have different goals for a future state.

Implications

A company’s approach to addressing these changes can vary depending on a variety of factors, such as the current maturity level of its IT architecture and structure, potential impact of proposed changes on earnings emergence and regulatory capital and current and planned IT and actuarial modernization initiatives. In other words, there is no “one size fits all” approach to addressing these changes.

Each company likely will be starting from a different place and may have different goals for a future state. A company should invest the time to develop a strategic plan to address these changes with a solid understanding of the relevant factors, including similarities and differences between the changes. In doing so, companies should keep in mind the following potential implications:

Accounting & Financial Reporting

  • Where accounting options or interpretations exist, companies should thoroughly evaluate the implications of such decisions from a financial, operational and business perspective. Modeling can be particularly useful in making informed decisions, identifying pros and cons and facilitating decisions.
  • Financial statement presentation, particularly in IFRS 17, could change significantly. Proper planning and evaluation of requirements, presentation options, granularity of financial statement line items and industry views will be essential in building a new view of an insurer’s financial statements.
  • Financial statement disclosures could increase significantly. Requirements such as disaggregated roll forwards could result in companies reflecting financial statement disclosures, investor supplements and other external communications at lower levels than previously provided.
  • Change is not limited to insurance accounting. Other areas of accounting change include financial instruments, leasing and revenue recognition. For example, the impact of changes in financial instruments accounting will be important in evaluating decisions made for the liability side of the balance sheet.

See also: The Defining Issue for Financial Markets  

Operational

  • Inherent in each of these accounting changes is a company’s ability to produce cash flow models and use data that is well-controlled. Companies should consider performing a current state assessment of their capabilities and leverage, to the extent possible, infrastructure developed to comply with other regulatory changes such as Solvency II and ORSA and identify where enhancements or new technology is needed.
  • Given the increased demands on technology, computing and data resources that will be required, legacy processes and systems will not likely be sufficient to address pending regulatory and reporting changes. However, this creates an opportunity for these accounting changes to possibly be a catalyst for finance and actuarial modernization initiatives that did not historically have sufficient business cases and appetite internally for support.
  • As these accounting changes are generally based on the use of current assumptions, there will be an increased emphasis on the ability to efficiently and effectively evaluate historical experience on products by establishing new or enhancing existing processes. Strong governance over experience studies, inputs, models, outputs and processes will be essential.
  • As complexity increases with the implementation of these accounting changes, the impact on human resources could be significant. Depending on how many bases of accounting a company is required to produce, separate teams with the requisite skill sets may be necessary to produce, analyze and report the results. Even where separate teams are not needed, the close process will place additional demands on existing staff given the complexity of the new requirements and impact to existing processes. Companies may want to consider a re-design of their close process, depending on the extent of the impacts.

Business

  • Product pricing could be affected as companies consider the financial impacts of these accounting changes on profit emergence, capital and other internal pricing metrics. For instance, the disconnect of asset yields from discounting used in liabilities under U.S. GAAP and IFRS could result in a different profit emergence or potentially create scenarios where losses exist at issuance.
  • Companies may make different decisions on asset and liability matching or choose to hedge risk on products differently. Analysis should be performed to understand changes in the measurement approach with respect to discount rates and financial impacts of guarantees such that an appropriate strategy can be developed.
  • The move to accounting models where both policyholder behavior and market-based assumptions are updated more frequently will likely result in greater volatility in earnings. Management reporting, key performance indicators, non- GAAP measures, financial statement presentation and disclosure and investor materials will need to be revisited such that an appropriate management and financial statement user view can be developed.
  • The impact from a human resources perspective should not be underestimated. Performance-based employee compensation plans that are tied to financial metrics will likely need to change. Employees will also need to receive effective training on the new accounting standards, processes and systems that will be put in place.

Forming a holistic strategy and plan to address these changes will promote effective compliance, reduce cost and disruption and increase operational efficiency, as well as help insurers create more timely, relevant and reliable management information. Given the pervasive impact of these changes, it is important that companies put in place an effective governance structure to help them manage change and set guiding principles for projects. For example, this involves the development of steering committees, work streams and a project management office at the corporate and business group level that can effectively communicate information, navigate difficult decisions, resolve issues and ensure progress is on track.

Each company has a unique culture and structure, therefore governance will need to be developed with that in mind to ensure it works for your organization. Companies that do not plan effectively and establish effective governance structures are likely to struggle with subpar operating models, higher capital costs, compliance challenges and overall lack of competitiveness.

Possibilities for Non-Traditional M&A

2015 was a record year for announced insurance deals, as long-anticipated industry consolidation finally started to occur. Several factors have driven consolidation, notably slow economic growth and persistently low interest rates, both of which have limited opportunities for organic growth and forced insurers to reconsider their long-term competitive strategies. Combined with record levels of corporate capital and private equity funding, these pressures have created the perfect opportunity for both buyers and sellers.

Historically, regulatory or financial pressures have driven insurance carve-outs. [An insurance carve-out is a transaction in which a seller divests part of its business (e.g., a particular customer group, product line or geographic area) rather than an acquirer buying the entire enterprise. The seller typically benefits from exiting sub-scale or unprofitable lines, while the acquirer is able to increase scale or geographic reach.] These pressures typically have included repayment of emergency funding received during the financial crisis, fulfillment of regulatory conditions for receiving state aid, divestment to free up capital and improve solvency ratios in preparation for Solvency II, or the shoring up of capital via asset sales following losses.

In recent years, we have seen the industry move away from complex multi-line business models. Insurers are exiting sub-scale business lines to improve returns and compete in an environment in which technology is disrupting tradition business drivers. There are many insurers considering carve-out transactions or IPOs as sellers, and there are even more looking to build market share by acquiring and consolidating businesses with their existing operations.

See also: Insurance M&A Stays Active in 2016  

However, insurance carve-outs tend to be more complex in both transaction structure and post-merger integration than an acquisition of an entire insurance enterprise, and require careful planning and execution to successfully separate the acquired business (“SpinCo”) from its former parent (“RemainCo”).

What should executives be aware of when they consider these types of transactions?

  • Planning and Organization
    • Confidentiality, maintaining optionality and speed of execution are critical to maximizing deal value.
    • The flexibility to execute deals via alternative structures (described below) helps maintain optionality. In addition, a thorough understanding of the M&A landscape is necessary for sellers to run a competitive sales process and for buyers to understand how to properly position themselves for success.
    • To facilitate speed of execution, executives need to simultaneously focus on multiple priorities, including deal execution, separation planning and negotiation of transitional service agreements (TSAs). Leading practices include having a transaction committee that can rapidly make decisions and a project office that guides the planning effort.
  • Transaction Structures
    • Acquisitions of an entire insurance enterprise typically involve the purchase of all of a holding company’s issued stock. The holding company, its subsidiary legal entities, assets and liabilities, products and licenses, people, technology and infrastructure transfer to the control of the acquirer at close. A carve-out requires a different approach. It is rare that the business being sold is fully contained within a single subsidiary legal entity. More frequently, the business being disposed of is written across numerous legal entities and is mingled with business that is core to, and remains with, the vendor. Therefore, carve-outs typically use a mix of strategies to separate the insurance business of SpinCo from RemainCo:
    • Renewal rights – The acquirer receives an option or obligation to renew the acquired business in its own legal entities.
    • Reinsurance – Renewal rights may be accompanied by reinsurance transferring the economics of the historical book either to the acquirer, to other entities owned by the vendor or to a third party.
    • Fronting – Certain domiciles, such as Japan and the U.S., require regulatory authorization of products or rates prior to their availability to policyholders, and such product approval frequently takes longer than regulatory approval for a change of control. When an acquirer doesn’t have regulatory approval to immediately write the business in its own legal entities, the transaction structure typically allows an acquirer to:
      • Continue to issue and renew policies using the vendor’s legal entities for a defined period of time, and
      • Assume the economics of the business via reinsurance. The acquirer frequently is responsible for administering the business (which is still the legal and regulatory responsibility of the vendor’s legal entities) via a servicing agreement.
    • Stock transactions – These are used when assets and liabilities can be segregated into legal entities (e.g. using the European Economic Area’s (EEA) insurance business transfer mechanisms), or when a legal entity, such as a specialist underwriting agency, specifically supports the business being sold.
      • Transfer of assets and contracts/TSAs – Just as the insurance business being sold may be diffused across the vendor’s legal entities, the same may also apply to the people, facilities, technology and contracts with sellers that support the business. While a certain portion of these will clearly align either to SpinCo (and will transfer at close) or RemainCo, there will be a significant subset (particularly in IT and corporate services) that support both and are not easily divisible. For such functions where SpinCo is heavily reliant on the resources of its former parent and it is not possible for the acquirer to fully replace such services prior to the transaction closing, a TSA provides the acquirer and SpinCo with continuing access to and support from RemainCo’s resources after close.

Negotiating the TSA

TSAs provide access to the resources and infrastructure of the former parent for a defined period. While in certain simpler transactions, TSAs can be for as little as three months and require only that the support provided previously be maintained at the same service levels and at the same cost basis, it is more common that acquirer and vendor during the months prior to close:

  • Understand and define the reliance of the business being sold on its parent (and vice versa);
  • Set the duration post-close for each service required under the TSA;
  • Agree on the charging basis e.g. fixed monthly fee, usage, hourly rates (for tax efficiency, each service is usually priced individually);
  • Establish service levels and post-close governance processes.

The acquirer should set realistic timeframes for exiting from individual services. The complexity of insurance policy administration systems, the frequent integration of certain capabilities (such as billing, commissions, and contact centers) across products and the need to separate networks, migrate data centers and implement replacement mainframes frequently require TSAs of 24 to 36 months.

TSAs also may cover centrally provided non-IT services, including HR/payroll/benefits administration, facilities management, procurement, compliance or financial and management and regulatory reporting. However, the duration of these TSAs tend to be shorter – usually a few months, or sufficient to support regulatory and financial reporting for the period following close.

Ideally, the acquirer should seek as much flexibility as possible with the duration of the TSA. It should have the right to terminate the TSA early, the option to extend it at pre-agreed rates and the inclusion of force majeure clauses (a natural catastrophe can significantly affect exiting from a TSA).

Contract assignment and access to shared reinsurance

An area of often-underestimated complexity in carve-outs is the need to ensure that the separated business can continue to receive the benefit of third-party contracts with suppliers, distributors and reinsurers. In most jurisdictions, contracts cannot simply be novated (the insurance business transfer mechanisms of the EEA provide certain exceptions), but instead each contract must be evaluated to determine if assignment simply requires notification to the counterparty or its express consent.

The challenges that arise in contract transfer are both:

  • Logistical – 85% of counterparties contacted typically respond at first instance. However, a recent carve-out had more than 50,000 contracts that needed to be assessed, prioritized and migrated. In this instance, chasing down the remaining 15% was a real challenge.
  • Commercial – Certain experienced counterparties, knowing the tight timeframe for most transactions, may try to renegotiate better terms either prior to the contract being assigned to the acquirer, or prior to permitting the vendor to use the contract to provide services under the TSA.

Also important in a carve-out is a clear apportionment of access to historic reinsurance programs shared between the vendor’s continuing business and the business being sold, as well as definition of the resolution process for any post-close disputes.

Executing close

Transaction close for virtually all insurance carve-outs is triggered by the receipt of one or more regulatory consents enabling the execution of fronting, reinsurance and stock transfer agreements.

When migrating staff and assets supporting SpinCo to the acquirer, supporting staff and assets are moved into a legal entity, the ownership of which transfers at close in certain cases. However, when the relevant staff are not employed or supporting assets are not owned by legal entities transferring to the acquirer at close, there will need to be arrangements for the valuation and transfer of both tangible and intangible assets (e.g. trademarks) and the offering of employment and enrollment in benefits to selected staff by the acquirer. This is a significant logistical exercise for an HR function.

See also: Group Insurance: On the Path to Maturity  

Insurance carve-outs are also particularly challenging for finance functions:

  • The combination of renewal, reinsurance and legal entity acquisition in the transaction structure complicates accounting immediately post-close.
  • Cross-border acquisitions can include acquirers and sellers with different accounting standards (e.g. IFRS, U.S. GAAP, statutory and JGAAP) that often have very different rules on the treatment of assets and liabilities.
  • The practice of closing at a month or quarter end – which in some ways can simplify the transition – may also introduce a tight and immovable timeframe for external financial and regulatory reporting.

Lastly, although there typically will be several months between the deal being agreed upon and the close, this may not be sufficient time – particularly in larger acquisitions across multiple locations – to roll out the acquirer’s networks and desktop technology prior to close. Therefore, full access to the acquirer’s IT capabilities may need to wait until later in the integration.

Post carve-out integration

While an acquisition of an entire enterprise provides a pre-existing governance structure, an insurance carve-out typically includes fewer members of senior management and requires rapid integration of functional management within the acquirer’s existing structure, the expansion of governance and compliance structures to include the acquired operations and the establishment and communication of delegations of authority and decision-making rights.

Due diligence should have provided the acquirer with initial hypotheses as to the organizational capabilities required by the combined organization, interim and end-state operating models, and opportunities for synergies.

As with any insurance acquisition, synergies in carve outs are typically realized through:

  • Functional consolidation.
  • Platform consolidation and process standardization, which enhances productivity and enables staffing efficiencies.
  • Facilities and infrastructure reduction, and
  • Reduced costs through more efficient third-party vendor selection.

PwC’s research indicates that the most successful acquisitions are those that develop momentum by demonstrating tangible integration benefits in the first 100 days. Accordingly, the acquirer should act fast but should also be prepared to revisit pre-deal assumptions and revise its integration roadmap as the two organizations integrate and new information becomes available.

Conclusion

Based on what we see in the market, notably a recent succession of P&C and reinsurance megadeals, we predict that insurance industry consolidation will continue apace. Multi-line insurers have divested themselves of numerous franchises and this trend seems likely to continue. Because these types of transactions are complex and depend on many internal and external factors, companies that are considering such moves will need to be aware of and address the many challenges and issues we describe above.

This article was written by John Marra, Mark Shepherd, Michael Mariani, and Tucker Matheson.

Tips for Avoiding Securities Litigation

Here are tips on how public companies can better protect themselves against securities claims — practical steps companies can take to help them avoid suits, mitigate the risk if they are sued and defend themselves more effectively and efficiently.

Avoiding suits

Companies can avoid many suits with what I’ll call “better-feeling” disclosures. Nearly all public companies devote significant resources to accounting that conforms with GAAP, and non-accounting disclosures that comply with the labyrinth of disclosure rules. Despite tremendous efforts in these areas, events sometimes surprise officers and directors — and the market — and make a company’s previous accounting or non-accounting disclosures appear to have been inaccurate. But plaintiffs’ lawyers decide to sue only a subset of such companies — a smaller percentage than most people would assume. What makes them sue Company A, but not Company B, when both have suffered a stock price drop because of a development that relates to their earlier disclosures?  There are a number of factors, but I believe the driver is whether a company’s disclosures “feel” fair and honest. Without the benefit of discovery, plaintiffs’ lawyers have to draw inferences about whether litigation will reveal fraud or a sufficient degree of recklessness — or show that the discrepancies between the earlier disclosures and later revelations was due to mistake or an unanticipated development.

What can companies do to make their disclosures “feel “more honest? An easy way is to improve the quality of their Safe Harbor warnings. Although the Reform Act’s Safe Harbor was designed to protect companies from lawsuits over forward-looking statements, there are still an awful lot of such actions filed. The best way to avoid them is by crafting risk warnings that are current and candid. A plaintiffs’ lawyer who reads two years’ worth of risk factors can tell whether the risk factors are boilerplate or an honest attempt to describe the company’s risks. The latter deters suits. The former invites them.Another way for companies to improve their disclosures is through more precision and a greater feel of candor in the comments they make during investor conference calls. Companies sweat over every detail in their written disclosures but then send their CEO and CFO out to field questions on the very same subjects and improvise their responses. What executives say, and how they say it, often determines whether plaintiffs’ lawyers sue — and, if they do, how difficult the case will be to defend. A majority of the most difficult statements to defend in a securities class action are from investor calls, and plaintiffs’ lawyers listen to these calls and form impressions about officers’ fairness and honesty.

Companies looking to minimize the risks of litigation should also take steps to prevent their officers and directors from making suspicious-looking stock sales — for obvious reasons, plaintiffs’ lawyers like to file suits that include stock sales. If a company’s officers and directors don’t have 10b5-1 plans, companies should establish and follow an insider trading policy and, when in doubt, seek guidance from outside counsel on issues such as trading windows and the propriety of individual stock sales, both as to the legal ability to sell, and how the sales will appear to plaintiffs’ lawyers. Even if officers and directors have 10b5-1 plans, companies aren’t immune to scrutiny of their stock sales — plaintiffs’ lawyers usually aren’t deterred by 10b5-1 plans, contrary to conventional wisdom. So companies should consult with their counsel about establishing and maintaining the plans, to avoid traps for the unwary.

Defending suits

Whether a securities class action is a difficult experience or a fairly routine corporate legal matter usually turns on the company’s decisions about directors’ and officers’ indemnification and insurance, choice of defense counsel and management of the defense of the litigation.

Deciding on the right director and officer protections and defense counsel require an understanding of the seriousness of securities class actions. Although they are a public company’s primary D&O litigation exposure, most companies don’t understand the degree of risk they pose. Some companies seem to take securities class actions too seriously, while others might not take them seriously enough.

The right level of concern is almost always in the middle. A securities class action is a significant lawsuit. It alleges large theoretical damages and wrongdoing by senior management and often the board. But the risk presented by a securities action is usually very manageable, if the company hires experienced, non-conflicted and efficient counsel and devotes sufficient time and energy to the litigation. Cases can be settled for a predictable amount, and it is exceedingly rare for directors and officers to write a personal check to defend or settle the case. On the other hand, it can be a costly mistake for a company to take a securities class action too lightly; even meritless cases can go wrong.

The right approach involves several practical steps that are within every company’s control.

Companies should hire the right D&O insurance broker and treat the broker as a trusted adviser.

There is a talented and highly specialized community of D&O insurance brokers. Companies should evaluate which is the right broker for them — they should conduct an interview process to decide on the right broker and seek guidance from knowledgeable sources, including securities litigation defense counsel. Companies should heavily utilize the broker in deciding on the right structure for their D&O insurance program and in selecting the right insurers. And, because D&O insurance is ultimately about protecting officers and directors, companies should have the broker speak directly to the board about the D&O insurance program.

Boards should learn more about their D&O insurers.

Boards should know their D&O insurers’ financial strength and other objective characteristics. But boards should also consider speaking with the primary insurer’s underwriting executives from time to time, especially if the relationship with the carrier is, or may be, long-term. The quality of any insurance turns on the insurer’s response to a claim. D&O insurance is a relationship business. Insurers want to cover D&O claims, and it is important to them to have a good reputation for doing so. The more the insurer knows the company, the more comfortable the insurer will be about covering even a difficult claim. And the more a board knows the insurer, the more comfortable the board will be that the insurer will cover even a difficult claim.

Boards should oversee the defense-counsel selection process, and make sure the company conducts an interview process and chooses counsel based on value.

The most important step for a company to take in defending a securities class action is to conduct an audition process through which the company selects conflict-free defense counsel who can provide a quality defense — at a cost that leaves the company enough room to defend and resolve the litigation within policy limits. Put differently, the biggest threats to an effective defense of a securities class action are the use of either a conflicted defense counsel, defense counsel who will charge an irrational fee for the litigation or counsel who will cut corners to make the economics appear reasonable.

Errors in counsel-selection most often occur when a company fails to conduct an interview process, or fails to consult with its D&O insurers and brokers, who are “repeat players” in D&O litigation and thus have good insights on the best counsel for a particular case. Although the Reform Act’s 90-day lead plaintiff selection process gives companies plenty of time to evaluate, interview, and select the right defense counsel for the case, many companies quickly hire their corporate counsel’s litigation colleagues, without consulting with brokers and insurers or interviewing other firms.

The right counsel may end up being the company’s normal corporate firm, but a quick hiring decision rarely makes sense under a cost-benefit analysis. The cost of hiring the wrong firm can substantial — the harm includes millions of dollars of unnecessary fees; hundreds of hours of wasted time by the board, officers and employees; an outcome that is unnecessarily uncertain; and an unnecessarily high settlement — and there’s very little or no upside to the company.

On the other hand, it costs very little to interview several firms for an hour or two each, and the benefit can be substantial – free and specialized strategic advice by several of the handful of lawyers who defend securities litigation full time, and potentially substantial price and other concessions from the firm that is ultimately chosen.  The auditioning lawyers can also provide guidance to the company on whether its corporate counsel faces conflicts and, if so, the potential harm to the company and the officers and directors from hiring corporate counsel anyway.