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Key insurance considerations in the wake of recent bank failures

Recent banking industry challenges have raised coverage and risk management concerns across the financial system, technology and life sciences sectors, and many areas of the economy.

Recent challenges faced by the banking industry have raised concerns throughout many sectors (i.e. finance, technology, and life sciences) and the collapse of the US-based Silicon Valley Bank (SVB) and Signature Bank have exacerbated negative global market sentiment and alarmed investors and account holders alike.

Although SVB’s collapse was followed by a rush of urgent reviews across the global directors and officers (D&O) and financial institution (FI) insurance markets, we foresee minimal impact in Asia at this point.

The majority of the notifications we have seen in Asia on this issue were provided by;

(i) Private equity, hedge fund, and asset managers that are related to directing client investments into the failed banks’ stock with potential exposure to claims of mismanaging and providing improper investment advice; and

(ii) Companies or organizations that made significant investments in SVB, which may face claims from shareholders for wrongful investment of company assets.

Why did SVB and Signature Bank fail?

SVB’s collapse partly resulted from the US Federal Reserve’s sharp interest rate increases over the last few months. The bank had massive growth in deposits from its client base, largely comprised of startups, venture-backed companies, and organizations that recently completed initial public offerings (IPOs). The bank could not lend all of these customer deposits out to other clients, so it bought billions of dollars of treasuries and other bonds — historically considered to be conservative investments and a common practice by banks. When the US Federal Reserve raised interest rates, the value of these bonds sunk.

At the same time, SVB’s clients, now facing higher borrowing costs, began to withdraw cash faster than anticipated. This caused the bank to sell its treasuries for a large loss — beginning the chain reaction that led to the bank’s failure.

Since March 9, there has been a focus on other banks in United States with comparable exposures, and concerns over the ripple effects on companies in technology, financial technology, life sciences sectors as well as other businesses or startups that rely on regional banks.

Insurance Considerations

While the collapse of a large financial institution such as SVB is uncommon, it is not unprecedented. As such, in the event that a SVB-type occurs with an Asian bank, here are six key insurance considerations for impacted companies which can serve as an important tool to minimize exposures.

Directors and Officers (D&O) insurance

Shareholders have already brought claims against SVB and Signature Bank arising from the recent events. Board members, C-suite executives, and other bank officers at these institutions or at-risk banks should confirm that they have suitable directors and officers (D&O) insurance to fund the defense and possible settlement of shareholder litigation.

Shareholders may accuse bank executives of negligence, or even fraud, for allegedly misleading investors about the risks of the interest rate environment or other factors, leading to a stock drop when the market recognizes those risks. Alternatively, shareholders could bring a derivative action on behalf of a failed bank against the board, accusing it of breaching fiduciary duties. Both types of actions can give rise to significant defense costs and settlements.

In addition to shareholders, government regulators at the US state and federal levels may bring investigations or enforcement actions against banks or individual executives. These investigations can focus on insider trading allegations, alleged fraudulent transfers ahead of a bankruptcy, and purported conflicts of interest, among other matters.

Banks and executives facing claims from shareholders or regulators, should familiarize themselves with their D&O policies, and be prepared to submit claims promptly and properly. In addition to defense and settlement costs, many D&O policies reimburse executives for legal fees associated with interviews, depositions, and other pre-claim inquiries by government regulators. Organizations may also be able to seek reimbursement, depending on policy terms, for shareholder books and records requests and shareholder derivative investigation expenses.

Companies that engage failed or at-risk banks for banking, payroll, credit lines, and other services could experience negative financial impacts. While customers of recently-failed banks have not lost their deposits due to the government's intervention, other harms could materialize.

Customers heavily reliant on additional services could see their own stock prices decline when they no longer have access to an important banking relationship. Shareholders may bring suits alleging that a bank’s customer misled its own investors about exposure to a particular bank or the broader interest rate environment, among other factors, or otherwise breached fiduciary duties.

Finally, where distressed banks or companies file for bankruptcy protection, the proceeds of their insurance policies may be an asset of the bankruptcy estate. This may require special permission from a receiver, trustee, or bankruptcy judge to access policy proceeds. An important feature of D&O coverage that is not expected to be made part of the bankruptcy estate is dedicated Side A coverage. Companies should review their Side A coverage a safeguard against executives’ personal liability.

Professional indemnity risk on banks and other providers

In addition to shareholder claims, failed banks likely will face litigation brought by customers accusing the bank of errors and omissions that caused the bank to fail. The US government has announced that it will backstop customer deposits in the case of SVB and Signature Bank even beyond the FDIC-insured amount. However, it is not clear whether a similar backstop will exist in every circumstance, and failed bank customers could claim other types of harm.

The FDIC, or the Federal Deposit Insurance Corporation, is a US government mandated consumer protection vehicle. In Asia, there are some similar schemes, although these vary from country to country.

Relatedly, government regulators could bring claims and enforcement actions against failed banks on behalf of injured consumers. Banks should look to their bankers’ professional liability insurance policies as a potential source of coverage against these claims.

Lawyers, accountants, consultants, auditors, and other organizations that provided professional services to a bank that later failed could also face exposure. A failed bank, under the FDIC as a receiver, or a bankruptcy trustee could bring claims against professional service providers, claiming that bad financial or legal advice contributed to the bank’s collapse.

Finally, private equity companies, hedge funds, asset managers, and other organizations that may have directed client investments into failed bank stocks could face claims by their customers, accusing them of mismanagement and other errors. Miscellaneous professional indemnity policies may protect these service providers against these claims.

Employment Practices coverage implications

As noted above, clients of SVB and Signature Bank were given prompt access to their deposits, thus largely avoiding payroll lapses and other limitations on their ability to operate. However, companies relying on other distressed banks could face challenges meeting payroll obligations down the road.

An Employment Practices Liability (EPL) policy typically does not protect against late or non-payment of wages or benefits. When distressed companies engage in reductions in workforce, layoffs, or furloughs, coverage under EPL policy could respond. Alleged violations of a salaried employee’s exempt status due to a furlough or failure to comply with laws due to a reduction in force could trigger coverage under such policies.

Employers should also be mindful of any potential breach of contract issues related to employment contracts or severance agreements. An employer may be obligated to continue paying an employee or maintaining their employment under the terms of an agreement. An EPL policy may respond to such claims, in particular its defense costs coverage.

Side A coverage under a D&O policy may also respond to claims against executives for alleged payroll violations.

Financial institution bond coverage could offer a limited backstop

Banks and other financial institutions can purchase a financial institution bond (FI bond), which is an industry-specific crime insurance policy. The FI bond covers loss of money, securities, and other specified financial assets whether owned by the insured or owned by any third party (including customers) but in the insured’s care, custody, or control due to theft, fraud, disappearance, or destruction.

Significantly, the FI bond will terminate immediately upon the insured being taken over by a receiver, liquidator, or other US state or federal official. Because the FI bond only responds to losses discovered prior to its termination, this provision may forestall claims by a receiver for a loss discovered during the course of a liquidation process.

At-risk banks may face heightened exposure to internal and external fraud. Low morale and reductions in staff, especially among those performing control functions, may leave the bank more vulnerable to theft by disgruntled employees. Similarly, outside bad actors may seek to take advantage of this vulnerability via various attack vectors, such as computer fraud, funds transfer fraud, social engineering, or on-premises theft.

Deposit insurance protection

The FDIC insures bank deposits up to US$250,000. Though the US federal government announced that it will make depositors of the two recently failed banks whole, there is no guarantee it will take similar actions with respect to future bank failures. Many countries have similar deposit protections schemes to protect bank depositors from losses caused by a bank's inability to pay its debts when due; however, the extent of cover will vary greatly from country to country.

Trade credit and structured credit solutions may be available

These recent events may prompt banks to revisit their risks and risk management approaches. Below are some considerations for banks:

For those banks active in account receivable financing, trade credit insurance can be an effective means of protecting against defaults. They can enable corporates to accelerate cash flow and liquidity by supporting the sale of accounts receivable to banks.
Non-payment insurance, like trade credit insurance, can be purchased to protect against defaults on banks’ unsecured lending. These loans can be in the form of balance sheet lending to corporates; corporate/project finance loans for sponsors across power, renewables, telecoms, and data centers; as well as bank-to-bank loans.
For bank-to-bank loans, non-payment insurance has traditionally provided coverage against defaults in growth economies, however there may be new interest in covering loans made to other US regional banks.

An unexpected situation like the SVB and Signature Bank failures highlights potential credit risk gaps and the need to address them before a situation deteriorates.

Where should impacted companies focus?

Banks and other companies impacted by recent bank failures or at-risk banks face a range of risks and challenges. Organizations should focus on reviewing their insurance coverages to fully understand their protections for liabilities resulting from such institutions, regulators, customers, or other possible losses.

Working with your insurance and risk advisory professional is the key to gain that understanding, develop strategies to maximize recovery in the event of a claim or a loss, and to consider new risk management approaches.

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