Do’s and don’ts of D&O Featured

7:00pm EDT December 26, 2009

Whether you are a non-profit corporation or a large cap publicly traded company, every decision an executive makes can lead to a lawsuit. Executives face higher scrutiny from shareholders, institutional investors, the Securities and Exchange Commission, other regulatory bodies, employees and any other stakeholder with interest in the organization.

This litigious environment has resulted in companies purchasing directors and officers (D&O) liability insurance, which, simply stated, protects executives against claims of mismanagement.

“A lawsuit against directors and officers most commonly occurs when shareholders feel they suffered a loss in the value of their shares because of actions that the board or senior management took or didn’t take,” says Anna Adams, managing director, Financial Services Group, Aon Risk Services, Inc.

Organizations need to review all areas of potential business risk and how those risks could affect their financial positions. Financial position is the key underwriting criterion to insurance underwriters, as they look at the probability and significance of certain events that would directly affect share value.

Directors and officers can also be subject to lawsuits when the company’s economic loss is a result of an area being uninsured or underinsured. For example, many companies have a cyber liability risk as a result of systems that contain sensitive and/or customer information. Any release, misuse or theft of this information can have a detrimental effect on the company’s financial position, and the directors and officers could face a lawsuit if the company’s share value drops because of a large hit to earnings.

Smart Business spoke to Adams about D&O insurance and why it’s so important.

Why is it necessary for companies to invest in D&O insurance?

The directors and officers of an organization can be personally held liable for their actions. Companies can offer indemnification to their directors and officers, but in certain types of actions, they are not permitted or required to indemnify. Thus, the directors and officers, absent an insurance policy, would need to use their own personal assets for defense costs and any settlement or judgment. When companies can offer indemnification, they must use balance sheet assets to pay for the costs incurred. Absent an insurance policy, this could amount to a very significant cost for the company and harm the company’s financial position.

What does D&O insurance cover?

Insurance will cover the cost to defend the lawsuit along with any corresponding settlement or judgment, if adjudicated. Some policies will also provide costs incurred if a director or officer receives a subpoena to appear before a regulatory body or if they have been named as a potential target by the SEC during an investigation.

One of the areas that a company with global operations needs to review is the ability of their insurance and insurance company to pay policy proceeds for a non-U.S. director or officer in a country outside of the United States. Your broker can assist you in determining if a locally placed policy in a foreign country is required.

What are some of the current trends that are leading to litigation?

The financial credit crisis led to many lawsuits in the financial institution, real estate, mortgage and insurance industries. Companies that deal with regulatory agencies such as the FDA or the HHS must constantly deal with risk related to compliance requirements. With globalization of companies, we see increased risk in FCPA, M&A and due diligence when moving into a new country. Institutional investors continue to be activists in the corporate governance area, and opt-out suits do not seem to be subsiding.

How can an organization determine what D&O insurance is right for them?

The limits purchased often depends on the comfort level of the board. Board members, especially independent directors, want to ensure that they are protected. Your broker will work with you on this decision by using analytical tools, including a potential loss scenario using market cap losses, claims trending information and proprietary benchmarking. A company should also look ahead when deciding upon limits to purchase, taking into consideration any major changes that could occur, such as acquisitions.

It is also important to review policy terms and conditions. All policies are not created equal. A policy that denies a claim will not be positively viewed when called upon by a director or officer after a lawsuit. It is important to work with a broker that has the expertise with the specialized language needs and the market position to get it negotiated.

What specific products should companies look for when considering D&O insurance?

Companies should consider a product that is commonly called Side A DIC. This product is specifically provided to the directors and officers when the company isn’t permitted, required or able to indemnify them. This can be critical if your primary insurance wrongfully denies a claim, if other insurance has been used up by a different lawsuit, if any of the insurance companies providing your insurance become insolvent, or if your board wrongfully refuses to indemnify you.

How often should an organization review its coverage?

Every single year — it’s an evolutionary product, an evolutionary litigious environment and companies are always changing. It should not be a product that you buy and just renew as is.

Anna Adams is the managing director of the Financial Services Group at Aon Risk Services, Inc. Reach her at (216) 623-4122 or anna_adams@ars.aon.com.