The environment in which officers
and directors operate has changed
considerably since the stunning collapse of Enron, WorldCom and Tyco.
The Sarbanes-Oxley Act, which was
signed into law in 2002, expanded the
responsibilities as well as the potential
liabilities of corporate officers and
directors.
In order to protect against claims that
can cost millions of dollars to defend, it
is important to have directors and officers (D&O) liability insurance in place.
“D&O liability insurance protects the
capital base of the corporation from catastrophic loss,” explains Jerry Henderson,
area executive vice president for Arthur
J. Gallagher & Co. “It also protects the
personal wealth of directors and officers,
who have unlimited liability for their
actions.”
Smart Business spoke with Henderson
about what D&O liability insurance policies entail, who should be covered and
what factors should be considered when
selecting coverage.
How does D&O liability insurance work?
D&O insurance policies usually have
three basic insuring agreements.
Insuring Agreement 1, or Insuring
Agreement A, depending on the policy
form, covers individual directors and
officers when indemnification from the
company is not available or provided.
Insuring Agreement 2, or B, covers the
corporation for its indemnification obligation to the directors and officers.
Every company has in its bylaws and
Articles of Incorporation a certain provision that says ‘we will indemnify, or be
responsible for, taking care of any liabilities that arise against our directors and
officers.’
Insuring Agreement 2 is the transfer of
risk from the company to the insurance
company for that indemnification obligation. Insuring Agreement 3, or C, covers the entity itself.
For public companies, the entity coverage is limited to securities-related
claims. For private companies, the entity coverage is for all claims. A D&O policy
covers claims brought by third parties
alleging that a company’s directors or
officers did something to harm them
under the provisions of these three
insurance agreements.
What risks can be mitigated by having a
D&O policy in place?
A claim can be catastrophic to the balance sheet of a company in terms of
providing defense costs. The largest
and most expensive area of D&O claims
for public companies are securities-related claims — claims arising out of
an offer to purchase or sell securities of
a company.
If you have a claim and you don’t have
D&O coverage, you could incur millions
of dollars worth of defense costs alone
— not to mention the impact of a multi-million dollar settlement.
Who should be covered by such a policy?
There is a lot of debate about this. It
really depends on your risk appetite and
how you want to use the coverage.
Historically, D&O policies only covered
a company’s directors and officers; it didn’t cover the entity and it didn’t cover
employees. But now they are also used
to cover the corporation, and in some
cases the employees, either directly or
on a co-defendant basis with the directors and officers.
What considerations should be taken into
account when selecting coverage?
Each carrier writes its own forms and,
while terms and conditions are similar,
every D&O policy is different.
You definitely need to take a close look
at the terms and conditions. For example, you have to understand the difference between one type of fraud exclusion and another type of fraud exclusion
and understand the severability clause in
one policy versus another.
Secondly, you need to look at the quality of the carrier: What’s its longevity?
What’s its financial wherewithal? How
much of this type of business does it
write? Does it outsource or does it have
internal claims people? All of these are
factors that should be taken into consideration. Finally, you should look at price.
How has the Sarbanes-Oxley Act expanded
potential liabilities of corporate officers
and directors?
The Sarbanes-Oxley Act has had a lot
of different effects in the D&O arena.
Claims are trending downward: 2006
was the lowest frequency level of claims
since 1995. A lot of people attribute the
drop in claims to Sarbanes-Oxley
because it has given people a road map
for disclosure and how to set up internal
controls. On the other hand, it has given
more responsibility to the independent
directors, specifically the chairman of
the audit committee. In the past, these
directors may have been only nominal
defendants in an action while the CEO
and CFO would have really been on the
frontline.
JERRY HENDERSON is area executive vice president for Arthur
J. Gallagher & Co. Reach him at [email protected] or
(818) 539-1328.
