Understanding your risk Featured

8:00pm EDT September 25, 2009

As the economy tumbles, the risk of lawsuits against corporate directors and officers increases, especially in the financial services industry.

Directors and officers face litigation from a variety of sources, including shareholders, vendors, employees and other stakeholders, and fighting such a suit can be costly. To protect yourself and your company, make sure you have the right D&O insurance by benchmarking it against that of your peers and conducting loss scenario analyses to determine your potential exposure, says Michael A. Becker, vice president and team leader for the financial services group at Aon Risk Services Central, Inc.

“You should also look closely at the indemnification provisions to make sure they are as broad as possible,” Becker says. “There has been an alarming trend of companies amending bylaws to reduce indemnification protections to directors and officers once they leave the company, despite the fact that former directors and officers are commonly named in lawsuits.”

Smart Business spoke with Becker about how to determine the best type of insurance for your company and how to mitigate risks for directors and officers.

What should directors/management look for in directors and officers insurance?

Traditional programs are structured to protect your balance sheet as well as your personal assets. The market has also designed programs focused on protecting individual assets only — Side A coverage; independent directors only — independent directors liability; and retired directors only — retired directors coverage. In limited instances, board directors have been able to purchase individual policies, somewhat like a personal umbrella, to cover their own exposures.

This approach ensures that an individual director has coverage that cannot be diluted by others. But this coverage has limited availability and has issues in coordinating its response with D&O programs covering all directors.

How do you determine which type of coverage to purchase?

There are 10 factors you should consider when determining which coverage and how much to purchase.

  • Level of protection desired by board members
  • Your capacity to retain risk
  • Your exposure to bankruptcy risk
  • Class-action settlement data for your industry and other market capitalization peers
  • Market capitalization and stock volatility
  • Merger and acquisition exposure
  • Cost of insurance versus budget
  • Industry and peer group purchasing patterns
  • Philosophical view on litigation management exposure
  • Claims experience

How often should you review your coverage?

D&O insurance policies should be reviewed on an annual basis because of changes in applicable case law and marketplace availability. You need to ensure that every layer of an insurance program will respond in the event of a claim and that your coverage is the most efficient.

As the severity of claims increases, any contractual advantage that favors an insurer will be used to deny a claim or reduce payment for loss. Policy language details are also critical. A successful collaboration among your risk management and legal departments, outside counsel and an insurance brokerage firm with specific D&O coverage expertise can ensure a D&O insurance program will respond appropriately.

How do you mitigate risks for directors and officers?

Excessive compensation is a common allegation in securities claims and is highly correlated at the board level with corporate governance exposure. You need to scrutinize the process to determine fair compensation for board-level positions. Having a diverse, independent board with members who have limited outside obligations also helps mitigate governance exposure.

There are other indicators of governance exposure that cannot be mitigated, including company size, industry and share volume. The larger the company is in terms of market capitalization, the greater the risk of a securities lawsuit.

Certain industries, including financial services, high-tech and pharmaceutical, have a greater exposure to this type of lawsuit.

What are the benefits of having the proper D&O insurance in place?

Directors and officers have basic duties of diligence, loyalty and obedience to shareholders or debt holders, the organization, and third-parties duties, regardless of what type of company it is. Directors and officers are exposed to personal liability as a result of their acts or failure to act with respect to these duties.

Organizations typically offer indemnification to their directors and officers for these acts, or the failure to act, to the fullest extent permitted by law. But this cannot be relied upon in all situations, and D&O insurance is particularly critical in these instances. For example, an organization may not be able to indemnify its directors and officers if prevented by the corporate bylaws or if it is insolvent and does not have the funds to indemnify.

Also, in situations such as a change of control, the organization may elect to limit or deny indemnification.

Michael A. Becker is a vice president and team leader in the financial services group at Aon Risk Services Central, Inc. Reach him at (312) 381-4474 or michael_becker@ars.aon.com.