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 Jerry_Henderson@ajg.com or (818) 539-1328.