While the majority of publicly traded companies carry director and officer (D&O) liability insurance, many aren’t certain that they are purchasing the best coverage for them, and enough of it.
In an environment where litigation is commonplace and the cost of litigation is significant, companies are increasingly concerned about having the appropriate limits, the proper structure and the best coverage, all with the most financially secure carriers.
“Companies face increased exposure when completing an initial public offering or private placements and engaging in merger and acquisition or divestiture activity,” says Scott Isler, the executive vice president and manager of the Financial Services Group at Aon. “But even companies not engaging in these activities do not escape all potential liability.”
Smart Business spoke with Isler about how a company can navigate the process of purchasing D&O insurance.
What does D&O insurance cover?
Simply put, the policy covers claims against directors and officers for mismanagement. Most common allegations are that the directors and officers made false or misleading statements or failed to disclose facts to the public that resulted in harm to shareholders. The public company D&O contract typically has three main insuring agreements: coverage for the directors and officers to the extent the company is unable or unwilling to indemnify them (Side A); coverage for the reimbursement of the company’s indemnity obligations pursuant to by-laws as a result of lawsuits against its directors and officers (Side B); and coverage for the company for securities claims made against the company (Side C). Privately held company policies and nonprofit D&O policies provide the same basic coverage offered for public companies with the addition of coverage for employment practices liability exposures.
How do you know you are purchasing the right amount of D&O insurance?
Many companies rely heavily on peer benchmarking data, but also look to other metrics for deciding on the correct limit. A quality insurance broker will maintain a robust database of timely, accurate and relevant data, in order to provide powerful benchmarking to its clients. The broker will then compare programs based on various metrics, including size (Fortune ranking, market capitalization, assets, employee count, sales, etc.), as well as industry class (by sector, NAIC code, etc.).
You’ll also want to perform a ‘stress test’ diagnostic on the program, which indicates how it will perform in the event of a Securities Class Action. It runs a simulation, based on certain industry statistics and various stock drop scenarios, to determine when policy limits will be exhausted. Some companies look to other more subjective means for determining whether or not they are purchasing the appropriate amount of insurance.
How should a company decide which structure is the most suitable for its exposures?
There are many ways to purchase D&O insurance. The most common is a stand-alone policy, which protects the individual directors and officers, as well as the corporation. With the increased size of settlements lately, as well as certain situations where individual directors and officers are not provided indemnification by the company, you should also consider purchasing Side A excess coverage, with differences in conditions (DIC) language. This additional level of personal protection to the directors and officers provides greater certainty that they will have coverage in the event of a significant claim.
The other structure options to consider include blending certain coverages together (i.e. D&O and Fiduciary), either on the primary layer or in excess policies; purchasing a separate independent directors liability (IDL) policy, which protects only outside board members; purchasing an excess policy with dropdown provision, which protects against a carrier’s financial insolvency; and evaluating various attachment levels of Side A excess.
Why is actual policy language important in today’s claim environment?
Recently we have seen an increase in D&O carriers taking severe and contentious coverage positions on claims. The carriers employ very skilled attorneys and claims adjusters who craft coverage positions which often times are punitive to the client. Given this, it is absolutely imperative that the policy language be precisely drafted at the time it is purchased, so that it performs in a predictable way when a claim occurs.
Some specific areas of coverage that are critical to the policy performing in a predictable way are the following:
- Severability of the application and exclusions: This restricts the insurance company’s ability to unjustly blame one insured’s knowledge or actions to another insured and void coverage.
- Non-rescindable coverage: This provision eliminates the insurance company’s ability to take the contract away as if it never existed. Recently, insurers have attempted to void coverage in major claim scenarios, either to truly avoid coverage, or as a negotiating ploy.
- Final adjudication in the underlying action language for the personal conduct exclusions: Every D&O contract has exclusions for personal conduct such as fraud and illegal profit. A D&O policy should be amended such that these exclusions can only be applied if a final judgment in the underlying action has found that there was illegal fraud or profit. If a final judgment has not been made, then the exclusion cannot apply.
- True worldwide coverage with local policies where appropriate: Foreign countries may not permit non-admitted insurance to respond in the event a claim is brought in a foreign jurisdiction against foreign directors and officers. For multinational corporations, careful consideration should be given to purchasing local policies in countries that prohibit non-admitted insurance.