There has been a proliferation of Side-A-only insurance forms tocover directors and officers in recent years, but few know thehistory of the underlying coverage of the full D&O policy–apolicy now more than seven decades old.

The first ever D&O policy came out of Lloyd's of London inthe late 1930s. Even after the depression, the directors andofficers did not see a great need for this insurance and thecoverage did not sell well. Companies were not permitted toindemnify their directors or officers at the time.

In the 1940s and 50s, corporations began to see the advantagesto corporate indemnification, thus prompting state legislatures topass laws that permitted corporations' by-laws to be amended byadding indemnification provisions. The courts upheld thesechanges.

The 1960s brought an onslaught of mergers and acquisitions. Thisperiod has been referred to as “conglomerate merger mania period,”and the mergers resulted in litigation against the corporation andits directors and officers. This litigation, in turn, resulted incourt interpretation of the securities laws–interpretations givingrise to the real possibility that boards of directors and officersof corporations could have personal liability exposure.

As a result of these events, the “original” D&O policy nowhad the opportunity not only to protect the legal entity's balancesheet but also the personal liability of individuals.

The “newly improved” D&O liability policy (circa 1960s) wasactually two policies usually stapled together, each word for wordthe same except each had its own insuring clauses.

Insuring Clause 1, or Side A as it later became known, providedpersonal financial protection to the corporation's directors andofficers when the company could not indemnify the individuals. Thiswas usually in the case of bankruptcy or the filing of a derivativesuit.

(Editor's Note: Derivative suits are suits brought byshareholders on behalf of the company, naming directors andofficers as defendants. Statutory prohibitions againstindemnification of derivative suits exist in many states.)

Insuring Agreement B, or Side B, reimburses a corporation forits loss when the corporation indemnifies its directors andofficers for claims against them.

Side B does not provide coverage for the corporation for its ownliability. This insuring agreement protects the company's balancesheet, and in this respect is no different from a property policy,which also similarly provides balance sheet protection.

By the mid-eighties, all insurers except INAPro had changed tothe current one policy with multi-insuring clauses format. (INA wasthe Insurance Company of North America, which later merged withConnecticut General to form CIGNA)

In the late 1980s, insurancecompanies–in the interest of becoming more efficient– started toissue one D&O policy with the two insuring clauses. Chubb tookadvantage of merging the two policies together to allocate certainpolicy exclusions to the particular insuring clause, thus in manyways enhancing the coverage. At the time, this was very innovativeand later became the standard we have today.

THE POLICY EVOLVES

The development of the Side-A coverage of the D&O policy hasa number of milestones and enforces how the D&O policy hasmatured over the years, reminding us of how the policy has had toadapt to both the litigation environment and human nature over thelast 70-plus years.

An excellent example that demonstrates the evolution ofever-ameliorating D&O policy is the addition of the“presumptive indemnification” clause.

In the mid 1980s, a New York Stock Exchange-listedpharmaceutical company based in Philadelphia had accepted aSide-B/corporate reimbursement retention of $5 million. The hardmarket of 1985 mandated that Fortune 500 firms would have corporatereimbursement retentions ranging anywhere from $2.5 million to $5million.

Shortly after the pharmaceutical company's renewal, thedirectors and officers became defendants in a class-actionsecurities lawsuit. Because the policy was silent on when theindividual side of the policy, Side A, would respond, and when thecorporate reimbursement, Side B, would respond, thepharmaceutical's legal department “creatively” reasoned that if thecompany just decided not to indemnify the directors and officers,the claim would shift from Side B–with a $5 million retention–toSide A. At the time, most underwriters applied a $1,000 perindividual and a $5,000 aggregate retention to the individualsprotected under Side A.

The policy wording on when a loss would be paid under Side Aversus Side B was so vague that by just declining to indemnify, thedirectors and officers shifted what normally would be a Side-Bclaim to Side A.

As the policy did not define the term “non-indemnification,” theunderwriter at the time handled the claim under Side A, thussupplanting the $5 million retention with a $5,000 one, even though$5 million is what was originally anticipated for this type ofclaims situation when the policy was written.

Almost immediately, the underwriting community responded byendorsing all D&O policies with a “presumptive indemnification”endorsement that stated that Side A would only apply when theinsured organization could not legally indemnify directors andofficers (as in the case of derivative litigation) or financiallyindemnify (as in a bankruptcy situation) indemnify, thuseliminating the insured organization's ability to just refuse toindemnify. Today, this clause is built into the policy.

For clarification, Side A then and now only protects theindividuals. Side B is designed to reimburse the organization whenit indemnifies the individuals, thus protecting the company'sbalance sheet.

Both Side A and B provide personal/individual protection. Theterm “corporate reimbursement” used to describe Side B is confusingand can be misleading. The legal entity is NOT an insured under anA&B D&O policy.

SIDE C INTRODUCED

For decades, the D&O policy had only two insuring clausesand with rare exceptions the claims process was fraught witharguments because the insured organization (company) was oftennamed as a co-defendant along with the directors and officers whenlawsuits were filed. This is frequent in securities class actionlitigation.

Because the intent of the D&O insurance has always been thatof an “individual protection” policy (unlike the general liabilitypolicy), the insurance company and the insureds were at odds whentrying to determine a fair allocation of defenses costs and anysettlement. Frequently, this led to litigation between the companyand D&O underwriters.

It was not until the now famous Nordstrom vs. Chubbdecision in 1995 that insurers were forced to address thishistorical allocation dilemma.

The U.S. 9th Circuit Court of Appeals in Nordstromdetermined that a means of differentiating the liability betweendirectors, officers and the legal entity did not exist insecurities litigation, and that Chubb was on the hook for payingthe entire settlement of a securities case that named both thedirectors and officers and the company as defendants.

The initial underwriting community response was to establish apredetermined allocation between the individuals and legal entityat the inception of the policy. The percentages ranged from 70percent to 100 percent, and the policies were supposed to be pricedaccordingly.

There was initially a cost involved, and the coverage wasendorsed to the policy via a Predetermined Allocationendorsement.

As a result of competition, this lasted less than a year, and100 percent became the norm with no increase in premium. As theinsurance industry revised and introduced newer versions of theirD&O policies, the Predetermined Allocation endorsement soonbecame SEC Entity coverage, also known as Side C.

By adding Side C, the insurance industry solved one problemwhile creating others, which to this day have not beenresolved.

The first problem is that the substantial increase in exposure(due to adding the entity as an insured) did not affect thepricing. Now, for the first time, insurance companies were insuringthe legal entity (although only in securities litigation) and thedirectors/officers. Some estimate that by adding Side C, the riskto underwriters increased five fold.

Second, most insureds continue to purchase the same limit ofliability. Many broker experts believe that by adding Side C, theindividuals' protection actually substantially decreased becausenow the limit of liability will be greatly diluted since it isshared with the legal entity.

This is an excellent reason to secure standalone Side-Acoverage, and it has contributed to the increased interest in thisstandalone coverage in recent years.

MONOLINE SIDE-A POLICIES: THE NEW GENERATION

Although theoretically available prior to 1986, it was not untilthe creation of Corporate Officers Directors Assurance (CODA) thatmonoline Side-A policies became commercially available.

The attraction to Side A has evolved over the last 20-plusyears. Initially it was created to address the lack of affordableand available coverage for Fortune 500 companies during the hardmarket of 1985. Lately, renewed interest has been fueled by severalfactors, including the high defense costs associated withsecurities litigation, the large number of corporate bankruptciesand insider versus outsider allegations of fraud.

Executive Risk Management Associates (the underwriting managerfor Executive Risk, which was acquired by Chubb in 1999) introduceda by-product of the standalone Side A policy, called IDL, or theIndependent Director Liability policy. The IDL policy introduced inthe late 1990s got off to a slow start; however, in the last fiveyears it has taken Side A to the next level by furthering expandingthe financial protection for the independent directorconstituency.

The needs of independent (non- employee) directors became veryevident during the litigation of companies like Enron, WorldCom,HealthSouth earlier in this decade. During the litigation of theseand other companies, we were reminded of the specific and uniqueduties, responsibilities and exposures of inside officers/directorsand outside/independent directors. Sometimes we refer to theseparation by referring to the guilty as “black hats” and innocentas “white hats.”

Keep in mind the D&O policy limit of liability is adepreciating asset and does not discriminate in its burn rate. Thusfirst to spend is first to be defended.

Layering a program with A-B-C, followed with Side A, topped withIDL is considered today's state-of-the-art architecture. (Seerelated article, page 28, for more on this layering approach.)

With that said, please take note that there is no standard orgeneric A-B-C, Side A and IDL policy language. Each underwriter hasits own propriety products with unique terms, conditions andexclusions.

Today's D&O policies have come a long way since the 1960s,and the insuring clauses are only one example how the industry hasresponded to the ever-changing environment over the years.

For many people who have not worked with the D&O policy to agreat extent, it is uniquely different from other insurancepolicies which are based on ISO forms (crafted by the InsuranceServices Office.)

In the absence of ISO forms, although D&O policies acrossthe industry might share similar “skeletons,” each insurancecompany's D&O policy has a different heart, soul and skin. Withthe right expertise, this aspect of D&O coverage can providesubstantial opportunities to be creative and enhance the coveragefor the directors and officers. Alternatively, without the rightguidance, if the D&O purchasing process is treated with ageneric commodity approach, it can lead to great problems.

Peter R. Taffae is managing director ofExecutive Perils, a Los Angeles-based national wholesaler solelydedicated to D&O, E&O, EPL, digital, intellectual property,media, legal malpractice, insurance agents E&O, crime andfiduciary liability insurance. He can be reached at [email protected].