Coverage for execs when they're on their own

Directors and officers have begun to question just how much protection they have under their organizations' D&O policies. Their concerns have been prompted in part by litigation in which D&O policies have failed to protect a corporation's executives completely because of the policies' obligations to the corporate entities themselves. No doubt, executives' increased responsibilities under the federal Sarbanes-Oxley Act, recent corporate scandals and well-publicized crackdowns on corporate misbehavior have added to the anxiety.

The D&O market has responded with a variety of products that provide separate or broader coverage for executives. Collectively, these products have been referred to as “Side A” D&O policies.

We reviewed a number of such products available from several leading carriers, primarily ACE, AIG, Chubb, CNA and St. Paul Travelers. (Products also are available from Monitor Liability Managers, Hartford, and Liberty International Underwriters, which we did not review because they had just been issued in late 2004 and thus little information was available about their experience. (Monitor offers a product for both private and publicly owned organizations, which is unusual.)

We tested carriers' responses to our request for information against our own experience and knowledge. Where they conflicted, we reviewed the inconsistencies with the carriers. However, the evaluation and conclusions are our own.

In most cases, we examined actual policy forms and endorsements. Rather than reproduce their exact policy wording (which of course can be voluminous), we often paraphrased their wording. Of course, the insurance policies govern the coverage provided, and the carriers are not responsible for our interpretation of their policies or survey responses.

Readers should understand that the information in this report applies to the standard products of the carriers, and that it may be possible to negotiate aspects of these policies.

The problem

Recent actions of courts and insurance companies have called into question whether D&O coverage will pay claims in certain situations. For instance, a D&O policy may be blocked from paying defense costs and damages if, a) the policy covers the entity as well as the directors and officers and, b) the entity is bankrupt.

This concern arose after a judge ruled in a case involving a corporate bankruptcy that the D&O policy was the corporation's asset, and that directors and officers also covered by the policy would have to wait in line for their claims payments, essentially as though they were creditors. This exposed them to the risk that their claim payments would be delayed while a plan to reorganize the corporation was prepared, and that their claims would be only partly covered. Even if a corporation is not an insured under a D&O policy, a bankruptcy court may withhold payments the bankrupt corporation owes to individuals directors and officers under the indemnification provisions of the corporation's bylaws.

Other concerns have also arisen. For instance, insurers have attempted, sometimes successfully, to rescind D&O policies, arguing that they were misled into issuing them. If management, for example, issues erroneous financial statements that carriers have relied on for underwriting purposes, insurers have argued they shouldn't have to cover any resulting claims. This has the unfortunate effect of denying coverage for one of the chief exposures directors and officers face: the organization's financial mismanagement.

D&O insurance originally was designed, in essence, to cover individual directors and officers only, who were insured for the “wrongful acts” they committed in carrying out their management responsibilities. Coverage was provided directly to the individual directors and officers (the so-called Side A of the D&O policy, since the coverage was typically labeled as such). Coverage also was provided to the corporation–but only to the extent that its bylaws required it to indemnify the directors and officers (Side B coverage). As the use of indemnification agreements in bylaws expanded, more claims from corporations resulted.

D&O insurance accomplished the goal of protecting executives against the risk of serving the corporation. The organization itself, however, was not covered for any role it played in any alleged mismanagement. This meant that many claims included a component that was not insured–specifically, that part attributable to a corporation (as opposed to an individual) named as a defendant in litigation. This forced insurers to decide how much of a claim was to be paid on behalf of individual directors and officers, and how much of the claim was not covered because it was attributable to the uninsured corporation.

This resulted in many squabbles, as insurers and insureds disagreed on the carrier's allocation of culpability. Insureds often contended that directors and officers were not getting as much coverage as they should because carriers attributed too large a percentage of a claim to the corporations. Such problems wouldn't have occurred if a corporation also was an insured, but since D&O insurance did not cover corporations as defendants, the uncovered part of the claim became a point of contention.

Concurrently, other forces in the market were acting to broaden D&O coverage. The fierce market-share battles of the 1990s led carriers to broaden their policies to include coverage for the entity itself. Thus, Side C coverage was born. While that took care of the allocation issue, it led to concerns that in the event of corporate bankruptcy, individual directors and officers might not have any coverage at all.

Other factors raised concerns about coverage. The success of several booming companies in the 1990s turned out to be illusory because of misleading financial statements and overly optimistic sales forecasts. D&O carriers were inundated with claims arising out of lawsuits against these organizations. Where insurers concluded that insurance applications were fraudulent, they acted predictably by attempting to rescind policies.

While such carrier action may have been warranted, it caused innocent executives to question the adequacy of their protection under traditional D&O policies. They began looking for coverage that would apply directly to them and that would protect them from such risks as policy rescissions and bankruptcy stays.

Insurers respond

Carriers have developed new products to meet this need. They fall into three broad categories:

oSide A only: This is simply a D&O policy that eliminates (or did not originally include) Sides B and C. The policy usually is purchased in connection with the organization's regular D&O policy and responds only when that policy cannot or will not pay. Generally it is not broader than the regular D&O policy.

oSide A enhanced: This policy provides coverage similar to Side A's, with additional features that we'll examine later.

oD&O DIC: This is similar to Side A enhanced, but it “wraps around” existing Side A to provide additional protection, much as a difference in conditions (DIC) policy written in con- nection with a property insurance policy does.

State of the market

Side A coverage is relatively new and has yet to achieve significant market penetration. We understand from carriers, however, that large, publicly traded companies are buying a substantial number of these policies. This makes sense. A properly covered director is more likely to make hard decisions, knowing he or she is protected. Nonprofits and private companies are not pursuing Side A coverage in significant numbers. We suspect this will remain the case, except possibly for large nonprofit organizations.

We were surprised to learn that the total premium written for Side A coverage in the U.S. ranges from $250 million to $500 million. We suspect the actual amount is at the lower end of that range, but $250 million is still a lot for a new product. Only a few carriers have experience in writing this coverage, but their 2004 growth rates were in the range of 40% to 75%. Few carriers are writing much coverage, except for the large D&O industry leaders, who are writing a lot of it.

For the most part, Side A has been a product for publicly owned companies, especially larger ones. The reason, of course, is that directors and officers of larger companies are high-profile targets for lawsuits and also have much influence on the purchase of D&O coverage. There seems to be only slight interest from private companies and not-for-profits.

The leading carriers tend to not have firm restrictions on the type of accounts they will consider, other than size. One carrier, for example, reports that it writes Side A with DIC generally for companies that have a market cap under $10 billion, but that companies of all sizes are considered for the Side A only coverage.

Several carriers will allow coverage to be purchased just for specified directors and officers. At least one, however, requires all directors and officers to be covered.

Product types

oSide A only: One benefit of Side A insurance is the non-cancellation feature. It protects individual insureds against the risk that a carrier will cancel a corporate D&O policy in the event of a financial restatement. Most Side A only products include this coverage, but one did not and the coverage was negotiable in another.

Another key feature is protection against recision, an action insurers may take when they believe the risk they've underwritten was misrepresented in the application. One carrier described its policy as non-rescindable under any circumstances. Other carriers will consider adding the feature by endorsement. One insurer has a non-rescindable feature for persons who did not have knowledge of the alleged misrepresentation.

oEnhanced Side A and DIC: Several key features apply to the these products, including:
–Non-cancellation and non-recision features.
–Coverage for claims in underlying D&O policies that have been rescinded.
–Wording at least as broad as wording in the corporate D&O policy.
–Coverage for an entity's wrongful refusal to indemnify the insured director or officer.
–Coverage for the entity's financial inability to indemnify the insured director or officer.
–Coverage excess over the underlying corporate D&O policy.

Most Side A enhanced and DIC products we examined had all these features. Excess employment practices liability limits also commonly are available if the underlying D&O policy includes EPL coverage.

All of the markets we reviewed said they were willing to write Side A products for directors and officers even if they do not write the corporately owned D&O policy.

Coverage particulars

oLimits and deductibles: Carriers generally offer Side A limits up to $25 million, although one will write $50 million. Minimum limits are generally $1 million; it is hard to picture an insured wanting less. Deductibles tend to be nil, since board members are accustomed to nondeductible coverage.

oPolicy type and definition of insured: All policies reviewed are written on an indemnification basis; none uses a duty-to-defend form. Coverage for an insured while serving on an outside board at the request of the entity (for example, serving on the board of a business association) is available by endorsement from several insurers. A couple of carriers will offer it, subject to underwriting. The entity must request the outside board service for coverage to apply.

oClaims reporting and extended reporting periods: Most carriers require the named insured to report claims “as soon as practicable.” In practice, unless an insured delays reporting for so long that it compromises the defense of the claim, there is little practical difference among the various carriers' products.

The extended reporting period is an under-appreciated feature of Side A policies, one that will take on growing importance if carriers lose interest in the market. It's important to determine whether the ERP is one-way or two-way (bilateral). The former is activated only if the carrier cancels or refuses to renew. The latter also takes effect if an insured cancels or does not renew. The products we examined differed in the length of the ERP and its nature (one-way or bilateral; standard feature or negotiated endorsement.) The particulars should be nailed down at policy inception, not later, when the carrier might be losing interest in the business.

oSelection of counsel: All carriers reviewed allow the insured to select counsel.

oConsent to settle: Side A policies generally are written on an indemnity basis, rather than duty to defend, and so insureds are not required to settle suits against their wishes.

oAdvancement of defense costs: As indemnity-based products, Side A policies require an insured to pay for defense costs and settlements, then seek reimbursement from the insurer. All carriers will advance defense costs as they are incurred, however, which reduces the insured's cash flow drain.

oPrior-acts coverage: All of the policies reviewed include prior-acts coverage in their standard forms. Insureds should carefully review the restrictions, such as for pending and prior litigation, and retroactive dates.

oTerritory: All of the reviewed policies include worldwide coverage (i.e., for suits brought anywhere), which is important, since aggrieved parties can be located outside the U.S.

oExclusions: All policies reviewed had similar exclusions, and insureds and their advisers certainly should pay careful attention to them. They include exclusions for anti-takeover activity; securities claims brought by bankruptcy trustees; claims arising out of short-swing profits; pollution; and libel, slander or defamation. There also may be exclusions for punitive damages and intentional acts.

oRisk management services: A few carriers offer risk management services in connection with Side A products. For instance, AIG offers corporate governance and transparency reviews at a discount, and Chubb offers a useful series of loss-prevention handbooks. Other insurers indicate they are developing services.

Summary

Side A D&O products, in their several forms, are gathering significant interest among larger companies, and we predict that they will become common in the larger institutional market as well. Their use also may grow among smaller organizations and private companies, but we are less confident in forecasting significant market penetration.

The concerns of board members that traditional D&O policies may not protect them adequately are understandable. The problem is real, and even if the concerns are exaggerated, it is important that board members have enough confidence in their coverage to execute their duties effectively. Side A coverage can provide that reassurance.

This article was derived from the October 2004 issue of The Betterley Report, which is published six times a year by Betterley Risk Consultants. The complete report can be purchased for $65. Annual subscriptions are available for $347. For more information, contact Richard S. Betterley, CMC, at (877) 422-3366 or at rbetterley@betterley.com.