While the downturn in the economy has adversely affected the sellers of directors’ and officers’ liability insurance – much as it has companies in all sectors of the economy – investing in D&O insurance is still a wise course of action. This Update offers nine suggestions for ensuring that a company’s directors and officers are adequately protected in this environment against potential liabilities that D&O insurance normally would pay.
Nine Suggestions to Manage Your D&O Insurance and Its Risks
1. Avoid an Unwarranted Sense of False Security. There is an almost desperate human need in a troubled economy to fixate on easy solutions to complex problems. It is tempting to think that you can avoid the consequences of a D&O insurer’s insolvency by (a) not using insurance companies that grab the headlines by accepting extraordinary government assistance or (b) paying close attention to the solvency ratings of the various insurance companies. The truth is that, in this environment, nobody knows which D&O insurers will remain solvent. Thinking counterintuitively with respect to which insurers may remain solvent might be the right idea. The insurers that accept government assistance could have a better chance of remaining solvent. By bailing out these insurance companies, the U.S. government puts its credibility at stake if the insurers fail, and governments do not like to see their projects fail. Seemingly healthy foreign insurers could pose more of an insolvency risk than seemingly unhealthy domestic insurance companies, because the foreign companies are not likely subjects of U.S. government largesse.
The bottom line is that, in this environment, companies and their directors and officers cannot minimize their risk by avoiding certain insurance companies or by following the rating agencies.
2. Review How Your D&O Insurance Program Is Structured. The first step in understanding a company’s ability to protect its directors and officers is to examine and understand how the company’s D&O insurance program is structured.
D&O Insurance Policies Offer Different Types of Coverage for Different Situations. A traditional D&O insurance policy provides three types of insurance. In the most common situation, where a company indemnifies its directors and officers, “Side-B” coverage will reimburse the company. This type of coverage is also called corporate reimbursement coverage. However, in situations where a company is financially or legally incapable of indemnifying the directors and officers, “Side-A” coverage will pay the costs of defense, settlements and judgments incurred by the directors and officers. Finally, entity coverage pays the defense costs, settlements and judgments that a company incurs in defending itself against securities claims.
Many companies purchase traditional D&O insurance that contains all three types of coverage –Side-A, Side-B and entity. However, a number of companies purchase policies containing only Side-A coverage. Many of these Side-A policies are “differences-in-conditions” policies, which are a special type of insurance policy designed to fill gaps in coverage under other insurance policies. It is important to understand what type of coverage the company has purchased.
D&O Insurance Is Purchased in Layers From Multiple Insurers. Most insurance companies manage their exposure to the risk of liability by limiting the amount of D&O insurance they sell to any one company. For example, a company needing $50 million in D&O insurance is unlikely to be able to purchase that coverage from a single insurer. Rather, the company will likely need to purchase D&O insurance in layers from several insurers. For example, if a company wants $50 million in coverage, it may only be able to purchase a maximum of $10 million from any one insurance company. Thus, it will have five $10 million policies: one with its primary insurer and four with excess insurers. The layers of insurance would look like this:
Excess Insurer D - $10 Million
Excess Insurer C - $10 Million
Excess Insurer B - $10 Million
Excess Insurer A - $10 Million
Primary Insurer - $10 Million
An Insurer’s Insolvency Could Lead to Gaps in Your Coverage. The insolvency of an insurer in your program could result in a gap in coverage that must be filled, either by the insured company or from its directors’ or officers’ personal assets, before the layers above that gap can be accessed. For example, if the primary insurer in the diagram above became insolvent, the company or its directors and officers would have to fill, through payments, the $10 million gap that was created before they would have any chance of collecting on the $40 million in coverage layered above the primary insurer. That is, the obligations of excess insurers in the higher layers of coverage usually do not arise until either the lower-layer insurance companies or the policyholders pay the limits of liability of the lower layers of insurance.
3. Limit Exposure to the Financial Problems of Any One Insurer. A company should be careful not to purchase multiple layers of insurance from the same insurance company because if that insurance company becomes insolvent, there will be multiple gaps in coverage that must be filled.
4. Consider Purchasing a Side-A Only D&O Insurance Program. An insurer selling Side A only D&O insurance will often agree to fill a gap caused by the insolvency of a lower layer of insurance by having its policy “drop down” to fill that lower layer. Typically, however, insurance companies selling traditional D&O insurance (insurance that protects a company’s balance sheet as well as its directors and officers) have been unwilling to offer this insolvency drop-down protection. Accordingly, a director or officer may be more secure if his or her company purchases Side-A only insurance, rather than traditional D&O insurance.
If a company decides to purchase traditional D&O insurance, despite this trade-off, the company should request that the insurers all agree that if the company becomes insolvent and cannot indemnify and advance defense costs to its directors and officers, the upper layers of insurance will drop down to fill any gaps in insurance created by an insurer’s insolvency. In essence, this will give the company and its directors and officers the best of both worlds: balance sheet protection for the company without foregoing the insolvency drop-down protection that Side A only insurance offers.
5. Consider Purchasing Smaller Insurance Layers. In a time of insurance company instability, small layers of insurance should be the rule, because companies can more easily fill small gaps caused by the insolvency of one of their insurance companies. Many companies now purchase insurance in layers as large as $25 million. The gap in insurance caused by the insolvency of an insurance company selling this large a layer of coverage is much larger and more dangerous than the gap caused by the insolvency of an insurer selling a smaller layer of insurance.
Some argue that having numerous small layers of coverage, as compared to a few large layers of coverage, could make the settlement of a lawsuit more difficult because more insurers would be involved. However, there is little empirical support for the contention that numerous small insurance layers make settlement more difficult. To the contrary, a D&O program built on numerous small layers of insurance makes settlement easier because no one insurer stands to lose as much in the settlement; and insurers are more likely to pay a small D&O loss than a large one.
6. Tighten the Order-of-Payment Provision. In response to concerns that a D&O insurance policy that covers the company, as well as the directors and officers, may be viewed as an asset of the company’s estate should it go into bankruptcy, most traditional D&O policies now specify that if directors and officers and the company have simultaneous claims on the D&O policy that exceed the policy’s limit of liability, the directors and officers are entitled to payment before the company. Order-of-payment provisions are often marketed as also preserving the D&O policy limits for the benefit of the directors and officers.
In reality, many order-of-payment provisions are drafted so vaguely that it is unlikely they will preserve policy proceeds for the benefit of directors and officers. Vaguely drafted order-of-payment provisions can easily be interpreted to allow the company to use D&O policy proceeds to fulfill its indemnification obligations, even if doing so is detrimental to the company's directors and officers. A company on the brink of insolvency may have a strong interest in using the D&O policy proceeds to protect its balance sheet to the extent possible. If the company then becomes insolvent, the directors and officers could find themselves without the company or the D&O insurance to protect them.
Accordingly, careful drafting of the order-of-payment provision is important. To ensure that he or she is protected, a director should insist that the order-of-payment provision be amended to limit payments to the company while the possibility of a claim against the directors and officers exists.
7. Consider Prepurchasing Tail Insurance. D&O policies are written on a claims-made basis. That is, the D&O policy covers only claims made during the policy’s effective period. Unfortunately, a claim can arise years after the wrongful act causing the claim. For example, during the policy period, the company may file an annual report containing misrepresentations, but plaintiffs may not sue for damage caused by the misrepresentations until two or three years after the expiration of the policy period. If a company renews its D&O policy each year, the claim will be covered under the policy purchased for the year the claim is made. If the company becomes insolvent, however, it may cease to purchase D&O insurance, and the claim may not be covered.
D&O policies typically give the company the right to purchase a “tail” (a period that covers claims made after the policy period based on acts that took place before or during the policy period) if the company is unable or unwilling to renew its D&O insurance. This right, however, may be a hollow one if the company becomes insolvent and files for bankruptcy protection before exercising the right to purchase a tail. Directors who have any concern about their company’s financial position may want to insist that their company prepurchase the tail as a condition of the directors continuing to serve the company.
8. Ensure Claims by Bankruptcy Trustee Are Not Excluded. D&O insurance policies contain “insured vs. insured” exclusions designed to bar coverage for claims by one insured party (for instance, the company) against another insured party (for instance, the officers and directors). A surprising amount of insurance coverage litigation has arisen on whether this exclusion bars claims by bankruptcy trustees against directors and officers. Insurers have argued that the bankruptcy trustee stands in the shoes of the company and should be treated as the company for purposes of the insured vs. insured exclusion, which in turn eviscerates coverage.
With the possibility of more business failures on the horizon, directors should ensure that the insured vs. insured exclusions in their D&O insurance policies specify that claims by bankruptcy trustees are not barred from coverage. In recent years, when the insurance market was buyer-friendly, most policies limited the insured vs. insured exclusion in this manner. However, as the economy worsens and the D&O insurance market becomes less buyer friendly, insurers will likely move to expand this exclusion.
9. Prepare for Increased Coverage Litigation. The convergence of a troubled economy, D&O insurer financial instability and the recent substantial increase in securities fraud and derivative litigation will likely result in increased denials and slowdowns on coverage claims by D&O insurers. Boards of directors may want to take steps now to protect themselves against future litigation over insurance coverage.
The cost of prosecuting insurance coverage litigation is not covered under D&O insurance policies, and only a handful of states allow a policyholder to recover the attorneys’ fees it expends in pursuing a claim to obtain insurance coverage. If a director's or officer’s company becomes insolvent and is unable or unwilling to fund insurance coverage litigation to protect the rights of its directors and officers under D&O policies, the directors and officers may have to pay for insurance coverage litigation themselves.
Planning may reduce this risk. By having the company undertake a legal review of the D&O policies when they are being purchased, a board of directors may reduce the possibility that the D&O insurers may wrongfully deny coverage. If a board has been sued in securities litigation and there is a concern about the company’s future financial strength, the board may want to consider having the company prepay a law firm to represent the board in any future insurance coverage litigation. Alternatively, the board could consider other funding mechanisms to ensure that directors and officers do not personally have to bear the heavy cost of insurance coverage litigation.
While no D&O insurance program can offer a director or officer perfect safety in our uncertain economy, attention to these fundamental aspects of the D&O program should greatly reduce the risk to directors’ and officers’ personal assets.
You can find discussions of other recent cases, laws, regulations and rule proposals of interest to public companies on our website.