Insurance FAQ

Isn't indemnity enough?
Do privately-held companies need D&O insurance?
How much insurance do we need?
What is allocation?
How should we select a broker?
What about broker competitions? Should we divide up the insurers and assign them to different brokers to see who delivers the best program?

Isn't indemnity enough?

The indemnification provisions a company's charter have limitations that expose the company's directors and officers to personal liability. They include:

The SEC has taken the position that it is against public policy to indemnify directors and officers for securities law violations.
Many jurisdictions hold that shareholder derivative suits are not indemnifiable by the company.
All charter indemnification provisions establish standards of conduct that must be satisfied in order for indemnification to be available.
Charter indemnification provisions are usually unclear on issues such as the advancement of defense costs that can put significant financial hardship on the directors and officers.
Even the best indemnification provisions are meaningless if the company becomes insolvent.

It is therefore impossible for a company to shield its directors and officers from exposure to personal liability solely by virtue of the indemnification provisions contained in the charter.

Do privately-held companies need D&O insurance?

Due to the ownership structure of most private venture backed companies, the risk for securities litigation is reduced substantially. As such, D&O rates for private firms are roughly one fifth the cost of their public counterparts. The largest areas of securities-based risk may be in merger-related activities and stock repurchases from founders or key executives. Additionally, employment practices-related litigation (EPL) now represents over 25% of all lawsuits against directors and officers. For many rapid growth companies, strong human resources practices and procedures may not yet be in place, which can increase the probability of litigation. Other areas of litigation may include intellectual property disputes, particularly if your industry has key technical employees moving between competitors. This type of litigation frequently names the directors or officers in recruiting the individual and soliciting trade secrets.

Today, D&O policies can be structured to provide protection against exposures private companies face. These provision include entity coverage for both securities and EPL claims with average corporate retentions (deductibles) ranging from $25,000-$75,000. Premiums are frequently under $10,000 for a $1 million limit of liability. Stand alone EPL policies are also available, often at competitive costs with lower retentions. EPL policies do not cover the other exposures discussed.

How much insurance do we need?

Public companies usually determine the desired amount of D&O insurance through an analysis of several factors. These include statistics on judgments and settlements in securities class action cases in their industry, the company's market capitalization, the amount of D&O insurance purchased by similar companies, and special risk factors that are unique to the company. Some brokers will provide you with various statistical and other tools to assist you with your evaluation process.

What is allocation?

Most securities lawsuits name both the corporate entity and the directors and officers of the entity. However, D&O insurance policies do not always consider the entity an insured party under the contract. Therefore, any defense and settlement costs which are deemed attributable to the corporate entity are not insured. This becomes problematic as: 1) defense counsel typically represents both parties and; 2) most cases settle, making it difficult to attribute defense and settlement costs between the two defendants. The result had been a great deal of litigation between clients and D&O insurance providers over what portion of the defense and settlement costs are attributable to the company and therefore uninsured.

There have been three major recent court decisions regarding allocation, all favorable to the insured rather than to the insurance carrier. As a result of these decisions, most carriers now establish a fixed allocation among covered and non-covered parties without regard to the merits of the securities-related claim. Most D&O insurers also offer entity coverage, which means that the company's own liability will be covered even if the individual directors and officers are dropped from the lawsuit. The industry has changed so rapidly that now insurers often provide entity coverage as part of their standard terms and as part of their initial quotations.

The principal risk of this trend is that coverage will be exhausted more quickly due to the higher payout. With entity coverage, a bankruptcy court could consider the D&O policy an asset of the company and therefore unavailable to the individual insureds. Further fixed allocation has largely been limited to securities litigation, which still leaves other types of D&O claims subject to allocation negotiations. A few carriers even incorporate the relative exposure rule into their policy for non-securities claims which is unfavorable to the insured. Currently, AIG and Lloyd's of London are the only carriers that offer fixed allocation for non-securities lawsuits. None of the carriers address allocation between insured and uninsured activities which are often left gray when lawsuits settle and facts remain unclear.

How should we select a broker?

D&O insurance is an unusually complex segment of the insurance industry. Brokers compete in a variety of ways, but ultimately what determines the success of a company's D&O program is the quality of the coverage. Some companies believe that the best broker is the one who can got the cheapest premium, but this is in fact the least useful way of trying to differentiate brokers. Any broker can make a submission and get a quotation. Market forces drive pricing, especially in this soft market. A broker's work only begins with getting quotations.

The broker's real value comes from its understanding of securities laws and other risks to the directors and officers, which in turn translates into the ability to negotiate favorable policy wording based on that understanding,to put together creative and effective programs, to work closely with the company and its lawyers at the time the policy is placed and in providing year-round service with respect to risk management and loss prevention, and to be actively involved on the company's behalf if there is a claim. D&O insurance is such a specialized area that the vast majority of insurance brokerage firms do not place or negotiate the coverage themselves, but instead hire a specialist firm or use in-house specialists to do it for them. One significant impact of this type of arrangement is that the broker who negotiated the policy has no year-round contact with the company and is much less likely to perform any client-focused, expert services in either loss prevention or claims management.

A company should expect the following things from its D&O broker:

It should understand the company's business well enough to be able to help the company protect against the kinds of D&O risks that you are likely to face, especially securities claims and claims arising out of merger-related activities;
It should be an expert in the intricacies of policy wording who negotiates aggressively on the company's behalf and plugs the critical holes in the D&O policy form;
It should understand the federal securities laws and the things the company should be considering in the wake of the securities litigation reform law to reduce the company's chances of being sued in a securities class action claim;
It should understand how litigation against directors and officers—especially securities litigation—unfolds in the real world and know how to structure and word the policy so as to maximize the company's advantages if there is ever a claim;
It should work comfortably and closely with the company and its lawyers, seeking the lawyers' input at several stages of the process. For example, seeking the lawyers' views about the nature and likelihood of certain types of claims;
It should work closely with the company and its lawyers in devising effective risk management strategies to reduce the risk of lawsuits;
It should be a highly involved, aggressive advocate for the company if there is ever a claim. Good brokers deal with policy interpretation all the time, and insurers know that if they take unlikely interpretive positions, they will have difficulties with future business;
It should provide year-round service in the following areas:
- With respect to acquisitions—to make timely reporting with respect to acquisitions that exceed the automatic coverage threshold;
- With respect to matters that may lead to claims—e.g., significant drops in the stock price;
- With respect to the reporting of claims and of matters that can lead to giving the insurer notice of circumstances;
- With respect to corporate announcements/press releases and SEC filings;
With respect to risk management/loss prevention matters:
- Development of loss prevention guidelines, together with legal counsel;
- Review of investor relations materials, to make sure that analysts' reports are not being included, or if they are, to make sure that they are not being selectively included and that appropriate disclaimers are made;
With respect to claims:
- Timely notice and the provision of necessary information;
- Obtain prompt consent from insurer to choice of counsel and incurring of defense costs;
- Coordinate claims process among multiple policies that might cover the claim—both D&O policies and other types of liability policies;
- Work with the company to properly interpret and respond to the insurer's reservation of rights letter;
- Facilitate proper communication and exchange of information among the insured, its counsel, the insurer and its monitoring counsel;
- Help parties agree with respect to timely advancement of defense costs;
- Remain aggressively involved in coverage matters arising from the interpretation of the policy;
- Assist parties in resolving allocation matters with respect to covered and uncovered claims and/or parties; and
- Get insurer's consent and financial commitment to settlement.

A company's legal counsel is typically underused in the D&O process. D&O coverage is legal liability coverage. A company's lawyers should be actively involved in helping the company assess the value of different coverages and in implementing risk management policies to reduce the risk of getting sued. A broker can help throughout this process, but implementing risk management measures is more properly the province of the lawyers. A broker is overselling itself if it suggests that it can guide the company through the risk management process.

What about broker competitions? Should we divide up the insurers and assign them to different brokers to see who delivers the best program?

The company is hurt by this process. One peculiarity of the D&O industry is that an insurer will work with only one broker with respect to any account. The insurer recognizes and will work with the first broker that makes a proper submission on the company's behalf. As a result, once a company announces that it wants a broker competition, there is a mad dash by the competing brokers to get submissions by fax and overnight courier to the most desirable markets. The brokers then proceed to praise their insurers and criticize the other broker's. At the end of the process, the company has two brokers, each with its own financial interest at stake, criticizing the policy forms of the insurers controlled by the competition. The company, not versed in the arcane ways of D&O insurance, cannot usually discern the better program in the midst of this morass and usually ends up picking an insurer based on price. As discussed in the previous answer, this is an ineffective way to select a D&O program. This process is especially unfortunate because each broker is reduced to criticizing insurers who may in fact be appropriate for the company, but whose form has not been adequately negotiated by the controlling broker.

The better practice is for the company to take the time up front to select the broker that it trusts to get the job done best, then give that broker full access to all of the insurance markets. The company can always make sure that the broker is not burying favorable quotations by asking the broker to submit all the quotations it has received. Given the complexity of D&O insurance and the multi-faceted nature of the broker's involvement with and on behalf of the company, the company is always better served by picking the broker it trusts most and then investing that broker with the authority and responsibility to get the job done. The company can provide its chosen broker with a broker of record letter that will cause the insurers to recognize that broker as the one acting on the company's behalf.