Critical aspects of private company D&O insurance
By Richard G. Clarke, CIC, CPCU, RPLU
Once thought to be unimportant, management liability insurance (and the exposures faced by organizations) has gained prominence over the past three years.
As a result of the corporate governance scandals of 2001 and 2002, officers and directors of organizations are much more sensitive to the quality and breadth of directors and officers liability insurance. Although most concern is held by boards of organizations subject to public scrutiny (essentially, the Securities and Exchange Commission or SEC), directors of private companies also are much more interesed in D&O insurance. These concerns range from specific coverage provisions ("Does my D&O insurance cover punitive damages?") to broader aspects, such as the financial viability of the insurer and its reputation for paying claims.
Evolution of D&O insurance
The concept of insuring directors for liability arising out of the corporate governance process began in the United States after the Great Depression. The first policies were issued by Lloyd's. (In the late 1980s, Lloyd's was also the first underwriters of employment practices exposures.) A review of an early policy shows a large premium (relative to the time), many restrictive policy conditions and a specific listing of each covered person with assigned management duties. There was little interest and few sales of the early products.
The first U.S. insurer to offer D&O insurance was St. Paul, in the 1960s, but there was still little interest among prospective customers, even into the 1980s. In 1992, major D&O underwriters Chubb Group and AIG Companies were dominating the market in offering coverage as the courts began, increasingly, to find liability for the corporate decision-making process.
For organizations subject to SEC regulation, D&O insurance evolved to encompass some aspects of coverage not previously addressed, such as direct liability exposure by the organization for "SEC liability." The concept of insuring the entity, as well as the directors and officers, moved rapidly for non-SEC regulated organizations, and soon D&O insurance coverage for non-SEC regulated organizations was prevalent, offering the same level of coverage for the entity, as was being provided for individual directors and officers.
As the corporate governance scandals of 2001 unfolded, D&O underwriters realized both a high potential for corporate governance allegations, as well as the effect of many years of overcompetitive pricing approaches, and the market for D&O insurance quickly firmed. Within just a few years, however, rampant competition for good private company/family business D&O risks returned and, today, the best private companies can enjoy highly competitive pricing, as well as numerous potential coverage expansion aspects in the market. Following is a review of some measures which can maximize coverage in the private company D&O market, as well as better prepare an agency for potential claims handling. (This list is in no particular order of importance.)
"Duty to defend" versus "no duty to defend"
For covered claims under a D&O policy written on a "duty to defend" basis, allegations and suits are forwarded to the insurer and defense counsel assigned; and eventually the claim is settled, often with very little involvement or communication with the insured organization or persons. For covered claims where the insurer has "no duty to defend," responsibility rests with the insured to find appropriate defense counsel and obtain the approval of the insurer for the chosen firm/attorney. Once the insurer has given this approval, the insurer essentially stays out of the picture until time to settle the claim, when it either approves the suggested settlement, or suggests an alternative approach.
Neither approach to handling allegations and suits is necessarily preferable for every single situation, but individual insureds will likely have a preference for one direction or the other. However, once the D&O policy has been purchased, the course is set for future covered claims handling, so it is incumbent on the seller of the insurance coverage to make sure that his or her insured understands how claims handling will proceed. A good strategy (using a "duty to defend" basis) is to have the insured organization fully understand who defense counsel will be or (under "no duty to defend"), obtain the insurer's approval of chosen defense counsel well in advance of any claim reporting situation.
Affirmative coverage grant for punitive damages
The insurability of punitive damages is decided by the individual states. Some are rather liberal (Georgia, Delaware and Nevada, for example), and some are adamant that insurance proceeds should not be used for punitive damage awards (Ohio, New York and Minnesota, for example). Although punitive damages are arguably more critical with respect to employment practices claims than for D&O claims, it is important for D&O buyers to understand this concept in advance of a claim situation. There are excellent sources on the insurability of punitive damages, including the Wilson, Elser law firm (www.wemed.com) and American Reinsurance (www.amre.com).
Generally, when coverage is excluded for punitive damages, this provision appears in the policy definition of "loss," or "claim," or "damages." The very best possible approach to have is an affirmative coverage statement that punitive damages are covered (except where prohibited by law), and with "most favorable jurisdiction" language. (The latter is important because it is difficult to know in advance where the final jurisdiction will be. Some possibilities would include the home state of the insured organization; the location of the incident giving rise to the claim; the home state of the affected employee(s); or even the state of domicile of the insurance company.)
Flexibility for one policy aggregate limit or individual coverage limits
Almost always, private company D&O insurance is packaged with employment practices liability (EPL) and fiduciary liability coverage, and sometimes with various errors and omissions liability, crime and kidnap/ransom coverages. Although the claims propensity for D&O exists, it is not nearly as prevalent as for EPL or for fiduciary liability exposures. Thus, the bulk of the premium charged would be attributable to EPL and fiduciary exposures. Many insurers writing private company D&O coverage are amenable to allowing higher limits for EPL and/or fiduciary liability coverages within the package. Allowing this approach can assist private company employers to better address management liability exposures, rather than an insurance product which provides one aggregate limit for all covered exposures.
Option for adding EPL "third-party" coverage
Many prominent underwriters of EPL exposures have been willing to offer a coverage extension which would provide coverage for claims brought by persons other than employees (customers, vendors or independent contractors, for example). The ability to purchase such an extension, which would effectively cover such persons bringing claims alleging harassment and/or discrimination, is very important for organizations engaged in retail trade, hospitality, financial services, and other similar organizations. Because there is a significant likelihood for such claims (based upon underwriting experience), not all EPL underwriters will make this potentially valuable coverage extension available. The ability to offer "third-party" EPL coverage is an important issue in terms of the overall insurance program for many organizations.
Option for ancillary coverages such as E&O liability
Some private company D&O underwriters also offer an option for covering miscellaneous errors & omissions liability insurance, to complement the other coverages offered within the package. An example would be a temporary personnel placement organization, a land surveyor, or a computer consulting organization. Generally, a separate insuring agreement is provided within the private company D&O package policy (with limits being included within the aggregate limit, or with limits in addition to other limits provided). Purchasing coverage in this way can be efficient as well as offering some economies of scale to the small business organization. In a society where when something goes wrong, the victim looks for a way to litigate, increasing emphasis should be placed on the exposures of delivering services to others for a fee, and corresponding errors and omissions insurance.
Extending fiduciary liability to cover HIPAA and employers' "managed care liability" allegations
Also with respect to the fiduciary liability coverage, it is important to have coverage for defense and settlement of HIPAA and employers' "managed care liability" allegations. Effective April 13, 2004, the Health Insurance Portability and Accountability Act of 1996 (HIPAA) is federal law for most employers in the United States. Essentially, it provides for some severe penalties in several areas, including the failure to properly protect employee health records and information. (Traditionally, this was done with a file cabinet; now, most records are stored on some type of online system, which presents more opportunities for abuse and unauthorized access to information.)
Also, as part of the 2004 election campaigns, the issue of the Patients' Protection Act legislation may re-emerge. Allegations of improper conduct or ineffective protection of information or use of managed care alternatives could subject many employers to additional litigation. The ability of the fiduciary liability insurer to offer coverage extensions to address these exposures is becoming increasingly important in management liability package policies.
Making sure all employee benefit plans are covered
What is often missed by both buyers and sellers of fiduciary liability insurance is that the ERISA legislation, which governs almost all employee benefit plans (notable exceptions are "nonqualified" plans, such as an executive deferred compensation plans), is applicable to ALL employee benefit plans, and not just pension and profit-sharing plans. Thus when working with the required employee dishonesty coverage, or optional fiduciary liability coverage, it is important to cover all employee benefit plans. The best way to accomplish this is through the use of omnibus language, but a less desirable alternative would be a listing of the legal names of all employee benefit plans. Regardless, fiduciary liability insurance which does not properly address all employee benefit plans can create a coverage gap which can cause problems in the event of a claim (literally, putting a client in technical violation of federal law).
A D&O option for full entity coverage
For organizations subject to SEC regulation, generally the only type of "entity" coverage available would be for allegations against the entity involving violations of Securities and Exchange Commission regulations or related litigation (such as alleged violations of the Securities Act of 1933 or related laws). As previously stated, "private" companies and family businesses can obtain, from any one of several prominent insurers, coverage within the D&O policy for a much broader range of allegations lodged against the entity, than for SEC-regulated organizations. These insurers of private companies are willing, subject to individual risk underwriting, to allow coverage for virtually any claim against the entity which would be covered for individual insureds (directors and officers). Often, an additional premium charge is applicable for this coverage extension. (Although not nearly as crucial exposure-wise as some other mentioned coverage aspects, obtaining this coverage extension can provide the small business insurance purchaser with long-term "peace of mind" in this particular exposure area.)
Favorable financial rating and claims payment reputation
In 2003, at least two prominent D&O underwriting organizations (both with substantial writings of private company D&O business) effectively "faded" from the D&O underwriting landscape. Granted, the insureds of these two organizations were effectively provided for with replacement insurers, as the original underwriters did not go into bankruptcy, but rather found buyers for their underwritten business. But whether a customer is private or public, to have to reveal to covered (prominent, no doubt) individuals that their D&O insurance has been moved to a succeeding insurer is uncomfortable for both the buyer and the insurance agent.
As part of any proposal for private company D&O insurance, the agent should explain the insurer's financial ratings (from A.M. Best, Standard & Poor's, Fitch or another prominent insurer rating organization) to the buyer. While there is no guarantee that a favorable financial rating will endure for any period of time beyond the immediate future, anything less than the best possible rating should be monitored and reviewed on at least a monthly basis. Further, the claims payment reputation of the insurer should be of importance to the buyer.
Words of caution
Not all "important aspects" can be addressed in a positive slant. There are several critical issues that can result in undesirable consequences and thus should be avoided, if at all possible.
Private company (as well as public company) D&O insurance products almost always have a policy provision that allows for some sort of automatic coverage for newly acquired (or constituted) entities which, for all practical purposes, ultimately relates to the formation of "subsidiaries," which is usually a defined term with the respective policy forms. But when a D&O policy's definition of "subsidiary" contains the requirement that such an entity be a "corporation," or a "corporate entity," the unsuspecting parent organization can find itself in a potentially uncovered situation. It is rather well known that partnerships and joint ventures are not afforded coverage by D&O underwriters unless such entities are specifically scheduled for coverage within the policy. However, if an organization has a subsidiary that is a limited liability company (LLC), then a D&O policy that requires that "subsidiaries" be corporate entities will not provide coverage unless additional coverage steps are taken, as LLCs are not "corporations" or "corporate entities," by definition.
Further, in most statutory jurisdictions within the United States, the new business application for D&O insurance functions as a warranty as to the accuracy of the information provided. In a strict sense, an insured organization's continuity is broken if the insurer for D&O is changed over a given period of time and the succeeding insurer requires a new business application (with "warranty language") to be completed. Thus, even to save premium dollars in a competitive D&O market, changing D&O insurers can certainly become counterproductive, coverage-wise, if new application information is re-warranted to one or more new D&O insurers.
Finally, it is important for nonpublicly traded organizations to pay attention to claims propensity--it is much more likely for these organizations to experience allegations from employees, than from either (internal) shareholders, or others. This means that coverage quality is of greater importance for EPL and fiduciary liability coverage, than for D&O coverage, based upon an historical claims perspective. (Underwriters agree, and will confirm, that the greatest percentage of the premium determination lies with EPL and fiduciary liability rating/underwriting factors, as opposed to D&O factors.)
Conclusion
Once thought to be unimportant, management liability insurance (and the exposures faced by organizations) has gained prominence over the past three years. Although organizations subject to SEC regulation have the most concern, private companies have developed increasing interest in buying this insurance, not solely because of exposure-related issues, but also due to increasing demand for protection from individuals involved with management. EPL and fiduciary liability exposures should be of much greater concern for nonpublic organizations, and there are several critical coverage issues in insurance products underwritten to protect private and family business organizations. Regardless, an appropriate objective in this process is maximum coverage at minimum cost, and with a high comfort level regarding the financial strength of the insurance provider. *
The author
Richard G. (Dick) Clarke, CIC, CPCU, RPLU, is senior vice president and major account resource at J. Smith Lanier & Co., a large Georgia-based regional brokerage. He is currently on the board of directors of The Academy of Producer Insurance Studies and is a frequent instructor in Ruble Graduate Seminars conducted by The National Alliance. He is a frequent speaker and writer on management liability topics and recently authored the book The Three Faces of Executive Liability, which was named as one of the Top Ten Risk Management Books of 2001 by Claims magazine. Dick can be reached at dclarke@jsmithlanier.com.