By Donald S. Malecki, CPCU
Most of what is written today about directors and officers (D&O) liability insurance deals with publicly owned businesses. That makes sense because in these types of businesses, executive decisions can generate a lot of dissatisfaction among the shareholders and lead to huge damage suits.
What should not be overlooked is that privately owned, for-profit businesses (hereinafter, closed corporations) and nonprofit organizations such as libraries, garden clubs, and soccer leagues also need D&O liability coverage. In fact, the market for these types of entities probably far outweighs the number of publicly owned businesses in the United States.
It is not unusual for a producer to encounter questions from a client who is being asked to serve on some board of a closed corporation or nonprofit organization. Questions such as: "Should a D&O policy be in place as a condition to my consent to serve?" or "There is a policy in place, but does it provide the kind of protection I need?" or "If shareholder derivative actions are undoubtedly the leading reason for litigation, then why is a D&O liability policy necessary for a closed corporation or nonprofit organization?"
Producers need to be prepared for such questions; however, they do not have to be lawyers to answer many of them. In fact, many of these questions come from lawyers themselves--whose clients have concerns about serving on boards.
However, there may be times when it makes good risk management sense for a producer to refer the client to an attorney. For example, many states have enacted laws that are intended to limit the exposure of nonprofit directors. An attorney is necessary to counsel individuals on that subject and to make a presentation about the policy selected.
Why the D&O policy is necessary
If derivative shareholder suits are the leading reasons for litigation against publicly owned corporations, what is the nature of allegations that will be worrisome for closed corporations and nonprofit organizations? Producers need to be prepared to inform prospective clients why a D&O policy is necessary for them.
Among the claimants who often institute suits against directors and officers are employees or former employees, competitors, customers, creditors, and governmental agencies. The allegations are limitless. Among the common ones are improper expenditures, civil rights and employment-related allegations, conflict of interest, and income tax irregularities.
Nature of coverage
Although D&O liability policies are not standard, there are similarities. To this extent, they also could be referred to as the "typical" policy. It is probably safe to say that most of them are written on a claims-made basis; that is, for coverage to apply, a claim must be made during the policy period.
It is difficult to say whether the policy will have a retroactive date. If a date is designated in the policy declarations as a retroactive date, it means that a claim during the policy period will be honored if the wrongful act was committed after the retroactive date.
Some insurers will provide a policy without a retroactive date, which should be viewed as advantageous. The reason is that a claim made during the policy period can still be covered even if the wrongful act was committed prior to the policy's inception.
The catch is whether the applicants knew about the potential for such a claim before purchasing the policy. The application, which is attached to the policy, is a warranty and a question will be asked about prior-known acts likely to give rise to a claim. It is important to note that one of the leading reasons claims are denied under these policies is because the executives knew of a wrongful act but answered the question as "none known."
The "typical" D&O liability policy for closed corporations and nonprofit organizations consists of two coverages. The first is protection for the individual officers and directors when they cannot be protected by the entity, such as in a shareholder derivative action. The second is reimbursement of loss to the entity for having defended and paid on the individual officers' and directors' behalf for allegations of wrongful conduct to the extent the entity is otherwise permitted by law to do so.
Since closed corporations and nonprofit organizations do not commonly have shareholders, derivative actions will be unlikely. Therefore, barring any law against an entity protecting its officers and directors, the major coverage will be the second one of the policy where the entity protects its officers and directors from financial loss and seeks reimbursement from the insurer.
Some insurers also will add entity coverage to these policies, just as they commonly do for publicly owned corporations that are in need of coverage based on suits over their securities issues. Without entity coverage, there is no coverage for the entity that is named alone in a suit or named along with its executives.
Defense coverage and limits
It is common knowledge that when a lawsuit is filed, the leading cost under any type of liability policy will be for defense. What is especially worrisome to insureds is whether the defense costs are within policy limits or in addition to them.
It is a legitimate concern. The bad news is that it is the rule, rather than the exception, that the policy will have "cannibal" limits. Thus, it is possible for the policy limits to be exhausted before the conclusion of a lawsuit, particularly with a serious case scenario and low limits.
Since insurers do not commonly defend the entities, and some entities cannot afford to expend defense costs and wait for insurer reimbursement, some insurers have made it easier by offering to advance reimbursement for some of the legal costs.
There commonly is a "string" attached to these provisions referred to as allocation. The message from the insurer is, in essence, that what the insurer will ultimately pay, in terms of defense costs and damages, is for those allegations that are considered to be covered. If the entity, for example, spends money on defense of an allegation not covered by the policy, the entity will have to reimburse the insurer.
When it comes to limits, producers can expect, without fail, to be asked how much insurance should be purchased. This is a business decision and not one that producers should even attempt to answer. It makes good risk-management sense to put the burden back on the executives who are purchasing the policy to decide on limits. It is not uncommon to respond to their question this way: "Purchase all the limits you can afford."
Other policy features
To be practical about it, there is no perfect policy. As has been mentioned in this column over the years, it is a matter of balancing one's priorities. Candidates for these policies therefore may have to give up some desirable policy features in order to obtain other enhancements.
Watch out for the extent to which wrongful act is defined. Since many of the decisions made by executives are intentional, "wrongful act" should not be limited to negligent acts. The majority of D&O policies for closed corporations and nonprofit organizations contain broad definitions of wrongful acts, but one never knows when an insurer will try to make coverage more limited.
An "awareness" provision is commonly viewed as a definite plus. This provision states that if the insured becomes aware of circumstances that could give rise to any claim and gives notice during the policy period, then any claim arising from those circumstances shall be considered to have been made during the policy period in which the circumstance was first reported.
Most, if not all, D&O policies require this kind of notice. But whether they contain a provision offering coverage back to when notice was given is the important feature that needs to be considered.
Most insurers offer insureds the opportunity to purchase extended reporting period (ERP) or so-called "tail coverage." This latter term is a misnomer that tends to cause confusion because an ERP is not a type of coverage. It merely extends the time within which the insured can make a claim after the policy has expired.
Watch for eligibility. Some insurers will offer an ERP only when the insurer cancels or non-renews coverage. The more advantageous policy will also give that option to the insured who decides to cancel or non-renew the policy.
Many D&O liability policies have the same exclusions. They apply to avoid covering what is available under other policies such as fidelity and commercial general liability policies. However, it is not unusual to find some employment-related liability coverage built into policies. How much coverage is a question that needs to be pondered.
The one major disadvantage of having employment-related liability coverage within a D&O policy is that the coverages apply subject to one limit. Considering that claims against entities sometimes involve employment-related offenses, it may be a good idea to keep them separate. It all depends on how large an operation the insured is conducting and what employment-related safeguards are in place.
One of the provisions of these policies that is a definite plus is commonly labeled as the "severability of exclusions" condition. This states that with respect to all exclusions (1) no fact pertaining to or knowledge possessed by an insured individual shall be imputed to any other insured individual, and (2) only facts pertaining to or knowledge possessed by an executive officer shall be imputed to the corporation.
These are some of the features that producers need to consider if they want to get involved in assisting clients with the selection of policies. The alternative is simply selling an "off-the-shelf" policy, which also is permissive practice if that is the custom of the producer, and clients do not request assistance. *
The author
Donald S. Malecki, CPCU, is chairman and CEO of Donald S. Malecki & Associates, Inc. He is a committee member of the International Insurance Section of the Society of CPCU, on the Examination Committee of the American Institute for CPCU, and an active member of the Society of Risk Management Consultants.