Directors and officers liability insurance is an essential coverage for organisations of all shapes and sizes. It aims to protect an organisation’s management from claims made against them in the performance of their duties. Without such coverage in place, an organisation and its management can be exposed to significant financial loss.
In this article, we will explore the concept of directors and officers liability insurance, and understand why it is an important part of any comprehensive insurance programme.
Directors and officers liability insurance: A definition
Directors and officers liability insurance is purchased by an organisation to protect its management, and to some extent itself, from the consequences of managerial-related claims. In other words, it protects an organisation and its management from claims that arise while managing its operations.
It is held by a wide variety of organisations, such as:
- Public companies
- Private companies
- Nonprofit organisations
- Charities
- Universities and other academic institutions
- Government departments
By purchasing directors and officers liability insurance, an organisation can not only protect its own financial interests but also that of its individual managers. When combined with an appropriate directors indemnification agreement, it can provide an organisation with the best possible opportunity for attracting talented individuals into the ranks of leadership.
What is its role in an insurance programme?
Directors and officers liability insurance typically forms part of a comprehensive insurance programme.
General insurance
A policy will often be purchased alongside a range of general insurance coverages, such as:
- Property damage and business interruption insurance
- General liability insurance
- Marine transit insurance
- Motor vehicle insurance
- Corporate travel insurance
- Workers compensation insurance
Financials lines insurance
And it will complement any other types of financial lines insurance that an organisation may have in place. Such coverages include:
- Employment practices liability insurance
- Commercial crime insurance
- Cyber insurance
- Professional indemnity insurance
Within a broader programme, directors and officers liability insurance is often considered an auxiliary type of coverage. Its premiums can be relatively small when compared with other insurance classes. However, from the perspective of an organisation’s management, it is arguably one of the most important; as it ultimately protects their personal assets.
What are the key managerial risks?
The directors and officers of an organisation, known collectively as management, play an important role in governing its activities. With this responsibility comes many risks.
Common sources of claims
An organisation’s management have a fiduciary responsibility to place an organisation’s interests ahead of their own. However, they must also consider the consequences of their actions on others; more specifically, an organisation’s stakeholders.
Common stakeholders include:
- Shareholders and members
- Government and regulatory authorities
- Creditors
- Competitors
- Suppliers
- Employees
Common claims
If a stakeholder becomes disgruntled with an organisation’s management they may wish to hold them accountable for their actions. As a result, any grievance may eventually be formalised in a claim.
Common claims against management include:
- Negligent management
- Inadequate disclosure in financial reports
- Misuse of company funds
- False and misleading representation in capital raising
- Failure to comply with employment laws
- Theft of intellectual property and poaching of competitor’s customers
- Breach of fiduciary duty resulting in financial losses or bankruptcy
- Lack of corporate governance
- Shareholders disputing merger and acquisition activity by the company
- Allegations of breaches in fair trading legislation by competition watchdogs
- Allegations of defamation by business competitors and politicians
- Regulatory authorities investigating corporate governance compliance
When a claim is made against an organisation or its management, it must be defended, no matter its merits. In this respect, a genuine claim carries just as much weight as a frivolous one and must be addressed with the same seriousness. With a little luck, a claim may be resolved quickly through mediation. But if not, it may need to be defended in a court of law.
Claim examples
Let’s take a look at a few claim examples to better understand what a directors and officers liability insurance claim might look like in practice.
Example 1 – Insolvent trading
A wholesale company fails to pay its debts as they fall due and enters into voluntary administration. A liquidator is eventually appointed and discovers that management may have breached their directors duties by trading while insolvent. Following consultation with the company’s creditors, legal action is taken against the former board of directors.
Legal counsel is appointed to defend management and costs of $150,000 are incurred. A regulatory authority issues the board with civil fines amounting to $100,000, and they are disqualified from operating a company for five years.
Example 2 – Misappropriation of trade secrets
A senior manager of a natural resource company decides to leave after many years of employment and immediately joins a competitor. His former employer then brings a claim against him alleging the theft of intellectual property, as well as claiming that he is in breach of his original employment contract.
The individual seeks indemnification from his new employer, who does so in accordance with the terms of a directors indemnification agreement. The claim is successfully defended and dismissed, resulting in legal costs of $125,000. This loss is reimbursed by the insurer.
Example 3 – Shareholder dispute
A technology startup issues share options to a new employee to secure her services. A minority shareholder of the startup becomes disgruntled as he was not consulted prior to the issuance, bringing a claim against the chief executive officer. The shareholder alleges that this decision was negligent and that his ownership is now diluted.
Legal counsel is appointed to defend the claim against the chief executive officer. After negotiations, a majority shareholder offers to purchase the claimant’s interest in the company for an undisclosed amount, and the matter is closed. Defence costs of $35,000 are incurred.
How do management risks arise?
An organisation’s management is responsible for overseeing its operations and monitoring ongoing performance. There are clear obligations imposed on them, and also potential consequences should these obligations not be fulfilled.
Directors duties
The management of an organisation are required to satisfy a range of directors duties in the performance of their role. Directors duties vary between jurisdictions, but are typically articulated in statutory law (enacted by government), regulatory law (enacted by regulatory authorities), and case law (established by court precedent).
Board of directors liability
If directors duties are not performed as expected, it can result in board of directors liability. If a stakeholder of an organisation believes that they have been adversely affected by the actions of management, they can attempt to hold them accountable. By doing so, they may seek compensation or some other remedy for the loss that they claim to have suffered.
What types of protection are available?
There are two common methods of protecting an organisation and its management from managerial-related claims.
Directors indemnification agreement
A directors indemnification agreement, also known as a deed of indemnity, is the first line of protection against board of directors liability. It is essentially a contract between an organisation and an individual, whereby an organisation promises to protect them from any personal liability arising in the performance of their managerial duties.
Directors and officers liability insurance
Directors and officers liability insurance is the second (and final) line of defence for an organisation and its management. It can protect an organisation from the costs of indemnifying management, and in certain situations protect an organisation from its own liability. Importantly, it will also protect an individual in the event that an organisation cannot indemnify them.
Core policy coverages
Now that we understand the responsibilities of management and the risks that they face, we can explore the insurance policy designed to protect them.
A policy will typically include two core coverages:
Directors and officers liability coverage (Side A)
Side A coverage, also known as directors and officers liability coverage, protects management when a claim is made against them personally and the organisation which they represent cannot or will not indemnify them. In these situations, without insurance coverage, an individual would be responsible for financing their own defence; often at a great cost.
Organisation reimbursement coverage (Side B)
Side B coverage, also known as organisation reimbursement coverage, reimburses an organisation for the costs incurred when indemnifying management in accordance with its indemnification obligations. In these situations, without insurance coverage, an organisation would be responsible for financing a legal defence from its balance sheet.
Entity coverages
In addition to its core coverages, a policy may also allow an organisation to insure its own liability in certain situations. This is known as entity coverage.
Entity securities coverage (Side C)
Side C coverage, also known as entity securities liability coverage, protects an organisation from claims arising from the issuance, purchase or sale of its shares. This coverage is typically made available to public companies, who are most at risk from shareholder related lawsuits – which often, and most severely, materialise in the form of a class action.
Employment practices liability
Employment practices liability insurance protects an organisation from its own liability in employment-related claims. While directors and officers liability insurance typically includes coverage for claims made against an individual, employment practices liability insurance extends this coverage to include claims made against the organisation itself.
Variations of directors and officers liability insurance
There are two common variations of directors and officers liability insurance designed for particular types of organisations.
Management liability insurance
Management liability insurance is designed specifically for small and medium enterprises. As a package policy, it includes a number of additional coverages that protect an organisational entity, in addition to the coverage intended for management. Such coverages include entity liability coverage, employment practices liability insurance, and a range of others.
D&O insurance for nonprofits
D&O insurance for nonprofits has been designed with nonprofit organisations in mind. Similar to management liability insurance, it also includes a number of coverages to protect an organisational entity, in addition to the coverage intended for management. Such coverages include entity liability coverage, employment practices liability insurance, and a range of others.
Who is insured?
A policy will be crafted to protect an organisation and its management in a deliberate manner, defining those who are considered to be an insured.
Insured organisation
A policy will typically cover a principal insured organisation and any subsidiary of this entity. Collectively, these entities will often be referred to as the policyholder. The principal insured organisation will typically be listed on the policy schedule, and the definition of subsidiary will be located in the policy wording.
A subsidiary will typically be defined as any entity of which the principal insured organisation owns or controls more than 50% of shares or voting rights, directly or indirectly. If an organisation wishes to insure an entity that does not fulfil the definition of a subsidiary, it may be considered for inclusion as an additional insured organisation by endorsement.
A policy is likely to include a provision for automatically covering an organisation’s new and acquired subsidiaries throughout a policy period. The coverage for new and acquired subsidiaries often aligns closely with cessation of subsidiaries coverage, which will maintain coverage for any subsidiary that is wound up or divested during a policy period.
Insured person
A policy will typically cover any insured person of the policyholder. The definition of insured person will be listed in the policy wording, and will be broadly defined to capture the types of individuals that are exposed to managerial-related risk.
An insured person is typically defined as:
- Any director, officer, or managing partner
- Any chairman, secretary, or committee member
- Any employee acting in a managerial capacity
Any past, present or future insured person will be covered as long as an organisation continues to purchase a current policy. This is certainly a great benefit, however, retiring individuals may be anxious that their ongoing coverage relies on an organisation continuing to purchase a policy. To address this risk, many policies will include some form of retired directors and officers coverage.
What acts are insured?
A policy intends to cover an organisation and its management for specific types of behaviour.
Insured capacity
A policy will cover an organisation’s management in their insured capacity as directors, officers, and managers more broadly. This means that an insurer’s intent is to only cover managerial-related risks and not those arising in another capacity. As a result, an insured will not be covered for acting in a personal or professional capacity – other insurances are required for these risks.
Wrongful act
A policy will cover an organisation’s management for any actual or alleged wrongful act while acting in their insured capacity.
A wrongful act will typically include any:
- Act, error, or omission that others perceive to be wrongful
- Misstatement or misleading statement
- Breach of directors duties
- Breach of fiduciary duty
- Breach of trust
- Neglect
Employment-related wrongful act
A policy will also provide coverage for any employment-related wrongful act, such as:
- Unfair dismissal
- Failure to employ or promote
- Harassment, discrimination, or humiliation
- Defamation, including libel (written) and slander (verbal)
- Retaliation
Remember that unless a policy includes employment practices liability insurance, this coverage will only apply to any claim made against an individual, not an organisation.
What types of loss are insured?
A policy will define what types of loss incurred by an insured will be covered in the event of a claim.
Insured loss
The definition of loss will typically include:
- Defence costs, for legal representation by a solicitor or barrister
- Settlement costs, such as a negotiated payment or court-awarded judgement
- Formal investigation costs, incurred in preparation for an official inquiry
- Prosecution costs, for overturning undesirable judgements handed down in the course of a claim
- Fines and penalties, issued by regulatory authorities where insurable by law
Uninsured loss
However, not all types of loss that an organisation and its management may incur will be covered.
The definition of loss will not typically include:
- Fines and penalties that are not insurable by law
- Taxes
- The cost of complying with a court order or injunction
- Employment-related costs, such as wages, salaries, commissions, and other benefits
How is a policy structured?
A policy consists of a policy schedule, policy wording, and endorsements. Of these, the policy wording plays a central role in defining the terms of coverage.
Insuring clauses
Insuring clauses, also known as operating agreements, outline the promise of an insurer to pay for or on behalf of an insured for a covered loss. They are responsible for articulating the coverage afforded by a policy. It is not unusual for a policy to include more than one insuring clause, each addressing a distinct risk that an insurer intends to provide coverage for.
Key term definitions
Key term definitions are contained throughout a policy wording and aim to facilitate a clear interpretation of its coverage. They are relied upon by all parties to reduce the ambiguity of important terms and are an essential link between a policy’s schedule, wording and endorsements. To aid identification, defined terms are often highlighted by bold, italic, underlined or capitalised text.
Extensions
Extensions broaden a policy’s coverage from its insuring clauses and provide additional protection and/or benefits to the policyholder and any insured person. Many extensions are automatically included, while some may be optional. An insurer will often use extensions to differentiate its product offering from that of its competitors.
Exclusions
Exclusions aim to eliminate an insurer’s exposure to undesirable risks faced by an insured. They are applied for many reasons; the risk of certain hazard may be too great for an insurer to bear, or be against the intention of a policy. Many exclusions will be included as standard, while some will be context specific and applied by endorsement.
Conditions
Conditions outline the various subjectivities that attach to a policy’s coverage. They explain how a policy is to be interpreted and what the obligations are of both an insurer and an insured. Conditions will also carefully explain important processes that are essential to a policy’s operation; such as applying for coverage, notifying claims, and maintaining adequate disclosure.
How does a policy function through time?
Directors and officers liability insurance has a number of unique features that determines how a policy functions through time.
Claims made policy
A claims made policy requires that a claim be made against an insured and be notified to an insurer during the policy period, for any subsequent loss to be covered. For this reason, it is best to refer to such coverage as claims made and notified, to adequately account for the second condition of notification. Additionally, a policy will require the notification of any circumstance that may reasonably lead to a claim.
Prior acts coverage
The natural language of a claims made policy allows it to provide prior acts coverage. By prior acts, we mean any act or decision that has taken place at some time in the past, even before the commencement of the policy period. Insuring behaviour that occurred prior to the inception of coverage, as long as the subsequent claim is made in the policy period, is a unique aspect of a claims made policy.
Retroactive date
A retroactive date, also known as a prior acts date, can be used to restrict a policy’s prior acts coverage. It is typically listed on the policy schedule and attaches to a retroactive exclusion or prior acts exclusion. A retroactive exclusion will state that no claim will be covered if it is a result of an act that occurred prior to the retroactive date. Alternatively, a policy may state that only acts occurring after a retroactive date are covered.
Pending and prior litigation date
A policy may also include a pending and prior litigation date, which attaches to a pending and prior litigation exclusion. It aims to exclude any claims that have commenced in any way prior to the specified date. It is an insurer’s way of excluding claims and circumstances that should have been most appropriately notified in a previous policy period.
How to acquire coverage
To acquire coverage, an organisation and its management will need to follow a number standardised procedures.
Application process
During the application process, an organisation is required to make a submission to a prospective insurer. A submission will typically include the following information:
- A proposal form
- Supporting documents
- Financial statements
- Ownership structure diagram
Any financial statements should be audited, or third-party prepared at the very least. An internal accounting report is generally not sufficient because it is difficult to determine its integrity. For larger and more complex organisations, financial statements are mandatory. However, for small and medium enterprises, there may be some flexibility on this requirement.
Duty of disclosure
An organisation is required to satisfy a duty of disclosure throughout the lifecycle of a policy. In practical terms, this means that it is under a strict duty to deal fully and frankly with an insurer – disclosing any material fact that is relevant to an insurer’s decision making. A failure to do so can result in severe consequences for all those that rely on coverage.
Underwriting process
An insurer will complete an underwriting process to analyse the risks faced by an organisation and consider its suitability for insurance. This aims to determine an adequate premium for accepting the risk and setting the terms of coverage. Once a quote is issued, it will typically remain valid for 30 days, subject to there being no material change to the underlying information.
Mid-term alterations to coverage
Once a policy in place, its terms will be set for the duration of the policy period. If an organisation would like to make alterations to its coverage mid-term, this will need to be completed by endorsement. Any changes to an organisation’s risk will need to be underwritten, and a signed no known loss letter will be required before any alterations are confirmed.
Expiry and replacement
As a policy period approaches expiry, a replacement policy will need to be arranged. In most situations, an organisation will need to complete a new proposal form and provide its most recent financial statements. Sometimes, an express or fast-track replacement process may be available; however, this is typically reserved for smaller and less risky organisations.
Client considerations
When an organisation and its management purchase directors and officers liability insurance, there are a couple of important points to consider.
Limit of liability
A limit of liability, also known as a limit of indemnity, is the maximum amount that an insurer is liable to an insured for covered loss in any one policy period. It is typically separated into three key components; an any one loss limit, an aggregate limit, and sublimits. Selecting an adequate limit of liability plays an important role in protecting an organisation from significant financial loss.
Self-insured retention
A self-insured retention, also known as a deductible or excess, is the amount of loss that an insured must incur for a covered claim before a policy will respond. Once the self-insured retention has been paid or eroded, an insurer will commence its payments to an insured. Selecting an adequate self-insured retention ensures that any insurance protection is reserved for significant losses.
How does a policy operate throughout time?
Once a policy is in place, there are a number of situations that can effect the coverage of an organisation and its management.
Change in control
If an organisation undergoes a change in control during the policy period it will result in a conversion of coverage. When this occurs, a policy will no longer cover an organisation and its management for forward-going acts. Rather, only acts that occurred prior to the change in control will be covered. This phenomenon is described as coverage being in run off.
Run off insurance
Run off insurance is a term often used to describe the practice of purchasing insurance coverage for an organisation that has incurred a material change to its corporate structure, such as a change in control or winding up. It attempts to address the long-tail exposures of managerial liability, which remain long after individual managers have moved on.
Extended reporting period
An extended reporting period is a type of run off insurance made available to an organisation after a change in control. If an organisation and its management would like to maintain coverage for the notification of claims and circumstances arising from past acts, an extended reporting period will allow them to do so; provided that it is willing to pay an additional premium for the privilege.
Discovery period
A discovery period may be made available to an organisation in the event that it decides not replace its expiring policy. This can provide an organisation and its management with the ability to notify claims that materialise after a policy’s expiry date, but only for acts that occurred prior to the commencement of the discovery period.
Claims handling
Directors and officers liability insurance is often purchased with the hope that it will never be required. However, realistically, it is only a matter of time before an insured becomes aware of a claim made against them.
Claim notification process
A claim notification describes the process that an organisation and its management must undertake to advise an insurer of a new claim or circumstance. It is an important aspect of protecting management, as it involves identifying a situation that is likely to trigger a policy’s coverage and then reporting this to an insurer in accordance with its relevant procedures.
Who has the duty to defend?
A policy will include a duty to defend provision that outlines which party – the insurer or the insured – has the right and obligation to defend an underlying claim. A policy with duty to defend language places this responsibility on the insurer, while non-duty to defend language (also known as duty to indemnify) places this onus on the insured.
Claim settlement process
An opportunity for claim settlement may arise throughout the defence of a claim. Claim settlement can describe the process of entering into negotiations with a claimant to bring a matter to conclusion, but also the process of an insurer discharging its obligation to an insured – by arranging payment to an organisation and its management for any covered loss.
Conclusion
Directors and officers liability insurance is an essential coverage for organisations of all shapes and sizes. It aims to protect an organisation’s management from claims made against them in the performance of their duties. An organisation and its management may be exposed to significant, and sometimes catastrophic, financial loss without such coverage in place.
Featured image by daryan / CC0
