Selecting a limit of liability is arguably one of the most important considerations for management when arranging directors and officers insurance. So important in fact, that most executives find the thought of not having enough coverage, almost as frightening as not having any at all. Below we discuss the limit of liability, why it matters, and what management should be taking into consideration when electing one.
What is a limit of liability?
The limit of liability is the maximum amount of money that an insurer has agreed to pay up to, on behalf of a policyholder in any one year, for claims made against them.Put simply, it represents the level of protection a company and its executives have against claims resulting from a wrongful act, during the course of performing their corporate duties.
The limit of liability is available for the payment of legal defence costs, settlements and court awarded judgements, which would be otherwise payable by a company or its executives. The policy limit generally operates on an aggregate basis, and is in addition to the initial deducible or retention paid by the policyholder. Whether there is one claim or a thousand claims against policy in any one year, an insurer is only responsible for costs up to the limit of liability; any costs exceeding the limit will not be covered by insurance.
The limit of liability is selected by the policyholder when applying for coverage, and will vary depending on the individual requirements of the organisation. The premium of a policy is directly related to the limit of liability selected; therefore the higher the level of coverage, the more expensive the policy.
Considerations when selecting a level of coverage
When selecting the limit of liability for a D&O policy, it certainly isn’t a case of one size fits all. Every company is different, not only in the scope of its operations, but also the type and number of stakeholders affected by the actions of directors. Employees, shareholders and executives all contribute to the exposures associated with occupying management positions, and in general terms, larger and more sophisticated businesses have a higher degree of risk.
From a director’s perspective, they need to consider a company’s ability to fulfil its indemnification obligations, because any shortfall, without the support of insurance, will leave them exposed. For example, if an organisation was to become bankrupt and company indemnification not available, would the limit of liability be sufficient to cover executives if a claim was to arise? Businesses operating within volatile and litigious industries need to take this into account, and set policy limits high enough to cover worse case scenarios, whilst also applying a sensible deductible strategy. Finally, what is the future prospect and expected growth of an organisation? If a company intends to undertake any significant merger, acquisition or capital raising, executives may consider higher limits, as these are considered riskier activities.
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The importance of getting it right
As the limit of liability is typically inclusive of defence costs, companies must ensure that they consider these expenses, in addition to the cost associated with settling claims. It is not uncommon for the entire (or at least a significant portion) of the policy limit to be consumed by defence costs, particularly when claims involving securities class action occur. Management should also keep in mind that the limit of liability is available to all those insured by a policy, and can be quickly eroded in instances when directors and officers involved in a common claim, require their own separate legal representation. For example, a situation where three directors are sued and each requires a lawyer to represent their own interest. Take into consideration that an average D&O claim can span two or three years, and the costs of settling the claim; a million dollar limit would be eroded in no time.
Also consider that the limit of liability is aggregated, therefore must satisfy all claims in a policy period. If the limit of liability is exhausted, a company and its executives can be left without financial support, leading to catastrophic losses and financial ruin. To put this in perspective, a director or officer without access to the protection of insurance may have to sell their family home and other investments assets, to fund the costs of a legal defence.
How much is enough?
Unfortunately there is no simple answer to this question, as ultimately directors and officers are required to make a decision on a range of factors specific to their situation. In addition to the considerations discussed above, the coverage limit and deductible selected will often be determined by a company’s financial strength (how much it can afford) and its tolerance of risk. For example, a small organisation with revenues of a few million dollars may only require coverage of $1m or $2m. Whilst it would not be uncommon to find larger private companies seeking a limit of $5m or $10m, to accommodate for their higher degree of risk.
Public listed companies, on the other hand, often look to acquire coverage of $50m or more, with many larger and more volatile businesses acquiring coverage of hundreds of millions, often involving multiple insurers. While it may not be possible to provide a clean cut guide, executives should take an active interest in the selection of D&O coverage, and ensure they are consulting with experienced insurance brokers and legal advisors, who can assist them through the process.