Understanding the limit of liability and structuring one adequate for your needs

Understanding the function of the limit of liability, as well as selecting an appropriate level of coverage, is a difficult decision for many organisations. Read on to learn more about how it works and what options are available.

The limit of liability specifies the amount of insurance coverage available to a policyholder, for the payment of claims in any one policy period. It sets the maximum value that an insurer is prepared to spend defending and settling claims, on behalf of an organisation and its management.

Any one claim and in the aggregate

The limit of liability applies to each individual claim, as well as all claims in the aggregate. This means it is possible to exhaust a limit by incurring a single large loss or many smaller losses aggregated throughout the period of insurance.

Whichever the case, once the limit is reached, the policy is cancelled and coverage ceases to exist for any additional claims.

To help minimise the effects of claim aggregation, the limit of liability often sits in excess of a self-insured retention. Whether retention applies to a specific claim or not, depends on the insuring clause involved.

Defence costs inclusive

Many D&O policy limits are inclusive of defence costs. This means that the fees of lawyers engaged to defend a claim, contribute to the overall policy limit.  In other words, as a claim is defended the limit of liability is eroded, leaving less funds available for settling the claim at hand as well as paying for any future claims.

For example, if a D&O policy has a $1 million limit of liability and $150,000 is spent on defending and settling a particular claim, $850,000 remains for the defence and settlement of claims occurring throughout the remainder of the policy period.

Defence costs exclusive

Defence costs are not always included in the limit of liability, as some policies, particularly management liability policies, provide coverage on a defence costs exclusive basis. This means that the defence costs are in addition to the limit of liability, thereby reserving the entire policy limit for the settlement of claims.

Important! A defence costs exclusive policy limit, where available, is an advantageous arrangement for any policyholder.

Selecting a limit of liability

Selecting a limit of liability is a challenging task for many organisations. The level of coverage selected can be the difference between being comfortably protected and facing financial ruin.

But what limit of liability can be considered adequate? And how does an organisation decide how much coverage to carry? Unfortunately, selecting a limit of liability is not an exact science, and it depends on a range of factors.

Described below are seven things that should be considered:

1. Ownership structure

An organisation’s ownership structure plays a significant role in determining the level of coverage required. While both public and private organisations face risks with varying complexity, it is public companies that are exposed to the most severe claims. As a result, they typically require much higher policy limits, with many carrying coverage of $100 million or more.

2. Organisation size

The risk exposures faced by an organisation and its management are directly related to its size. The size of an organisation can be measured in a number of ways, such as:

• Annual revenue
• Market capitalisation
• Number of employees

In short, large organisations experience larger and more frequent claims. By comparison, small organisations are generally less risky and have been known to comfortably carry policy limits of as little as $1-5 million.

Did you know? Underwriters may not offer higher levels of coverage where the limit of liability is larger than the total value of the organisation itself. This way, the policy is less likely to be abused as an ‘asset’ of the organisation.

For example, a private company with annual revenues of $2 million, may not be permitted to acquire any more than, say, $5 million of coverage, as this may encourage misuse.

3. The number of directors and officers to be insured

The number of executives requiring protection from a single D&O policy has a significant effect on the level of coverage required. When defending claims, each executive may not have the same interests and therefore, may require their own separate legal counsel.

A limit of liability should take this into account, whilst also reserving enough funds for potential settlements.

4. Operational location

The geographical location of an organisation’s operations and commercial interests should be considered. Organisations operating in foreign markets may face a higher risk of claims due to relative unfamiliarity with local laws and increased compliance obligations.

Additionally, organisations operating in highly litigious jurisdictions, such as the United States and Canada, should pay special attention and consider raising policy limits to account for the additional risk that this brings.

5. Peer benchmarking

A popular method of determining policy limits is benchmarking an organisation’s requirements against the purchasing trends of other similar organisations, in terms of both industry and size.

Whilst comparative information provided by brokers and underwriters is certainly helpful, directors and officers should ensure that their D&O coverage is adequate for their own circumstances.

6. Claims trends

After considering peer benchmarks, it makes sense to take into account claims trends within the D&O market. A lot of insight can be gained by simply staying informed of litigation trends reported in the media. However, many insurers, industry publications and intelligence services such as Advisen, are also an excellent source of claims related data.

7. Budget

Finally, most organisations will need to take into account the cost of acquiring coverage. While an ideal world would provide unlimited resources for purchasing D&O insurance, budgetary constraints are often considered.

Despite cost often being an important factor, especially for smaller operations, executives may be able to reduce these overheads by altering their coverage or the level of self-insured retention.

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Implications of entity coverage

By including entity coverage within a D&O policy, the operation of the limit of liability is altered. It can have a positive effect by aligning the interests of an organisation and its insurer, but may also impact negatively by infringing on the protection available to executives when they need it most.

Removing cost allocation disputes

The inclusion of entity coverage removes the tedious issue of costs allocation. In the absence of entity coverage, there is potential for a diversion of interests when an insurer, which is paying on behalf of executives, and an organisation, which is paying for itself, attempt to divide the costs of litigation.

With entity coverage in place, management and the organisation are insured under the same policy. Therefore, the interests of all parties are more closely aligned with the interests of the insurer, possibly leading to a simpler and more straightforward resolution.

Sharing the policy limit

Despite the benefits of incorporating entity coverage into a D&O policy, there can be negative implications. One of the main downsides is how claims against the entity affect the limit of liability.

The limit of liability is typically shared across all sections of a policy. This means that any costs incurred in defending the entity from a claim affects the overall policy limit.

This impact can be significant, as the coverage available to management is effectively reduced while an organisation defends its own interests. In a worst-case scenario, the limit of liability can be eroded to the point of exhaustion, leaving individuals without further coverage for claims.

Ironically, by sharing the policy limit, executives can end up being exposed to the very claims which the purchase of D&O was intended to prevent.  Hence, the inclusion of entity coverage must be carefully considered, so not to leave management unprotected in situations where an organisation cannot indemnify them.

Solutions for shared limit of liability

In recent times, a few solutions have been developed to overcome the issues created by including entity coverage within a D&O policy:

1. Remove entity coverage

By electing not to insure Side-C or EPL coverage, an organisation removes the issues of a shared limit altogether. By doing this, the entire policy limit is preserved for the use of directors and officers (Side-A) and reimbursing the organisation when indemnifying them (Side-B).

2. Purchase stand-alone entity coverage

For employment practices liability and other entity insurances such as crime and statutory liability, an organisation may have the option of removing these coverages from its D&O policy, and instead insuring them on a stand-alone basis.

While this often a more expensive option, it prevents entity claims from contaminating the D&O policy limit.

3. Elect separate towers

When an SME acquires management liability coverage, it may have the option of electing separate towers for each insuring agreement. By isolating each section of coverage, each one gets its own limit of liability. Therefore, say, in the event that the corporate liability coverage applying to the protection to the entity is exhausted, this will not affect the other insuring agreements, which remain intact.

4. Purchase additional Side-A coverage

Many insurers offer stand-alone Side-A coverage to compliment their traditional ‘primary’ D&O policies. Stand-alone Side-A, purchased alongside a primary D&O policy, provides a higher level of Side-A coverage over and above the policy limits of the primary policy.

Stand-alone Side-A coverage ensures that directors and officers remain protected, even if the primary D&O limit is exhausted. Its benefits are often two-fold:

1. Difference-in-limit (DIL): stand-alone Side-A can provide difference-in-limit coverage (DIL); whereby it sits in excess of the Side-A coverage of the primary policy, ready to indemnify individuals if the primary policy limit is completely exhausted, and the organisation cannot indemnify executives any further.
2. Difference-in-conditions (DIC): additionally, stand-alone Side-A can provide difference-in-conditions coverage (DIC); whereby coverage can ‘drop down’ and indemnify executives if an organisation and/or the primary D&O policy cannot protect them. This is possible because Side-A DIC policies often provide broader coverage than primary D&O policies, as they deliberately include fewer exclusions.

Note: Many stand-alone Side-A policies include the benefits of both difference-in-limit (DIL) and difference-in-conditions (DIC).

D&O programmes

Any organisation requiring a large limit of liability will work with an experienced broker to develop a D&O programme. D&O programmes are constructed to allow an organisation to acquire its total policy limit from multiple insurers when its requirements are too high for any one insurer to satisfy.

Layering of indemnity limits

The panel of insurers that make up a programme are headed-up by the lead insurer. The lead insurer is typically experienced with D&O liability issues and is responsible for issuing the policy wording and handling claims. It is responsible for issuing the first layer of coverage, the primary layer, which means it is also the first insurer to pay out when claims arise.

Following the lead insurer, excess layers of coverage are acquired from other insurers and are stacked on top until the desired limit is reached. Excess layers are typically follow-form, in that they are subject to the same terms and conditions of the primary layer.

Any claims lodged against a D&O programme erode the limit liability from the bottom up. Once a claim exceeds the self-insured retention, the primary layer of coverage is eroded until the first excess layer is reached. The first excess insurer then pays up until to the second excess layer. This continues until the total programme limit is exhausted or the end of the policy period, whichever occurs first.

In practice, the lead insurer will usually incur the majority of losses, and is responsible for paying claim settlement and defence costs on its own. The excess layers often play a secondary role, existing for the purposes of covering claims that are large or that have aggregated to a significant level.

In relation to the underwriting of a programme, the lead insurer also invests the most time into negotiating the terms and conditions of coverage. As a result, it receives a much larger share of the premium than excess layer insurers. The amount of premium allocated to each excess layer insurers reduces as the overall programme limit increases; as higher layers are less likely to incur claims.

Co-insurance

An alternative programme structure to layering is proportionate co-insurance. Co-insurance requires that a panel of insurers share the risk equally, by agreeing to pay the same percentage of any claim made against a policy. In this arrangement, each insurer receives an equal split of the premium, because they all effectively share the same risk.

Conclusion

Selecting a limit of liability is arguably one of the most important insurance decisions for an organisation’s management. It’s a difficult process and it’s certainly not made any easier by the fact there are no hard and fast rules. Each organisation is different and will require different requirements for D&O policy limits, programme structures and executive protection products.