D&O Insurance: What Every Director Should Know

Insurance to protect corporate directors and officers from professional liability lawsuits has been available for decades. But never have corporate leaders in the financial services sector served in an era that is more tenuous, volatile, and litigious.

Bank directors and officers are particularly vulnerable in an increasingly hostile business environment. The responsibilities of protecting both the depositor and the shareholder create a greater need than ever before for professional liability insurance. The better board members understand directors and officers liability coverage, the more likely they are to continue, or begin, their board tenures.

The most frequent source of D&O suits for corporations in general is shareholdersu00e2u20ac”for banks, it is customers. Bank directors may be held individually responsible for losses sustained by the institution they serve as well as by its shareholders. Directors have even been held personally responsible by regulators when their bank’s financial institution bond coverage was deemed inadequate.

D&O insurance can offer broad and meaningful protection to the directoru00e2u20ac”broader than that provided by even the most carefully drafted corporate indemnification agreements. But D&O policies are nonstandard. Each insurer has its own form, insuring agreements, exclusions, and conditions; no two are alike. Therefore, it is vital that bank directors understand those coverage issues most critical to their personal protection and make sure that they are adequately and appropriately addressed.

Directors today must ask pointed questions in order to determine if they are properly and sufficiently protected. The following are five such critical questions.

Who procures and maintains your D&O coverage?

It’s important to know that the individual with the responsibility of procuring and maintaining coverage is competent and without conflicting interests. If the corporate insurance manager is a clerk in the finance department with no insurance background who depends entirely on the broker for coverage design, for example, there could be a problem. Even the most competent broker must consider not only your coverage needs but also his relationship with the insurer and his firm’s profit margin, and these considerations may conflict at times.

The Model Business Corporation Act allows a director to rely on the opinions of unconflicted outside experts. If the insurance manager doesn’t have the necessary expertise, an independent insurance expert whose income is not affected by how much insurance you buy should be consulted. Additionally, it is important that the auditor is not also the consultant who structures the insurance program upon which his or her firm must later provide an opinion.

What is excluded from coverage?

Exclusions are influenced by the insurance carrier’s profit motivesu00e2u20ac”the more it can exclude from coverage, the fewer its losses and the greater its profit. It is essential that a board acquiring insurance coverage makes sure that policy exclusions are reasonable and do not leave directors unprotected in critical areas of exposure to loss. Even the best D&O policy can be rendered ineffective by the exclusions attached to it.
Directors should demand a full explanation of their policy’s exclusions. Here are examples of areas where exclusions should be closely examined:

  • securities laws;
  • change-of-control issues, such as hostile takeovers, mergers and acquisitions, tender offers, greenmail, and private and public offerings;
  • fiduciary responsibilities under ERISA (a concern to directors on benefit committees);
  • payments and gratuities;
  • prior and pending litigation;
  • suits brought by one insured against another.

Modifying or removing as many of these exclusions as possible can greatly increase the scope and value of your personal protection.

What about losses discovered after cancellation, change of insurers, or board departure?

D&O policies are almost always written on a “claims-made” basis. They respond only to losses discovered and claims made during the policy period. This is clearly a matter of great significance to directors who are not selected for the surviving board in the event of a merger or acquisition, directors who simply retire from their boards, and directors whose policies are canceled.

Underwriters have responded to these conditions with two policy provisions that vary with each policy form.

“Notification” or notice of loss allows the insured to maintain coverage for occurrences that might become claims later, even after the policy has been canceled, not renewed, or allowed to lapse. It stipulates that if the insured gives the underwriter written notice of an occurrence that might result in a claim, the underwriter will be responsible for covering the loss no matter when it actually materializes. Prior to policy expiration, directors should make a conscious effort to identify any occurrences that may lead to claims.

“Extended discovery” provides that if the insurer cancels the policy or refuses to renew it, then the insured may purchase an extended period of time during which acts discovered afteru00e2u20ac”but occurring beforeu00e2u20ac”the cancellation date of the policy would still be covered. This extended discovery period should be for at least 12 months and preferably 24 months.

Do misrepresentations on an application really matter?

Since D&O policies can cover acts that occurred well before the inception of coverage, insurers have a keen interest in prior situations that may give rise to claims. They protect themselves from this eventuality by requiring full disclosure on the application for coverage.

Misrepresentations can affect your coverage as an individual director, and inaccurate or false representations by an employee you don’t even know can void your coverage. The effect on coverage depends upon how your policy addresses “severability”u00e2u20ac”a provision that allows for each insured’s rights and obligations to be treated separately.

Because each D&O underwriter addresses this issue in its own way, you should insist on the most favorable severability provision available in your policy. The actual verbiage should come as close as possible to the following:

The application shall be construed as a separate application by each independent director. No statement in the application or knowledge or information possessed by an independent director shall be imputed to any other independent director for the purposes of determining the availability of coverage hereunder.

This will give you some assurance that your coverage will not be voided as the result of representations made by someone over whom you have no control.

How do I defend myself in a lawsuit?

When you are sued, it is a little like a patient going into surgery. You want the best professional help and are not too concerned about the cost. By then, however, it may be too late to negotiate the type of latitude you think you need in assembling the best possible defense.

You should look carefully at both your and the insurer’s rights and duties before purchasing a policy and attempt to make any necessary revisions then. The insurer has little incentive to adjust claims reimbursement and defense provisions once a claim is filed.

Under the typical D&O policy, unlike its general liability counterpart, the insured controls the defense, retains counsel, and directs the defense. But the insurer must be consulted about counsel selection and any settlements, and consent to them. Such consent generally must not be “unreasonably withheld.”

Each insurer has its own policy provisions pertaining to defense and legal costs, but an insurer rarely assumes any “duty to defend.” Some D&O policies provide that the insurer, at its option, will advance defense costs on behalf of directors. Others have what is termed a “consent-to-settlement” clause, which stipulates that if the insured does not agree to a settlement amount proposed by the insurer, the insured will not be reimbursed for any costs over the amount proposed. Finally, there is the issue of how defense costs are allocated between the corporation and the individual directors, should both be named in the suit.

These issues become even more critical once litigation is imminent. Directors should be sure they understand the defense provisions in their particular policies and make sure that their insurance adviser has resolved them satisfactorily. If they cannot be resolved adequately, it may be advisable to change insurers. A policy is no better than its ability to defend and indemnify you, the director, against claims brought against you in your board capacity.

The Wall Street Journal reports that property and casualty insurers will have a $120 billion shortfall this year, equaling about 80% of annual premiums collected. The size of this shortfall means insurance premium costs will continue to rise precipitously. Recent attention to corporate and directorial accountability in the wake of scandals at Enron, Global Crossing, WorldCom, and others, combined with the Securities and Exchange Commission’s order requiring that CEOs certify the accuracy and completeness of their companies’ financial reports, is putting further pressure on D&O premiums.

But a strong and viable D&O insurance market still exists, and its product is more important than ever to corporate America’s boardrooms. Directors deserve reasonable and fair protection for liabilities arising from the critical service they perform. |BD|

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