Managing D&O Liability in a Risky Environment

Kurt Rosenberger will need to renew his bank board’s liability insurance in September, and he sees what’s coming. The president and chief executive officer of Owen Community Bank will need to swallow a hefty premium increase of at least 40% to 60% for directors and officers liability insurance, his lawyers estimate. The Spencer, Indiana-based bank, with $67 million in assets, may also face lower dollar limits for its directors and officers liability insurance coverage and new exclusions that will restrict it. In the summer months, Rosenberger’s staff will have to answer much longer questionnaires than those for its last renewal process, three years ago.

For Rosenberger’s board, as well as directors of other financial institutions, the D&O insurance changes are part of the fallout of the recent corporate scandals and a bad convergence of market forces. In short, there’s more liability for directors and officers, and more worries. “So much is changing so quickly that they are a little befuddled,” Rosenberger says of his board. “The liability they are assuming in the role is not fully covered by the monetary compensation.”

D&O insurance claims against banks come from many sources. Customers can sue for privacy, loss of data, security breaches, or lending practices. Employees can sue for discrimination, environmental hazards, and wrongful discharge.

And the Sarbanes-Oxley Act of 2002, which made broad changes in the law governing public companies, likely means more government enforcement actions and class-action suits than before. For financial institutions, the liability is especially acute. “It is more complicated for a bank director than in any other business,” says Edgar Armstrong, managing director of insurance and risk management services for Pottridge & Associates Inc., a bank consulting firm in Alexandria, Virginia.

Choosing insurance will be no less tricky. Premiums for D&O insurance started increasing in 2000, and then soared 29% among all industries in 2001, according to a survey of more than 2,000 U.S. companies by Tillinghast-Towers Perrin, a Chicago-based consulting firm. Premiums are estimated to have jumped another 30% last year. The increases were a long time coming. Before 2000, companies enjoyed more than five years of annual premium decreases, as insurers competed for customers in a soft market. A sharp rise in the cost of D&O coverage due to securities class-action suits also has fueled the jump. Meanwhile, insurers themselves are facing much higher premiums as reinsurance costs have gone up in all lines of business in the wake of 9/11.

D&O underwriters have moved to stem the losses and curtail their risk. For banks, deductibles have skyrocketed over the last two years. Banks with $1 billion in assets or less have seen deductibles jump to a range of $100,000 to $1 million, up from $25,000, according to data from Chubb Corp., the Warren, New Jersey-based insurer. For banks $1 billion to $5 billion in assets, deductibles have risen to the $1 million to $5 million range, up from $250,000. And for banks with $20 billion or more in assets, deductibles have jumped to the $1 million to $10 million range, up from $500,000.

Insurers have also lowered limits, requiring banks and other companies to seek more carriers to obtain the limits they seek. In addition, the once-popular three-year policy has been practically eliminated. Insurance companies also are requiring clients to share in the losses by introducing coinsurance, which they say will give their customers more incentive to limit risk.

This year, bankers face a new front: Insurers are weeding out certain types of policy coverages. “What we are seeing now is more of a push to either amend the contract, take away coverage, or add endorsements which take away coverage,” says Lou Ann Layton, global D&O practice leader for Marsh Inc., the New York-based insurance broker.


Compared with other industries, banks are considered riskier business for insurers, because D&O claims can arise from many directions. Banks answer to more regulators than most other industries. They also must comply with a host of federal and state laws. The latest challenge affecting D&O policies is Sarbanes-Oxley, Congress’s reaction to the recent chain of corporate scandals. The law grants new powers to the Securities and Exchange Commission, and provides plaintiffs’ lawyers new avenues to go after directors and officers. Perhaps most notably, the act introduces additional criminal penalties, such as felony penalties for securities fraud. Another provision allows for a fine and imprisonment for altering or destroying records during an investigative process. Corporate attorneys are poised for action. “Expect more criminal proceedings,” says Stephen J. Weiss, a partner at the Washington office of Holland & Knight.

Meanwhile, a wave of securities class-action suits has besieged holders of corporate D&O policies, including those alleging fraud, insider trading, and IPO kickbacks. Suits from the merger and acquisition wave of the 1990s have hit banks hard, most notably in a $494 million settlement by Bank of America Corp. Overall, securities class-action suits for U.S. companies resulted in settlements of $3.1 billion in 2002, up from $2.9 billion in 2001, according to Securities Class Action Services in New York. That compares with an average of $2 billion a year during the 1990s.

In some cases, banks’ D&O policies also cover employee actions. Employee claims accounted for 26.8% of all D&O claims in 2001, making that the most common type of D&O claim among all U.S. companies, according to Tillinghast. One reason: Banks increasingly have been exposed to a series of laws passed in the 1990s that are driving up employers’ exposures to employment practices liability. That includes the Civil Rights Act of 1991, the Older Workers Benefit Protection Act of 1990, the Americans with Disabilities Act of 1990, and the Family and Medical Leave Act of 1993.


Experts say bank directors should first focus on preventive measures. Companies need to take basic steps to minimize their risks, and that starts with recruiting and retaining qualified directors, says Dan Bailey, a partner at Arter & Hadden in Columbus, Ohio. The directors and company should have periodic board meetings that review corporate governance best practices, such as creating long-term credibility for the bank, maintaining zero-tolerance for unethical behavior, and having a good CEO succession plan, he says. To minimize litigation from clients, “the main thing directors can do is keep track of their customer satisfaction approaches,” adds Mark Larsen, consultant and D&O survey director at Tillinghast.

From an insurer’s perspective, tougher laws might not be such a bad thing. “Sarbanes-Oxley, in our minds, creates a lot of criminal penalties and fines,” says Evan Rosenberg, a senior vice president at Chubb. “But at the end of the day, it is really codifying what directors should have been doing all along. It’s all about being truthful, having adequate disclosure, and presenting your numbers in a fair manner.”

When it comes to insurance, the bottom line is that directors need to get more involved, says Nicki Locker, a partner at Wilson Sonsini Goodrich & Rosati in Palo Alto, California. “Directors need to educate themselves about the key provisions in insurance policies and the types of products that are out there in the market.”

Ronald Glancz, a partner at Venable LLP in Washington, D.C., recommends that directors sit down with their broker or insurance specialist to go over the policy to help them understand it. “A lot of the SEC stuff is not covered by D&O policies,” Glancz says. “It is important to make sure your policy is in order and that you have the coverage you think you have.”

To hedge themselves, banks can purchase a few types of D&O insurance, which typically feature two or more agreements. One is personal coverage for losses incurred by directors and officers that the corporation cannot indemnify. This is also known as A-side coverage. There’s also insurance for the corporation that covers any of a company’s responsibilities to indemnify its directors and officers, typically referred to as B-side coverage. Another layer, called entity coverageu00e2u20ac”or C-side coverageu00e2u20ac”covers some claims made directly against the corporation. Today, a number of insurance companies are selling a new concept for individual director’s insuranceu00e2u20ac”essentially it’s an individual policy sold to independent directors who serve on the boards of several companies.


When renewing a policy, directors should be aware of the terms and what alterations are occurring. Lawyers recommend having the contract reviewed by outside counsel. The wording of a D&O contract can be substantially different from one policy period to the next, directly affecting the quality of coverage. Remember, “everything is negotiable,” says Weiss of Holland & Knight. The devil is in the details: Directors also need to be mindful of how these small changes or omissions may cost their company millions of dollars. Here is a checklist to consider:

Severability. Insurers are trying to restrict this part of D&O policies, and it has now become one of the biggest issues for directors and officers. Severability means facts, knowledge, or the conduct of one insured person cannot be used to deny coverage to another insured person. The policy is “severable” among the insureds, meaning a separate policy is issued to each insured person, and the actions or knowledge of one will not jeopardize the coverage of another. This feature has become all the more important after last year. “You don’t want to have your coverage negated because of some bad apples,” says Paul Kim, a managing director at the Los Angeles office of Aon Financial Services Group, an insurance broker.

Personal profit and fraud exclusions. Insurers are trying to change the wording to allow them to negotiate how much they are going to pay if there is alleged fraud or dishonesty. Historically, wording in these exclusions required alleged fraud or dishonesty to be proven in a court of law, otherwise, the policy had to respond. Without this wording, the client would not have as much bargaining power during negotiations of payment, says Marsh’s Layton.

The application. During the soft market of the 1990s, insurers often waived the requirement for an application. Now they not only require them, but also are using the application as another way to protect themselves. “You really want to review what is included in the policy, what questions are being asked, what attachments are being asked for,” Layton says. Any misstatements or false information can be grounds for cancellation of the policy. Even SEC filings that are later revised due to an earnings misstatement can be grounds for rescinding a policy, depending on the agreement.

Entity Coverage. Entity coverage goes beyond the traditional D&O policy, allowing for some claims against the corporation. It had become a popular offering by insurers by the late 1990s, as they rushed to offer the additional coverage in a soft market. Banks and other companies happily paid for entity coverage because it wasn’t much more expensive. With so many securities claims, this feature is now costing insurers bundles, and they are seeking to eliminate it, or are hiking the premiums. Stronger banks with solid financial performance may still have an edge here.

Lisa Murphy, a corporate insurance manager for Memphis-based First Tennessee National Corp., says insurers not offering it will be at a disadvantage when the bank looks to renew its policy in May. “I can’t see us wanting to move into a position where we retract from the position of the coverage we have today,” she says.

Professional errors and omissions exclusion. “Directors and officers should make sure they do whatever they can to have [errors and omissions] exclusions eliminated from the contract,” says Kim of Aon. While this exclusion is common, an argument could be made that the professional errors and omissions exclusion within the D&O policy negates all coverage for the directors and officers for a claim based on professional service loss.

Reputation and rating of the insurer. A policy is as good as the health of the company behind it. “A bank director needs to make sure, first and foremost, about the financial strength of their carrier,” says Tim O’Donnell, division president of the National Union Financial Institutions Group, a unit of AIG in New York. “You have got to be comfortable that if something bad happens, you know who you are dealing with on the other side.”

Criminal proceedings. With the new criminal penalties of Sarbanes-Oxley, directors need to make sure the policy covers criminal proceedings in order to pay for defense lawyers, notes Weiss of Holland & Knight.

Advancement of defense costs. These expenses can become stratospheric rather quickly, especially for criminal defense lawyers. So directors should make sure the insurer pays up front for defense costs. This is also a good idea because of a provision under Sarbanes-Oxley that makes personal loans by a corporation to directors or officers unlawful. It’s unclear whether an advancement by the corporation for defense costs would constitute a personal loan, Weiss says. But payment by the insurer avoids the issue.

Definition of claim. “Seek to expand the definition,” Weiss adds. To trigger a D&O policy, a claim is needed. But there’s no standard definition, and beyond a certain point it gets tricky, ranging from civil lawsuits to written demands for money. The definition should also cover other types of legal proceedings, such as SEC administrative proceedings, which are almost sure to become more frequent.

Still, experts note that directors need to find a happy medium with all the changes. These days, it’s easy to get consumed by new procedures and lose sight of a director’s function of overseeing corporate operations and advising on long-term planning. “The new regulations can take on a life of their own without really increasing the quality of what directors are about,” warns Bailey of Arter & Hadden.

Directors also need to be mindful of balancing the benefits with the costs of insurance, says Kim of Aon. “You need to do what’s right for the company,” Kim says. “You shouldn’t be just wasting company assets by buying lots of D&O insurance for yourself.” On the other hand, banks need to attract talent and high-caliber individuals to serve as directors on their boards. Adds Kim: “They are going to have to pay for D&O coverage.”

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