Directors And Officers Liability Insurance Overview Underwriting Considerations

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Directors And Officers Liability Insurance

INTRODUCTION

Underwriting always begins with identifying hazards. With Directors and Officers coverage this means identifying the following:

  • Persons who could commit the wrongful acts
  • Potential impact of such wrongful acts
  • Processes or procedures in place to prevent the wrongful acts from taking place
  • Types of wrongful acts that could be committed

GENERAL INFORMATION

The basic starting point is the name and address of the organization along with the date and place of incorporation.

A description of the business along with its primary and secondary operations is needed. All subsidiaries must be listed along with their dates of acquisition or creation and their primary and secondary operations. Other owners of the subsidiary must be disclosed if the organization does not own 100% of the subsidiary.

Ownership is very important because it reveals who has control. Information is needed on the total number of common shares outstanding and the total number of common shareholders. The number of shares controlled by each director and officer should be disclosed. It is also important to identify the shareholders who control more than five percent of the outstanding common shares.

Securities that can be converted to common stock should also be disclosed.

Shareholder suits are one of the leading causes of lawsuits. So information about who holds the securities is important.

FINANCIAL INFORMATION

Financial condition is an important component of underwriting any type of exposure. Financially secure organizations are usually more willing to institute appropriate practices and procedures that can control wrongful acts. When the financial condition worsens, controls may be short circuited when jobs are combined and departments eliminated.

There are many important financial elements to examine. However, the simple and most basic one is whether or not the organization has enough cash or available credit to fund its operations and service its debt during the policy period. This analysis should not examine just the most current year. It should include a change in financial position analysis in order to develop a trend line.

Applicants must supply, minimally, their latest annual statement and balance sheet data. Underwriting includes careful consideration of financial performance, including critical information found in any footnotes. Additional information is typically required to provide further explanation of relevant footnotes such as evidence that a company has changed its accounting method. Underwriting typically pays attention to whether the balance sheet and earnings information appears to be accurate.

Often underwriting requires use of outside financial service providers for models of comparisons that apply to companies in given industries and services. Attention to the financial data should provide insight to the company’s operating ability.

Financial information is only as good as the firm that performs audits on the information. It is important to understand who does the audits, the audit procedure, and the timing of such audits.

MERGERS AND ACQUISITIONS

Mergers, acquisitions, and other financing initiatives are the kinds of activities that often generate claims. As a result, details of such transactions are needed in order to consider the wrongful acts that could result or have resulted from them.

PAST EVENTS

Another important factor in underwriting the organization is to determine if it has experienced circumstances or events in the past that may lead to claims in the future. Examples of such events are:

  • Alleged violations of federal or state securities laws or regulations that result in civil or criminal actions or administrative proceedings
  • Antitrust, copyright, or patent litigation
  • Breaches or violations of any debt covenant, loan agreement, or any other important contractual obligation
  • Current litigation against the named organization or its directors or officers
  • Current or anticipated restructuring, legal, or financial reorganization or filing for bankruptcy
  • Derivative suits, representative actions, or class actions
  • Disappointing actual earnings compared to forecasted earnings
  • Disappointing regulatory decisions and setbacks
  • New public securities offerings
  • Officer resignations or other changes in the organization’s board of directors or senior management
  • Recent changes in auditors
  • Significant drops in stock price

VULNERABILITIES

Any organization should be concerned about whether or not it is vulnerable or susceptible to any one event or circumstance that could dramatically affect it. If such an event could occur, and the officers and/or directors did not plan effectively, a wrongful act claim could be filed. Some examples are:

  • An imminent regulatory roadblock for an organization with only one product being developed
  • An organization-dependent debt obligation with a single-trigger acceleration clause or covenant
  • Certain activities are usually given even more scrutiny by underwriters, such as corporations with a substantial amount of business in government contracts, corporations in the electronics field, corporations that have completed a number of mergers in the past five years, closely held corporations and newly formed corporations.
  • Significant dependence on a single customer, contract, product, or supplier

Another source of liability is participation as volunteers on the boards of other organizations, usually non-profits and charities. Separate coverage is needed to handle this exposure.

STOCK VOLATILITY

Relatively small or minor events may dramatically affect the stock prices of some organizations. Such organizations may be viewed as sub-standard risks. However it is important to note that, while volatility is an important consideration, it should not be the only one. Not every organization that has volatile stock prices is involved in securities class action or derivative lawsuits. In many cases, other factors better predict risk than volatility alone.

OFFICERS AND DIRECTORS

The background and experience of senior management and the board of directors is very important. Providing information about recent changes in these positions along with the reasons for them is extremely important. Independent boards are valued because they view decisions objectively for the health of the organization instead of being concerned about only their personal financial benefit or potential. Accusations of placing personal gain over organization health are a common stockholder complaint.

Executive compensation is an important and significant related issue. Excessive executive compensation can be an important factor that leads to dangerous and destructive behaviors. There also have been claims of excessive director compensation.

Directors’ and officers’ involvement in corporate takeovers also has resulted in a significant number of D&O claims. A primary reason for this is that directors and officers are faced with conflicts of interest in any takeover attempt. The conflicts include the directors’ duty to shareholders that they receive a fair and maximum price for their investment; and a duty to the corporation to protect the best interests of the corporate entity; and a self-serving interest.

GOVERNANCE PRACTICES

Carefully examining the organization’s governance practices is an important component of the underwriting process. Standard organizational governance practices alone do not guarantee that the organization will not be involved in a claim. However, established and logical policies and procedures are important in any potential claim. Such practices should include the following:

  • Claim documentation/management procedures
  • Disclosure Procedures
  • Independent Outside Auditors
  • Insider Trading Policies
  • Other regulatory agencies that affect corporate liability are the Environmental Protection Agency, the Federal Trade Commission, the Federal Communications Commission and the Internal Revenue Service. Years ago, the deregulation of the banking industry and subsequent bankruptcies amongst banks and savings and loan corporations have heightened claims against officers and directors of financial institutions. The vulnerability of board members to suits will remain high due to increased sensitivity to board actions that have created unprecedented levels of business crises. The heightened concern with financial accountability is best represented by the reporting requirements of Sarbanes-Oxley and the Dodd-Frank Wall Street Reform Act.
  • Regularly Scheduled board meetings-monthly or quarterly

WRONGFUL ACT HISTORY

Underwriting loss history is part of underwriting every account. However, underwriting it in conjunction with this coverage must go beyond just the actual claim filed. It should also consider any act, error, omission, fact, or circumstance that could lead to a claim.

DEDUCTIBLE AND PERCENTAGE PARTICIPATION

The underwriter must determine the appropriate deductible and percentage participation for a specific risk. These items can keep the named insured focused on loss prevention methods. When the specific director or officer realizes that a loss is not solely the responsibility fo the insurance company, more attention may be paid to implanting effective procedures to prevent losses from occurring.

Depending upon the carrier, a per loss deductible may be accompanied by individual deductible established per director or officer. The latter is typically subject to a modest cap, such as $1,000. A per loss deductible can vary substantially depending upon whether the risk is a small, medium or large enterprise. Even for smaller operations, a mid-level, five-figure deductible is the norm.

Some carriers participate with insureds for coverage. Once the deductible is satisfied, the insured must continue to pay part of the loss called participation.

It is important to note that high deductibles and significant participation percentages will not turn a poor risk into a good risk. These are useful only if the named insured is an active partner in controlling its exposures.

ENTERPRISE RISK MANAGEMENT

ERM is having a significant impact on D&O Liability underwriting. Evaluation of an applicant company typically includes an assessment of that company’s philosophy in handling its overall loss exposures. Therefore, carriers are likely to request information on the use of ERM. A high level of awareness regarding an exposure to loss as well as a company’s appetite for risk can be key indicators of how well a company is run.

Today, ERM represents a more holistic focus. Companies with a high dedication to ERM are those that tend to find optimum was to eliminate loss exposures as well as look for successful business opportunities. Claims against directors and officers often involve allegations against boards that, in their conservatism, are perceived as negligent for missing ways to exploit corporate resources.