Directors and Officers insurance is becoming more and more prevalent these days as a necessary protection for companies and their management. Quite often, I am asked how the coverage works. Since a full explanation is pretty detailed, this post will give a broad, detailed response.
Directors and Officers insurance protects the management of a company against a broad array of potential claims. If an act should occur that triggers one of these claims, what happens next? How does the coverage kick in? To answer this we need to look into the different parts that make up a D&O policy. Most every policy begins with three main parts known as Side A, Side B and Side C. These components determine which part of the coverage would be responsible to pay for defense and damages when a claim comes to bear.
Side A: Side A coverage of a directors and officers insurance policy is the component of the policy that will indemnify a director or officer when the company cannot cover such an officer for defense and damages. This is especially important to directors and officers because a situation such as this puts their personal assets at risk.
Nine times out of ten, a company will cover costs to defend company officers if a claim is levied and needs to be defended. If the suit is lost, the company will cover the damages….nine times out of ten. But what if there is a situation where the company can’t indemnify an officer in this situation? A common cause of this is bankruptcy. If a company goes belly up and there is a claim against an officer of that company, how would that officer be indemnified? The answer is he or she wouldn’t.
This is where Side A coverage would kick in. Since the director or officer would not be indemnified in certain scenarios, the Side A coverage steps into the gap in order to cover defense costs and potential damages for which a director and officer would be liable. In absence of such coverage, if the company is not in a position to indemnify, the officer is on the hook for defense and damages costs.
Side B: Side B coverage of a directors and officers insurance policy is the component of the policy that will indemnify a company when such a claim arises. As mentioned, nine times out of ten a company will defend and indemnify a director or officer if a claim is filed. If a company indemnifies a director or officer once a claim is defended and damages paid, there are substantial costs associated with defense and damages that the company has to cover. So where does that leave the company? This is where Side B of the Directors and Officers policy comes into play.
Side B does not cover directors and officers personally. Side B covers the company in the event that the company is picking up the tab for defense and damage costs associated with a suit brought against that company’s directors and officers. This is how a company gets made whole.
Side C: Side C of a directors and officers insurance policy is the part of the coverage known as ‘Entity Coverage’. Entity Coverage covers a company should a company been involved in a claim along with its directors and officers. Often if a claim is made against a director of officer of a company, that company will be named in the suit as well.
Side C covers the firm’s liabilities in such a scenario. This is opposed to Side A or B where the liabilities of the director or officer is taken into account.
Retention: Retention is just another word for deductible. A retention amount will typically be assigned to Sides B & C ranging from $5k to $25k. The choice of retention is up to the company and will affect the premium amount for the company. The higher the retention, the lower the cost. In the event of a claim, the retention becomes the company’s responsibility after which the insurance kicks in.
In most cases, Side A coverage will have a $0 retention. The rationale behind this is that Side A is the part of the coverage that covers directors and officers personally when a company does not provide cover. Because of the personal cost nature of Side A, a large retention such as $25k becomes unaffordable. Hence, Side A coverage is typically first dollar coverage (or $0 deductible).
For more information on Directors and Officers insurance you can check the following related posts:
Somewhere in the back of my head as I write this I can hear the intro music for Hulk Hogan as he heads toward the ring. ‘ I am a real American…fight for the rights of ev’ry man …. Da, da, da da da …….da da da da….’
If you have been following the news lately, you may have seen that Hulk Hogan recently won a huge judgment in his invasion of privacy lawsuit against Gawker Media. $115 million in compensatory damages for invasion of privacy stemming from the sex tape that Gawker posted on their site without permission. Putting aside the morality of posting a sex tape of someone online and then defending it by calling it newsworthy, that’s a noteworthy amount. If it doesn’t come down in appeal it could bankrupt the company.
I personally can’t get enough of this case, it has everything. Sex tapes, lawsuits, new media, 80’s wrestling legends… and now a smooth segway to Directors and Officers insurance coverage.
For the purposes of this blog post I am going to focus on what happened in day two of the penalty phase of this trial. A key point to remember in this is that Hogan not only sued Gawker Media, Hogan sued both the CEO of Gawker, Nick Denton, as well as the editor-in-chief, AJ Daulerio. In day two of the penalty phase, Nick Denton was hit with a $10 million dollar judgment and AJ Daulerio for $100k.
Somewhere in my head on 80’s wrestling commentary…..
Gorilla Monsoon: ‘ Ohh look out Brain, Hogan’s hulking up!!!’
Bobby ‘The Brain’ Heenan: ‘Wha… this guy’s not human, GET OUT OF THERE NICK, GET OUT OF THERE!!!’
Gorilla Monsoon: ‘Too late for that Brain! Here comes the big leg!!!’
Now for a guy who is at the head of a huge media empire, odds are Nick Denton will be covered by Gawker Media’s Directors and Officers coverage. Good thing too because even on appeal, Mr. Denton likely won’t get completely off the hook for the damages that he is personally liable for at this point. Depending on the kind of policy Gawker has, perhaps AJ Daulerio could be covered as well. Some policies will cover non-executive directors to a limited degree.
As far as the argument that ‘Hey, even if he gets nailed for $10 mil, he owns the company. The company will pay him back’. A good argument, two things go against it. One, if the company is solvent after all is said and done, who pays Gawker Media for making their CEO whole? The D&O coverage, that’s who. Without it (provided Gawker reimburses officers in such cases as standard operating procedure), Gawker Media would be out another 10 million. With the coverage, Gawker will be covered for the amount needed to make its officer whole.
But what if the $115 million dollar judgment holds up on appeal? What if the worst case comes to pass and Gawker goes under? That $10 million dollar personal judgment is still there. Nick Denton would still be personally liable with no entity to make him whole. Once again, here’s where having a comprehensive D&O policy becomes so important. If a company goes under due to a lawsuit and a firm’s directors and officers are still liable, there had best be a healthy D&O policy in place. The policy would be there to cover said directors and officers against a judgment, protecting their personal assets. Without it, well….. someone will get left holding the bag.
Now Gawker is not a publically traded company, note that this is a perfect example of how Directors and Officers coverage isn’t just for publically traded companies. In this day and age, if there is a lawsuit worth pursuing, it’s worth pulling everybody in, and that includes a company’s leadership. In this case, company policies that filtered down to what Gawker saw as admissible to post as news came back and bit them…hard. Ultimately a jury found Nick Denton had a personal responsibility for the actions taken at Gawker that lead to where we are now. Hogan hit ’em hard on it in day 2 on the penalty phase.
Note to directors and officers of a business, even small businesses, you don’t need to be a huge publicly traded company to have a risk. This is just a recent example in a long line of examples where directors and officers find themselves in the line of fire. If this is something your company has not taken up yet and merits discussion, please feel free to reach out. I would be happy to act as a resource for you on the matter.
When you are putting a full Management Liability policy together there are a few things you will need to take into consideration. Here are a few of the big ones.
Is Directors and Officers coverage all you will need?
Directors and Officers coverage protects a company’s directors and officers from claims that fall within the policy provisions. In a complete Management Liability policy, there are other lines of coverage that protect against different management risks. EPLI (Employee Practices Liability Insurance) is probably the best known.
EPLI coverage is the insurance that covers management in the event that a claim stems from a company employee. Harassment, discrimination, wrongful termination, there are a number of issues that can be brought to bear against directors and officers of a company. EPLI protects specifically against those risks. EPLI would be a separate component in a Management Liability policy.
A company would need to be sure that any complete Management Liability quote included such coverage as it is a distinct line of coverage from Directors and Officers. With the rise in the types of claims covered by EPLI, these days it’s a must.
Shared versus separate limits?
If you find that you do need EPLI (and if you have several employees you really ought to) as well as D&O, you will need to consider whether you need shared or separate limits.
With shared limits, the stated coverage limit is the overall amount of coverage you get for a given policy year between both coverage lines. Say you purchase a Management Liability policy with D&O and EPLI coverage with a 1mm shared limit. All the sudden, here comes a claim and you lose. The claim ultimately costs 700k between defense, settlement and any associated costs when it is all said and done. The amount of total coverage going forward for either a D&O or EPLI claim would then be 300k.
Separate limits means that each coverage line has its own separate coverage limit if a claim was directed toward it. Separate limits means that you would have 1mm for each coverage aspect. In practice, if you had a D&O claim and lost and the whole thing cost you 700k, you would have 300k left in coverage for D&O, but the EPLI would maintain a 1mm coverage limit…separate limits.
Separate limits certainly will cost more. It also is an important consideration to make.
Do you want a separate defense limit?
So what is a separate defense limit and do I really need it? A separate defense limit sets aside a separate bucket of money purely for legal costs surrounding a suit. This limit will typically be the same amount as the standard coverage limit. If you have a 1mm limit on Directors and Officers coverage and have a separate defense limit, it’s likely to me 1mm as well.
Defense costs can account for huge sums of money when one is forced to defend themselves from a D&O claim. The average cost of a D&O claim including defense cost, settlement and judgments is $697,000. A large piece of this cost is associated with the legal costs of defending the claim in court.
The separate defense limit protects a policy holder from exhausting the coverage on legal defense and not having enough if you lose a case. For example, say you had a straight up 1mm D&O policy and a claim came in against you. If one were to mount a $500k legal defense, you are already down to 500k in coverage. Legal defense would go against your 1mm in protection.
If you lose, and the judgement is 1mm against a director or officer, someone is going to be out $500k. Without a separate limit, the $500k defense cost goes against your original 1mm coverage, leaving $500k in protection. If the judgement against you comes in at 1mm, you only have $500k left after you’ve mounted a defense. Not good.
If you have a 1mm separate defense limit, the $500k defense cost goes against its own 1mm bucket of money. In this example, a $1mm D&O coverage with a $1mm separate defense limit means that after defense costs have been accounted for, the 1mm judgement against a company director or officer would be completely covered.
Since 2014 the Affordable Care Act, AKA Obamacare, has been giving employers fits with regulations and rules that they need to be in line with. It’s been fluid to say the least as far as determining what is in bounds, what is out of bounds, what was once ok, isn’t anymore. It’s a regulatory minefield, and the feds keep laying out more mines it seems.
The most recent change to the rules isn’t so much a change as it is a running clarification that has recently come to a head. Prior to 2014 it was a common practice for employees to go out and get individual (non-group) medical insurance and have an employer reimburse the premium cost. This would be used with a section 105 HRA in most cases. Technical guidance from the IRS prior to Obamacare’s January 1, 2014 kickoff dictated that these plans were considered to be group health plans and subject to market reforms.
You better watch out doing this now. Reimbursements by companies for individual medical plans (HRA’s, Section 125’s or otherwise) has been deemed out-of-bounds by the ACA (Obamacare). There have been several technical releases by the IRS, Dept of Labor and HHS on the matter. At the end of the day, if a company is reimbursing employees for individual health insurance policies, or direct paying insurance companies for individual health insurance policies you are opening yourself up to a fine by the Feds.
This link The Affordable Care Act Implementation Part XXII goes to technical guidance released November of 2014 and goes into detail and clarifications from prior (Sept. 2013 and May 2014) releases from the IRS. The fines are as much as $100 per day per effected employee or up to $36,500/year.
More recent guidance from the IRS in February 2015 with Notice 2015-17 (Employer Health Care Arrangements) gave a moratorium of sorts to companies to get in line by June 30th 2015. While it may seem magnanimous on one hand to give companies a break, it would seem that the gloves will come off as of July 1.
The one way i’m aware of that you can do this and stay in bounds is to pay employees more salary. You can’t dictate to employees that it is used for coverage (per mandate as it would constitute a reimbursement) and there is the tax issue and expense because it can’t be treated as a pre-tax deduction.
My advice, don’t do it. Go with the group plan, PEO or otherwise. Stay out of the Feds crosshairs. If you need more help on the matter or to find a suitable plan, i’d be happy to help (shameless plug).
Members of a board of directors will be making a flurry of decisions that will have a profound impact on a company. Some of these decisions will be difficult and will have an impact on many interested parties. Put simply, not every decision a board makes is going to sit well with everyone.
If a board of directors makes a decision that could potentially harm another party, that party can turn around and sue not only the company but the directors and officers themselves. Because directors and officers can be sued personally, this can result in the personal assets of such directors and officers being at risk. This is where the D&O insurance comes into play. It insures directors and officers against such risks.
What if a company makes it a point to protect their Directors and Officers by indemnifying them in the event of such a lawsuit? D&O coverage also insures companies from going out of pocket to reimburse directors and officers by indemnifying the company in that case. Either way, the insurance sees to it that neither a director, officer or the company itself is left holding the bag.
D&O actions can stem from many different parties, company stakeholders, customers, competitors, even a company’s own employees. It can come from a lot of places. The stakes are high, according the Chubb 2013 Private Company Risk Survey, the average total cost of a D&O claim was $697,902 including judgments, settlements, fines and legal fees.
Needless to say, were talking about big money. Companies need to take steps given the rise in D&O claims and the exposure that they encompass.
Another potential key reason to this doesn’t directly speak to risks a board runs, but more to a requirement by a third party. Funding mechanisms such as venture capital and seed funding will typically require Directors and Officers insurance as a pre-requisite to closing out a funding deal. These outside parties want to see that their interests are protected and as such will make it a contractual obligation that a company get this in place before signing off.
For starters, let’s assume that you want to limit this to the basics, medical and dental. Let’s also assume that you want to make a competitive contribution of 75% on a moderate to high level plan for both benefits.
On medical coverage, a good cost yardstick for a plan in CA, NY or MA (a few of the higher cost markets) would be $500/month for a single employee, $1,000/month for couple or single parents and $1,800/month for a full family. For dental coverage, yardstick numbers would be $50, $100, $150/month for single/couple or single parents/family plan price points.
If you are a funded startup looking to recruit and retain employees, that 75% employer contribution will make for a good yardstick as far as how much an employer will contribute. If a startup isn’t funded it will be less. If you are not a startup at all and in the tech space, it will likely be more. Industries where perhaps the fight for talent isn’t as bad (manufacturing, retail) this may a lesser percentage for startups.
Getting to the bottom line on a 75% contribution on medical and dental, the employer contribution costs break out a follows:
single participant: medical is $500/mo, dental is $50, $550 total. 75% of this would be $550 x .75 or $412.50/mo ($4,950/annual)
couples or single parents: medical is $1,000/mo, dental is $100, $1,100 total. 75% is $825/mo ($9,900/annual)
family: $1,800/mo, $150 dental, total $1,950/mo. 75% is $1,462.50/mo. (17,550/annual)
Keep in mind, properly set up the 25% employee contribution will be pre-tax payment on the coverage. Both parties would gets the tax break on the contribution so it’s not straight after tax dollar expense. These employer contributions in the mock up example would constitute what a startup would pay in benefits per year in pre-tax dollars on medical and dental coverage. It’s not directly paid to employees as the question is written, but if you are doing a group medical plan for the company, direct payment isn’t how it works. If a company is paying or reimbursing employees directly for non-group medical policies that an employee directly owns, that’s a violation of the ACA/Obamacare laws which is a whole different can of worms you don’t want to open.
I advise my clients to take these numbers into account as well as the demographics of their hiring. Use a figure the works as an average total annual outlay for benefits expenses per employee and figure that into a total compensation package when setting up and offer for a potential hire. Don’t just throw extra salary at a potential employee with a family while having a very low contribution level on benefits and expect things to go well. Benefits matter to those with spouses and children.
I’m going to break this question down into a few bite size chunks because there are a few different ways this can go. The current guidance to this question falls to IRS notice 2011-1 spelling out non-discrimination language in the Affordable Care Act. Here’s the rub. The provisions have been put on hold until the IRS comes out with new guidance regarding what is to be considered a highly compensated employee for the purposes of non-discrimination testing on a company health insurance plan. Even when the guidance comes from the IRS, any changes will not take place for at least 6 months after issuance of the guidance. This new guidance has not been released by the IRS up to this point.
Can a startup offer health insurance to salaried executives and not to hourly employees if those employees are considered full time?
No. This goes to vendor level specifications in their contract provisions and underwriting guidelines. There isn’t a health insurance vendor that I am aware of nationwide, and i’ve dealt with all the majors, who don’t spell out what is to be considered an eligible employee in their contract and in their employer level application. Usually the employer application will spell what is to be considered a full time eligible employee at 30 hours a week or allow for a company to dictate a guideline up to 40 hours. The point is that the vendor will require that all employees above a certain number of hours (considered full time) to be considered eligible employee and as such be offered coverage. Does that make it federal statute, not yet. At the same time, are you putting your signature to the health insurance application, yes.
The insurance companies know what is coming, that’s why they do it. If a company is doing something they shouldn’t when the enforcement begins, the vendors are going to cover themselves. Indirectly, they are covering their customers by forcing their hands too.
Can a startup offer more to executives in terms of benefit toward health insurance versus hourly (rank and file) employees?
As of the time of this writing, yes, but that will be changing and probably soon. Obamacare dictates that paying more in benefit to an executive class of employee violates the non-discrimination provision of the Affordable Care Act. This is laid out in full in IRS release 2011-1. But, and it’s a big But, these aspects regarding non-discrimination testing (not so dissimilar to what you would see on 401k plans) were put on hold, were held for comment on the laws by the IRS, and subject to further guidance before the components of the laws were to be enforced. Once again, as of this writing, the guidance hasn’t been handed down by the IRS, therefore a company can offer more in terms a contribution or benefit to an executive class of employee versus the rank and file.
Does this make it a good idea? Not my call, that’s yours. Understand that when the other shoe drops….and it will….violating the enforceable statute will be costly. A resource from the Society for Human Resource Management that goes into more detail concerning this are as follows:
For those that want the quick and dirty, penalties of $100 per day, per employee who gets less favorable treatment up to 500k is the penalty. Not someplace you want your company to be knowing that these rules are going to be enforced at some point down the road.
Needless to say this issue is fraught with potential landmines. My advice, just don’t do it. If you need to make things right with an executive, make it up someplace else besides on healthcare, the downside is just too big given the changing environment.
Here are a few trigger points where a company will want to get this directors and officers coverage in place.
A prerequisite to a funding round
You are trying to land a board member and they require it
CYA-Cover Your Ass
For more information you can check the following related posts:
Speaking from my experience with clients, it is very common, pretty much expected, that employer contributions for health insurance would extend to dependents. As a caveat to this post, understand that my clientele primarily are in the high-tech startup space and the competition for talent is very high. Maybe this pertains to your business maybe not.
If a company is not contributing to dependents health insurance, consider these rough numbers. Say you want to place a high level group medical program for your company and the monthly cost for an individual participant is $500. Rough numbers would dictate about a 2x multiple on cost for couples or single parents and approximately a 3.5x multiple for a family plan. Those those numbers would be $1k/month and $1,750/month. Now let’s say you wanted to contribute 100% of the cost for an employee, 0% dependent coverage. If you are a single employee with no kids, Huzzah, 100% employer paid health insurance, awesome benefit, can’t do better. But what if you are married? That employer contribution just went down to 50%. Have a family? That contribution is down to about 30%.
I went through something similar with a company that had three single employees (no kids) and a married employee and wanted to only contribute to the employee medical coverage, no dependent contribution. The first thing I asked was do you think you are doing right by everyone? If you are recruiting and you put this package in front of a potential hire that has a family, do you think you will land the hire? Good luck with that. Needless to say we discussed a more equitable strategy that not only did right by the entire employee base but also would not put the company at a disadvantage in recruitment.
There are different ways i’ve seen to mitigate the issue. I’ve seen companies set a contribution for an employee and set a smaller percentage for dependents (100% employee, 50% dependents). I’ve seen companies stagger different contribution amounts based on tiering (100/85/70 contributions on ind/couple/family). What I rarely see, and I mean just once, was $0 contribution to a dependents health insurance coverage.
As mentioned, my take is a little industry specific where that industry has a lot of competition for talent. I get the funding issue, if you are not funded, how do you pay for it? If you are funded though, take the issue of equitable treatment, recruitment and retention into account. If you grow, inevitably people get married and have kids.
There are several components that will go into a written buy-sell agreement. Part of what goes into the agreement will be dependent on the type of agreement it is. Items such as whether it will be a cross-purchase or an entity agreement, how the company is set up in terms of company structure and tax implications will have an impact as to how the plan is written. Below are some components that will be included in every agreement.
One of the things that go into every buy-sell arrangement is a means of valuation. The valuation method will be what determines the value on which all terms and conditions for a buyout will depend. The valuation model takes care of any disagreements or debate about what one stakeholder or heir of a stakeholder believes the value of one’s stake in a company may be. There will be no debate, the value will be predetermined so that the mechanisms and terms under which the actual buy sell operates will move forward smoothly. Some common valuation models one would find in a buy-sell include an ‘agreed value’ model where the company ownership in conjunction with corporate accountants will come to an agreed upon price. This pricing model would be revisited at times, typically annually, to reset the valuation. An ‘appraisal method’ is a valuation method where an independent valuation specialist would provide a valuation. The written agreement can dictate who would do the work, if there would be more than one person doing the evaluation and set in motion parameters if there were to be disagreements or large discrepancies. Say you had two evaluators pricing the company and each set of numbers were way off from one another. The agreement could stipulate a third valuation be done and an average of the three be the agreed value. A third common model is a ‘formula model’ where the valuation is based on an agreed upon valuation formula such as simple book value or adjusted book value.
Triggers for a buyout are also a standard component that goes into a buy-sell agreement, common triggers include death, disability and retirement. Some secondary triggers that can and should be considered would be an owner quitting the company or a shareholder actually being fired. The triggers set forth will do exactly what it is stated to do, trigger the terms of the buy-sell should any of the stated events in the agreement come to pass.
Obligations on the parties part will be a mandatory component of the agreement. The obligations lay out each parties responsibilities once a trigger is triggered. One such example would be in the case of the death of an owner. Obligations on the part of ownership will typically dictate that a deceased owners share will be purchased back into the company and distributed evenly amongst surviving ownership. Based on valuation models, the value of the deceased owners stake in a company would be paid for and the proceeds distributed to the estate, next of kin, what have you. Circumstances such as disability or retirement would trigger other contractual functions to occur. Such functions would dictate buyout terms for the exiting owner as well as financing triggers such as disability buy-sell insurance policies. These obligations would be laid out in the written agreement and ultimately redistribute the shares to ongoing ownership. If a shareholder quit the company, or worse yet is fired, this is really where the language of the agreement becomes important. If certain parameters are not discussed or alluded to, it can become a messy divorce. It’s one thing if someone is leaving the company to go do something else entirely from what the existing company does, but what if the quitting owner is leaving to start their own company as a competitor or leaving for an existing competitors firm? You’d have some serious conflicting issues there. If there is a need to outright fire someone who is a stakeholder? Those are some real fireworks. Too often this can lead to the downfall of a company if processes are not set in place in order to get ahead of such things. Obligations on the part of existing and outgoing owners in these scenarios need to be agreed to in writing beforehand. No crossing the bridge when you get there, no handshake agreement. Do it in writing, do it early.
A couple of very important aspects that will be part of the agreement or be part and parcel to making the agreement work properly will be the tax implications and financing. The tax issues will revolve around the structure of the company be it sole prop, S or C-Corp, or LLC. Make sure any agreement and financing method is reviewed by qualified tax consultants to see that no landmines go off should an agreement be triggered. The most common method of funding is through insurance. In cases of death and disability, life and disability insurance policies will tend to be the financing method. Such events will trigger the insurance so as to provide funds to the appropriate entities and complete the buy/sell process. In instances such as retirement or buyout of a stakeholder leaving the company where insurance doesn’t apply, terms are financed through other types of financing mechanisms such as bank loans or installment purchase agreements.
So here comes the shameless plug. If your company is in need of such an arrangement feel free to reach out.
Business Insurance & Benefits Services of MA