How does Directors and Officers insurance work?
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.
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 does directors and officers insurance work? 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 types of 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 D&O Coverage
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 typically cover the damages as well…. 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 unless there was insurance coverage in place. Another cause where a director or officer may not be indemnified by their company in the event of a claim would fall to regulatory rules. There are instances where laws will not allow for a company to indemnify a director or officer in the event of a particular claim. As with bankruptcy, if there is no insurance to cover the breach, a director or officer may be on their own to cover defense and damage costs.
This is where Side A coverage with a D&O policy would kick in. Since the director or officer would not be indemnified in certain scenarios, the Side A coverage steps into the gap to cover defense costs and potential damages for which a director and officer would be liable. As mentioned, 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. Hence, this puts the personal assets of directors and officers at risk.
Side B D&O Coverage
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 that the company must 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 if the company is picking up the tab for defense and damage costs associated with a suit brought against that company’s directors and officers. Side B coverage reimburses the company in this event. This is how a company gets made whole.
Side C D&O Coverage
Side C of a directors and officers insurance policy is the part of the policy known as ‘Entity Coverage’. For publicly traded companies this policy part is specifically designed to provide coverage against securities claims. The nature of such claims deal primarily with shareholder actions against the company based on movements of the stock price.
An example of such an occurrence would be a drop in the stock price of a company due to a financial restatement. If an error in reporting of financials requires a restatement, this can have an immediate negative effect on the stock price of a company. Stockholders may view the company and its directors as accountable and file suit. Because the nature of such actions is predicated on the drop in the value of the company stock, Part C of the D&O coverage would be applicable toward defense costs and damages the company may be liable for.
Side C coverage provides entity coverage for privately held companies as well. The primary difference between coverage for a private company versus a publicly traded one is that Side C coverage will be broader considering it is not typically contingent on a securities claim.
Claims coverage for private companies would protect against clams made by customers, vendors, competitors and regulators. Claims can also be made by shareholders of private companies. While a private company may not have publicly traded shares, that does not negate the fact that there may be private shareholder interests that directors and officers need to be concerned with.
Side D D&O coverage (sometimes)
Side D coverage, or Derivative Investigation Coverage, is a portion of the policy that covers costs associated with a shareholder derivative claims. So what is a shareholder derivative claim?
A shareholder derivative claim is a suit brought by a shareholder on behalf of the corporation against a company’s directors and officers. Such claims give the shareholders a legal means to protect a company against its own leadership. Side D coverage covers the costs associated with such actions on behalf of the directors and officers in question.
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).
So here comes the obligatory pitch. If this is something you’d like to talk about in a little more detail, free to reach out. I’d be happy to act as a resource.
Business Insurance & Investment Services of MA
For more information on Directors and Officers insurance you can check the following related posts:
The links provide will connect you with content contained in our company blog. The content in our blog can help to answer questions you may have concerning these and other related topics important in protecting your company.
I hope this post has given you some insight as to how does directors and officers insurance work. If you have any questions after reading this content I invite you to reach out to us with a call or an e-mail. We are always available to act as a resource.