How does Directors and Officers insurance work?
How does Directors and Officers Insurance work?
Company officers and board of directors’ members make a flurry of decisions that 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 is going to sit well with everyone.
If a board of directors or a company officer takes an action that harms 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 their personal assets being put 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 a lawsuit? In this case D&O insurance indemnifies companies when they go out of pocket to cover their directors and officers. Either way, the Directors & Officers 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? This post will give a pretty broad and detailed response.
Directors and Officers insurance protects the management of a company against an 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 in the event of a claim.
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 for defense and damages when the company is unable to do so. This is especially important to directors and officers because a situation like this can put their personal assets at risk.
Nine times out of ten, a company will cover the costs to defend directors and 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 a director or officer?
A common cause of this is bankruptcy. If a company goes belly up and there is a claim against a director or officer of that company, how would that director or 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 of 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.
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. An error in reporting of financials that requires a restatement can have an immediate negative effect on the stock price of a company. Stockholders may view the company and its directors 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 and range from $10k to $50k. The choice of retention is up to the company and will affect the cost of the policy. The higher the retention, the lower the cost and vice versa. 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 $50k becomes untenable. 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, feel free to reach out. I’d be happy to act as a resource.
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Nondiscrimination Health Plans
Can a startup company offer health insurance to salaried executives and not to hourly workers?
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:
Nondiscrimination Rules for Health Plans Loom Ahead
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.
When should a startup consider Directors and Officers liability coverage?
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:
Management Liability policies: Is it just Directors and Officers coverage?
Health Insurance Premiums for Dependents
How common is it for a startup to pay health insurance premiums for dependents?
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.
What to Include in Buy-Sell Agreements
What are some typical things that go into a buy-sell agreement?
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.
Tax Implications and Financing
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