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.
Business Insurance & Investment Services of MA
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:
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.