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How to Determine Whether to Insure Directors and Officers

In the world of small and mid-sized businesses, there are many misperceptions about directors and officers liability insurance.
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Some small business executives believe that this type of policy, called D&O for short, is only for publicly traded companies. Not true, experts say. Although privately held businesses don't risk exposure to securities class action suits, a business doesn't have to have shareholders in order for its directors and/or officers to be personally sued. "It really depends on if you have relationships with vendors or customers, or if you intend to seek venture capital funding or other financial investors," says Lisa Jones, a vice president for private business management liability products for the Chubb Group of Insurance Companies. "These are all external exposures for which small business executives can be held accountable."

Second, some small business executives believe that their general liability or umbrella business insurance policies will cover claims involving directors and officers. Not usually, Jones says. "The general liability or umbrella policies don't respond to management liability lawsuits," she says.

Third, some small business executives believe that D&O policies are only for large companies. Not true, again, experts say. A business of any size will usually have officers and possibly directors who can be targeted by litigants over their management of company affairs. Many insurance companies now offer small business executive liability coverage starting at $1,500 per year to protect directors and officers. That's small change to protect against a potential six- or seven-figure settlement.

"It's available. These policies are out there. To not purchase this insurance is foolish," says Chris Cavallaro, managing director of ARC Excess & Surplus, of Garden City, New York, a wholesale insurance brokerage specializing in professional liability products and services.

The following guide will review what D&O insurance is, what types of coverage D&O insurance provides, and tips on purchasing D&O policies for your small business.

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D&O Insurance 101

D&O liability insurance protects corporate directors and officers in the event they are personally sued -- often in addition to the company being sued -- by investors, employees, vendors, competitors, and customers, among other parties. The insurance protects directors and officers by covering legal fees, settlements, and other costs; in addition, the coverage sometimes can extend to protect the company if it is named in a suit, as well.

In many cases, when you appoint directors or hire new officers they will demand D&O coverage as a condition of serving or employment because they don't want to put their personal assets at stake. Sometimes outside investors, such as venture capitalists or other financiers, will require D&O policies before providing funding to your business -- they often see the coverage as a way to protect their investment.

Directors and officers are sued for a variety of reasons connected with their company positions, including misuse of company funds, misrepresentation of company assets, fraud, failure to comply with workplace laws, and lack of corporate governance among other issues, Jones says. Simply hiring employees potentially exposes directors or officers to employment practices litigation (EPL), which may be covered by some D&O policies, she adds. "However, if more robust coverage is warranted, it may be best to also purchase an EPL policy that protects not only the directors and officers, but the company itself," says Jones. Claims over employment practices are now the most common lawsuits brought against a company's management. A 2008 Towers Watson (now TowersPerrin) survey found that 40 percent of all reported D&O claims from public, private, and nonprofit entities involved employment practices.

One in six company executives -- or 17 percent -- believe their business will experience a D&O related loss in the next years, according to a survey of decision-makers at 451 U.S. companies, more than 90 percent of which had annual revenues of less than $25 million. The survey, sponsored by Chubb, found that one in eight survey respondents -- or 12 percent -- had experienced a D&O lawsuit within the past five years. The costs to settle and/or litigate those cases averaged $225,682, with some losses approaching $5 million, the survey found.

"Customers of private companies are a leading plaintiff in litigation against directors and officer of private companies," Jones says, citing the survey results. Another growing area of D&O suits is over "employee piracy," she says. That's when a key employee leaves a company to start or join a competing firm and the previous employer files suit against the new firm -- and often its directors and officers -- over theft of intellectual property, customers, and other business information.

Bankruptcy is one of the leading causes of loss for a business -- and one of the leading causes of D&O lawsuits, Cavallaro says. A bankruptcy can spark litigation against directors and officers from creditors, lenders, customers, as well as investors. Even if a company doesn't go bankrupt and just needs to downsize, employee layoffs may still prompt claims personally targeting directors and officers, in addition to the business. When a company needs do layoffs, some employees might sue because they feel unfairly persecuted, he adds. They may claim they were let go because of some form of discrimination.

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Types of D&O Coverage

The cost of D&O insurance is based on a variety of different factors, but smaller private companies are considered low-risk by underwriters and could pay as little as $500 per year per million in premiums, according to the Insurance Information Institute (III). (On the other hand, large publicly traded companies are usually considered high-risk and III says they can pay from $10,000 to $30,000 per million in annual premiums.)

For eligibility and rates, D&O insurers look at many different aspects of the business, including the type of business, the company's profit, whether they have had prior claims, and the amount of debt.

In addition, insurers want to see that you have communicated the company's policies to employees. "You should have a most up-to-date employee manual. Codes should be posted in the lunch room. And everyone should be disclosed. People need to sign an employee waiver, upon employment because it's hard to get someone to sign something after they've been employed," Cavallaro says. That employee statement should indicate that the person is employed at will and can, essentially, be fired at any time, he says.

There are a few different types of D&O coverage, although most often the coverage is rolled into a package that contains a portfolio of products designed to respond to a private company's management liability exposure, one of which is D&O.  Insurance carriers have different packages, including varying levels of coverage and the ability to add additional coverage levels. Here is a rundown on the typical construction of a D&O policy designed for a privately held business:

  • Side A covers directors, officers, and employees for defense costs, settlement fees, or judgments in the event that the company or non-profit cannot indemnify them, such as if the company has declared bankruptcy.
  • Side B covers the company or organization for directors', officers', and employees' losses when it does indemnify them.
  • Side C coverage is also known as "entity coverage" because it financially protects the corporation in its own right.

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Tips on Purchasing D&O Policies

As with any type of insurance coverage, small and mid-sized businesses should work with an agent or broker who understands D&O policies and the intricacies involved in coverage. D&O may be offered with a portfolio of other products, as well. 

Some of the issues to consider when shopping for a policy include the following:

  • Should you limit coverage to directors and officers or include coverage for the entity, as well?
  • Make sure the policy will cover innocent directors if one member is found guilty of wrongdoing. Policies will cover allegations of criminal misconduct up to the point of adjudication.
  • Do you need additional coverage, which is usually sold in increments of $1 million of coverage?
  • Read the fine print to ensure that the policy covers a wide range of claims, from regulatory actions to criminal investigations to employee lawsuits.

Jones also advises businesses to have a separate coverage limit for D&O policies if that coverage is being bundled with an EPL policy. The reason is that you want to ensure coverage for personal liability of directors and officers in the event a claim against the company depletes the EPL policy limit.

Unfortunately, some business executives find out too late why they need D&O insurance. "Once they have had a claim, they understand why they need the insurance," says Jones. "It's really important to have that executive understand before they're sued where they're vulnerable and who might sue them."

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Recommended Resources:

D&O Market Overview
Insurance powerhouse Aon's quarterly look at the latest available information on pricing, limits, and deductibles/retentions. Registration is required.

Taking Risks with Risk
Highlights from the Chubb 2010 Private Company Risk Survey.

Directors and Officers Liability Insurance Trends
Survey of D&O purchasing trends by TowersPerrin.

Complete Guide to D&O Insurance
Directorship magazine's special report on D&O risk and liability.

Last updated: Dec 15, 2010




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