Value analysis in the current D&O market

Competition in the insurance market is heating up, and as the directors and officers (D&O) market continues to soften, primary carriers are looking for new ways to differentiate themselves and broaden their “A-B-C” D&O policy offering. In this tight market, policy enhancements have become requisite marketing tools that assist in attracting new customers, retaining preferred business at reasonable rates, and offering the industry’s acknowledgement of improved claim frequency.

Difference in Conditions

The Side A DIC (Difference in Conditions) D&O policy is a relatively new offering and is most often written excess of a primary “A-B-C” policy. “ABC” coverage refers to the traditional D&O policy, which provides coverage for non-indemnifiable and indemnifiable loss of D&O insurance as well as entity coverage under three insuring agreements referred to as A, B, and C.

Meant to speak to cursory coverage gaps in the primary policy, Side A DIC will even drop down as primary coverage in certain situations. Developed many years ago, but of particular value since the time of the Enron and WorldCom corporate failures, the Side A DIC policy was created to provide an added measure of protection for individual directors and officers. It is coverage dedicated specifically to protect individual directors and officers, rather than the corporation, in situations where the company cannot, or is unable to, indemnify.

Examples of current situations that could give rise to a Side A DIC claim are:

1. Sub-prime-related bankruptcies, where the insured is unable to indemnify, as a result of a company’s over-extended financial exposure to the sub-prime housing market or failed mortgage securitization.

2. Potential rescission or pollution-related coverage concerns where there is no coverage for a securities fraud class action case as a result of non-disclosure by the company of global warming issues.

With competitive primary carriers expanding their policy coverages via endorsements, many of those perceived gaps — such as bankruptcy carve-back language, Side A pollution — are eliminated. Furthermore, the Side A DIC policy pricing is often within 10 percent of the pricing of an A-B-C excess policy. The questions, then, are: Does the Side A DIC policy still provide a value to the customer, and are the cost savings worth the perceived benefits of a Side A policy, when compared to the broad A-B-C follow form coverage available?

Enhancements offered

First, let’s review the conventional enhancements offered by many Side A DIC markets.

Non-rescindable policy, for any reason. The DIC policy stays in force despite restated financials, or cooked books, and responds to a shareholder suit from a corresponding stock price drop, for example.

No ERISA exclusion. Coverage continues for employee lawsuits as a result of alleged abuse of fiduciary obligations under the Employee Retirement Income Security Act.

No pollution exclusion. Coverage for shareholder derivative actions resulting from stock price drops caused by pollution violations. Note that coverage is generally not excluded for bodily injury/property damage claims resulting from pollution violations.

No presumptive indemnification. Coverage applies if the company rightfully or wrongfully refuses to indemnify.

Narrow insured v. insured exclusion. Excludes coverage only for claims brought by or on behalf of the company. The insured v. insured exclusion does not apply to defense costs, claims by whistleblowers, bankruptcy trustees, or claims outside the U.S. or Canada.

Narrowed conduct exclusions. Exclusions for fraud, illegal personal profit, or improper remuneration are not applicable to defense costs, or for Securities actions involving Section 11 or 12 of the Securities Act of 1933 (concerning Initial Public Offerings).

Coverage. Follows any broader provisions in any underlying insurance and does not follow underlying exclusions, unless they are also excluded on the Side A DIC policy.

Notice provisions. “Notice” constitutes “Claim” in the DIC definition, and coverage includes defense costs for these potential claims.

Blanket non-profit. Outside directorship liability coverage.

Drop down coverage. In event an underlying insurance carrier is financially insolvent, unable to pay, will not pay, or rescinds coverage.

DIC difference

Now, let’s review the current state of the primary D&O market. As stated previously, brokers and the competitive market are pressuring primary insurance carriers to broaden coverage. Because of this pressure, it is now almost routine to include enhancements in the primary policy that mimic the Side A policy. These enhancements would appear to dilute the benefits of the Side A DIC policy — making the Side A DIC policy excess of certain underlying coverages instead of first dollar, gap fillers, as they were originally intended. But they don’t dilute it at all.

Take, for example, the WorldCom directors, whose company went bankrupt due to corporate malfeasance, and were required to fund $24.75 million out of their own pockets for the settlement. A separate $36 million was contributed by insurance companies, who agreed to withdraw their rescission defense for the perceived favorable settlement amount, and the elimination of continued legal costs in defending the case that they believed offered no policy coverage.

Likewise, 10 former Enron directors personally paid, under the terms of the agreement, a total of $18 million. This was an amount equal to slightly more than 20 percent of the directors’ combined net worth. Insurance companies paid $36 million. Especially noteworthy in Enron’s case, none of the former directors admitted to any wrongdoing and the directors’ settlements did not include their own legal defense costs.

In both of these cases, in the absence of a rescission defense, an ERISA exclusion, a Bankruptcy Trustee carve-back, a presumptive indemnification clause, or any other defenses that the carriers likely asserted due to the policy language presented, the insurance payment would have been greater if the directors had had a Side A DIC policy. More importantly, the hit to the innocent individual directors would have been significantly less, if any. Given the enormity of the entire settlements in these cases ($6.13 billion for WorldCom and $7.1 billion for Enron), a Side A DIC policy with dedicated limits to the individual directors would have been a huge value.

Added protection

This much is abundantly clear: if you are an independent director sitting on a corporate board or an internal officer or director, you can be held accountable for failure to detect fraud, even if you were not directly involved. This accountability could easily be extended to a director’s failure to detect or respond to global warming issues or sub-prime exposures, and the resulting financial impact to the company.

Above and beyond their careful due diligence when accepting a board position, directors and officers need to take additional steps to be sure they will be protected. Even in a competitive marketplace where coverage is routinely broadened, Side A DIC policies still provide a dedicated measure of protection and the broadened primary policies underlying them simply provide further support for the directors and officers of the corporation.

While the Side A DIC policies have not yet been regularly tested in the courts, it seems obvious that, once litigation commences, the process will move significantly faster, and with greater efficiency. Individual directors will have dedicated defense dollars, which will alleviate concern that the corporation could consume all available policy limits. Insurance carriers will have fewer defenses without rescission or bankruptcy exclusions and with the benefit of full or partial severability; as a result, the intent of the policies, which is to protect innocent, individual corporate directors and officers, will be realized.

Indeed, directors of financial-related companies who have exposure to the sub-prime markets and potential allegations of mismanagement, malfeasance, or resulting bankruptcy may well benefit from the comfort that the Side A DIC policy provides. If this policy is an in force reality for these insured individuals, we will have the chance to see the provisions truly tested in court. My guess is that the process and the outcome will be vastly different for these directors and officers than those of Enron or WorldCom.

Put a different way, what is the value of a dedicated Side A policy to an honest director or officer involved in malfeasance? Priceless.