Why Should Private Companies Buy D&O Insurance?

Most public companies don’t need to be persuaded that their company needs directors and officers insurance. However, the view among some private company managers is different. These officials, particularly those at very closely held companies, believe they are unlikely to ever have a D&O lawsuit. Executives who have survived a claim know better; too many company officials learn the hard way that when they recognize they need insurance after all, it is too late. The fact is, the right time to buy the insurance is when you think you don’t need it.

Many of those who resist the need for D&O insurance are affiliated with companies that have few shareholders. They conclude their company could never have a D&O claim, but this perspective overlooks the fact that the array of prospective D&O claimants is broad. They include customers, vendors, competitors, suppliers, regulators, creditors and others.

When a company has a claim, expenses mount quickly. Even frivolous suits can be expensive to defend and resolve. At the same time, the cost of private company D&O insurance is relatively low. Indeed, the incremental costs, on top of the company’s employment practices liability insurance (and no entity should do business in this country without EPL insurance) is relatively slight.

For the relatively low cost, private companies obtain coverage that is quite broad. Private company D&O insurance is materially broader than public company D&O insurance. The entity coverage in public company D&O insurance policies is generally limited just to securities claims. However, private company D&O policies contain no such limitation, so the private company policy provides significant financial protection for the insured entities.

Combined or Separate Limits?

A recent D&O insurance innovation is the development of modular management liability policies. These combine various management liability coverages in a single policy. The typical modular policy consists of a declarations page, a general terms and conditions section applicable to all of the separate coverage parts, and separate coverage parts for each of the various management liability coverages, such as D&O, EPL, fiduciary, crime, etc.

These modular policies have advantages. The policies simplify the management liability insurance acquisition process by reducing discrete transactions into a single insurance acquisition. The modular structure also coordinates the various coverages, which could be important if a claim straddles several coverages.

Many buyers, attracted by the convenience of combined coverages, elect to combine the limits of liability into a single, combined aggregate limit, under which a claim payment would reduce the amount of insurance remaining for a separate claim under any of the coverages.

A single aggregate limit does afford costs savings for the buyer. For some insurance buyers, particularly very small enterprises, the cost saving consideration justifies the decision to purchase a single aggregate limit.

For most other enterprises, however, the combination of all of the coverages into a single limit may be a poor choice. With a combined limit, a prior claim under one coverage will reduce the amount of insurance available for a later claim under a different coverage. The fact is that when things go wrong, multiple problems can arise at once.

A prior unrelated claim against the company might leave company executives with insufficient remaining insurance to protect them if a separate claim later arises against them as individuals. This concern is particularly applicable in bankruptcy, when company indemnification is unavailable. The executives could be left without insurance or with insufficient insurance at the time when they need it most.

I favor separate limits for separate coverages because I believe that there should be a fund of insurance available to protect the individual executives, without a concern that entity claims might drain the insurance away. Of course, cost considerations may nevertheless dictate that some small enterprises purchase combined limits. But most insurance buyers should not allow relatively small premium differences to drive important insurance decisions, potentially leaving the company insufficient protection.

Duty to Defend or Duty to Indemnify?

Public company D&O insurance is written on reimbursement basis, based on the insurer’s duty to indemnify or reimburse the insured company for defense expenses and claim resolution costs. Under this duty to indemnify type of coverage, the insureds select their defense counsel, subject to the insurer’s consent, and the insureds control the claim. The insurer reimburses the insureds for these costs.

Private company D&O insurance is often written on a duty to indemnify basis. It is also sometimes written on a duty to defend basis, under which the insurer selects the defense counsel and controls the defense.

There are certain advantages to the duty to defend structure. The first is ease of administration. Under the duty to defend coverage, the carrier appoints defense counsel and takes care of managing the claim. The policyholder doesn’t have to deal with legal bills and so on. This can be particularly helpful for smaller and more routine claims. In addition, the counsel the carrier selects often is experienced with these kinds of claims, which can also contribute to smoother claims resolution.

Another advantage of duty to defend coverage is that, in general, if any part of the claim is covered, the insurer must defend the entire claim, even those parts of the claim that are not covered. This unified defense avoids what can be a recurring problem under a duty to indemnify policy when a claim encompasses both covered and uncovered matters. In that circumstance under a duty to indemnify policy, the defense costs must be allocated between the covered and uncovered matters, and the insurer reimburses only the defense expenses associated with the covered matters. The process of determining the allocation can be contentious and disruptive.

There may be times when duty to defend coverage is not the best choice, however. In particular, many policyholders are not comfortable having the insurer’s counsel defending a claim. This may be particularly true with more serious and more sophisticated litigation, which some insureds feel are outside the capabilities of some insurer-selected defense counsel. Also, issues arise when the insurer is defending a claim subject to a reservation of rights to deny coverage.

One innovation introduced in recent years is an optional duty to defend policy, which gives the policyholder the option of tendering the claim defense to the carrier at the outset of the claim. This arrangement allows the policyholder to let the carrier handle more routine matters, while allowing the company to select its own counsel and manage its defense on matters of greater concern.

Despite the coverage nuances, private company D&O insurance policies provide broad coverage at relatively low cost. Thus, it should be a part of every private company’s risk management portfolio.