Directors and Officers Liability Insurance Guidance and Advice for Risk Managers The insurance market has responded to recent corporate failures by requiring more information from organisations seeking to purchase Directors and Officers Liability (D&O) insurance. Also, changes to the responsibilities of company directors introduced by the Companies Act 2006 and other recent legislation have increased the profile of this important class of insurance cover. Risk Managers must help ensure that the company purchases adequate D&O insurance cover for an appropriate cost. This paper explores the current D&O concerns and discusses some of the alternatives. It also provides guidance on what to include in a presentation to underwriters to ensure that necessary coverage is obtained at the best available cost. It is fundamentally important that Risk Managers understand (and challenge) the reasons why the company is buying D&O cover. The D&O cover may only be intended to provide protection for the assets of directors and officers, or it may also be purchased to provide a degree of corporate balance sheet protection against D&O claims. The Institute of Chartered Secretaries and Administrators (ICSA) has updated the guidance note entitled Directors and Officers Insurance. The ICSA publication sets out information on many aspects of D&O insurance. It is not the intention of this paper to either duplicate or challenge the information and advice provided by ICSA. A copy of the guidance note can be obtained from the ICSA website: http://www.icsa.org.uk/images/pdf /Guidence/030925.pdf
Directors and Officers (D&O) Liability Insurance Contents of this Guide 1 Purpose of this AIRMIC Guidance 2 2 Director Responsibilities 5 3 D&O Risk Financing Strategies 7 4 Rating of D&O Risks by Underwriters 10 5 Summary and Conclusions 12 Appendix A: Rating of D&O Risks by Underwriters 14 Appendix B: Presentations to D&O Underwriters 15 D&O Liability Insurance 1
Purpose of this AIRMIC Guidance The purpose of this AIRMIC guidance is to: Review the background to current Directors and & Officers Liability (D&O) issues and concerns Review and consider the alternative risk financing strategies that may be appropriate for D&O exposures Consider the factors that underwriters take into account when setting premium rates and policy terms and conditions Outline the issues that should be covered when making a formal D&O presentation to underwriters Background to D&O Insurance Organisations face a wide range of risks and exposures that can result in legal proceedings being brought against the company. In certain circumstances, a director or officer of the company may be exposed to the possibility of being personally sued. The company may wish to purchase insurance to protect the assets of the individual director. When buying this type of insurance, the company will also have the option of purchasing cover for the protection of the company itself, in the event that legal proceedings are also brought against the company arising from the same circumstances. Historically, D&O insurance policies have offered cover for the consequences of the following types of legal actions: Claims against the director in circumstances where the director can not be indemnified by the company (Side A cover) Claims against the director in circumstances where the director is indemnified by the company (Side B cover or company reimbursement) Certain types of claims against the company from shareholders (Side C cover or entity cover) Side A, Side B and Side C Cover Most companies purchase D&O insurance to protect directors in circumstances where the company cannot provide indemnification for the actions of directors. 2 An AIRMIC Guide to
Recent changes to company law in the UK allow full indemnification of officers of the company in some circumstances. Insurance for nonindemnifiable circumstances is Side A cover and it may initially (or even ultimately) be the sole justification for the purchase of D&O insurance. Restrictions have also been relaxed in the UK in relation to the circumstances where companies can indemnify directors. When fully implemented, the Companies Act 2006 and associated legislation will allow companies to indemnify directors in a wider range of circumstances than previously. However, this is not the case in all countries and the need for many companies to purchase Side A cover may not have been reduced significantly by the planned changes to UK law. In fact, Romania has made the purchase of D&O cover compulsory. Having decided that Side A cover is required, the company can then decide whether to also purchase Side B cover (company reimbursement) and Side C cover (entity cover). Most companies purchase Side B cover in addition to Side A cover and many companies also purchase Side C cover. In recent times, there has been a trend towards a more aggressive approach to the purchase of D&O insurance, with some organisations accepting the cost of defending indemnifiable legal actions against directors as a company balance sheet risk. The basis of this decision is that claims rarely arise and when they do, they should be managed and funded in the same way as any other (uninsured) legal action against the company. Different Types of Side A Cover It is important to note that there are different types of Side A cover available from the insurance market. Although the terminology used for denoting the types of Side A cover can vary, common labels used to denote the three types of Side A cover are: Side A Broad Form Side A Excess / DIC Side A D&O Liability Insurance 3
Purpose of this AIRMIC Guidance continued Side A is used in a traditional Side A and Side B (A / B) or in a traditional Side A, Side B and Side C (A / B / C) insurance policy. Broad Form Side A refers to a policy that is purchased as primary insurance and provides Side A cover only. Excess / DIC (Difference-in- Conditions) Side A refers to a policy that provides Side A cover only, but is purchased as an excess layer above a traditional D&O insurance policy providing Side A / B or Side A / B / C coverage. The Excess / DIC Side A policy can fulfill two separate functions. It can provide excess coverage for loss that exceeds the limits of underlying D&O insurance (this is the excess coverage). It can also provide coverage if the loss is not covered by the primary (or underlying) D&O insurance but would be covered by the broader Excess / DIC policy, and it can provide coverage with a zero deductible (this is the DIC coverage). It should be specifically noted that the Side A cover in a Broad Form Side A or an Excess / DIC Side A policy is usually broader than the Side A cover provided by a traditional Side A / B or Side A / B / C D&O policy. 4 An AIRMIC Guide to
Director Responsibilities The Companies Act 2006 consolidates and amends company law in the UK, as well as introducing certain new requirements. The provisions of the new act will come into force progressively until the requirements come fully into force during 2008. In relation to director responsibilities, the Companies Act 2006 states that a director of a company must act in the way the director considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. Directors duties to shareholders continue and in complying with the duties imposed by the Companies Act 2006, a director must (so far as reasonably practicable) pay regard to the following: the likely consequences of any decision in the long term; the interests of the company s employees; the need to foster the company s business relationships with suppliers, customers and others; the impact of the company s operations on the community and the environment; the desirability of the company maintaining a reputation for high standards of business conduct; and the need to act fairly as between members of the company. The need for D&O cover should be assessed in light of the responsibilities of directors, as set out above. If D&O cover is purchased to protect directors, then consideration will need to be given to developing a specific deed of indemnity for directors in order to clarify the scope of cover provided by the Side A only insurance policy. The granting of any deed of indemnity will need to be consistent with any restrictions in the articles of association of the company. Legal advice will be needed to draft the deed of indemnity and it will need to be compatible with the requirements of the Companies Act 2006. The deed of indemnity should provide details of the indemnity provided to the director by the company with respect to the following: D&O Liability Insurance 5
Director responsibilities continued Scope of indemnity provided by the company Cover for outside directorships Historical liabilities Director obligations to notify claims or circumstances Director obligations to defend claim Protection following retirement or resignation Deed governed by laws of England 6 An AIRMIC Guide to
D&O Risk Financing Strategies There are a number of possible alternatives for the funding of the legal and related settlement costs and expenses associated with claims against directors and officers of the company. These alternatives include: Directors and Officers Liability (D&O) insurance Use of captive insurance companies Mutual insurance companies Co-insurance arrangements Letters of credit or other company guarantees The main practical difficulty when considering D&O risk financing options is that the company has to operate within the constraints of the Companies Act 2006. Although the circumstances where a company can indemnify its directors have been relaxed, there are still limits on the extent to which the company can indemnify its directors. These restrictions appear to limit or even eliminate the use of letter of credit mechanisms and / or company guarantees to protect directors fully from the financial consequences of D&O claims. However, professional advice may be needed on this matter before making a final decision. Risk retention techniques may have a role to play, but consideration may still need to be given to legal constraints. As part of designing the risk financing arrangements, it should be noted that acceptance of large deductibles on Side B exposures should reduce costs. Likewise, a captive insurance company can be used as a funding mechanism for large retentions and (if no claims arise) this will also reduce costs. Similarly, co-insurance arrangements between the primary or fronting insurer and the company (perhaps involving use of a captive as co-insurer) should also reduce costs. In case of a captive insurance company and coinsurance, the situation where the company itself is providing protection for non-indemnifiable risks may give raise to concern and unease on the part of shareholders and (even) the Board itself. Mutual insurance arrangements can offer a long-term sophisticated financial solution, but such arrangements take some time to organise and the essence of mutual arrangements is that risk is shared with other companies. Mutual insurance arrangements generally D&O Liability Insurance 7
D&O Risk Financing Strategies continued require that the members have similar risk profiles. Therefore, the establishment of a mutual insurance company will usually require cooperation between competitors. Buying D&O Insurance It therefore seems that the conventional D&O insurance market is likely to offer the most appropriate solution to the funding of D&O claims against directors of the company and the legal expenses associated with the claims. Companies are allowed to fully indemnify officers of the company in some circumstances, but the extent of such indemnity is a matter for the company to decide. Companies will need to consider (at least) the following when deciding what D&O cover to purchase: Basis of cover, i.e. Side A / Side B / Side C Nature of the Side A cover that is required Appropriate limit of indemnity required Separate sub-limits for different types of claim Aggregate limits and reinstatement arrangements Deductibles to be applied on Side B and Side C cover Acceptable exclusions and restrictions Decisions on the above issues will be based on internal company discussions, as well as discussions with brokers and underwriters. At the time of writing this guide in mid 2007, D&O claims resulting in payment of compensation to the claimant are very rare. In any case, such payments are likely to be very large and may result in payments of tens of millions of GBP. Such payments could be well in excess of the limit of indemnity purchased. It is worth noting that legal expenses payments on D&O policies are far more common, although rarely exceed a million GBP. Therefore, in almost all circumstances, the D&O policy acts as legal expenses cover, rather than a means of paying compensation to the claimant. However it is worth remembering that past claim payments and patterns are not a guarantee of future claims activity. If Side A only cover is purchased, then a lower limit of indemnity may be appropriate than if Side A together with Side B and (perhaps) 8 An AIRMIC Guide to
Side C is purchased. The level of deductibles applied to the policy will depend on the risk appetite of the company, as well as underwriter requirements and whether risk retention arrangements, such as co-insurance and / or a captive insurance company, are in place. If the decision is taken to purchase Side A only cover, then consideration will need to be given to developing a specific deed of indemnity for directors in order to clarify the scope of cover provided by the Side A only insurance policy. A decision will also need to be taken on the circumstances in which officers of the company will be fully indemnified. Director Indemnification Under the Companies Act 1985, indemnification of directors by their company was prohibited, except in specified situations. This restriction is now being replaced by the requirements of the Companies Act 2006 that allow a company to indemnify its directors in a wide range of circumstances. All restrictions on corporate indemnification of officers and company secretaries have been abolished. In relation to directors, the only situations in which corporate indemnification remains unlawful are now: damages awarded to the company; fines and penalties in criminal and regulatory proceedings; and defence costs incurred in unsuccessfully defending proceedings brought by the company itself The Government rejected calls for directors to be able to limit their liability to the company, although the Companies Act 2006 did introduce proportionate liability for auditors. The new corporate indemnification requirements give rise to a number of implications for directors and their companies. It is important to consider the articles of association of the company and the terms of the director contracts. These should be considered together with the terms of any D&O liability insurance and any director deed of indemnity to ensure that there are no unintended or unexpected gaps in cover for directors and officers. D&O Liability Insurance 9
Rating of D&O Risks by Underwriters There is a lack of reliable insurance industry statistics regarding the profitability of D&O insurance over the past 5 years. Insurers are not obliged to disclose to the regulators the premium and claim statistics for D&O insurance as a separate class of business. The D&O performance of the market is included in the Miscellaneous Liability category and so there is no useful information available to Risk Managers. D&O insurers appear to be reluctant to provide specific information on premium income and detailed claims experience. It would be helpful if the Financial Services Agency (FSA) were to decide that D&O should be reported as a specific class in the annual returns provided by insurers to the regulators. Appendix A provides a broad outline of the factors that underwriters take into account when rating D&O risks and deciding on the premium that should be charged. The information in Appendix A is intended to help Risk Managers understand the underwriter s view of the nature of the risk that is being presented to the market and to help the company evaluate whether any of the adverse rating factors can be reduced or eliminated. Underwriting Presentations It has become more usual in recent years for companies to make presentations to D&O underwriters. Appendix B sets out a wide range of issues that could be included in the content of a D&O presentation to underwriters. The information on the profile of the company is an established part of the presentation. However, it is becoming increasingly important to also describe the corporate governance standards that are established within the company. The structure suggested for the corporate governance part of the presentation is based on the COSO framework referred to in the Sarbanes-Oxley Act. This framework is becoming the established internal control framework and it is a convenient basis for the structure of the presentation. 10 An AIRMIC Guide to
D&O Exclusions and Restrictions A range of exclusions and restrictions are applied to D&O policies and these have become fairly well-established in recent times. Individual companies need to decide whether all of the suggested exclusions are acceptable. In general, fewer exclusions are applied to Side A cover and it is normally the case that a zero deductible is applied to these non-indemnifiable risks. As noted earlier, Broad Form Side A and Excess / DIC Side A policies provide broader Side A coverage than the traditional Side A / B or Side A / B / C policies. D&O Liability Insurance 11
Summary and Conclusions Restrictions on the scope of the indemnity that a company can provide for its directors remain in place, although the company now has greater freedom to fully indemnify officers of the company and the Company Secretary. Nevertheless, it appears that insurance remains the most appropriate solution to meet the costs and compensation related to the exposure of directors to D&O claims. It is against this background that the following summary and conclusions are offered: The most important and overriding consideration is why the company is purchasing D&O cover If the cover is being purchased only to protect the assets of directors, then only Side A cover is necessary Options are available for the funding of large deductibles, including coinsurance, captives and mutuals Presentations to underwriters should include information on standards of corporate governance, as well as details of the trading position and future prospects of the company Structure of D&O Programs As an example, consider a company that currently purchases D&O insurance with a 100 million limit of indemnity based on conventional Side A, Side B and Side C cover. This same structure could be maintained on renewal, or the company could focus on the fact that it only purchases D&O cover to protect the assets of its directors. The options available on renewal range from the aggressive to the conservative, as follows: The aggressive renewal position might be to purchase (say) 40 million of Broad Form Side A cover only The less aggressive renewal strategy would be to purchase (say) 40 million of Side A / B / C cover plus a further (say) 40 million of Excess / DIC Side A cover The neutral renewal position would be to purchase 100 million of Side A / B / C cover as per the expiring program The conservative renewal strategy would be to purchase 100 million of Side A / B / C cover, plus an additional (say) 20 million of Excess / DIC Side A only 12 An AIRMIC Guide to
D&O Underwriting Presentations Whatever the decision on the scope and limit of cover that will be purchased, it is fundamentally important that the company presents the best description of the D&O risk. Risk Managers need to be aware of the rating factors that are important to underwriters (Appendix A), so that necessary and appropriate assurances can be provided to underwriters at renewal (Appendix B). D&O Liability Insurance 13
Appendix A: Rating of D&O Risks by Underwriters The following factors are examples of the issues that have a specific impact on the rating of the Directors and Officers Liability (D&O) insurance premium by underwriters. The range column indicates the possible percentage spread of premium increases (+) or decreases (-) related to each of the features. At times of competitive insurance market pricing for D&O risks, the ranges quoted below will be narrowed. Financial Features Range Credit rating and volatility -10% to +10% Share price volatility and market capitalization -5% to +5% No US stock-listing -50% to -15% Company is ADR listed only -5% to 0% Mutual or private company -45% to -35% Bond or share issue planned +10% to +40% Infrastructure Features Rapid growth of the company +10% to +60% Recent major merger or restructuring +30% to +65% Acquisitive approach +10% to +25% Divestments in hand +5% to +25% Board reputation and profile -10% to +10% Asset distribution (especially North America) -5% to +25% Reputational Features Brand profile and quality -10% to +10% Product volatility +5% to +15% Legal review procedures -5% to +15% D&O claims history -20% to +20% Customer and supplier dependency 0% to +10% Business diversity and diversification -10% to +15% Marketplace Features Trend, stability and types of the business -10% to +50% Regulatory changes anticipated 0% to +10% Specific exclusions imposed -50% to -10% Specific extensions required +5% to +30% Outside directorship cover +5% to +25% Entity coverage (Side C) +20% to +40% Corporate Governance Quality of the control environment -10% to +10% Robustness of risk assessment procedures -5% to +5% Confidence in the control activities -20% to -5% Details of monitoring and review protocols -5% to +5% Procedures for performance certification -5% to +15% 14 An AIRMIC Guide to
Appendix B: Presentations to D&O Underwriters The following are suggestions for the issues to be addressed when making a D&O presentation to underwriters. The presentation should be in two parts: Factual information about the financial structure, operations, reputation and the developments / prospects in the marketplace where the company operates Governance standards within the company, presented in a format based on the components of the COSO internal control framework COMPANY PROFILE 1. Financial Structure Company funding, debt, share capital and credit rating and the need to raise funds by stock or bond offering Established accounting procedures, including revenue recognition and progress towards any new standards Treasury activities, including scope of activities and involvement in swaps and off balance sheet financing instruments Control and funding of pension plans and whether the pension fund is adequate to meet current and deferred liabilities 2. Operations and Activities Company activities, including geographical spread; market share and planned mergers and / or acquisitions Details of income from different segments, territories, etc. and analysis of growth prospects for the future Details of any significant writedowns in the previous period and information on any potential management distractions Description of key customer or supplier dependencies and details of the business continuity plans in place 3. Reputation and Brands Significant litigation currently in hand, including update on those cases disclosed in the annual report and accounts Description of any investigations that are in hand or pending, especially if the Stock Exchange or SEC is involved D&O Liability Insurance 15
Appendix B: Presentations to D&O Underwriters continued Company in breach of debt covenants, loan agreements or contractual obligations in previous 12 months Procedures for responding to whistle-blowing and outline of procedures for disclosing and dealing with conflicts of interest 4. Development & Prospects Company visibility in its marketplace(s), activities of main competitors and current market share Changes in profile of the marketplace and possible mergers and acquisitions, including details of growth opportunities Analysts opinions and declared prospects and whether all the analysts agree on details of the performance of the company Current strategies for growth in the marketplace and success of plans for implementation of the key strategies CORPORATE GOVERNANCE 1. Control Environment Board, including executive and non-executive directors, changes in the past 12 months and need for more experience Management structure and style, including details of communication lines and code of ethics and / or code of conduct Audit Committee, external audit and internal audit function and settlement of disagreements over accounting practices 2. Risk Assessment Details of economic forecasting process in place and the importance of risk assessment in the forecasting process Assessment of specific business continuity issues, including the terrorism threat and business continuity planning 16 An AIRMIC Guide to
Risk assessment procedures that are in place to comply with Turnbull and Sarbanes-Oxley requirements 3. Control Activities Controls on exercise of share options schemes, insider trading and corporate communications policy Response to the auditor s CPA letter and the activities of the Remuneration Committee and Nominations committee Activities of the Audit Committee, including consultancy policy and meetings between non-executive directors and auditors 4. Monitoring and Review Use of SAP and controls to monitor and review activities to ensure correct revenue recognition and accounting Litigation report and contingencies and the extent and nature of the impact of the regulatory environment on company activities Communications policy and general nature of arrangements for reviewing effectiveness of management and the board 5. Performance Certification Details of the accounting practices and certification procedures that are followed, including Sarbanes-Oxley procedures Mechanisms for reporting financial results to the main shareholders and activities of the Disclosures Committee Investor relation communications and information on the recent communications with key investors D&O Liability Insurance 17
Notes 18 An AIRMIC Guide to
Notes D&O Liability Insurance 19
Revised 2007