Why Private Companies Should Buy D&O Insurance

Broad Coverage, Relatively Low Cost, Innovative Programs Available

Most public companies don’t need to be persuaded that their company needs directors and officers insurance. However, the matter is viewed differently by some private company managers, particularly those at very closely held companies who 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.

Many who resist the need for D&O insurance are affiliated with companies that have few shareholders. They look at their ownership and conclude their company could never have a D&O claim. This perspective overlooks the fact that the array of prospective D&O claimants is broad and includes 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. 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 is relatively slight.

For the relatively low cost, private companies obtain coverage that is quite broad; in fact, D&O insurance for private firms is materially broader than it is for public companies. The entity coverage in public company D&O insurance policies is generally limited just to securities claims, while private company policies contain no such limitation, thereby providing significant financial protection.

Separate Limits?

Modular management liability policies are a recent D&O innovation. 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 then separate coverage parts for each of the various management liability coverages (such as D&O, EPL, Fiduciary, Crime, etc).

These modular policies have advantages. They simplify the insurance acquisition process by reducing discrete transactions into a single 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 some buyers, particularly very small enterprises, the cost saving 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 the 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. Most insurance buyers should not allow relatively small premium differences drive important insurance decisions.

Duty to Defend or Duty to Indemnify?

Public company D&O insurance is written on a 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 also often written on a duty to indemnify basis. In addition, however, this insurance is also sometimes written on a duty to defend basis, under which the insurer selects the defense counsel and controls the defense. Many carriers offer the choice.

There are certain advantages to the duty to defend structure, the first being 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.

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 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, the defense costs must be allocated between the covered and uncovered matters. The allocation process can be contentious at a time when the insured and the insurer ought to be working together.

Despite the advantages of the duty to defend coverage, it isn’t always the best choice. In particular, many policyholders are not comfortable having the insurer’s counsel defending a claim. Also, issues arise when the insurer is defending a claim subject to a reservation of rights to deny coverage.

Whether the coverage should be written on a duty to defend or a duty to indemnify basis is a question each buyer must decide in consultation with an insurance adviser.

Another recent D&O innovation 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 allows the policyholder to let the carrier handle the smaller or more routine matters, while allowing the company to select its own counsel and manage its defense on more significant matters.

Private company D&O insurance provides broad coverage at relatively low cost. Thus, it should be a part of every private company’s risk management portfolio – not just private firms with a broad ownership base.