D&O Insurance Basics

In recent years, companies and their leadership teams have experienced a dramatic increase in legal costs due to the exposure created by the increasing number and size of lawsuits and settlements. To mitigate the financial risk presented by potential lawsuits, and to attract and retain quality leadership, including board members, many firms choose to purchase directors and officers (D&O) insurance. This article will help business leaders understand the basics of D&O insurance and the costs that D&O insurance covers. D&O insurance policies vary widely in their coverage and cost. However, understanding the basics of this insurance market will help companies get started as they consider whether to purchase D&O insurance and try to determine which policy is best suited to their specific needs. This article is structured to answer the five questions leaders will face as they learn about D&O insurance:

1. Why Do Companies Need D&O Insurance?
2. How Does D&O Insurance Work?
3. Who Needs D&O Insurance?
4. How Much Coverage is Appropriate?
5. How Much Does D&O Insurance Cost?

Why do Companies Need D&O Insurance?

Leaders in every business are faced with a modern economy that is becoming increasingly complex and litigious. From technological advancements and activist shareholders to environmental reporting and cybersecurity, business leaders have never had more to think about. The legal environment has also placed an increasing level of personal responsibility on business leaders. Together, these trends have led to a dramatic increase in the number and size of lawsuits brought against companies and company leaders. The increase is exemplified by the rising number of securities class action lawsuits, as shown in Figure 1.

The rising number of lawsuits has increased legal costs and the level of organizational and personal financial risk faced by companies and company leaders. From startups to large public corporations, firms are experiencing a growing need to create a plan that deals with this growing legal exposure. Board members and executives are personally responsible for many of the actions they take while running the company. Thus, they can face personal lawsuits alleging a breach of one of their duties. In many cases, firms can indemnify (compensate for legal costs) the director or officer, but in some instances, the company can’t legally indemnify these individuals. This fact leads nearly all directors and officers to consider a D&O insurance policy a necessary prerequisite to working for an institution.

Without D&O insurance, firms will not be able to attract top talent to their management teams and boards. Board members and executives know that without D&O insurance, their personal assets are at risk. Lawsuits can be long, complicated, and incredibly expensive. Many companies do not have the resources to fight unexpected legal battles and indemnify directors and officers for the costs that they might incur. Even when companies do have the resources to fight legal battles, D&O insurance can still create significant cost savings.

The two most common types of lawsuits against management and boards are class action lawsuits and derivative lawsuits. Class action lawsuits occur when a group of shareholders files a lawsuit against the company for damages, usually in the form of lost value on the stock price. In a class action lawsuit, the company will be responsible to pay shareholders for any assessed damages. Derivative lawsuits on the other hand are claims brought by a shareholder against management and/or the board of directors on behalf of the company itself. In these cases, the suing individual doesn’t collect damages directly; rather, the officer or director will be required to pay any assessed damages directly to the company. Both class action and derivative lawsuit cases have become increasing in frequency over the past several years.

How Does D&O Insurance Work?

Many companies are turning to D&O insurance to cover the legal exposure their management teams and boards are frequently encountering. On a basic level, D&O insurance is financial coverage that companies can purchase to protect the assets of the company and its individual leaders against the costs of a lawsuit. Legal costs that are covered by a D&O insurance policy include legal fees, assessed damages, settlements, and other legal expenses. Because D&O insurance can cover both individual leaders and the company itself, D&O insurance policies are structured in several different ways.

D&O Insurance Coverage Structure

D&O insurance policies can include several different types of coverage. These coverages can be packaged together or purchased separately depending on the company’s needs. D&O insurance includes coverage types referred to as Side A, Side B, and Side C. Side A coverage only protects officers and directors from claims made against them in which the company cannot provide indemnification. Side B coverage protects both the individual directors and officers as well as the organization itself by directly covering the costs of indemnification on behalf of the firm. This coverage is triggered by actions of the directors and officers that are indemnifiable. Side C coverage protects the assets of the firm specifically. Side C coverage differs between public and private companies. For public companies, Side C includes coverage for securities claims. Figure 2 provides a visual for these details including what and who is covered by each side.

Businesses have the option to purchase D&O insurance in several different packages depending on which of the three sides they need covered. Some companies choose to purchase all three sides and others may only purchase a Side A policy. Side A is the most common coverage to purchase alone, but each type of coverage can be purchased individually, depending on the policy. If the company expects to be able to pay for indemnification, then Side A coverage may be the only coverage the company needs. Companies should consider their individual needs, budget, and exposure when deciding which type of insurance coverage to purchase.

If a policy is large, then one insurance company is unlikely to provide coverage for the entire amount needed by the insured. In this case, insurance companies normally structure the insurance coverage with what is referred to as an excess policy. An excess policy breaks the insurance coverage amounts into levels of coverage paid by different insurers in a specified order of priority. Most policies have an initial layer that is called the self-insured retention. This is similar to a deductible in other types of insurance. Like a deductible, a firm is responsible to pay the self-insured retention out of its own pocket before the primary level of insurance coverage is triggered. After paying the retention, the first layer of coverage will normally cover up to the first $5 to $10 million in coverage. After that amount is reached, the second insurer will take over and pay the next $5 to $10 million. In this way, layers of insurance can be added until the firm reaches its desired policy cap.

For example, if a company that has been sued reaches a settlement of $21 million, then that amount would be covered by an excess layer structure in the following manner. First, the firm pays its self-insured retention of $10 million. Then, the primary insurer pays $5 million followed by the first and second excess layer insurers who pay $5 and $1 million respectively. This layer structure is represented visually in Figure 3.

In addition to excess policy layers, companies can also purchase Side A Difference in Conditions (DIC) coverage. This type of policy can cover legal costs for company leaders that are not included in the normal D&O policy coverage. For example, Side A DIC coverage may be triggered when the company cannot indemnify leaders because of special circumstances. Side A DIC coverage can also provide excess coverage and fill in any potential gaps in coverage created a dispute with an excess layer provider over the validity of a particular claim. Thus, Side A DIC coverage can play a key role in creating the security firms need when purchasing a D&O insurance package.

Most businesses will have excess layer coverage structures like the example above, often coupled with a Side A DIC policy. However, the structure of a D&O policy can also include other structures, such as proportional coinsurance. These other types of insurance are often more complex and go beyond the basics that we cover in this article.

D&O insurance can often be packaged with several other types of insurance that aren’t directly related. For example, firms may choose to purchase employment practice liability insurance (EPLI), crime insurance, and fiduciary insurance from the same provider. EPLI insurance provides coverage against lawsuits involving employment-related claims such as wrongful termination, sexual harassment, and failure to promote. Crime insurance covers potential crimes by employees and officers or directors. Fiduciary insurance covers claims relating to the distribution of employee benefits. Purchasing these policies together may be beneficial for some firms.

Common Exclusions for D&O Policies

Most company leaders and firms are exposed to a nearly endless list of potential claims. Because of this, a D&O policy is referred to as an omnibus policy. This means that the insurance policy covers everything that is not specifically excluded in the terms of the insurance agreement. In most policies, there are several common exclusions, including those that are listed below:

• Deliberate criminal acts or omissions by any of the insured
• Acts that lead to personal profit or financial advantage for the insured persons
• Acts of fraud

Companies should be careful to check that the policy they purchase covers the areas that are most relevant to them, as every policy will have different exclusions. When reviewing the exclusions in a policy, firms should also pay close attention to the definition portion of the policy. The definitions will delineate exactly what is meant by the terms included in the exclusions. Definitions are key because they can act as an inclusion or exclusion based on their nature. For example, the definition of “fraud” in a policy may require a legal conviction by a judge, which requires the lawsuit to go to trial. In many cases, lawsuits are settled prior to trial. Because a settlement is not a conviction, the settled claim might still be covered under the policy. It is in the best interest of the insured firm to carefully review both the coverage and definitions in the policy to ensure that the language is as broad as possible. In this way, a firm can ensure they are purchasing the best possible policy.

Who Needs D&O Insurance?

Most companies, even startups, should consider getting D&O insurance because most firms are exposed to liability from multiple directions. Claims can come from investors, creditors, employees, suppliers, competitors, regulators, and customers. Several of these groups are, by definition, a part of every business. Thus, it is important for all companies, public or private, large or small, to consider purchasing D&O insurance.

Although all companies are at risk of being sued, some companies may be more exposed than others. This will often mean that the company needs a greater amount of coverage, and thus the overall policy will be more expensive. This is the case in certain industries such as technology, healthcare, biotech, and financial institutions. Companies will also need more coverage when they start seeking outside investors or decide to go public. In the end, companies should be thinking about D&O insurance long before it becomes a necessity so that they are covered when they need to be.

Lawsuit Examples

There are dozens of potential examples of claims and lawsuits that companies could face. The examples included below are meant to demonstrate the size and potential variety of lawsuits that are possible for all companies to face. The examples included here are taken directly from the websites of D&O insurance providers. For more information about D&O claims and example cases, these websites have been linked in the footnotes.

Class Action Complaint

“A large group of outside investors in a particular company filed a class action complaint in which they claimed that the D&Os of this company did not disclose vital and accurate facts and information. More specifically, Plaintiffs claimed that the company did not disclose the inadequacy of company’s Information Technology (IT) department, and that several managers had been hired and fired in an unacceptably brief time frame. The firm eventually dissolved. In the complaint, causes of action were fiduciary breach, negligence, and common law fraud.  The grand total for defense and settlement was more than $2,000,000.”²

Credit Fraud

“A creditor filed a complaint against individual directors and officers of a company alleging that its CEO, CFO, and COO conspired to use the plaintiff’s services to furnish, install, and repair the company’s equipment knowing that it was insolvent and was planning to file for bankruptcy protection. Causes of action included: (1) fraud, misrepresentation and non-disclosure; (2) deceptive trade practices; and (3) civil conspiracy. Total settlement and defense of the individually named defendants exceeded $100,000.”³

Run-Off Claim

“A few months after purchasing an Insured Company and while the account was in Run-Off, the purchaser filed suit against the Company and its former D&Os for alleged fraud and conspiracy to commit fraud. The plaintiff alleged that prior to the sale, the defendants conspired to withhold crucial information regarding deficiencies in one of the Company’s products causing the plaintiff to greatly overpay for the Company. […] Settlement and defense exceeded $2 million.”⁴

Non-Profit D&O – Improper Voting of Directors

“Members of a country club alleged negligence and breach of fiduciary duty against the club and certain board members stemming from the improper voting and election of its board of directors. Plaintiffs alleged that due to the failure to follow proper voting protocol, certain board members were elected who then mismanaged the club through self-dealing and other improper acts. […] Settlement (including new elections) and defense exceeded $100K.”⁵

How Much Coverage is Appropriate?

Once a company understands its risks and exposures, the next important consideration is how much coverage to purchase. This is a complicated question that often involves a variety of factors such as industry, average cash reserves, market cap, and legal philosophy. Businesses with more cash may choose to purchase less coverage, seeing large insurance premiums as a less productive use of shareholder funds. Small companies may choose to purchase only a single layer of insurance. On the other hand, large private or public companies often need coverage that totals $50 million or more. Another important factor is a company’s legal philosophy. If the company takes a “porcupine” approach to lawsuits, and never settles, then they may experience fewer lawsuits, and lower overall costs, making less coverage necessary.

Luckily a wealth of information about D&O claims and policy amounts is publicly available. By using this information, a company can perform an analysis to see how much insurance would be appropriate for them. This analysis could include various pieces of information. A firm may start by examining the types of claims it is exposed to. Then a firm could create a risk profile that takes various pieces of information into account such as market cap, previously filed claims in the industry, and the size of settlements. This information can specifically help companies estimate the potential size of a shareholder suit. By performing this type of analysis and comparing itself to relevant competitors, an organization can find a reasonable range of estimates for how much coverage they will need.

How Much Does D&O Insurance Cost?

The cost of D&O insurance varies widely depending on the size of the policy and the attributes of the firm. Companies that are public, large, or work in high-risk industries, have more expensive policies. Small companies that need minimal coverage have less expensive policies. Overall, each company is unique, and needs to communicate with insurance providers in order to find a suitable policy that fits the company’s needs and budget.

Public companies pay significantly more for D&O insurance because of their increased public exposure; however, the hardest hit group in terms of risking costs have been IPO companies. D&O insurance has become very expensive for IPO companies. These rising costs are due to the fact that IPO companies are held strictly liable for everything that is stated in the documents they file ahead of the IPO. Any misstatement or misrepresentation can and likely will lead to a lawsuit against the company. In most cases, IPO companies will end up paying more for D&O insurance than both private and publicly traded companies.

Companies should be aware that D&O insurance costs have been rising dramatically. For years, the cost of policies has been rising consistently. The Coronavirus pandemic also seems to have pushed costs up even further. Marsh, an insurance provider, reported that the cost of D&O insurance had gone up dramatically in 2020.⁶ In addition, forecasts have continued to predict rising D&O insurance rates in the near future. Companies need to account for these rising costs as they consider how to budget for a D&O policy.

Another important factor in determining how much money to budget for a D&O policy is the policy’s self-insured retention. Many D&O policies have a high self-insured retention that a director, officer, or the company will have to pay before the coverage kicks in. Firms need to ensure that they have the cash on hand to cover these potential costs.

Company leaders should remember that while purchasing D&O insurance does create a new cost for the company, it can save the company from potentially lethal legal fees. In addition, companies with D&O insurance policies can often attract and retain better talent on their senior leadership teams. This will reduce the indirect costs of leadership transitions, recruiting, and training.

What Else Should Companies Consider?

There are a number of important factors to consider when a company decides to purchase a D&O insurance policy. Steve Albrecht, who has experience as board member at several organizations, related the following best practices when it comes to purchasing a D&O insurance policy.

1. Not all D&O policies are the same. Look for an underwriter that serves your firm’s specific needs. Do not become overly focused on price.
2. You should find a D&O broker you trust. Find a quality D&O insurance underwriter that will try to provide real value at a fair price by investing the time and resources necessary to understand your business.
3. Company ratings matter. Make effort to only purchase coverage from a highly rated insurer that is secure and won’t leave the company uncovered by going out of business.
4. D&O policies are negotiable. As with most purchases, D&O policies are negotiable. Both the insurer and the insured should know what their priorities are and be ready to negotiate both the price and terms of coverage.
5. Continuity with a carrier does matter. In most cases, developing an ongoing relationship with an insurance provider is advantageous. That being said, there are cases where better policies may be available, and this may warrant a switch.
6. Terms matter when comparing policies. In the same way that all policies are negotiable, companies purchasing a policy should always look to establish the best possible terms, and should confirm the quality of potential policies by comparing them to other available options in the market.

Summary and Key Takeaways

Because of the increasing prevalence of lawsuits and the potential legal costs, most businesses that want to hire quality leadership teams need to purchase D&O insurance. Having the necessary coverage provides security for members of the leadership team as well as the company itself. In the end, a good D&O policy can save a company from potential ruin in the face of debilitating lawsuits.

Resources Consulted

• Allianz, “D&O insurance explained.” Accessed 28 Jan 2021.
• Allianz, “Directors and Officers Insurance Insights 2020.” Nov 2019.
• Allianz, “Introduction to D&O insurance.” 2010.
• Embroker, “D&O insurance.” Accessed 28 Jan 2021.
• GB&A, “D&O Insurance Guide.” Accessed 28 Jan 2021.
• LaCroix, Kevin. “The Top Ten D&O Stories of 2019.” The D&O Diary. 5 Jan 2020.
• McIntosh, Janeen and Svetlana Starykh. NERA Economic Consulting. “Recent Trends in Securities Class Action Litigation: 2019 Full-Year Review.” 12 Feb 2020.