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How much D&O coverage do former officers and directors need?
Russ Banham, CFO Magazine
April 1, 2008
Frank Borelli is concerned about his directors' and officers' liability coverage — and that's saying something, since Borelli is a former CFO of insurance broker Marsh & McLennan Cos. Why the worry? "I'm on three boards now, and if I left one of them today and a claim is made four and a half years from now, I have no assurance that the D&O policy existing at that time will cover me fully," he explains. "There's a risk it could be a lesser policy than the one in effect today."
Unlike other liability insurance policies, D&O insurance is underwritten on a claims-made basis. That means the insurance policy that absorbs liability is the one in effect the year in which a claim is filed — not the year in which the alleged wrongdoing occurred. Naturally, an executive who leaves a company or a director who resigns from a board has no say over the terms and limits of the insurance policy that covers his or her future liability.
Thanks to the Sarbanes-Oxley Act, the statute of limitations on a securities claim against a director or officer has been extended to five years following the alleged wrongdoing (formerly it was three years). The e personal liability for former directors and officers can be high. The former outside directors of Enron, for example, had to hand over $13 million in personal cash in addition to the company's D&O coverage. Former directors and officers of WorldCom, in settling class-action claims against them, paid a total of $18 million. In April 2007, five former directors of shoe retailer Just for Feet coughed up $41.5 million of their own money to settle litigation.
To address such potential exposure, Ace Westchester, an Atlanta-based insurer, has introduced a new retired director and officer liability policy. The policy is the only one of its kind in the United States, though similar policies are sold in the United Kingdom and Australia. The insurance is sold to individual directors and officers (paid for out of their own wallets), although a company may buy it to cover its current directors and officers for their post-retirement liabilities.
The insurance is noncancelable, nonrescindable, and buyer-specific — the coverage belongs entirely to the director or officer and cannot be diluted by other people or entities. It provides full coverage for up to six years after the insured resigns, retires, or is fired. The financial limits can be as high as $10 million, though since the insurance responds only after underlying D&O policy limits have been exhausted, not many people would likely need that much coverage. "We haven't had any requests for the full limits," says Steve Wilson, president of Dallas-based Retired Directors Assurance Underwriting Services, the agency licensed by Ace to sell the insurance in the United States. The cost of the one-time premium is roughly $3,000 to $8,000 for $1 million in insurance for the full six years.
A Single-Digit Probability
But do directors and officers really need additional D&O insurance as they move on with their lives? Opinion is mixed. While the postemployment liability of directors and officers is not in doubt, the actual risk of traditional D&O policies not absorbing this liability is considered small for a simple reason: D&O claims are typically filed almost immediately after the incident that brought rise to the claim. "D&O claims rarely are filed years after an event," says Lou Ann Layton, a managing director at Marsh & McLennan.
Layton adds that most claims filed against directors and officers are predicated on a precipitous decline in stock value, with the claim following soon thereafter. "There is probably a single-digit probability that a claim will be filed three or four years after the event," she says.
Thus, the issue may boil down to whether or not former directors or officers can live with even a single-digit probability of losing their shirts. The problem is, they have no way of knowing just how protective the D&O insurance covering them in retirement will be. While their former employers may have bought the most comprehensive D&O policies available, if the insurance market tightens and prices soar, they may decide their financial resources are better spent elsewhere. "There's no guarantee a D&O policy that exists today will be renewed with the same terms, conditions, limits, and deductibles five years from now," says Dan A. Bailey, an attorney at Bailey Cavalieri LLC.
Another factor that could result in less-protective D&O insurance is the acquisition of the former employer by another company. New management may not be inclined to adequately protect former directors and officers, says Bailey. Also, since D&O insurance covers all past, present, and future directors and officers, the more people covered in a policy following a series of acquisitions, the less financial coverage for each.
"There's the risk your limits can be eroded by someone else's acts," says Ace president Dave Lupica. Bailey has experienced just that. "We're seeing lead plaintiffs settle with only some of the D&O defendants for the entire amount of the available insurance, leaving the remaining D&O defendants uninsured," he says.
The Soft-Market Factor
Although Layton cedes the possibility that coverages and limits of future D&O policies could be reduced, she says that in the current competitive "soft" insurance market, "we're seeing the opposite occur — more coverages at greater limits. Average prices on D&O came down 20 percent in 2004, 15 percent in 2005, and 10 percent in 2006 and 2007. Someone who left a board four years ago probably has better protection today than they did then." She adds that the scenario of a public company deciding to forgo buying D&O insurance "practically never happens."
Despite Layton's assertion of minor risk, some CFOs of public companies are fretting about their postemployment liabilities. "Things can change very dramatically where you have no control or influence," says Dave Butler, CFO of Biopure Corp., a Cambridge, Massachusetts-based manufacturer of medical devices. "I've heard of situations where companies decide not to renew their D&O insurance and just run naked. It makes me gulp."
Ruth Tave, principal of Chicago-based insurance broker Tave Risk Management, says she has received several inquiries about retired director and officer insurance but has sold no policies to date. Nevertheless, both Tave and Layton say the coverage might come in handy if and when the cyclical insurance market turns from its current cupcake softness to something approaching a week-old scone. "Industries that are more volatile in terms of D&O vulnerability — like technology, life sciences, and financial services — should give it a look," says Tave.
Observes Layton: "If you're a director and want to be assured that when you leave the board the D&O insurance coverage the company purchased remains in place four years from now, this is your comfort. It's really sleep-easy insurance."
Russ Banham is a contributing editor of CFO.