Executive Protection: D&O Insurance Guards Your Personal Assets (At a Price)

Normally, a corporate legal entity provides its executives with protection against the risk of losing personal assets in a lawsuit. Only the assets of the corporation would traditionally be at risk as a result of litigation claiming negligence or breach of contract.

But, in certain situations, the personal assets of the directors and officers of the corporation may be seized as a result of corporate mismanagement.

What is D&O Insurance?

Once thought appropriate only for large public companies, these policies are growing in popularity among small to midsize privately owned businesses as well. Simply put, D&O insurance protects the assets of the directors and officers named under the policy should those individuals be named in a business-related lawsuit.

Shareholder disputes and employment litigation are typical triggering events, but they may also include claims brought by employees, customers, creditors, banks, suppliers, competing businesses, and even federal or state regulatory agencies.

Many corporations believe the coverage offered under a D&O policy is already included under their general liability or commercial umbrella policies. Others think D&O insurance is synonymous with errors and omissions coverage. Neither of these assumptions is accurate.

Most general liability or umbrella policies don’t provide coverage for many (or any) of the types of lawsuits that D&O insurance addresses. And errors and omissions policies are designed to cover performance failures and negligence related to products and services rather than those related to management. An insurance agent or forensic accountant can spell out the difference.

Why Might You Need It?

Lawsuits covered by a D&O policy usually involve allegations that the director or officer made decisions or acted in a manner that materially diminished the company’s stock value, squandered its assets or weakened its competitive advantage. Claimants may also contend that the director or officer failed to act, missing out on a substantial growth or investment opportunity.

While this type of litigation is possible under any circumstances, many of the laws passed over the last 10 to 15 years have exacerbated the threat. The Americans with Disabilities Act of 1991, the Family and Medical Leave Act of 1993, and, most recently, the Sarbanes-Oxley Act of 2002 have whetted the appetites of many litigious individuals.  A forensic accounting specialist can help explain these laws in detail.

Moreover, carrying a D&O policy can help you attract and retain talented, qualified key employees to help you run your company. And with the influence of Sarbanes-Oxley trickling (some say pouring) down to private businesses, finding and keeping competent — and confident — directors and officers is more important than ever.

How Much Does It Cost?

The cost of a D&O policy, like that for any type of insurance, will vary depending on a number of factors. These include the expansiveness and complexity of coverage, the relative risk level of your position and industry and how many people the policy will cover.

The good news is that the cost of D&O coverage is much more manageable than it once was. Just a few years ago, premiums for D&O policies skyrocketed as the demand for such coverage spiked in the wake of Sarbanes-Oxley and the many IPO lawsuits that followed the bursting tech bubble.

Smelling blood in the water, the number of D&O providers surged, flooding the marketplace. As a result, supply has come to outweigh demand and you’ll probably find coverage relatively more affordable.

In fact, an index tracking the average D&O premium for U.S. for-profit companies (compiled by risk management consultants Tillinghast) dropped 9% last year after falling 10% in 2004. In addition, a survey by the same firm showed that the average D&O policy limit for U.S. for-profits rose from $13.6 million in 2004 to $14.3 million last year.

But how long this “more coverage for less money” phenomenon will last is uncertain. The same survey showed a sharp rise in D&O claims last year. So the cost of coverage may soon rise to compensate for all of those payouts.

What Should You Look Out For?

If your corporation opts to invest in a D&O policy, the directors and officers need to study your options carefully, with the consultation help of a forensic accounting firm. These policies are nothing if not complex, with most containing more than 100 variables capable of nullifying coverage if violated. To ensure the directors and officers are safely protected under the policy:

• Apply with care. Inaccurate or incomplete statements on the policy application can lead an insurer to rescind the policy. Ask your professional advisors to double-check your application before you submit it. For instance, if you’re including financial statements with the application, which many insurers require, make sure that your CPA’s report is included with the financial statements.
• Know what’s covered (and what’s not). Many business owners who buy D&O insurance make assumptions about what the policy covers. Bear in mind that a policy may not cover fraud- or securities-related claims unless specifically designed to do so. Also check into when you’ll receive reimbursements for defense costs. Some policies pay out within a stated time frame while others leave it up to the insurer’s discretion.
• Consider backup coverage. Every D&O policy has its limits — literally. Think about adding non-rescindable excess coverage (sometimes also called “excess executive liability insurance”) to your policy. Not unlike an umbrella policy, this coverage guards against unforeseen circumstances that could rescind or exhaust your primary D&O policy.

Is There an Easy Answer?

If you’re thinking there’s an easy answer to whether you should buy a D&O policy (and, if so, which one you should buy), think again. As mentioned, these policies are complex and, though prices have dropped recently, they remain a significant investment.

All that said, we live and work in a highly litigious business environment. So looking into whether D&O coverage, with the help of a forensic accounting firm, might be a prudent choice for you would be time well spent.

Contact our forensic accounting services by email or call us at 1 (888) 875-9770 to look at some ways you can tighten your internal controls to prevent fraud.

related links