In 2005, the directors' and officers' liability (D&O) insurance market in the UK is set to go through some evolutionary changes. There are several dynamics at play. Chief among these are the change in a UK company's indemnification rights to its directors and officers, certain developments in the US D&O insurance market that are migrating to the UK, and the increased competition for primary lead positions in D&O insurance programmes for large UK companies. What will be the effect of these evolutionary changes and how should risk managers take them into account when arranging their D&O insurance programme renewals?
Below is a summary of some of the recent changes and the considerations they present for UK companies.
- Changes to the indemnification rights of a UK company: Most risk managers will now be aware that the limitations placed on a UK company by Section 310 of The Companies Act are no more. The Companies Act has been revised to clarify a company's right to indemnify its directors and officers in a variety of situations. Just as importantly, the law has been clarified as to the circumstances under which a company cannot indemnify its directors and officers.
Given this change in UK law, one of the questions that has arisen is whether a UK company should even buy D&O insurance.
- More UK insurers are competing for primary D&O positions: For several years, the primary D&O position for large UK companies has been dominated by two insurers. However, in 2004, for a variety of reasons, a wider spread of UK insurers were successful in obtaining the primary lead position on D&O insurance programmes for large UK companies. In 2005, there is no reason to believe that more UK insurers, in addition to the two that have dominated the scene for several years, cannot successfully lead a D&O insurance programme for very large UK companies who are seeking large limits for their programme.
Given this development, UK companies must ask themselves whether to put their primary policy into a competitive bidding process for their 2005 renewal.
- Excess/difference-in-conditions (DIC) Side A insurance is being sold by UK insurers - The US has experienced an explosion in the purchase of excess/DIC Side A insurance for companies of larger middle market, Fortune 1000 and Fortune 500 size (small-to-medium enterprise - SME - companies, as well as smaller middle market companies, have not purchased the cover in meaningful numbers). The demand for the cover appears to be coming from two sources. First, there are directors and officers who understand that the Side A coverage in a broadly-worded excess/DIC Side A policy is much broader than Side A coverage in a traditional US D&O policy. Second, risk managers are being proactive in ensuring that some of the Side A coverage in their programme is the broadest Side A insurance available in the US market (because they are attempting to create a D&O programme that will help attract new and retain current high-quality independent directors).
Broadly-worded excess/DIC Side A insurance from a UK-based insurer first became readily-available in 2004, although CODA in Bermuda and some other Bermuda-based carriers have been willing to sell such cover to UK-based companies in the past. More and more UK insurers have such forms under development, and will be launching them in 2005. Until that time, such carriers are more than willing to sign onto a quota share programme led by one of the insurers that already have their own excess/DIC Side A form available for the UK market.
In view of the fact that this product is now readily available in the UK, companies must consider whether such insurance should be incorporated into their D&O insurance programme structure.
What should you be considering?
Given the above, UK companies should consider the following macro issues during their D&O insurance programme renewals in 2005.
- Should your company buy D&O insurance? With the changes in UK law regarding the right of a UK company to indemnify its directors and officers, some risk managers may well be asking whether their company should even buy D&O insurance at all. However, in my view, there are a number of reasons why cover remains essential.
There is the 'permissive vs obligatory' indemnification consideration.
While a UK company is now permitted to indemnify its directors and officers for certain types of claims, it is not obligated to do so (unless the company has by separate agreement, such as a deed of indemnity, subjected itself to obligatory indemnity obligations for those situations under which it is permitted to indemnify).
This permissive indemnification feature poses the following risks for directors and officers. First, there is the falling-out-of-favour risk.
What happens if a director or officer does something to get him or herself at loggerheads with the board of directors? If, after this situation has occurred, a claim is made against such director or officer, whether by a third party or shareholder or otherwise, what happens if the board decides not to indemnify that director or officer?
And worse, what happens if the board itself decides to bring a claim against the director or officer? In that situation, the board is not likely to advance defence costs on behalf of the director or officer. Unless there is D&O insurance in place, the director or officer could be left without any protection for such claims.
Second, there is the change-in-control risk. What happens if the controlling interest of the company is purchased by another person, group of persons or entity? The new owner can then gain control of the board by electing new directors representing a majority of the board. This development poses the same two risks for directors and officers as the falling-out-of-favour risk. If a third-party claim is made against a former director or officer, the new board might not approve indemnification of the director or officer.
And if the new board pursues a claim against former directors or officers for pre-takeover actions, the new board is not likely to approve indemnification.
The now infamous Equitable Life case is perhaps the best-known example of these risks. Although some perceive the case as an example of the falling-out-of-favour risk, and others see it as an example of the change-in-control risk, the fact remains that Equitable Life stands as just one forceful example of why D&O insurance should be purchased by UK companies notwithstanding the changes to UK corporate indemnification law.
Some may dismiss the falling-out-of-favour and change-in-control risks discussed above; focusing on the risk of shareholder claims and arguing that shareholders in the UK have far fewer rights than shareholders in the US when it comes to claims that they can bring against directors and officers of a company. An additional argument is that it is irrelevant that a UK company might be trading American Depository Receipts (ADRs) or have a direct listing on a US exchange, because a US court cannot obtain jurisdiction over a UK director or officer. However, the US Extradition Treaty of 2003 should give pause to anyone adopting such a philosophy.
Although it is unclear whether any UK director or officer has been extradited to the US pursuant to this treaty, the fact remains that the following risk exists. It is at least hypothetically possible that US shareholders of a UK company could bring a direct action on behalf of themselves and/or a derivative action on behalf of the company in the US, and then seek to extradite one or more directors and officers of the company to the US to stand trial in US courts. This risk is another reason why UK companies should buy D&O insurance notwithstanding the changes to UK corporate indemnification law.
And it almost goes without saying that another reason for UK companies buying D&O insurance is the risk of their inability to indemnify even when they want to do so because they are in bankruptcy proceedings or otherwise insolvent. A liquidator or bankruptcy trustee might not permit indemnification by the company. Unless there is D&O insurance in place to protect the directors and officers, the directors and officers could be left bare to defend and indemnify themselves.
- What are you looking to achieve through insurance? If a UK company decides it wants to continue to buy D&O insurance notwithstanding the changes to UK indemnification law, the next question to ask at the renewal strategy meeting is, 'Why is the company buying D&O insurance?' Is it buying balance sheet protection, personal asset protection, or both?
If the only reason why a company is buying D&O insurance is to protect the personal assets of its directors and officers, then the optimal programme structure for the company to consider is to buy only excess/DIC Side A insurance (when such coverage is bought this way, it is called 'Broad Form Side A' insurance), and not buy traditional D&O insurance at all.
Indeed, that programme structure has been adopted by several very large companies in the past couple of years.
On the other hand, if one of the reasons a company is buying D&O insurance is to protect the company's balance sheet (ie to insure the company's indemnity obligations to directors and officers, as well as securities claims against the company), then that company should continue to buy traditional D&O insurance and should consider buying excess/DIC Side A insurance as well.
Considering and agreeing the programme structure well in advance gives the broker the best opportunity to go to the market and obtain the most competitive quotes for that programme structure.
- Should you invite competition for the primary policy? Given the increased number of insurers interested in, and able to write, primary D&O insurance for large UK companies, the next question that should be asked for a 2005 D&O insurance programme renewal is whether to put the primary D&O policy up for competitive bidding. In my view, now is the time to conduct such an exercise, to allow the market to compete for the business.
A good risk manager and broker team should be able to create valuable competition, not only on pricing but also in policy wording, presenting each carrier that has provided a quote with a list of policy wording changes to make to the carrier's standard forms and endorsements. Such lists can have anything from 10 to 30 policy wording change requests.
Some insurers might balk at such wish lists, but enough UK carriers have been willing to negotiate in this level of detail since the latter part of 2004 to make the process worthwhile. The end result is either a much-improved programme offered by the incumbent carrier (because they had to respond to the competition), or a programme from a new carrier that is much improved over the expiring programme (because the incumbent carrier could not compete with the breadth of wording and competitive pricing offered by the competing carrier).
- Do you need excess/DIC Side A insurance? As stated above, if a UK company is buying D&O insurance to address both the balance sheet risk faced by the company and personal asset risk faced by directors and officers, it will want to buy traditional D&O insurance that provides more than just Side A coverage. In such a case, should the company also buy excess/DIC Side A insurance? I believe the answer is affirmative in most circumstances, for at least the following reasons.
The breadth of Side A coverage in a fully-negotiated excess/DIC Side A policy purchased in the UK typically is broader than the breadth of Side A coverage in a fully-negotiated traditional UK D&O policy providing corporate indemnification coverage (aka Side B coverage) and/or entity coverage for securities claims (aka Side C coverage) in addition to Side A coverage. Accordingly, once the UK company decides to buy a traditional Side A/B or Side A/B/C policy as its primary policy, typically the only way to provide the directors and officers of a UK company with the broadest personal asset protection available in the UK market is to buy excess/DIC Side A insurance.
The UK D&O insurance market is experiencing evolutionary changes. Hopefully, these comments will help insurance professionals better understand these changes as they deal with D&O insurance programme renewals in 2005 for their companies or clients.
- Michael A Rossi is president of Insurance Law Group, a boutique insurance law firm which advises risk managers of Fortune 500 and FTSE 250 companies, and brokers on property/casualty policy wording issues, E-mail: email@example.com