Is your D&O insurance up to scratch?

As boards are becoming increasingly exposed to class actions directors must ensure they have effective insurance in place.

In a heightened risk environment where directors are being held responsible for their organisations’ risk strategies, directors need to be closely involved in their own and their organisation’s insurance protection. The starting point for many is directors and officers (D&O) liability insurance, which protects directors in the event of legal action against them personally.

The cost of D&O insurance has skyrocketed in the past year or two, in part due to an increase in shareholder class actions, but mainly because of insurance market dynamics. After several years of intense competition drove the cost of cover down to unsustainable levels, several insurers have left the Australian market and premiums have risen, accompanied by substantial increases in the excess.

While the price of cover is back around where it should have been all along, it can still come as a rude shock. Lucy Terracall, an insurance and risk partner at Clayton Utz who advises organisations on policies and renewals, says directors are surprised to be paying so much more for D&O insurance, but not receiving any more coverage for it, although the quality of cover remains high. In the current market, there is less wiggle room for negotiations on policy conditions with underwriters.

“Previously, we could go in with, say, 10 or 15 suggested amendments — some of which are clarifications, some of which are definitely to the benefit of the insured,” says Terracall. “We might get 10 out of 15. Now, some insurers won’t even speak to you about it. They’ll just say, ‘It is what it is. You purchase it, or you don’t’.”

She cautions companies to be wary of what’s known as Side C cover, which can sometimes form part of D&O policies. Unlike the more standard Side A and Side B covers, which protect the directors themselves, Side C cover is for the company.

The issue is that if, for instance, a legal claim that has nothing to do with the directors is made against the company, it can be covered by the D&O policy under Side C. This can erode the entire limit of the policy so the directors and officers are left with zero.

“The directors and the board need to turn their minds to whether or not they need Side C on their policy at all, or whether that should be put on as part of the cover that’s separately provided for the company,” she says. “Most companies have a general liability insurance or some other liability insurance for the company, which is where that cover should be.”

Craig Claughton, head of financial and professional practice at insurance brokers Marsh Australia, says not all D&O policies are the same and directors need to look closely at the breadth of cover and the policy wording. “Sadly, directors often don’t work that out until they’re actually in a loss situation,” he says.

The current climate of corporate litigation is unprecedented and this is reflected in much higher fines from regulators and significant rises in insurance costs, he says. “Where companies may have spent hundreds of thousands of dollars previously on D&O cover, now they can spend millions.”

Currently, there are large class actions pending against the Commonwealth Bank and Colonial First State, Woolworths, AMP and BHP. The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry has demonstrated how expensive such exercises can be, even without allegation of wrongdoing, which is only where some policies apply.

“We believe that the D&O market is at a tipping point, and that class action liability and third-party litigation funders are contributing to a situation that has grown increasingly dire,” says a submission by Marsh to the Australian Law Reform Commission. It says data over the past seven years suggests there is a direct link between the growing size and number of securities class action claims involving D&O insurance, and its cost and availability.

According to King & Wood Mallesons research, funded class actions rose from 28 per cent in 2013–14 to 66 per cent in 2017–18. Increases in premiums of 353 per cent, and a corresponding increase in retentions of 440 per cent — as Marsh’s ASX 200 clients have experienced — are unsustainable in the long term. Worse, claims experience is adversely impacting the appetite of insurers to write the coverage at all, or in a meaningful way to meet market demand. If Australian companies cannot secure sufficient D&O coverage, they will struggle to attract, retain, and develop capable and experienced directors and officers.

Risk

Of particular importance to businesses is the insurer’s claims handling ability. “When a director finds [him or herself] in a class action situation — or, indeed, any other form of claim — that might be the first time in their life they’ve ever had to deal with that,” Claughton says. “Insurers are dealing with these on a regular basis. If you partner with the right insurer, they can actually help you through in terms of strategy, planning and funding.”

It is also important to have a pre-agreed legal panel, because while most D&O policies will provide for “reasonable” defence costs when legal action is launched, what the insurer considers reasonable could be quite different to what the director fighting the action wants, says Claughton. He adds there is a heightened risk environment for directors where they are being held more responsible for the risk strategies their organisations adopt.

“Insurance is no longer something directors can pass down to the management of the company. They must be involved and they’ll have to prove to the regulators that they’re involved.”

For instance, when Marsh works with companies on cyber liability, it doesn’t start by asking about insurance. It asks the board what the company understands to be its risks and the due diligence it has carried out to establish that.

“Very often, they’ll say, ‘Well, I’ve got my security information officer across that’. With all due respect to those very experienced people, they’ll often tell directors what they want to hear. They’re not going to tell them that the company is in a bad situation because they’d be showing themselves up,” says Claughton. “They must engage external consultants to look at that risk. Identify the risk, quantify it, and only then can you start to manage that risk.”

For many years, risk and insurance were treated as separate issues by boards. Now they are being combined. When a company identifies a risk, it must reduce and mitigate it. The risk portion that can’t be eliminated must be assessed and either transferred — via insurance — or retained. Essentially, self-insurance.

“Directors have got to take that assessment. We now know they’ve got to have demonstrated they’ve contemplated the risk and made an assessment about whether the company can take that risk or whether they should transfer it,” says Claughton.

John McCabe GAICD, senior vice-president Asia and COO at Liberty International Underwriters, says ensuring a business has adequate insurance forms part of a board’s risk strategy. “Directors have an obligation to ensure the company is adequately protected and not taking on too much risk or risk greater than they’ve stated they want to take on to achieve the company’s objectives.”

Regardless of size and industry sector, all businesses will need the basics — property cover, public and general liability cover, workers compensation insurance for employees, key person insurance, cyber risk and D&O and management liability policies.

What is needed beyond that will depend on the business itself. For example, professional organisations offering advice need professional indemnity cover, says McCabe. Businesses in food and beverage manufacturing buy crisis management policies to protect against product recall or malicious product tampering. Businesses that manage public spaces are seeking terrorism-type cover. Those with staff travelling overseas will need kidnap or ransom cover for directors and employees.

McCabe says companies should also talk to their insurance broker about the benefits of having one lead insurer across a range of policies to reduce the chance of disagreements between insurers over which policy should respond when a claim is made.

Directors should check their organisation hasn’t chosen the cheapest cover and is taking a cost-management perspective on insurance without also considering the scope of cover being provided. They also need to get to know the insurers.

“Who are our insurers? What is their reputation around paying claims? What is their ability and willingness to pay claims?” he asks. “We take the claims people out with the brokers to meet the client because you don’t necessarily want to meet the person handling your claim for the first time in the middle of a crisis. It’s better if directors and management know who their insurers are and what their willingness is to settle a claim quickly and fairly.”

Do your research

Insurance brokers are a good source of information, along with surveys run each year by JP Morgan and Taylor Fry, which rank insurance companies on measures such as their technical ability and claims paying ability. Sarah Lyons, CEO at Arthur J Gallagher, says early planning ahead of policy renewals is important because insurers’ risk appetites have changed and some risks are harder to place. Boards should engage with a risk specialist and provide potential insurers with as much information as they can.

“Insurers are looking for a comprehensive understanding of the risks they are being asked to cover,” she says. “They want to have the confidence that boards and directors are aware of emerging risks and issues that could become market sensitive.”

Senior staff and directors should be available to meet insurers in person to present their case and be fully prepared for detailed questions on claims history, “particularly for claims with a more complex back story”, says Lyons.

With increased regulatory scrutiny on director capability and performance, boards should ask whether there are any improvements they need to make to ensure they meet all mandatory requirements. And how do they demonstrate that to insurers? A key consideration is whether the organisation has a robust governance framework and risk management culture in place, and whether there are any gaps they are aware of and any expected changes they should be planning ahead for.

“Insurers are more focused on the decision-making process than the substance of risk management solutions,” says Lyons. “Insurers take comfort from well-reasoned due diligence.”

Several insurers mentioned in this feature have advertised in Company Director, but have had no involvement in or influence on actual editorial content.

Director checklist

Directors should review their insurance cover annually to ensure they and their organisations are adequately protected for risk appetite.

Questions to ask

• What is the organisation’s risk strategy?
• How are risks being identified and mitigated?
• For those that can’t be mitigated, where does insurance fit?
• What are the emerging risks caused by changing technology, business models and regulations?
• Who are the insurers and what is their reputation and ability to pay claims?

D&O coverage
Questions to ask

• What risks, errors and claims does the D&O policy cover me for?
• Are the policy limits ($A) appropriate?
• Is the D&O policy the right one for me (is the relevant company publicly listed, private, NFP)?
• Does the policy provide for inquiries and investigations?
• What is the insurer’s claims-handling ability?
• Is there a pre-agreed legal panel?
• What are the common extensions to policy coverage and are there any needs specific to my industry or circumstances that should be specifically addressed in my D&O coverage?
• Are there exclusions I’m not comfortable with?