The negotiations of directors’ and officers’ policies tend to follow a bit of a different pattern from that in other lines of insurance, and the reason for this is plain: the insureds under these policies include the most important individuals at a company who are trying to cover their own assets. D&O negotiations for sophisticated companies often will involve not only price negotiations but an unusual amount of negotiations over wordings, too.
In general, D&O insurance has several coverage components that may co-exist in a single policy. The background corporate and securities laws impose personal liability on the directors of a corporation for various forms of non-, mis-, and mal-feasance and seeks to hold them accountable to the absentee owners of the company, the shareholders. Corporations will provide direct indemnification for directors for some or all of these liabilities, and the indemnity may be mandatory or at the discretion of the board at the time a claim is made (permissive indemnification). What is know as “Side B” insurance is a vehicle for the corporation itself to obtain funding from the insurer for the corporation’s statutory, bylaw, or contractual obligation to indemnify the directors.
A corporation, however, may not be permitted to indemnify a director for certain types of claims or may be unable to do so financially. Accordingly, directors desire protection above and beyond the corporate indemnity, and it is this exposure that often is the focus of D&O insurance policy purchases. “Side A” insurance provides direct coverage for directors (and other covered persons) for their liabilities and defense expenses that are not indemnified by the corporation. Side A insurance can be included in a D&O policy with Side B or Side A coverage can be a standard alone vehicle safeguarding the director. (Th latter usually is called “Side-A DIC” coverage or “A-Side DIC” coverage, with DIC being the abbreviation for “difference in condition,” a shorthand for coverage that plugs in gaps left when other insurance policies do not respond.)
I have previously addressed some of the technical wordings issues that potential insureds may wish to consider in evaluating the coverage under D&O policies (of whatever stripe). I firmly believe that the investment in working closely with capable insurance brokers – and (self-interestedly) coverage counsel – is important, because whether coverage will be found to apply in some circumstance really can depend on a change in one word (such as a change from “any” insured to “such” insured). But it takes two to tango as they say, and just because we may want a change in policy language does not mean that the underwriter will be inclined to accept it or to accept it at a reasonable price. Accordingly, what are the steps that insureds can take to make their insurers most comfortable in providing coverage and, one hopes, broadening its scope?
Professors Tom Baker of the University of Connecticut and Sean Griffith of Fordham have put together a working paper that is available on a website for academic papers that reports on their empirical effort to understand what makes D&O underwriters comfortable and influences their pricing (and presumably wording) decisions. See Tom Baker and Sean J. Griffith, Predicting Corporate Governance Risk: Evidence from the Directors’ & Officers’ Liability Insurance Market (June 15, 2006) (revised August 15, 2006). There is little pretense in insurance markets that D&O policies are not scientifically priced. This is not to suggest there may not be guidelines for underwriters in establishing the price of coverage or in the willingness of underwriters to negotiate policy terms – or even to bind the coverage at all. One should draw a distinction between the “absolute” price and the “relative” price: the first being the rational economic value of the risk transferred and the corresponding services to be provided; the latter being the price of a roughly equivalent policy compared with other sellers in the marketplace. While the “absolute” price may be elusive if not ignored in insurance markets, the relative price is not: the impact of competition affects the price of goods, especially for insurance where the seller’s cost of the product will not be known until after the sale (i.e., the payments it might make under the policy). See generally Sean M. Fitzpatrick, Fear is the Key: A Behavior Guide to Underwriting Cycles, 10 Conn. Ins. L. J. 255 (2004); Richard Stewart et al., The Loss of the Certainty Effect, 4 Risk Mgmt. & Ins. Rev. 29 (2001).
Further, I do not mean to suggest that the liability regime, the breadth of the coverage provided, and the nature of the insured has no impact on pricing; my point is that this all is hardly scientific. Given that insight, however, one should recognize that the process of underwriting – especially D&O insurance which is considered to be highly personal (as compared with fire insurance, for example) – is a human process, affected by making the seller comfortable with the insured whose interests the insurer is promising to protect.
In this context, the work by Baker and Griffith is especially enlightening, for they highlight that the prospective insured’s “deep [corporate] governance” cultural norms and constraints affect the willingness of underwriters to play ball (selling a policy, negotiating its wordings, and establishing a price). According to the survey, underwriters believe they can separate the wheat from the chaff and select good risks to underwrite.
Underwriters look to objective data: information from public filings, private databases or analysis services, claims history, company knowledge of ticking time bombs, and especially any intent to acquire other companies or issue securities. Market capitalization and stability is important; as Baker and Griffith explain:
Insurers, unlike investors, do not look favorably upon high-growth companies. Insurers focus more on downside risk because they have a fixed return (the policy premium) that is modest in relation to their exposure to loss (the policy limits), while equity investors have a fixed exposure to loss (their initial investment) and a potentially unlimited upside (their share of the business’s growth.) (p. 30)
While business intelligence affects the basic modeling of policy premiums, Baker’s and Griffith’s information suggests that corporate governance practices and culture differentiates one risk from another and in turn the willingness of underwriters to negotiate. “Culture and character, we were regularly told, are at least as important as and perhaps more important than other more readily observable, governance factors in assessing D&O risk.” (p. 32)
Underwriters seemed keen to know how incentives for executive action are determined, such as executive compensation formulas and the strength of internal controls (and the compliance culture, such as the vigor of the insider-trading prohibition). Revenue-recognition procedures are considered especially important as are channels for compliance, dissent, whistle blowing and the like. (And it is the way culture norms shape action that is key – not dead-letter policy manuals on bookshelves or corporate intranets.) Process and controls are especially important when business acquisitions are contemplated – not just that M&A activity is in the offing but how the company goes about the acquisition and the integration of acquirees.
The subjective assessment of underwriters seems to include questions of ethics, morality and humility, in personal conduct and in the conduct of the business. Arrogance and excessive risk taking are markers for bad risks. (Even the number of speeding tickets by the CEO was felt to be an indicator of D&O risk.) Overcommitment to growth, excessive risk taking, aggressive earnings-per-shares targets may create a culture where individuals may be tempted to shave a little here and there.
Perhaps all these factors are obvious and nebulous in their actual effect on underwriting pricing and term negotiations. Nevertheless, Baker’s and Griffith’s results counsel that prospective insureds put together their underwriting submissions and prepare for their underwriting meetings to feature corporate-governance culture and character issues. The policies and procedures – but more important the company’s norms and practices – are key differentiators among prospective insureds. Risk managers and chief financial officers should be empowered by these results, as should corporate counsel, internal auditors, and chief compliance officers.
Negotiating the wordings of policies is a tedious, time-consuming process that may prove outcome determinative at the point of claim. But to have the opportunity to engage in such negotiations at all, insureds need to have a willing partner – an insurer willing to sell a policy to them at a reasonable price for value. And these days, questions of culture and character separate which insureds are good risks and which are not.
In short, what D&O underwriters search for (without trying to overstate the point too much) are companies that abide by the classical idea of virtue, set forth well by Aristotle:
For instance, both fear and confidence and appetite and anger and pity and in general pleasure and pain may be felt both too much and too little, and in both cases not well; but to feel them at the right times, with reference to the right objects, towards the right people, with the right motive, and in the right way, is what is both intermediate and best, and this is characteristic of virtue.