D&O Insurance Limit Setting Considerations: How Much Is Enough?

When structuring D&O insurance, one of the most difficult questions to address is, how much is enough? You’ll often hear brokers referring to limit adequacy or insufficiency, but what exactly is an adequate limit? When deciding on an optimal limit, there are a number of factors that can affect both the likelihood of a claim, and the potential severity of a claim, both of which need to be considered when structuring coverage.

Public Company vs Private Company: The question of limit adequacy is very different for public companies vs their private company counterparts. The potential for securities claims, greater likelihood of regulatory actions, risk of derivative litigation, larger boards, and more costly (and complex) litigation in general, result in public companies requiring higher limits. Many lawyers argue the minimum for any public company regardless of size, should start at 5-10 Mill. Public companies also generally have more complex towers with multiple layers of coverage, including Excess Side A insurance. Despite the need for higher limits, it’s actually a bit easier for public companies to set their limits, as there is plenty of peer data available that can be provided by their brokers. While private companies can often get away with somewhat lower limits, peer data is more difficult to come by so unfortunately there are no similar benchmarks to measure against, making limit setting a bit more nuanced.

Revenue and Financials: The size of the company is an obvious factor in limit setting. Larger companies have larger client bases, provide a wider range of services, have a larger pool of investors and often larger boards, all of which can result in more costly regulatory actions and litigation. Suits against larger companies can also attract larger plaintiff firms, litigation funding, activist groups and media attention, further adding to the potential damages. However this doesn’t mean small startups are immune to litigation - even smaller companies can sustain costly litigation. It’s all relative. What’s costly to a company with 30 Mill in revenues, is likely under the policy retention for even a small public company. The company’s financial health is an equally important consideration. Companies with distressed financials are more likely to encounter claims brought by investors looking to recoup their investments, and/or claims brought by debtors or creditors should the company become insolvent.

Sector/Industry: Certain sectors are also more prone to costly litigation. Biotech companies, life-science companies, and financial institutions are a few good examples. Given the weight of their disclosures, intense regulatory scrutiny and high volume of acquisitions which could result in M&A litigation, the potential for larger D&O claims is greater. Additionally, any professional service failures have the potential of creating very large losses which can cross over into allegations involving the management of the company itself. Accordingly, companies operating in such higher risk sectors should consider higher policy limits.

Investor Profile: The manner in which funds are raised can also affect the potential for litigation. Securing smaller raises from a greater number of investors, often carries less risk than securing a greater amount of equity from fewer investors. The more an investor loses, the more likely they are to make accusations of wrongdoing in order to recoup their loss. Many D&O carriers often address concerns of claims brought by majority shareholders, by drawing a line in the sand, excluding coverage for claims brought by investors with 10% ownership or greater (unless the respective director/officer has a seat on the board). For the purposes of limit setting, let’s take 2 examples. In the first example, let’s assume a company has 3 investors, each with 12% ownership, with the remaining 64% being owned by the corporate officers. The D&O policy also contains a majority shareholder exclusion with a 10% threshold. In this example, the company could likely consider slightly lower limits, given that the policy really isn’t providing any coverage for claims brought by shareholders. Using the same example, if each of the shareholders owned 9% (under the threshold max), there’s a good argument to opt for higher limits, as the potential for shareholder claims is brought to the forefront. This is of course assuming that none of these officers have any board representation, as that would implicate the ”insured vs insured” exclusion, which would also preclude most coverage. Private companies raising considerable amounts from non-accredited investors are also likely subject to a greater risk of investor suits, especially when such investors have invested amounts near the maximum of any applicable regulation imposed thresholds. Certain raises also carry greater risk, simply due to their nature. The registration requirements required by regulations such as the JOBS Act open the door to greater regulatory oversight. In fact, Reg A offerings are often treated as mini-IPO’s due to their tremendous risk.

Board Composition: There are a number of ways in which the board’s composition can dictate its risk. Boards with a greater number of directors/officers can incur higher defense costs, due to the potential of multiple insured persons being named in litigation, and possibility of directors/officers opting for their own counsel. Boards that have notable officers may also attract more aggressive litigation as they become targets due to their deep pocket executives. This can even hold true for companies that have “deep pocket” individuals on their advisory boards. In some instances, high level board members may be the ones requiring higher policy limits. In one such example, a medical foundation, looking to appoint a celebrity to their board, encountered the demand for a 15 Mill limit prior to the individual agreeing to serve. Lastly, the experience and attitude of the board also plays a role. Whereas experienced, cautious executives are less likely to encounter litigation, inexperienced and/or overly aggressive executives are more likely to attract litigation and enforcement actions, which could warrant the need for higher policy limits.

Insurance Policy Terms: Coverage terms themselves can also play a critical role when limit setting. Some D&O policies may include other lines of coverage, such as EPLI insurance. These additional coverages can either have their own dedicated limits, or may be shared with the D&O limit. When coverage limits are shared, claims made against one line of coverage will exhaust any remaining available limits for the other lines of coverage. As an example, a company that has secured a 5 Mill D&O policy with shared limits, that incurs an EPLI suit costing 1.5 Mill, will only have 3.5 Mill remaining for any subsequent D&O claims made during that policy period. The more coverages that are shared, the greater the risk of limit exhaustion. There’s also some merit to broader policies warranting higher limits. Consider the following: a D&O policy with no coverage for regulatory actions, and only basic coverage for derivative actions, versus a D&O policy with robust regulatory coverage and broad coverage for derivative actions (including enhancements such as coverage for books and record demands). The weaker policy leaves the organization effectively self-insuring a wider range of costs, whereas the broader policy is agreeing to incur a significantly wider range of damages. In order to capitalize on those broader terms, it would be sensible for the organization to consider slightly increasing their policy limits.

Emerging Risks: Companies operating in emerging sectors are often subject to considerable volatility due to uncertainty involving both their regulatory environment, and what plaintiff litigation could look like. Companies involved with cannabis and cryptocurrencies are two such examples. In light of this uncertainty, it’s often wise to err on the side of caution and opt for higher policy limits. Emerging systemic risks can also play a role. The rise of ESG initiatives are one such example. Companies accused of greenwashing, can encounter litigation from regulators, shareholders and customers alike.  The same holds true for companies that fail to live up to their diversity & inclusion or privacy initiatives. While most ESG related claims seemed to be aimed at public companies, private companies are not immune.

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