Introduction to the Directors & Officers Policy

The Directors & Officers (D&O) policy has many similarities with other forms of liability insurance. However, the D&O policy is specifically used to protect the upper management (CEOs, CFOs, etc.) and/or board members from lawsuits claiming that they've made poor decisions that have negatively affected the company/organization.

The Directors and Officers (D&O) policy is another straight-forwardly named insurance policy. It insures Directors and Officers of both for-profit and not-for-profit organizations, including educational institutions and privately held firms. It was created for CEOs, CFOs, and other directors, officers, and board members as they can be sued for their company's/organization's poor financial performance, and/or mismanagement of funds. Directors and officers have high levels of liability since they are such key players in their firms. Since they are often sued for being the cause of adverse financial situations, whether or not it was a foreseeable/preventable event, the D&O policy is often looked at as an extension of an Errors & Omissions/Professional Liability policy.

Triggering coverage of the D&O policy would happen when one or all of the directors and officers are brought into a suit that demands financial compensation for decreased value, mismanaged funds, and/or poor performance of the organization (supposedly) caused by their managerial decisions. (Note: the D&O policy will not cover claims of bodily injury or property damage, because those should be covered by other types of insurance) ‘Supposedly’ is in parenthesis because all accusations against the directors and officers, even if they are completely unfounded, will trigger coverage from the D&O policy. Once the policy has been triggered, it would then pay for their legal defense costs, and would cover any settlements or judgments made.

Noteworthy Elements of the D&O Policy:

Typically, the D&O policy acts as a reimbursement for the expenses incurred by the company/organization in defending themselves, as opposed to other policies that have a Duty to Defend. In a Duty to Defend policy, the insurance company pays for the legal representation/defense costs, but also provides the lawyer(s) as well. However, most D&O policies require the company/organization to find their own legal representative(s).

Most D&O policies are written on a ’Shrinking Limits’ basis, meaning that the defense costs reduce the D&O policy limit. This is different from other liability policies, such as the standard Commercial General Liability (CGL) policy. With the CGL policy, its policy limit is not reduced by defense costs. To say this in another way, the CGL’s defense costs are paid outside or on top of the policy limit. Conversely, in the D&O policy, defense costs reduce the policy limit. 

Shrinking Limits Example:

Your firm’s officers get sued after stock prices drop, so your $1mil limit D&O policy with Shrinking Limits responds. It costs $250K to defend the officers in court, and then the suit is settled for $1mil. Your D&O policy would only cover $1mil of the claim, leaving $250K to be paid out-of-pocket.

Another Element of almost all D&O policies is that they are written on a 'Claims Made' basis instead of an 'Occurrence' basis. This may require the insured to purchase 'Tail Coverage' when switching carriers. If this is the case, make sure to discuss Claims Made and Tail Coverage with your agent.

Policy language varies greatly in D&O policies, and one policy provision you need to watch out for is the Hammer Clause. The Hammer Clause refers to the policy language that states that if the insurance carrier suggests that the insured(s) offer a settlement but the Insured(s) refuse it, the insurance carrier will not pay for anything that happens afterwards. So any defense costs, new settlements or a final judgment against the insured(s) will be paid out-of-pocket. The Hammer Clause effectively forces the insured(s) to agree to the settlement, even if they believe they didn't make any mistakes. The basis for the Hammer Clause is that it is often far less expensive to make an initial settlement out of court than to battle out the suit in court. However, agreeing to pay the settlement is effectively accepting responsibility, and can be personally damaging to the insured(s) career(s) and/or can be detrimental to the firm's image when the insured(s) didn't actually make a mistake.

A Soft Hammer Clause is the policy language that allows the insured business to retain coverage after rejecting a proposed settlement from the insurance carrier. However, all expenses incurred after the rejection will be subject to a coinsurance penalty (typically 50%), requiring the insured to pay their part of the coinsurance percentage.

Stop, Hammer Time:

Your $1mil D&O policy is triggered when stockholders sue for poor managerial decisions that lead to reduced stock prices. Before the court date, the insurance company offers a settlement of $300K. Since you don’t believe you made any wrong decisions, and you don’t want your public impression to take a hit, you reject the settlement and continue to the hearing. However, the final judgment ends up in favor of the stockholders and they are awarded $400K, and an additional $200K in defense costs was incurred after the settlement rejection.

With the strict Hammer Clause, you would have to pay the excess $600K out of pocket.

(400 + 200 = 600)

With a Soft Hammer Clause of 50%, you would have to pay $300K of the excess out of pocket.

( [400 + 200] x .50 = 300 )