Directors and officers (D&O) liability is traditionally insured in the
world's commercial insurance markets. However, many medium and large
organizations eschew the commercial insurance markets in favor of
self-insurance. Self-insuring D&O liability is more complicated and nuanced
than self-insuring general liability or workers compensation loss
exposures.
The primary reason why D&O liability is not widely self-insured is the
lack of claims frequency and the tendency for claims experience to confound
attempts to forecast frequency and severity. Another reason why D&O is not
routinely self-insured is the notion of "optics." In the absence of a
detailed understanding of the self-insurance plan, company directors and
officers often assume that the firm is assuming additional risk, as compared to
purchasing insurance. However, for the right company, self-insurance can not
only provide protection comparable to that which is available in the commercial
insurance markets, it can do so less expensively and more efficiently.
A typical D&O liability insurance program might cost $200,000 in annual
premium, purchasing $10 million of coverage, subject to a $250,000 per-claim
self-insured retention. Unlike self-insurance, commercial insurance must be
purchased annually, regardless of claims activity. At the end of each policy
year, the $10 million insurance limit must be purchased once more, even though
no claims were paid.
The best candidates for self-insurance are companies with strong balance
sheets and adequate cash reserves. For firms with little or no historical
claims activity, the economics of self-insuring D&O can be quite favorable.
The company would no longer spend irretrievable insurance premiums each year.
The company would have the option of funding each year or funding based on
perceived needs.
D&O liability insurance provides more than just claims payments. D&O
insurers are experts in defending D&O claims. A portion of the
company's annual premium is allocated to these expert legal services. This
is not a problem for the self-insured company, as it would be able to retain
the same outside legal expertise, as would the insurance company. This article
provides an overview comparison of the salient features of D&O insurance
procured in the commercial markets and the use of an indemnification trust.
Purchase D&O Insurance from Conventional Insurers
Purchasing insurance is the most popular method of managing D&O risk.
Claims costs excess of a self-insured retention (as defined in the insurance
policy) are transferred to an insurance company in exchange for an annual
premium. The coverage form is "claims made," meaning that reported
losses are paid assuming that they occurred after the retroactive date.
Insurance allows business to thrive without the risk of unmanageable loss.
It is, however, subject to the changing conditions of the insurance market and
the decisions of individual insurers. Market pressures force premiums and
available capacity up and down based on insurer profitability and supply and
demand for coverage. Insurers may choose to exit lines of business that are
deemed to be unprofitable. Policy exclusions may apply to prevent, or reduce
the amount of, claims payments. So, while commercial insurance companies remove
certain risks from their clients’ balance sheets, the insurance transaction is
subject to some volatility and uncertainty.
Self-Insure D&O Risk through an Indemnification Trust
Indemnification trusts are a relatively common method of retaining the
D&O liability exposure for large companies with significant capital and
cash reserves. A trust is not insurance in that it does not transfer risk to a
third party—it is a self-insurance vehicle designed to establish a pool of
funds; legally segregated from the company's general account; managed by a
third party; and designated to finance pretrial settlements, court-ordered
judgments, and legal expenses associated with D&O liability.
Trust Program Structure—an Example
Company A funds an indemnification trust with $10 million. This fund is
designed to cover each director and officer subject to company indemnification,
nonindemnifiable losses, and coverage for the company as the entity.
Excess of the trust, Company A may decide to purchase D&O liability
insurance. The pricing of the excess insurance should reflect the fact that the
trust is fully funded, thus eliminating any counterparty risk charge built into
the premium. The premium should also reflect the fact that the cover applies
excess of $10 million, a significant self-insured cushion.
Indemnification trusts are formal financial structures. They are not unlike
any other trust arrangement wherein funds are legally segregated and designated
to be used for a specific purpose—a detailed description of which is codified
in the trust agreement. The D&O trust is typically funded at a level deemed
to be adequate to cover legal costs and potential court-ordered judgments,
based on the company’s exposure to loss, capped at a reasonable level.
Since the trust is fully funded (eliminating credit risk) and segregated in
a formal trust administered by a third party, it provides the security expected
by the company’s board of directors and senior officers in the absence of
commercial insurance.
Highlight Comparison of Salient Features
Company A—Estimated 5-Year Financial Picture (Highly
Simplified)
Assumptions
- No losses and no tax effect
- $10,000,000 loss funding in the trust mirrors insured limit of
liability
- Annual commercial D&O premium $250,000
- Trust funded only once, in the first year, assuming losses permit
- Trust expenses based on the $10,000,000 funding and include bank and
trustee fees
Conclusion
This treatment highlights the important differences between commercial
insurance and self-insured trusts. A trust, in my humble opinion, is the clear
winner, for companies that can afford them.
However, there is one issue in this comparison that has not yet been
mentioned and must be considered. As noted above, D&O insurance is written
on a claims-made form. If Company A leaves its insurer for a trust and then,
after a period of years, decides to reenter the commercial insurance market, it
will find that the new policy's inception date will also be its retroactive
date. This makes sense, of course, because the new insurer is not going to
cover prior acts—they are self-insured in the trust.