Insuring your business
You’ve just started your business . . . or you’ve grown it to a point where you have something worth protecting. In any case, sooner than later, the issue of “what makes sense to insure” will come up. This chapter is intended to help you answer this question.
Growth stage: risk management for private companies
Once a growing private company determines that it wants to recruit and retain excellent directors, it’s time to think about acquiring directors and officers (D&O) liability insurance. D&O insurance covers directors and officers of companies when they are sued in this capacity. Placing this insurance sooner than later gives directors and officers the comfort of knowing that there is more than just the company’s balance sheet standing behind them should they be sued.
Some of the reasons private companies purchase D&O insurance include:
- Attracting new directors
- Venture capital requirements
- Emerging risks
- Regulatory exposures
- Mergers and acquisitions
- Shareholder lawsuits
- IPO considerations
Let’s take a closer look at the details of private company D&O insurance, including how it works and what to watch for.
The ins and outs of D&O insurance
It’s helpful to understand how D&O insurance is structured and responds. There are typically three insuring agreements in a private company D&O insurance policy: Side A, Side B, and Side C (Figure 1).
Side A responds when a company is unable to indemnify its directors and officers. Side B reimburses a company for its indemnification obligations to its directors and officers. Side C provides corporate coverage whenever the company is sued alongside directors and officers.
Private companies can purchase D&O insurance as a stand-alone product or combined with other policies for cost savings (Figure 2).
A policy exclusion removes a particular claim from the policy’s coverage. The scope of these exclusions can sometimes be negotiated. Some areas of negotiation include:
Intentional fraud: Insurance carriers will not insure intentional fraud, but companies can negotiate the point at which the conduct is excluded. If the fraud exclusion can be triggered only after a final judgment, insurance can cover defense costs until then.
Insured versus insured: Private company D&O insurance carriers will not cover claims in which directors and officers (former or current) of the same company sue each other. However, companies can negotiate limited exceptions to the exclusions (also known as “carve-backs” that give back coverage), for example, limiting the number of years a director must be separated from the company before the exclusion no longer applies.
Duty to Defend vs. Duty to Indemnify
Defense costs are a big part of what’s covered in a D&O insurance policy and are always part of the total limit that will be paid for this type of insurance. Private companies can purchase either a duty to defend or a duty to indemnify policy.
‘Duty to indemnify’ means a company selects its own counsel. However, the carrier will only pay “reasonable” defense fees. The difference between what a company thinks is reasonable and what an insurer thinks is reasonable can be significant.
‘Duty to defend’ means the insurer chooses the defense counsel, who may or may not be the company’s first choice. However, the upside to a duty to defend policy is that the insurer is typically responsible for paying the defense fees for all allegations brought in the litigation and not just the allegations that are covered under the policy.
Choosing Policy Limits
How much coverage does a company need? Two common ways for a company to identify a prudent limit for its D&O insurance policy are to:
- Benchmark against similar companies; and/or
- Work through common private company litigation scenarios and then contact outside counsel to understand the costs associated with them.
Younger and smaller private companies will typically buy only $1 million to $3 million in limits. As private companies mature, they start to look at $5 million to $10 million in limits. Amounts may be higher for companies in highly regulated industries.
The next question is usually: How much will the insurance cost? The answer depends on many factors, including the overall state of the D&O insurance market.
In purchasing D&O insurance, pricing should not be the end of the analysis. D&O insurance is highly customized—in other words, policy contracts are not standardized. The same carrier has the discretion to offer many different versions of policy terms to different companies.
At the end of the day, money spent on an insurance program with broad coverage terms offered by a quality insurance carrier will provide a better value for a company than a less-expensive program with poor contractual terms offered by a carrier that has no intention of paying future claims.
Choosing a Broker
Because D&O insurance is a highly customized financial product, partnering with the right insurance broker is critical. Here are five key questions you might ask when looking for an expert partner.
What can you tell me about your firm and its culture? This question allows interviewees to give an overview of their brokerage firm, including their culture. Listen for things like team cohesion and stability. This matters because in difficult situations companies need brokerage teams to row hard in the same direction on their behalf.
In your view, what are the key exposures my company faces? This question is a chance to get free advice from the experts as well as gain insight into how the brokerage teams are thinking about a company’s risk. In the best case, the answer to this question will also tell if you like the broker’s style of communication.
What do I need to know about the insurance policies you would recommend and your process for placing them? An insurance program needs to be customized for a company’s specific risk profile. This question will give good brokers the chance to identify critical insurance policies and share their process for placing them.
What additional services do you provide? This question is about client resources. Some brokers have invested more than others in client resources such as access to databases, secure online platforms, claims advocacy, and other client services. Some of these services will be more useful to you than others. In general, most sophisticated brokerages provide more support than just placing insurance.
What will all of this cost? Cost is important, and a good broker will break down the costs in an understandable way. Remember that the cost of insurance has two elements: the premiums paid to insurance carriers and the amount paid to the broker. In this part of the interview, look for how the broker thinks about premiums and how the broker manages premiums over time. This is also where a company learns if the broker wants to work on commission or fee. Finally, a company can find out if its prospective broker is planning to charge separately for certain services, for example, claims handling.
International D&O Considerations
If a company has foreign subsidiaries, it will want to consider how to optimize its global D&O insurance program. The issue is that while your D&O insurance policy probably says that it provides coverage on a worldwide basis, whether or not insurance can legally respond in a local jurisdiction depends on the laws of that jurisdiction.
In many countries, the stakes may be quite low because advancing legal fees from the local subsidiary to an individual director or officer is easy and straightforward. Where this is not the case, however, there is a lot more pressure to have local insurance that complies with all local regulations.
Depending on a company’s situation, there are options. Some companies will rely on the worldwide coverage provided by a master program and call it a day. Others will decide to take advantage of certain features that some European-based D&O policies can provide when it comes to international coverage.
Many companies will decide to purchase a few local policies in some of the countries where the company does business. Some conservative companies will decide to purchase D&O insurance in every country where they do business. A few companies may even build a tower of insurance for the “rest of the world” that is separate from the insurance program they use for their U.S.-based exposure.
In all cases, decisions about international D&O insurance coverage are rarely static. Part of the risk management process is to routinely review the international program with an eye on the changing business, political, and regulatory environment.
Other insurance products to manage risk
D&O insurance is not, of course, the only insurance that growing companies need to buy. Consider the following guidelines when putting together your company’s entire insurance risk management program:
- Invest in Insurance When it’s the Law
Certain insurance coverages such as workers’ compensation or auto liability for owned vehicles are statutorily required in nearly every state. Other insurance requirements will vary by industry, for example, clinical trial insurance for life science companies. Companies will want to work with trusted advisors such as their attorney and insurance broker to understand the insurance requirements in each state or country where a company does business or has an office.
- Invest in Insurance to Fulfill Contractual Requirements
Signing a lease, entering into an agreement with a prospective customer, and signing up with a preferred employer organization are all examples of contracts that require a company to maintain basic commercial insurance. Along with legal review, have an insurance broker review the details of the insurance and indemnification provisions in all your contracts.
- Invest in Insurance to Transfer Catastrophic Risk
A catastrophic, multimillion-dollar claim can quickly strangle a growing private company, for example, an auto accident involving an employee on work assignment with major injuries to third parties or a class action lawsuit related to a defective consumer product. For these scenarios, products such as a general liability policy and auto insurance are key. It usually makes sense to supplement these with an umbrella policy that provides an additional layer of protection.
- Invest in Insurance for Operational Risks
Companies with unique operational exposures, such as those that use hazardous chemicals or companies in the life sciences sector, will want tailored insurance for these exposures. Most businesses will also accumulate some quantity of sensitive information they have an obligation to protect, even if only on the company’s own employees. Cyber liability insurance has come onto the scene to address risks associated with the financial impact of a data breach.
Exit stage: risk management strategies for private companies
At some point, your growing private company might be interested in a liquidity event, be it a merger and acquisition (M&A) or IPO. Insurance can help you optimize these outcomes.
The M&A route
Reps and warranties insurance: A merger or acquisition is a common exit for many fast- growing private companies. During M&A, representations and warranties insurance can be a powerful bargaining chip for both buyers and sellers. This insurance protects against breaches of the representations and warranties made in a purchase and sale agreement. This insurance is typically used to reduce the total size of the escrow in the deal.
Buyers in the M&A transaction are the ones who most frequently purchase this insurance (because buyers can insure against a seller’s fraud), but it is available to the seller as well.
If a buyer agrees to purchase a company based on the reps and warranties given and those reps and warranties turn out to be false, the buyer has the right to submit this claim to the insurance carrier. Similarly, should the seller purchase the insurance and the buyer file a dispute, the seller can expect the insurance to cover the claim.
D&O insurance tail policy: When a company is acquired, its existing D&O policy will terminate at the end of the policy year—not ideal if you are worried about claims that may arise against your directors and officers in the future. A tail policy, also known as a run-off policy, is the solution.
Because D&O insurance is a claims-made type of policy, the D&O insurance policy that responds to a claim is the policy that is in place at the time the claim is made. So, for example, if in 2016 a set of actions took place that is later challenged in 2017, it’s the 2017 policy that would respond.
This is where a D&O tail policy is crucial. After companies sell themselves, they stop renewing their D&O insurance. A tail policy covers what would otherwise be a gap in coverage for directors and officers after the sale of a company.
The gap exists because the D&O policy of the acquiring company will typically not respond on behalf of the selling company’s directors and officers for claims that arise post-closing that relate to pre-closing activities.
It is completely standard for a buyer to allow a seller to purchase a six-year tail policy. The policy should be placed and serviced by the seller’s broker. This arrangement gives the seller confidence that, even when the company is gone, someone loyal to the seller’s directors and officers will be in charge of the insurance program that protects them.
The IPO route
An IPO is an exciting time for any private company. But with it come risks—especially for directors and officers.
When it comes to D&O insurance and an IPO, it’s best to ramp up the D&O program during the renewal cycle the year prior to the IPO. This allows companies to make a few simple—but strategic—moves. For example, increasing limits early on gets the all-important warranty statement out of the way. Whenever a company purchases a higher limit of insurance, the company has to tell the insurer selling the new layer of insurance that the directors and officers of the company know of nothing that’s likely to give rise to a claim (a “warranty statement”).
When contemplating an IPO, consider the five key steps to building a D&O insurance program that run parallel to the IPO milestones that a company must achieve (Figure 3):
Let’s look at those five steps in closer detail.
The first step is to prepare, which includes developing a risk-management strategy. This process takes place while the company is drafting its S-1. Some of the key questions that need to be answered in this stage are:
- What is the timing of the IPO and is the company on a dual track?
- What is the size of the IPO and will there be selling shareholders?
- What is the company’s philosophy on risk transfer and buying D&O insurance limits?
- Which insurers best fit the company’s needs?
- Does the company face any unusual risks?
- Who are the key executives and who will be involved in the insurance process?
- How involved does the board of directors want to be in the insurance decisions?
In addition to its D&O insurance, a pre-IPO company will want to upgrade all of its other lines of insurance as well.
The next stage in the D&O insurance process ahead of the IPO is launch. This process typically takes place after a company files its first S-1 registration statement with the SEC. During this time, companies want to make sure their insurance broker is modeling policy limits based on their unique needs and negotiating with the insurance markets on the company’s behalf.
Next comes the brokering phase. This is where all the negotiation happens around insurance coverage, pricing, and higher limits warranties. The proposed D&O insurance program will be presented to and discussed with the board of directors, who will no doubt want to ask your broker questions about the program. After all, like the officers of the company, directors face the possibility of personal liability should the company fail to perform post-IPO.
The final stage is implementation. This is where the program is finalized, the warranties are executed, and subjectivities (carrier-imposed conditions) are addressed. When the Securities and Exchange Commission declares a company’s registration statement effective and a company prices its IPO, it’s time to contact the company’s insurance broker to bind the D&O insurance program.
Finally, expect ongoing support from your insurance broker. Keeping directors and officers up to date with training and advisory services helps to mitigate risk all year long. Of course, should the need arise, companies will also want the benefit of robust claims handling and advocacy as well.
When done well, insurance can be extraordinarily useful to a growing company, serving to support and protect a company’s growth over time.
Sometimes insurance can seem both opaque and expensive. However, when you work with an experienced and technically skilled insurance broker, insurance can be straightforward, fairly predictable, and very helpful.
Priya Cherian Huskins, Partner and Senior Vice President, Woodruff-Sawyer & Co.
Wade Pederson, Partner and Senior Vice President, Woodruff-Sawyer & Co.