When someone serves on the board of directors or as a company officer, they represent that organization. If it's perceived that their actions have an adverse effect on the company, they're vulnerable to lawsuits. Directors and officers (D&O) insurance covers fiduciary claims made against those who serve as directors or officers of the company, protecting their personal assets.
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What is D&O insurance?
D&O insurance is a type of business insurance that pays for the costs of lawsuits that claim a director or officer breached their fiduciary responsibility while serving the company. Without a D&O insurance policy, directors and officers could be held personally liable for losses. The insurance policy can either pay legal fees directly or pay for the company's defense of its directors and officers.
D&O insurance is available for directors and officers of nonprofit and for-profit companies. It gives those serving on the board of directors the confidence to devote their time and energy to the organization without the fear of being held personally liable for damages. If they're accused of misuse of funds or other fiduciary violations, the D&O policy kicks in.
Why do you need D&O insurance?
Without a D&O policy, it would be hard to convince qualified executives and board members to become part of your company, because they'd have too much at risk. Stakeholders with a financial interest in seeing the company – and its board – succeed may also require a D&O policy to ensure the proper protections are in place.
A D&O policy is critical because it protects people who represent the company through the board of directors or as company officers if they're accused of financial mismanagement of company funds. Without a D&O policy, they could be sued personally. The D&O policy steps in and pays costs associated with any potential lawsuits.
The D&O policy also protects directors and officers if the company declares bankruptcy. If bankruptcy proceedings seek financial restitution for those who are owed money – for example, a creditor who financed equipment purchases – the D&O policy protects the personal assets of those on the board.
Who needs D&O insurance?
Some types of companies and organizations may benefit more from a D&O policy than others. Many nonprofit organizations have volunteer directors on their boards; these people would be taking on liability for no real benefit if the organization didn't have a D&O policy. By getting D&O insurance, you demonstrate your desire to protect those who are helping to build the organization.
When it comes to for-profit companies, including publicly traded companies, you'll want to get a D&O policy to appease stakeholders. Often, startups or companies that fundraise fall under heavier scrutiny for the actions of their board of directors. Without this insurance policy in place, raising capital could be more difficult.
For smaller companies, perhaps run by family members, there will be less scrutiny from stakeholders regarding the actions of those on the board. While less common among smaller businesses, if you have an active board making critical business decisions about operations or financial strategies that could raise concern among other stakeholders, you should consider a D&O policy.
What does D&O insurance cover?
While the D&O policy is designed to protect directors and officers from personal financial loss in a claim, policies have different aspects that offer coverage in various situations.
When you choose your business insurance provider, they'll explain the three parts to a D&O insurance policy:
| Side A | This protects directors and officers in cases where the company cannot indemnify the participants. This is often the case in bankruptcy proceedings. |
| Side B | This protects the company when it decides to indemnify the participants. This might happen if the board is sued and the company defends the directors. In this case, the D&O policy will reimburse the company for any defense costs. |
| Side C | This protects the company itself from lawsuits over financial mismanagement. This might occur if stockholders sue the company instead of the board of directors directly. |
Often, a company and its board of directors will be named in the lawsuit. By naming all parties, including the company, those filing the lawsuit stand the best case of getting restitution from one or more of those named in the suit.
What does the D&O policy pay?
The D&O insurance policy will pay for the legal fees involved as well as any settlements or judgments obtained. It's important to understand that the policy's limits are an aggregate total, meaning the policy limit includes both legal fees and awards. Depending on how costly the litigation is, the D&O policy could quickly reduce claim limits.
For example, if the D&O policy had an aggregate limit of $1 million and there were $300,000 in legal fees, there would be only $700,000 left to pay settlements.
Duty to indemnify vs. duty to defend
There are two ways the D&O policy will approach legal defense. Either it will reimburse the costs of the defense, or it will pay them directly. While that doesn't seem like it would really matter, there's slightly more to it.
When a policy is designed with a duty to indemnify, it allows the insured to choose their own counsel. This gives the insured the confidence that they are getting the best representation possible. However, if this is the case, the D&O policy will indemnify those costs based on what is deemed reasonable. This is where the frustration can occur: An insured's idea of what is reasonable can be very different from the insurance company's view. This may leave some costs not paid by the insurance company.
When the policy is designed with the duty to defend, the insurance carrier directly pays the costs of the legal counsel. In this case, the insured doesn't have a choice of counsel. While this mitigates any extra costs that might not be paid and often expedites the settlement process, an insured may feel they're not getting the absolute best defense since they didn't get to choose their legal counsel.
What doesn't D&O insurance cover?
As with any insurance policy, there are limits to what a D&O insurance policy will cover and what it excludes. While it is designed to protect directors and officers from lawsuits over organizational mismanagement, there are parameters.
A D&O policy will not protect directors and officers who sue each other. If there is an internal conflict, this falls outside the scope of the policy. And while covered lawsuits deal with mismanagement of financial assets, the policy will draw the line on fraudulent acts. If a final judgment is made against a director or officer that finds them guilty of fraud, the insurance company will not pay the claim. In that case, the defendant would have to pay all legal costs on their own.
How much does D&O insurance cost?
Many factors affect the price of a D&O insurance policy. The insurance carrier will consider things such as:
- Legal and claims history
- Company assets
- Company debts
- Revenue
- Industry
Obviously, the bigger you are, the more risk you have and the more your policy will cost. Insurance carriers are looking for financially stable companies with a low incidence of lawsuits and claims. That's where premiums remain the lowest, but that isn't to say that D&O policy premiums are inexpensive.
As a rule of thumb, you'll pay approximately $5,000 per year in premiums for every $1 million in coverage. The more coverage you need, the costlier the policy gets. If you already have critical business insurance policies in place, such as employment practices liability insurance or professional liability insurance, check with your insurance provider about adding a D&O policy.