Meghan Day

Principal Solution Designer

Directors & officers (D&O) insurance: How to know if you need it

Directors and Officers (D&O) insurance is critical to effective corporate governance. Over a quarter of private companies have experienced a D&O loss in the past three years, 96% of which created significant financial impact.

Despite the value of D&O insurance, it is also complex. Directors, officers and entire organizations expose themselves to liability by failing to recognize the critical moment in purchasing the right policies for the right people. This blog post aims to demystify D&O insurance, addressing:

• What D&O insurance is
• Why is D&O insurance important, and who needs it
• Types of D&O insurance
• What D&O insurance covers and how the policies work
• Tips for choosing the right policy

What is D&O insurance?

D&O insurance is a specialized liability insurance policy that protects current and past directors and officers of a company if they face a lawsuit. The policy mitigates financial losses if a third party alleges wrongful acts in the officer or director’s official capacities. These allegations can encompass:

• Breach of fiduciary duty: This refers to failing to act in the company's and its shareholders' best interests.
• Misrepresentation of financial statements: This could involve deliberate or unintentional inaccuracies in financial reporting.
• Employment practices: This includes allegations of discrimination, wrongful termination or harassment against employees.
• Regulatory breaches: This covers violations of laws and regulations applicable to the company's operations.

Who needs D&O insurance?

Any director, officer or board member of a for-profit or nonprofit organization needs D&O liability insurance. While the U.S. gives company leaders discretion in how they execute business activities, D&O policies further shield leaders from civil and criminal action, which is important because directors often face both simultaneously. This extends to investigations from regulators.

Should an executive be sued, the D&O claim will be paid directly to them to replace financial losses or reimburse legal defense costs.

Why is D&O insurance important?

D&O insurance insulates directors and officers and their organizations. These policies protect executives from personal liability, but organizations — both for and nonprofit — can also use them to recoup legal fees and other costs.

This comes with myriad benefits, including:

• Financial protection: D&O insurance covers defense costs, settlements and judgments associated with lawsuits against individual board members. Without this coverage, directors’ personal assets could be at risk, even if they are ultimately exonerated.
• Attracting and retaining talent: D&O insurance demonstrates the company’s commitment to supporting its board and protecting it from personal liability. This can be crucial for attracting and retaining qualified individuals to serve on the board.
• Promoting confident decision-making: Knowing they are covered encourages directors to make informed and responsible decisions without undue fear of personal repercussions, fostering a more engaged and effective board.
• Enhanced corporate governance: D&O insurance reinforces the principles of good corporate governance by demonstrating a commitment to protecting stakeholders and fostering a culture of responsible leadership.

Types of D&O insurance

Different D&O insurance types cover distinct risks that directors, officers and the organizations they serve often face. Each type of coverage protects against the liabilities stemming from alleged wrongful acts, errors or omissions in governance.

Here’s a closer look at the main types of D&O insurance policies.

Side-A coverage: Protection for individuals

This policy protects individual directors and officers from personal liability for lawsuits alleging wrongful acts. Executives need these policies in situations when their company cannot indemnify them, which typically arises when:

• The organization is bankrupt or insolvent
• Corporate bylaws or public policy restrictions prevent the company from offering indemnification

Side-A coverage ensures that individuals do not become personally liable for defense costs, settlements or judgments from lawsuits alleging wrongful acts. Leaders opt for these policies to safeguard their financial security, mainly if the organization is high-risk or financially unstable.

Side-B coverage: Reimbursement to the organization

Side-B is a companion to Side-A in that it explicitly reimburses the company, not the individual, for defense costs. The company pays for the defense costs, settlements or judgments, and then the policy pays them back.

These policies are attractive to company leaders because they signal the company’s commitment to shielding executives. Side-B coverage can also be a mitigation strategy for governance-related risks.

Side-C coverage: Entity coverage

Side-C coverage, or entity coverage, protects the organization from governance-related claims. While Sides-A and B address individual liability, Side-C covers the entire entity in the event of:

• Securities litigation against the organization as a whole
• Claims alleging misleading financial statements or corporate misconduct

Publicly traded companies commonly have these policies to cope with the risk of shareholder lawsuits and regulatory scrutiny.

What does D&O insurance cover?

Many claims and legal actions fall under the D&O insurance umbrella, but some are more common than others, and coverage varies based on the policy type. However, individuals and organizations often invoke their policies to cover:

1. Breach of fiduciary duty: Individuals and organizations may face legal action if they fail to act in the best interest of shareholders or stakeholders or mismanage company resources.
2. Misrepresentation or inaccurate disclosures: Allegations of false or misleading financial statements would be covered by D&O insurance, as would errors in public disclosures, like earnings reports.
3. Regulatory and compliance failures: Individuals and organizations can use D&O coverage to defend themselves against alleged regulatory violations or non-compliance with employment laws or securities regulations.
4. Employment practices allegations: Employees can bring legal action related to claims of wrongful termination, discrimination, harassment or unfair hiring practices. D&O insurance applies to all of these instances.
5. Cybersecurity and data breaches: If governance failures lead to data theft or breaches, individuals and organizations can be held liable. This includes failing to oversee cybersecurity protocols properly.
6. Governance errors: Conflicts of interest, failures to disclose material information, or the poor handling of corporate mergers are all governance missteps that can trigger legal action — and the need for a D&O policy.
7. Third-party claims: Individuals and organizations can invoke D&O insurance to defend themselves against vendor, client or competitor lawsuits alleging harm due to executive decisions. Coverage also spans claims of anti-competitive behavior or defamation.

What does D&O not cover?

Though D&O policies protect individuals and organizations, they do not shield misconduct. It does not protect individuals from intentionally wrong or illegal actions, such as:

1. Fraud or criminal acts: D&O insurance does not apply in the event of intentional wrongdoing, fraudulent behavior, embezzlement, theft or other criminal activities.
2. Personal profit: If legal action arises due to a director or officer allegedly gaining a personal profit or advantage, D&O coverage will not apply.
3. Bodily injury or property damage: Directors or officers who cause physical harm to individuals or property damage cannot fall back on D&O policies. They may, however, be able to use general liability insurance instead.

How does D&O insurance work?

Understanding how D&O insurance works is critical. Knowing its policy structure, claims process, limits and deductibles will help you understand which policy — or mix of policies — is right for your directors, officers and organization.

Policy structure

D&O insurance policies are typically divided into the three coverage areas explained above: Side-A, Side-B and Side-C. Each covers distinct risks, and many organizations ultimately select a mix of policies to get the right coverage for their governance and operational needs.

Organizations can also add endorsements or extensions to their policies to address specific risks, like employment practices or cybersecurity.

Claims process

The claims process begins when someone takes legal action against a director, officer or the organization. Most processes proceed as follows:

1. Notification: The policyholder must notify their insurer when they become aware of a claim or potential claim.
2. Investigation: The insurer reviews the claim to determine whether it’s valid and falls within the policy’s coverage.
3. Defense: If the claim is covered, the insurer either provides legal representation themselves or reimburses the insured for defense costs.
4. Settlement or judgment: The insurer may pay settlements or judgments up to the policy limit, minus any deductibles.

Limits and deductibles

A D&O policy won’t have unlimited coverage. Before purchasing a policy, consider any of the following:

• Policy limits: These are the maximum amounts the insurer will pay for covered claims. They are typically set annually or per claim. Organizations should choose limits based on size, industry risks and governance complexity.
• Deductibles (retention): This is the portion of the claim the insured must pay before coverage kicks in. Side-A coverage often has no deductible, but Side-B and Side-C usually include retention amounts for the organization.

Best practices for choosing the right D&O policy

Selecting the right D&O insurance policy involves carefully considering the risks your organization faces, as well as the governance structure and industry requirements. Use these best practices to identify the correct type of coverage for you:

1. Assess your risk profile: Identify the potential risks requiring D&O coverage. Consider regulatory, shareholder and employment-related exposure. Your organization’s size, industry, and sector can determine your needed coverage.
2. Understand your coverage needs: Whether you need Side-A, Side-B, Side-C, or a combination of these policies depends on your organization’s ability to indemnify executives. Determine whether you need additional endorsements for specific practices.
3. Review exclusions: It's crucial to understand any specific actions or situations not covered by the policy. Scrutinize these exclusions to ensure your most critical risks are covered.
4. Analyze policy limits: Select limits that align with your organization’s risk exposure, financial capacity and industry benchmarks. It can also help to consider your sector's typical settlement size and legal defense costs.
5. Compare deductibles and retention levels: Ensure your organization can cover deductibles, especially for Side-B and Side-C coverage. Weigh these costs with your budget for defending your organization against claims.
6. Evaluate the claims process: All insurers handle claims differently. Research insurers under consideration to assess their reputation related to claims. Look for an insurer that is efficient and fair.
7. Benchmark against similar organizations: Research the coverage types and limits similar organizations typically care about. Identifying the policies other organizations choose can help validate your D&O insurance decisions before purchasing a policy.

Drive good governance with D&O insurance

D&O insurance plays a vital role in supporting effective board governance, especially as risks and liability issues continue to evolve.

With careful planning and consideration, governance professionals and board members can collaborate to ensure proper coverage, fostering a climate of confidence, responsible decision-making and strong corporate governance.

However, effective planning depends on leaders providing accurate and comprehensive information in their D&O questionnaires — and organizations managing those insights effectively. As risks rise, more organizations are turning to board portal software to manage their D&O questionnaires, ensuring no D&O insurance details get overlooked.

Learn more about the power of Diligent Boards, part of the Diligent One Platform, to unlock the D&O insights you need to mitigate risk.