November 22, 2021

D&O Coverage Alternatives: Self-Funded Side A Directors and Officers Coverage

The costs of directors and officers (D&O) insurance continue to climb, in large part due to higher legal costs, increasing complexity and the severity of securities class action litigation and derivative suits. In 2020 alone, the amount of the average securities class actions settlement doubled. With companies facing claims arising out of cyber breaches, sexual misconduct, the COVID-19 pandemic and the opioid crisis, among other things, it appears these trends will continue at least for the next few years. The rising premiums have companies looking to cut costs with some considering going bare, other companies only purchasing Side A coverage and still others considering D&O coverage alternatives.

The standard form of a D&O policy has three insuring agreements, commonly referred to as sides A, B and C, or, ABC coverage. Side A insures individual directors and officers against losses that the company is not legally or financially able to indemnify, whether due to financial insolvency of the company, legal prohibition or the specific allegations of the claim. Side A often has no or a low deductible or self-insured retention (SIR). In contrast, Side B and C coverages afford coverage to the company itself. Side B coverage reimburses the company for costs incurred on behalf of directors and officers, while Side C is entity coverage, covering claims made directly against the company. Both Sides B and C have an SIR.

Because Side A coverage protects individual officers and directors when indemnification from the company is not available, many companies purchase Side A coverage on a standalone basis, even if the company decides to forego the other coverages. Companies may also purchase a standalone Side A policy in addition to a standard ABC policy. The separate policy may simply provide higher limits to the individual officers and directors or it may be a Difference in Conditions (DIC) policy, which provides broader coverage to officers and directors.

Last year, Tesla announced that — because of the rising premiums it was facing — it would not purchase D&O insurance. Instead, Tesla informed the Securities and Exchange Commission that Elon Musk would provide substantially equivalent coverage through an agreement with Tesla. While many companies do not have a shareholder or board member wealthy enough for Tesla’s arrangement, companies nevertheless are exploring alternatives to traditional D&O coverage.

One unique insurance solution is a “self-funded” Side A policy. This approach makes sense when, for example, a controlling shareholder is willing to take on some financial exposure for Side A D&O claims. Under this arrangement, the insurer issues a standalone Side A policy to the company covering its officers and directors. The policy has a large deductible/SIR, sometimes equal to the limit of liability of coverage. The company pays the policy premium and the controlling shareholder or shareholder group posts collateral in favor of the insurer equal to the large deductible/SIR or agree to reimburse the insurer for all amounts paid by the insurer for covered loss falling within the deductible/SIR. The collateral, or a combination of collateral, would typically take the form of a letter of credit, or sometimes other liquid assets. The obligation to reimburse the insurer or post collateral can be set forth in a separate agreement among the controlling shareholders and the insurer.

Under this approach, the officers and directors can look to the financial strength of the insurer instead of the company, even though the insurer is ultimately relying on collateral posted by a controlling shareholder(s). Further, decisions relating to the response of the Side A policy are independent of the company and/or the individual indemnifying parties (like controlling shareholders), and at all times remain vested with the insurer. In this fashion, self-funded Side A coverage can avoid potential concerns about influence by the company’s management, board members and/or indemnifying parties, and potential public policy issues that may arise for certain types of claims. Because the insurer can look to the collateral or indemnification agreements supporting the large deductible/SIR, the insurer would shoulder much less risk than under a typical Side A policy, resulting in lower premiums than a traditional policy.

While such arrangements could provide cost savings, their non-traditional nature may raise other questions and will require more planning than a traditional D&O policy purchase. Consult your broker, insurance, legal, tax and accounting advisors to determine what risk protection best suits the needs of your company.

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