Driving D&O

On the one hand, directors' and officers' (D&O) coverage is the bedrock of entrepreneurialism and innovation.

It inserts a buffer between the personal finances of an individual director and any mishaps that may occur while they are in office. And that negates in turn the potential neuroticism of senior management, freeing them up to implement strategy without the burden of sleepless nights fretting about the possible personal cost of their decisions.

But on the other hand, by removing - or at least mitigating - the element of peril inherent in those riskier decisions, insurers become more likely to take a gamble. The recognition that the policy will be there to pick up the tab should a decision go awry risks encouraging reckless behaviour by managers.

And there is a further conflict. If management overstep the mark and stray into murky decision-making, the insurers are required to defend those directors in court even when there is a presumption of fraud. Under the terms of any other policy an allegation of dishonesty would have the underwriters dusting off the template for a letter outlining a reservation of rights.

However, there is yet another oddity embedded within the coverage terms of most D&O policies: they cover civil fines.

Intuitively, fines are imposed to discourage bad behaviour by corporations and their executives. In other words, they're supposed to hurt. But if D&O carriers are stepping in and saying: "Oh, don't worry about that, I'll pay it for you", it becomes trickier for regulators - and ultimately governments - to discourage wrongdoing.

And the carriers are only hurting themselves. By offsetting the downside risk of poor decisions, bad management and even fraud, they are increasing the exposure they face.

Misaligned interests

A slight misalignment of interest between the carrier and the policyholder exists in most classes of business where the insured wants to be paid more and the insurer wants to pay less, or not at all. But both sides are generally agreed that neither party wants a loss.

However, that dynamic is somewhat more skewed in the D&O space because in business greater risk tends to yield a greater reward. These policies facilitate a director's ability to maximise the potential upside while at least partially offsetting a portion of the downside risk.

Despite this unusual market dynamic D&O losses rarely get much airtime in the mass media. In recent years, however, catastrophic losses for the sector have rarely been out of the spotlight.

Most recently, Volkswagen (VW)'s third quarter results revealed that it had taken a EUR6.7bn charge in the quarter to cover costs related to the emissions testing scandal, where software was used to influence the test results for the manufacturer's diesel cars.

And the recent spate of high-profile losses in the banking and automobile sectors, among others, is likely to serve as the perfect advertisement for D&O coverage, which could further bolster demand.

However, it may be a stretch to suggest insurers have driven - or at least contributed to - the culture that makes big corporations think they can get away with behaviour like cheating emissions tests or rigging Libor rates.

Tim Finch, D&O underwriter for ArgoGlobal, explains that for the larger risks the downsides far outweigh any potential recovery under the limits of a D&O policy.

"The D&O policy won't cover every eventuality, so you can't take a risk knowing it will be covered," he says.

"No matter how much D&O is purchased it doesn't stop you possibly having your assets frozen or being put in jail."

Grey area

But when executives do slip up - through deliberate actions or otherwise - D&O insurers are duty bound to stand with them unless they admit guilt or their wrongdoing is proved in court. And that process can take years.

What constitutes an admission of wrongdoing is still, in the UK at least, largely a grey area.

Jacquetta Castle, partner at law firm DWF and vice president of the British Insurance Law Association (BILA), says the VW scandal could shine a light on a number of significant and previously unreported D&O coverage issues.

Most D&O policies contain an exclusion for any fraudulent or dishonest act that has either been proven in court or has been admitted. The car manufacturer's former CEO Martin Winterkorn - who stepped down once the full scale of the scandal came to light - has admitted that there was wrongdoing by the company but has denied knowing about it at the time.

While VW has admitted that it used fraudulent devices, all the company's senior officials have rebutted any allegations of misconduct. So, at present those individual directors' cover would remain unaffected and will require insurers to advance defence costs.

But Castle says the admissions of responsibility at a very high level could spark some significant issues around liability.

She explains that quite apart from any policy exclusions, lawyers are likely to be looking at the pre-contractual disclosure made by the company and by the insured persons. And the policy is likely to specify whose knowledge is relevant for such purposes.

In addition, there are also likely to be some significant issues around aggregation that will see lawyers on both sides poring over the relevant clauses within the contract, Castle says.

If there were multiple claims not caught by an aggregation clause, the insured would have to pay a deductible for each claim - but this would give the insured access to more than one limit.

Castle argues that VW's coverage is likely to have been written on a claims-made basis, but she warns that it is too early to say whether the claim will be viewed as a single loss or whether it is subject to multiple deductibles.

Another fine mess

What's more, Castle adds, the question of whether a particular fine is to be classified as civil or criminal could be unclear.

"Given the sums at stake in the pending VW claim, it is likely that this question will be explored further by lawyers on both sides," she explains.

But BILA vice chairman David Nayler, who is responsible for wordings and claims in Aon's financial and professional services team, says that while an examination of the terms could bring some "much-needed clarity", the cover for fines may be of "limited use".

"There are very few fines and penalties that can be imposed on an individual without a finding of wrongdoing on the part of that individual, which would likely trigger the final adjudication provision and end cover anyway," he explains.

And the policy will respond differently according to the applicable laws of the country in which the fines are doled out.

Andy Pecover, D&O class underwriter at MSIG, says VW is likely to pick up civil fines in a number of jurisdictions.

He warns that local laws may prevent insurers from reimbursing the car manufacturer for the penalties.

In the US, for example, which Pecover describes as the "king territory" for fines and punitive damages, civil penalties are uninsurable. But insurers can cover defence costs up until a fine is awarded.

However, Spanish law does allow companies to insure against civil fines and penalties.

"So if there was [a fine] awarded [in Spain] and there was any limit available for that then potentially the policy could respond," the executive says.

One of the more significant concerns for insurers will stem from class action lawsuits filed against the car manufacturer and its directors in the US.

So far, US attorneys have filed more than 350 suits on behalf of shareholders and car owners in the wake of the scandal, with the number of filings increasing daily.

"We are already hearing of a multitude of different claims that have either already been brought or are in the offing - from shareholder class lawsuits and derivative actions, to product recall [and] consumer claims," says DWF's Castle.

The urge to settle

Lawyers on both sides will be "crawling all over" the policy wordings, Castle adds, with a multitude of arguments available for them to make.

But although the numbers sound almost overwhelming, the suits are likely to be consolidated into a single action. And once they are, it is in the interests of both parties to settle the dispute as quickly as possible.

"Nine times out of 10 the insured and the insurers just want to settle it," MSIG's Pecover says.

He explains that, historically, the plaintiff bar had a 50 percent success rate, so rather than take the matter before the courts lawyers for the claimant preferred to settle because the likelihood of winning the case was the same as their odds of losing.

The impulse to settle is also driven by both parties' desire not to be embroiled in a lengthy and costly legal battle.

"[A client's] insurers usually sit down and go 'we could still be sitting down in 10 years and arguing the toss or we could strike a deal'," the underwriter says.

The carriers do have one final trick up their sleeves. Should a director be found criminally culpable or should they admit to wrongdoing after a settlement, insurers have subrogation rights.

"They can look to recoup cash," Pecover says. "But usually what happens is that those guys are in jail and their assets are frozen."

Despite the significant numbers involved, the underwriter concludes that the VW loss is not a "true cat" event, adding that he will be surprised if the insurers gave the full policy limits to VW.

Cost of capital

Nevertheless, the numbers involved are significant; so it may come as a surprise that in the face of such large claims capacity is still pouring into the sector.

David Walters, executive director at broker AJ Gallagher, said the cost of capital for D&O risks had gone down "massively".

"It's competition in the market, so having 50-60 carriers offering the product in the marketplace means that there is constant pressure on price and product development, which as a broker we will always applaud because our clients are benefiting from those arrangements," he says.

"There's a lot of capacity available in the D&O market," he reiterates, adding: "I don't think we'll be seeing a price correction in the near term."

But Argo's Finch says the increase in capacity and falling rates could cause a problem for insureds when the tide of capacity goes out.

"My fear for clients is that much of this new capacity may disappear when returns increase in other asset classes and the capital moves to find higher profits," he says.

"Brokers may suggest new capacity for a short-term saving but, given the length of time a D&O issue can take to resolve, which can be several years, I think clients are best served by markets who have a proven long-term track record, crucially both in underwriting and claims handling."