DandO liability insurance defence and settlement AICD Review

Saturday, 01 June 2002


    Directors and officers do not always get the defence that they might expect when they have a claim against them. 

    In this article Shane Crocker and Colin Smith* provide an insight into policy responses and conditions that impact on claim defence. They also advise on what to look for when purchasing Damp;O liability insurance to maximise objectives should a claim occur.

    There are no standard directors and officers liability (D&O) insurance policies. Terms and conditions vary greatly between insurers. One major variance is how insurers are required to respond to actions and allegations that are brought against insured directors and officers. The value of any insurance policy faces its ultimate test when a claim is submitted. D&O insurance is no exception. So you have submitted your D&O claim. What will insurers do to help you? Are your interests the same as the insurer's interests? The insurer may wish to minimise the financial impact of a claim. You may wish to defend your reputation. The insurer may wish to defend an action while you want to settle to avoid a long and drawn out legal battle. To maximise your objectives, you need to be prepared to negotiate the defence and settlement clauses prior to entering into the D&O contract. The most common defence and settlement clauses are discussed below.

    The insurer takes over conduct of defence

    In many instances D&O Insurers have a right, but not a duty, to take over and conduct the defence of allegations or actions against directors and officers.

    The insurer has complete control over the manner in which the defence and settlement negotiations are conducted. It is possible that they will seek an outcome that is favourable to them and may have scant regard for the wishes of the insured directors and officers. The election of defence counsel will become an issue for both parties. If the insurer has a right to take over the conduct of the defence it may wish to use its own lawyers to defend policy coverage areas, while the directors and officers will feel more comfortable with their own lawyers. Insured directors and officers are required to provide all information and assistance to the insurer to enable settlement, yet they are unable to actively participate in negotiations. The insurer may not be convinced that a claim will be payable, in whole or in part, under the D&O policy. This often brings about a "reservation of rights" letter. The insurer elects not to take over the defence and reserves its rights. In these circumstances, the payment of defence costs becomes the responsibility of the insured directors and officers, pending further consideration.

    The insurer has a duty to defend

    Where the allegations are indemnifiable under the policy, the insurer has a duty that requires them to maintain complete control of defence and settlement negotiations. As is the case above, the insured directors and officers are required to provide all information and assistance to the insurer to enable settlement while not having direct control of the outcome. If the insurer determines that a claim is not covered by the policy, they may elect to reserve their rights, leaving the defence to the insured directors and officers.

    The insured retains the right or has a duty to defend

    The insured directors and officers assume the duty of their own defence. This is preferable because it enables the insured directors and officers to actively participate in their own defence. The insurer retains the right to actively participate in the defence and settlement negotiations. In a practical sense it is placed in a position of having to influence rather than control the action and settlement.

    No defence costs or settlements can be agreed to by the insured directors and officers without the insurer's prior written consent. Generally this consent will not be unreasonably withheld. The insurer remains able to investigate and negotiate settlement if they feel that it is expedient. They are required to obtain the written agreement of the insured directors and officers prior to entering into an agreement to settle. Given that it is the duty of the directors and officers to arrange their own defence it is imperative that the insurer is obligated to pay defence costs on an ongoing basis.

    Payment of defence costs

    Actions against directors and officers are often complicated and involve numerous causes of action, not all of which will be indemnifiable under the contract of insurance. For example; an action by shareholders may allege a breach of directors' duty which will be insured. The defence costs for allegations of misuse of position to gain a personal advantage are often not insured. Actions may also involve parties that are not insured, such as the company itself.

    In these instances insurers are required to defend only the insured directors and officers and may have little regard for the needs of the company. A single defence is usually in everyone's best interests. However, it will lead to a discussion on the proportion of defence costs which are covered by the policy. This is known as "allocation of defence costs".

    Allocation of defence costs

    The insurer's obligations under the D&O policy are to the insured directors and officers and not to the company itself. For the provision of defence costs, insured and insurer will have to agree a fair allocation of the defence costs between:

    • directors and officers and the company

    • insured and uninsured allegations or claims

    This is usually based on a negotiated agreement of the legal exposures of each party. If agreement cannot be achieved the insurer may determine the allocation or both parties can agree to be bound by independent arbitration. Regardless, the ongoing payment of defence costs is imperative and you should ensure that they are the responsibility of the insurer in all instances.

    This is particularly important when directors do not have the capacity to fund the defence costs.

    Advance/interim payment of defence costs

    In the early stages of litigation, it is not always obvious that the allegations against the directors and officers are covered. Insurers may choose to reserve their rights and not provide immediate indemnity. When this happens, the insurer should advance defence costs in the interim. Most D&O policies will provide for advance defence costs, but your policy should be checked. The insurer should be obliged to advance defence costs while considering its position. Some D&O policies only require costs to be advanced solely at the discretion of the insurer. This should be avoided. If it is ultimately determined that there is no cover for the particular allegations, the directors and officers could be required to reimburse the insurer for the costs that were advanced. This is in the best interests of the directors and officers.

    Aggregate limit of indemnity

    Unlike some other classes of insurance, the limit of indemnity for D&O insurance is inclusive of legal defence costs.

    The total amount payable by Insurers applies to all claims and or circumstances notified, inclusive of defence costs made against all directors and officers during the policy period. This becomes a significant issue when the directors and officers of the company are unwilling to work together to ensure a unified defence to a claim. This can result in additional legal fees which erode the total policy limit for the period of insurance. If further claims are reported, directors and officers who were willing to act together will consider their position as having been prejudiced as the policy limit has been unnecessarily diminished. In an attempt to satisfy all insureds, most D&O policies contain mediation clauses to deal with these situations. Conclusion In the event of a claim, it is unlikely that there will be a straightforward resolution of the inherent conflict between the interests of directors and officers and their insurers. Directors and officers can maximise their position and reduce conflict by arranging D&O insurance that:

    • provides them with the duty to defend themselves and therefore the choice of their legal defence counsel - control versus influence; and

    • obliges the insurer to advance defence costs on an ongoing basis pending resolution of indemnity.

    * Shane Crocker is senior insurance and risk consultant and Colin Smith is principal consultant with Strategic Insurance & Risk Solutions. Jon Broome, a director of Proclaim Management Solutions, provided independent feedback on their comments. The latest work, A Guide to Directors and Officers Liability Insurance, is now available through AICD Publications


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