The question of how to choose a Directors and Officers (“D&O”) liability policy limit is one which is frequently visited. Unhelpfully, there is no clear and unequivocal way to answer. Marketing literature to support the sell on D&O liability seems to have altered little over many years without providing any meaningful guidance on the limit organisations of a certain size and nature ought to consider. The playbook response of ‘buy what you can afford’ is also less likely to be as panacean as it was prior to the recent sharp increase in costs in the D&O liability market and the focus is perhaps a little sharper because of this. To be fair, it is difficult to get beyond anecdotal evidence and the highest profile cases to identify what a typical loss looks like. That probably stands to reason, because there are no industry statistics, or many statistics at all, on D&O liability losses in the United Kingdom (“UK”). Confidentiality and sensitivity are huge issues and directors are unlikely to be terrifically keen to see their case histories and loss costs brandished across the market as an example of what could go wrong.
Whilst behaviours are ultimately always likely to be an intrinsic element of D&O losses (purported or real), there are indicators of the likelihood of a claim in the first place, and the potential extent of any costs that might follow, which can influence the limit choice that an organisation might take and which an underwriter would factor into the consideration of a risk. Whilst they do not deliver a prescription they can be instructive, nonetheless, remembering that no risk characteristic will ever be mutually exclusive and able to be used as a single metric to decide on what might be the sensible policy limit.
Activities: there are unquestionably trades and sectors that present more obvious challenges to underwriters of D&O liability than others. Telecommunications and biotechnology feature prominently here, for example, because of potential issues around valuations and the more frequent need for investments in areas where the product or idea may be untested and unproven. Intellectual property can be more contentious, particularly where knowledge is young and thinly distributed. Natural resources and mining are examples where front-end costs actually do come with the territory and are inherently more speculative. Other obvious areas where D&O losses might feature more frequently include professional football clubs and financial institutions, with underwriters inclining to the view that the relationship between fortuity and inevitably can be uncomfortably imbalanced. Whilst all organisations will evidence a D&O liability risk, activities are a useful start point on the probability of a claim, but the extent and severity of those will largely be determined by other ingredients.
Scale: whatever the activities look like and feel like, their size and scale will be important in driving the potential extent of any loss. Below a certain level, the fiasco arithmetic may not interest litigation funders or aggrieved creditors because of the potential costs associated with recovery. But there is no doubt that limit choice has to be a function of size and, viewed in isolation, the very simple observation is that the bigger the risk, the bigger the limit requirement should be.
Financial Profile: many risk characteristics of D&O liability risk are straightforward and debt is no different. If you borrow money, you have to pay it back. If you don’t pay it back, the owner of the debt will want to know why and will seek to establish if the reasons might be based on any mismanagement or misrepresentation. Debt ties into a broader assessment of the financial condition of an organisation and a heavily indebted business has the contemporaneous challenge of a narrowed field of enthusiastic underwriters and a higher limit of liability requirement to align against their financial metrics. Foremost in the minds of brokers when recommending a limit will be financial scandals and corporate casualties where it is known that interrogations have been long, expensive and involved several investigatory parties proceeding against those involved in the management of the organisation.
Public versus Private: it is indisputable, and understandable, that publicly traded companies have a broader risk spectrum than those which are not. Regulatory scrutiny is more intense and they must undergo rigorous initial evaluation as well as meeting ongoing transparency requirements. They will be exposed to shareholder and regulatory issues that do not affect private companies. As a general observation, plcs will need to buy higher limits than their similarly sized private counterparts and it is unusual to find a plc that does not buy D&O cover. The limit choice may be more heavily influenced by other factors (activity, size and scale, territory, etc.) than whether they are listed or not but there is no doubt that, absent any other factors, an exchange listing raises the risk of a claim. What evidence does exist points directly to the conclusion that publicly traded risks suffer a disproportionate number of large losses (7 figures and above). This is driven partly by those disclosure and transparency requirements and a wider pool of potential claimants, but also because they tend to be larger, more geographically diverse, or in areas that are intrinsically more exposed to loss. There is also the feature that scale, or a desire for this, is often the reason for a public listing in the first place. The need to access capital with the agility that a listing delivers happens with more regularity, involves higher sums and is more tightly regulated than in the private sector.
Merger and Acquisition activity: valuation disputes feature commonly on the list of D&O liability losses and are fertile ground for disagreement. There can often be an understandable tension between vendors, who seek to maximise the value of their asset, and buyers who desire the best possible terms. Alleged misrepresentation is a common feature of this kind of claim and, again, the nature, location and scale of the acquisitions(s) will feed the narrative on limit requirements. It is important to keep the critical consideration of ‘capacity’ in mind, however. A D&O liability policy will only cover wrongful acts in the capacity as a director or officer, not as a shareholder, so any acts committed in that capacity falls outside of the scope of a D&O liability policy and drop into the territory of Warranty and Indemnity cover.
Prevailing Regulatory Regime: according to The National Audit Office there are more than 90 regulatory bodies in the UK with a total expenditure of almost £5 billion a year. Most D&O surveys support the evidence of a marked rise in regulator activity over the last 10 years so the prevailing regulator environment of an organisation should be an important consideration on how to choose a D&O liability limit. All organisations are exposed to health and safety risks, although an insurance company will be less so than a construction risk. Not all will be exposed to Trading Standards or Vehicle Certification Agency risks, where 7 figure losses are in evidence, so the regulator universe specific to an organisation is very important in the consideration of a limit choice. Of perhaps the greatest concern is the Serious Fraud Office (“SFO”), and this is potentially the most catastrophic regulatory risk in the UK. A recent AIRMIC/AIG report on D&O put the potential costs at £4,000,000 per director, maybe even higher, as individuals will seek to retain the best lawyers possible. Activity from the SFO in the UK and other prosecutors around the world has increased over the last decade and there is now more international co-operation than ever before. The focus of these investigations includes accountancy fraud, bribery (and other forms of corruption), environmental violations, and health and safety breaches so an assessment of an organisations exposure in this context is important and examination of previous SFO cases (Our cases – Serious Fraud Office (sfo.gov.uk)) can provide useful guidance on potential exposure to risk.
Territory: location of activity is a key consideration in any assessment of limits and the extent of any exposure to the United States (“US”) drives the risk profile more than any other territory. If an organisation has a publicly traded programme in the US, even if it has minimal physical risk there, it is opened up to a higher likelihood of a claim and exponentially higher costs than a domestic event. US securities class actions remain one of the biggest threats to directors and is a critical factor in the consideration of limits. Litigation in the US is typically expensive, time-consuming and requires knowledge and understanding of the US legal system. The chances of being hit by a US securities class action are now greater than at any time in the past, with 433 US federal securities class actions filed in 2019, the third consecutive year with more than 400 filings (NERA’s Securities Class Action Litigation Report). This was almost double the level observed in 2014 and far above historical annual filing levels. This might only affect a limited number of organisations in practice, but any overseas activity increases unpredictability. Loss handling costs are invariably higher in overseas territories and foreign language challenges can make that landscape more difficult to navigate in every context.
Emerging risk: one of the duties of a director is to scan the horizon for emerging risks. In the context of making policy limit provisions for this, much will depend on how likely these are to crystallise into current or immediate risks an organisation might face and when they could manifest themselves. Climate change and Economic and Social Governance (“ESG”) are good examples of this, although at this stage they are most likely to be more of an issue for listed firms and larger organisations. The environment, health and safety, human rights and community impact are gaining management attention and as pressure for ESG disclosure mounts, organisations will have to consider their risks and, in some cases, rethink their strategies. Pressure will be applied to treat sustainability as more than a tick-box exercise and to undertake a cultural review of how an organisation creates value. Risks may emerge if investors begin to seek compensation for the failure of an organisation to adapt to climate change or to adequately disclose environmental risks. Shareholders have recently warned they will vote against the election of directors at companies where their commitments on climate change, biodiversity and human rights fall short of their expectations.
Recent focus has been on the potential introduction of fines for UK directors for accounting failures as part of an overhaul of the audit sector in an attempt to improve standards. Directors would be held personally responsible for financial reporting if they were found to have fallen short in their duties. This did provoke a hostile response and has since been diluted but the messaging is clear for the future around expected improvement in behaviours and willingness to hold directors to account.
Prior Losses and basis of cover: prior losses are a very useful indicator on limit appropriateness but also the most difficult to get to due to market confidentiality on the performance of D&O liability. It is possible to use the likes of Carillion, Tesco and Patisserie Valerie, all of which are likely to have been significant 7 figure losses, and to use some of their characteristics as a guide but it may not get any more scientific than that. Buyer/advisor attitude to risk will feature in the narrative and is an area where there is likely to be very little consistency. Decisions may be also be influenced by the availability of any one claim (“AOC”) cover (although the benefits of this may have been exaggerated). Aggregate limits were fine for as long as D&O liability had been around and the shift in the market from aggregate to AOC in the 2010’s went almost unnoticed in the untrammelled progress of the soft market, due in part to that lack of loss frequency. Yet the switch back to aggregate from AOC can present an awkward conversation and challenging psychological sequencing for directors. Is a limit set for one large loss with an amount to cover another just in case? Does the limit need to go up because it is now in the aggregate? Despite that lack of frequency no one can ever ignore the possibility of exceptional events or risks. The fact that something has not happened before does not mean it cannot, but that might not necessarily be the best way to select a limit for buyers of D&O liability.
Number of Directors and Offices: it might sound rather obvious, but the number of directors and officers is a feature in selecting a limit. A standard policy will cover past, present and future directors and officers, but if there is only 1 director then there is only 1 director than can access the policy limits. Having ‘enough to go round’ is one quite straightforward factor in that assessment of limit requirement.
As we said at the start, the rather unhelpful conclusion is that there is no answer to the question, at least not in any scientific or empirical sense, and any attempt at precision is incredibly difficult. At the same time, there are some indicators to use that illuminate the path to an informed decision. One option might be to ask experienced D&O liability underwriters how many total policy limit losses they have seen, on what kind of risk, with what kind of characteristics. Even then, there will be no correct answer, for that very simple reason that there isn’t one, but it might help to navigate an area where there has never been a particularly elegant response.