Executive Risk/Directors’ and Officers’ Insurance

The directors’ and officers’ insurance policy (D&O) was originally designed to protect the directors and officers from allegations of mismanagement and bad decisions. Over the last twenty years, the policy has evolved to include a wide range of exposures, from fiduciary and entity coverage to employment practices liability insurance. It is really much more accurate to call these policies “executive risk insurance,” for they actually protect organizations and executives from a wide range of decision-based exposures.

There are no standard D&O insurance policies. Coverage provided varies widely by insurer. Each policy and proposal of coverage must be reviewed and analyzed carefully to determine the best offering based upon the needs of the financial institution.

Summary of Coverage

Bank directors and officers have a fiduciary responsibility to customers, shareholders, and the general public in all dealings. They must work to the interests of the stakeholders in their dealings. There are also regulatory issues.

A prime purpose of directors’ and officers’ insurance is to protect the personal assets of the directors, officers, and employees of a financial institution from losses arising from “wrongful acts.”

Each insurer’s policy has a unique definition of “wrongful act.” The term refers to any actual or alleged act, omission, error, misstatement, misleading statement, instance of neglect, or breach of duty by an “insured person” in the discharge of his or her duties with the financial institution.

“Insured persons” are (generally) any past, present, or future director, officer, employee, or honorary director or trustee of the financial institution.

Losses include any amount that the insured persons are legally obligated to pay, including judgments, settlements, defense costs, pre- and post-judgment interest, and punitive damages (where insurable by law). Fines and civil money penalties are almost never covered by insurance — without special endorsements.

Pure D&O policies do not provide protection for the “entity” – the bank itself. Many lawsuits name one or more “insured persons” as well as the bank. In such a case, without entity coverage in a D&O policy the judgments, settlements, and costs of defense will be allocated by the insurer between the financial institution and the individual insured persons. If the allocation determines that sixty percent of the action was attributable to an insured person, the D&O policy (without entity coverage) would pay only sixty percent of the judgment. The balance would not be covered.

Today’s broad executive risk policies include entity protection, making the D&O policy a broad “errors & omissions” type of contract with coverage for:

-securities-related suits.

-shareholder suits.

-lending-related suits brought by borrowers or guarantors.

-suits brought by depositors alleging negligence with regard to any kind of forgery, unauthorized withdrawal, or employee dishonesty.

-suits related to electronic banking activities.

-suits related to IRA or Keogh plan administration.

– suits alleging breach of fiduciary duty or employee benefit plan liability.

-suits alleging notary errors and omissions.

-suits alleging negligence regarding investment advice.

-suits related to data processing operations performed by the financial institution.

-suits brought by business partners.

-suits served against the bank by third parties wronged by business partners or scam artists, alleging that the bank is negligent simply by virtue of being the perpetrator’s depository.

-nuisance suits initiated by those who go after the “deep pockets” of the financial institution.

D&O policies also can include protection for “employment-related practices” such as discrimination, wrongful discharge, sexual harassment, and the like.

Indemnification

The idea that D&O protects directors and officers is actually a bit off. In most claims, D&O reimburses the bank for the bank’s indemnification of the officers and directors.

Your bank’s bylaws include an indemnification agreement that requires the bank to reimburse directors for expenses incurred in their duties. In reality, it is the assets of your bank that protect your officers and directors. Your D&O insurance reimburses your bank.

No Standard Coverage

As there are no standard D&O policies, each policy and proposal must be evaluated on its own merits. No two policies use the same definitions or exclusions.

Claims-Made Policy

See claims-made policy issues.

Policy Limit

What amount of coverage is provided by the insurance policy? What is the total amount of protection offered for the total of all claims during the covered time frame (also known as an aggregate limit)? D&O policies are “claims-made contracts.” Coverage applies to any claim brought during the policy period. Multiple claims can, in effect, use up the limit of coverage.

Many factors must be considered when deciding what policy limits your institution should carry: price, terms of the policy, peer data, regulatory requirements, and capital levels. Almost every banker wants to know how much insurance they should buy. It’s an unanswerable question. However, I’ll try…

Each year I put out an update of my recommended minimum limits of insurance for banks. Go to www.UofBankInsurance.Com for the latest edition.

Aggregate Policy Limits, Separate Limits, or Both

Each policy has limits on the dollars that will be paid out. Coverage is changed dramatically by the structure of the limit. Does the policy have an aggregate maximum, a total limit of all claims? Do claims in one section deplete limits of coverage available in other coverage sections?

Examples:

Suppose you have an a policy with an aggregate limit of three million dollars, a D&O limit of three million dollars, an entity limit of two million dollars, and an employment practices limit of one million dollars. Here, employment practices claims reduce the coverage available for claims against the directors and officers.

Then consider a policy with no aggregate limit, a D&O limit of three million dollars, an entity limit of two million dollars, and an employment practices limit of one million dollars. In this example, claims in one part of the coverage do not impact the coverage available.

Entity Coverage Included in Policy Limit

While entity coverage is an important protection, improperly designed coverage can dilute the insurance available for true D&O claims. If claims in the entity section of coverage reduce the limits available, the bank could run out of insurance to protect directors.

Having entity claims outside the basic policy limit or as a separate limit protects the bank from using up the coverage. Alternately, the bank can purchase higher limits of coverage.

Side A, B, and C

Some D&O policies break up the coverage into three traditional coverage sections: A, B, and C.

Side A is coverage for individual directors and officers for claims where indemnification by the bank is not allowed by law or because the entity has no assets. Derivative suits are also covered here — suits by the bank against the directors.

Side B pays for incidents where individual directors and officers are sued when indemnification of the individuals is allowed. These are by far the most common claims.

Side C is coverage for the company (a.k.a. the bank). Some policies use the term “entity” to describe who is insured by this section.

Excess or Dedicated Side A Coverage

As has been said, directors’ and officers’ insurance covers a great deal of territory. All the bells and whistles, however, can draw coverage away from the primary purpose of the policy — protection of the directors and the officers. The addition of separate, inviolate coverage just for claims that cannot be indemnified (so-called side A) can be a last ditch “stronghold” of coverage for D&Os.

Think of this as the “panic room” of bank insurance protection. A director is in legal trouble. For whatever reason, the bank cannot indemnify him or her. Dedicated side A protection is there, untouched by other bank claims.

The above scenario is the bleakest. When things are that bad, I’m not sure any amount of insurance is enough. Many banks are unwilling to offer such coverage, as it takes premium from other, perhaps more pressing, insurance needs.

Positions Covered by D&O

All policies define the term “insured persons.” The contract may indicate directors, officers, employees, or some other variation. Most contracts extend coverage to “past, present, and future” directors, officers, and employees.

Defense Within Limit

It is common for D&O policies to include the cost of defending a claim (attorneys’ fees, etc.) within the policy limit of liability. That means that the amount of coverage purchased must be enough to cover the awards and defense costs of all claims. This can also be an issue to consider relative to aggregate limits.

When you buy one million dollars of auto insurance, you get defense costs plus the one million. In D&O (most often), a five hundred fifty thousand dollar lawyer bill depletes the coverage available to pay the court-ordered award.

Duty to Defend

When there is a claim, who is responsible for the defense of the claim, the insurer or the insured? Who determines which attorney is used? Most common is a duty to defend by the insured, allowing the bank to choose defense counsel (usually with the approval of the insurer).

Common D&O Exclusions

The variety of D&O policies means that the unique exclusions number in the hundreds. Here are the most common:

  • undue personal gain or profit
  • intentional wrongful acts
  • fraudulent, dishonest, or criminal acts
  • bodily injury, property damage, or personal injury
  • invasion of privacy
  • ERISA claims
  • employment practices liability
  • lender liability
  • trust activities
  • nuclear reactions and contamination
  • terrorism
  • construction defect claims
  • pollution
  • acts while working as an officer or director of an outside entity
  • failure to buy adequate insurance
  • claims made by one insured against another insured

Some of the above exclusions exist because other policies provide better protection (as in the exclusion of bodily injury, where coverage is provided under a general liability policy). Other exclusions exist so that only insurance buyers with that exposure will buy the additional coverage. Why include trust liability coverage for all banks when only some have trust exposures?

Insured vs. Insured Exclusion

This exclusion prevents coverage when one director sues another director. If this exclusion is present, coverage should exist for past directors sued by current directors. There should also be coverage for actions brought against the board by bankruptcy trustees, as well as coverage for actions brought against the board by a “whistleblower.”

Regulatory Exclusion

Regulators may sue directors of troubled banks. A regulatory exclusion removes coverage for such actions. Accepting a D&O policy with a regulatory exclusion should be a desperate move, accepted only when there are no other options available in the marketplace. Ask your insurance advisor if there is a regulatory exclusion in your policy.

Hammer Clause

This appropriately named policy provision limits the insurer’s liability should the insured refuse to accept a settlement offer from the plaintiff. In many cases, the insurance policy limits the insurer’s obligation to the amount of the settlement offered. Some also restrict defense costs when the insured wishes to continue the fight.

Marital Estates Extension

The marital estates extension is now common in most D&O policies. It provides protection for the spouse of an “insured person” when a suit is brought against community property or property held jointly. Coverage only applies when the actions of the “insured person” cause the claim. For example, an officer is sued over issues surrounding a loan application. The officer’s spouse is also brought into the suit, as he or she owns the family home. The marital estates extension provides the spouse with coverage.

Non-Cancellation Endorsement

Who can cancel your policy? Can the insurance company decide it no longer wants to provide coverage? Too often, I see policies with terms that allow the insurer to bail out with sixty days’ notice. Look for your insurer to provide coverage through the full policy term. Get the cancellation clause adjusted to prevent midterm cancellation—other than for nonpayment of premium.

Note: Most policies do not guarantee premiums. An insurer may not be able to cancel your policy, but it may be able to triple your premiums!

Multiyear Policies

Unlike most business insurance contracts, many D&O policies are issued with two- or three-year terms. Depending on competition or the current condition of the insurance market, insurers may offer discounts for prepaying premiums for multiyear policies.

While the policy may be issued for three years, insurers often have policy provisions that allow for premiums to be adjusted if circumstances at the bank deteriorate or if there have been claims.

Multiyear policy coverage limits are stated for a single year. Aggregate limits are annually reinstated. A $1 million claim in year one does not reduce the coverage available in year three.

Nonprofit Service

It is quite common for community bank officers to serve on boards of directors for nonprofit organizations. Nonprofit service coverage provides protection for actions by an “insured person” arising out of his or her work as a board member for a nonprofit when it is considered part of his or her bank duties to perform such a public service. Coverage is usually in excess over any insurance or assets the nonprofit has.

Frankly, this coverage is nothing to crow about. For coverage to apply, the nonprofit has to exhaust its assets and insurance. Having coverage on the bank’s D&O is certainly better than nothing. However, the insurers are not giving away much here.

Civil Money Penalties

Look at the definition of “loss” in your D&O policy. You will find that fines and penalties are not included in the coverage. The FDIC does not care. Neither do your state regulators.

Civil money penalties (CMP) insurance is a part of many D&O policies. It provides coverage for penalties assessed by regulatory agencies against directors and officers. The bank itself is not eligible for coverage.

Some insurers require that the individual directors who want CMP pay for the coverage with a personal check. Others allow the bank to pay the premiums as long as the bank certifies that the directors have paid the bank for the protection.

Premiums for CMP for community banks are almost always under one hundred dollars per director per year for one hundred thousand dollars of coverage.

There is currently a fair amount of discussion about this issue. Supposedly, the FDIC is concerned that buying civil money damages coverage could cause problems.

Here is what an underwriter recently told me: “We are getting lots of questions on this from our community bank agents on how to advise their clients on whether or not to purchase this coverage. (Our) position is that this has been the long-standing position of the industry to make D&O civil money penalties coverage available to our clients. We believe that there continues to be a reasonable basis under the law to support the permissibility of this coverage. We want to remind our clients that (we are) not in a position to provide insureds with legal advice. The client will have to make a determination for themselves, in consultation with their own legal counsel on whether to purchase or retain this coverage[sic].”

Good advice. Talk with your bank’s attorney.

I counsel against buying CMP coverage. I think it goes contrary to the expressed desires of the regulators. We may not like it. However, regulators have made no secret of their interpretation of the regulations on this issue.

Employment-Related Practices Coverage

Employment practices liability coverage can be a part of the D&O insurance or a separate policy. The protection provided includes such issues as wrongful discharge, harassment, discrimination, etc. Check the policy’s definition of “wrongful employment act.” Does it include only certain acts, such as sexual harassment? Or is the coverage broad, including workplace harassment, for example? Are discrimination suits brought by third parties covered? Remember that including employment practices claims in your organization’s D&O policy could affect the limit of liability available for other claims. Negotiate your coverage so that claims paid for employment practices suits are outside the limits of coverage for your entity and directors’ and officers’.

See the separate discussion on employment practices liability policies.

Bankers’ Professional Liability Insurance

Some insurers use a separate coverage section of the D&O policy called Bankers’ Professional Liability (BPL). Coverage is provided for a broad range of financial services, including:

-depository services

-insurance services

-notary services

-investment and brokerage services

-certain real estate services

-general banking services

-electronic data processing services

-escrow services

-estate planning

-loan servicing

-serving of lock boxes

-tax planning

-administration of credit cards

Lender’s liability claims are often included in a separate coverage section. Some insurers will exclude insurance sales and brokerage operations in their basic policies. Coverage can be added back by endorsement.

Trust operations are also commonly excluded. Banks that need protection for such operations can have coverage added for an additional premium. See the separate section on trust errors and omissions insurance.

Be aware of policies that provide only coverage for professional liability suits brought by customers. Many causes of legal action can come from third parties — spouses, beneficiaries, the vendors, customers, or contractors of your customer. Regulators may bring suit, as may other financial institutions that participate in loan packages with your bank.

Some policies require that the relationship between the bank and the party bringing suit be based on a fee relationship. Review the policy to be certain that insurers use a broad definition of professional services to include any transaction where the bank receives some tangible benefit, rather than a narrow requirement that there be a direct monetary relationship.

Here are exclusions that are common to bankers’ professional liability insurance:

  • pollution liability
  • construction defect claims
  • investment banking activities
  • fee and commission disputes
  • bodily injury and property damage
  • personal injury

Fiduciary Liability

Several years ago, I was meeting with the president of a small bank and the head of the human resources department. I’d been hired a few weeks earlier to perform a due diligence review of the bank’s insurance, and we were going through a list of concerns I had identified in my analysis.

“Your ERISA exposure is not covered,” I said. The HR VP laughed. A few minutes later, she was not laughing.

The Employee Retirement and Income Security Act (ERISA) is the federal law passed in 1974 that governs employee benefit plans. Most people know it for its impact on pension plans. It also makes administrators of employee benefit plans personally liable for errors and mistakes. The act covers pension plans, group health insurance, disability coverage, dental, and any other employee benefit program an employer offers — what ERISA calls “welfare plans.”

It was the “personally liable” part that got the HR manager’s attention. “Explain what you mean by personally liable,” she said.

The issue is pretty straightforward. If you administer a health insurance or pension plan, you are liable for any mistakes you make— you, not your company, is liable. If you forget to add an employee to the health insurance, it’s your house and bank account that is tapped to pay a claim. If the premium doesn’t get sent and the policy is cancelled, it’s your assets on the line. Fail to make decisions in a prudent manner about the 401(k) plan, and guess what happens to your savings account.

The HR manager had even more to be upset about when I mentioned the next kicker. In addition to personal liability, ERISA specifically forbids indemnification by the administrator’s employer. If you make a mistake, your company cannot bail you out. Insurance is the only third-party solution to the personal liability provision.

The Fiduciary section to the D&O policy (or a separate policy) is the solution to the ERISA problem. The coverage provides protection for “wrongful acts” that result in a claim against the administrator of benefit plans. Premiums range from a few hundred dollars to thousands of dollars, depending on the size of the employer.

We are not talking about errors to customer accounts here. Fiduciary liability provides coverage for errors in administering your bank’s employee benefit plan.

By the way, many people confuse ERISA fiduciary liability with the ERISA bond requirement. The law mandates that employee pension and retirement plans have a bond of 10 percent of the assets (up to five thousand dollars) to cover loss of the funds through embezzlement. Some fiduciary policies include the fidelity coverage. Most do not. For most banks, your financial institution bond provides an extension of coverage for the ERISA bond requirement.

Some businesses and insurance agents confuse employee benefit liability insurance with the FRIP. Bad call! The FRIP covers errors and omissions in the administration of benefit plans. The employee benefit liability policy covers mistakes but excludes ERISA liabilities. The wrong claim against an employer with employee benefit liability could result in a “for sale” sign going up in front of the HR manager’s house.

IRA/Keogh/Welfare and Retirement Plan Liability

This coverage section provides coverage for the bank against liability caused by errors or omissions while acting as administrator or trustee of IRA or HR 10/Keogh plans for others.

Here are some of the issues that come from such plans:

-errors in overall administration

-failure to add employees

-removing employees improperly

-imprudent advice

-failure to follow laws and regulations

Lender Liability

Lender liability insurance protects the financial institution against lawsuits alleging improper procedures, extension of credit, refusal to lend, or improper servicing of loans. The exposure is often excluded in the professional liability section of the D&O policy and then added back at an additional premium. Limits of coverage and deductibles may be separately applied as well.

Every directors’ and officers’ liability policy is unique. Read your policy! 

Securities Liability

Securities liability provides protection for the entity against lawsuits resulting from the purchase, sale, or offer to purchase or sell any securities issued by the insured (sale of the bank’s own stock).

While not a lot of explanation is needed to describe this coverage, stockholder actions against board members are the most frequent area of D&O claims for publicly traded banks.

Trust Errors & Omissions

Trust E&O coverage protects the bank from liability arising out of wrongful acts in the administration of trust accounts. The coverage may be an endorsement to the D&O policy or a separate, stand-alone policy. In any event, make sure that coverage for this protection does not erode the aggregate limit of coverage on the D&O. If you offer trust services, your trust E&O coverage should be a separate limit of coverage.

Electronic Banking Liability

Some insurers provide this coverage in the D&O policy. Some make it a separate policy. See the chapter dedicated to this important protection.

 

 

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