Differences in D&O Coverage

A new survey of TSX-listed companies indicates that Canadian public companies are increasing their use of enterprise risk management (ERM). The study shows directors are themselves acutely aware of the increasing risks they face and are taking steps to manage those risks. At the same time, according to the survey results, directors appear to have some serious misconceptions about what protection they have from D&O insurance.

The study presents opportunities for brokers, advisors and underwriters to offer added-value services such as detailed technical analysis of policies and added coverages. Adjusters should also anticipate some backlash as Canadian insureds query why they are treated differently than U.S. insureds.

The survey is the first of its kind in Canada in 10 years to survey D&O insurance coverage of Canadian public companies. The CIBC Centre for Corporate Governance and Risk Management at Simon Fraser University’s Segal Graduate School of Business conducted the survey. It was sent to all TSX-listed companies. About 70% of the respondents included board chairs, chief executive officers or both.

RECOGNIZING RISK

The survey was commissioned by Bishop Phillips Canada, a risk-management consulting firm, and looked at the nature of risks directors face and their attitudes and practices towards those risks. It found that directors see their current risk of potential claims as high, with future risk even higher. The majority of respondents are taking measures to manage these risks and to meet the increasing demands of shareholders and regulatory authorities for improved corporate governance standards.

As Jay Cassidy of Marsh Canada Ltd. points out: “Publicly-traded companies and their directors and officers must take measures to control their liability. Such measures should include implementing appropriate corporate governance practices and ensuring adherence to these practices. As well, adequacy of the corporate indemnity provisions and directors and officers insurance (both amount of limit and form or coverage) are crucial to ensure that maximum financial protection for both individual assets and the company’s balance sheet exist.”

Eighty-eight percent of respondents report having established checks and balances over the past five years within their companies through audit or risk management committees. Eighty-seven percent have taken steps to strengthen the role of independent non-executive directors. Eighty-four percent have improved transparency in reporting through such practices as timely and comprehensive information disclosures, interim reports, and Internet-based disclosures.

Oversight by outside independent professionals, such as auditors and investment banks, has increased to 66%. And 46% of responding companies are now providing training on corporate governance issues, with 27% joining associations or organizations working towards enhancing corporate governance standards.

Respondents say they expect changes in Canada’s business climate will result in increased litigation and mounting legal costs. The majority of potential claims are anticipated to arise as a result of inadequate or inaccurate disclosure. In addition to these financial and regulatory risks, ethical risks such as interested party transactions, conflicts of interest and insider trading, strategic risks from overseas operations, human resources policies and mergers were also identified.

The greatest perceived source of claims, respondents say, will be from shareholders and large institutional investors; this runs counter to the situation in other countries, where the risk from institutional investors is quite low. The survey also showed directors downplayed the risk of claims from employers, whereas court statistics show that almost 25% of D&O claims come from employees.

THE TRUTH ABOUT RISK

A common misconception is that all D&O insurance policies are alike. Sixty-three percent of survey respondents said ‘Yes’ when asked: “Do you think that most D&O policies sold in Canada offer generally similar terms and use substantially similar language?”

The truth is, there is huge disparity in exclusions, extra cover and definitions. Most underwriters’ policies have widely differing policy clause and language. D&O policies are complicated. As one respondent pointed out: “The D&O policies are almost incomprehensible (and I am a corporate lawyer!). It is almost impossible to deal with issues such as priority of payments, allocation, insured versus insured exclusions, cancellation rights, non-renewal, extended reporting and a number of other exclusions.”

Catherine Richmond, senior vice president of Willis Canada, points out: “The D&O market has evolved tremendously and insurers have developed very different approaches to providing and excluding coverage. Directors need a detailed, technical analysis of their policy to ensure they are with an appropriate insurer, have the broadest coverage possible and no surprises if they ever do experience a claim.”

The survey also revealed that barely half of the respondents knew whether or not their coverage would still be valid if the company’s staff or other directors provided inaccurate information or omitted key information in the annual application for insurance. Only 28% of respondents said their company has financial reserves or money in trust to cover director’s legal fees or liability incurred before D&O policy deductible is exceeded. Given that two Canadian courts in 2006 prohibited companies from reimbursing directors’ legal expenses, directors ought to be reviewing added insurance or setting up trusts to hold an amount at least equivalent to the deductibles on their D&O policy.

A 2004 study of U.S. and Canadian companies indicated Canadian directors are twice as likely as U.S. directors to find the insurer dispute coverage of a claim (14 % in Canada compared with 7% in the U.S.) That number is on the rise. In this most recent study, although the actual number of claims was small, a staggering one-third of Canadian companies making D&O claims experienced a coverage dispute with the insurance company.

This presents a serious problem for companies trying to recruit directors. Do you tell a prospective director that if there is a claim, there’s a 33% chance the insurance company may not step up to cover it? As one respondent said: “Ten years ago we said: ‘If you conduct yourself in a prudent manner, you don’t need D&O insurance’. The outside environment has changed. You will not attract good directors without D&O.”

D&O COVERAGE: THE NEW NECESSITY

Elissa Sirovatka, principal of Tillinghast, a risk-management consulting firm owned by Towers Perrin, commented on the situation in the Jan. 26, 2006 online issue of Insurance Journal. “The inclusion of directors’ and officers’ personal assets in the Enron and Worldcom settlements accelerated the number of inquiries from boards,” Sirovatka said. “Board members now recognize their accountability and are questioning their own levels of coverage.”

As David Price and Jordan S. Solway of Arch Insurance Group (Canada) explain in the November 2005 issue of Canadian Underwriter: “Conventional D&O insurance appears to offer a reasonable degree of protection to the independent director. But the precise type of D&O insurance is of crucial importance in assessing the effectiveness of the overall risk management regime.”

The Simon Fraser study reveals the importance of keeping directors fully informed of their D&O coverage and how crucial D&O insurance is for retaining experienced directors. Respondents also strongly agree that D&O insurance is essential for good corporate governance. (See graph)

According to the survey, 25% of independent directors engaged an insurance consultant to review their policy coverage; close to 40% requested changes to their policies including special clauses, extra coverage, and changes in policy language. These figures are high compared to the United States. They represent a sign that Canadian directors are increasingly paying attention to their personal risks. Sixty-eight percent of the companies who responded to the survey engaged the services of an insurance consultant with special expertise in D&O insurance. Sixty-two percent of respondents have their corporate counsel review the annual application and policy, with 42% of respondents retaining external legal counsel.

Clearly boards are realizing the importance of reviewing all aspects of their D&O risk, and they are taking necessary steps to assess such issues as their corporate indemnity (a necessity whether or not there is D&O insurance), qualifications of their insurance broker or consultant, the reputation of their insurance company, and the terms of their existing policy.

Paul Reynolds is a former law professor and general counsel to three multinational corporations. He was formerly chief legal counsel to Reichmann International in Toronto. He serves as secretary to the Canadian Corporate Counsel Association in B.C. He can be reached at: reynoldsp@bishopphillips.com