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Buying D&O Tail Coverage
June 22, 2006
We generally recommend that our U.S. buy-out clients tell the companies in which they invest to buy Directors & Officers, Employment Practices Liability and Fiduciary Liability insurance, collectively referred to as Management Liability Insurance. This often is the only insurance available to protect their executives who serve on the boards of directors of investee companies. Additionally, management liability policies cover the cost of defense and damages that otherwise would be paid by the investee. This way, management liability insurance covers both the investor's and the investee's executives against claims of wrongful acts.
The largest number of wrongful acts claims are asserted by employees. Trailing behind, in no particular order of proportion or danger, are lenders, competitors, service providers and regulatory bodies.
What is tail coverage? Tail coverage is a means of extending the time the insured has to report claims under expired or terminated claims-made insurance policies. It's purchase is essential because wrongful acts often involve a chain of unfortunate events taking place over a period of months or years. Unlike occurrence form policies, claims-made policies only cover claims that are reported during the policy period. In other words, if the wrong occurred before the business is sold and it is not reported before closing, the insured has as little as 30 days to report claims after closing.
Fortunately, the purchase of tail coverage is a benefit to which the policyholder is entitled under the policy provisions discussed on the opposite page. Nonetheless, it is important that insurance brokers, attorneys and consultants analyze the details of management liablity insurance policies in force before advising sellers on the indemnification and insurance provisions of the transaction.
The PA Agreement
As soon as is permissible following signing of the letter of intent, the insurance expert should review the insurance and indemnification provisions of the purchase agreement "PA." It is not uncommon for the boiler plate of these agreements to call for the purchase of a six-year tail. Other agreements we have reviewed do not mention management liablity insurance at all. However, all agreements require the seller to indemnify the purchaser for specified liabilities, certain categories of which may be carved out or limited in amount and time barred.
Tip: Suggest changes to the PA if the seller is required to purchase insurance that is not "commercially available," which is the contemporary term for insurance for which there is no market or too costly.
Review the Current Policy(ies)
Management liability insurance policies, generally speaking, must be renewed each year. From time-to-time the insurance companies change the wording of their forms. Insurance companies frequently modify the coverage wording via endorsements. Some insurance companies, most notably Lloyds of London, do not always number the pages nor embed form and policy numbers in footers.
Tips: Most insurers will list all of the forms comprising the insurance policy. Tick and tie the forms you have to the Schedule of Forms. Be on the lookout for omissions of the even or odd pages of policies that are printed both sides. Count the policy endorsements and make sure the broker has given you all of them.
Dec Pages
The policy declarations pages may or may not disclose the insured's right to buy Extended Reporting Period insurance. For example, we recently reviewed a Federal Insurance Company form which said that the insured was eligible to buy one year of Extended Reporting Period insurance for a premium of 150% of the annual premium. So did a Zurich American Insurance Company D&O policy and a St. Paul Travelers form, but for different percentages of premium. On the other hand, the dec page of a National Union Fire Insurance Company of Pittsburgh policy did not declare this coverage right at all.
Tips: Don't count on the dec page to tell you if tail coverage is offered -- and on what terms. Look to the coverage form itself to find this grant. Next, ask the underwriter if he or she is willing to offer this extension of coverage with options that extend beyond one year.
Extended Reporting Period Section
All of the policies recently reviewed by us have a coverage section treating Extended Reporting; however, the section title and purpose will differ from one insurance company form to another. For example, the purpose of Federal's Extended Reporting Period section is to confirm the right to buy it within 60 days of termination of the policy and to say that the insured is not going to get any premium back for the unexpired term of the policy.
The Optional Extension Period section of a Canadian Lloyds policy imposes a 45-day time limit. A St. Paul Travelers policy imposes a 30-day limit.
Tip: Use whatever time you have to negotiate the length of and premium for the Extended Reporting Period. One disadvantage is that the insurance company knows that they are the only company that is required to offer the extension. On the other hand, if there have been no claims and a material portion of the unexpired premium will be left on the table, use these as negotiating points with the underwriter.
Changes In Exposure
We have had only one transaction in which the underwriter agreed to not terminate a D&O policy. Otherwise, all of the policies recently reviewed automatically terminated following a change in ownership. Other Changes In Exposure include the acquision of a business that increases the company's total assets by one-quarter or more.
The Federal policy calls this Changes in Exposure. The Lloyds Canadian policy mentioned previously doesn't even address the issue. St. Paul Travelers put it into the Change In Control paragraph of their insurance policy. Regardless what it is called or whether it is in the policy, D&O underwriters are going to terminate coverage after ownership changes.
Tip: Insurance advisors should tell their clients to plan on having to purchase Extended Reporting Period insurance and establish a reserve for its cost.
Should All Companies up for Sale Buy Tail Coverage?
Management Liability insurance policies contain other conditions and definitions relating to this question. First, the Reporting section of the policy condtions usually says that the insured must notify the insurance company of a claim "as soon as practicable." Second, policies usually define the word claim as a "written demand for monetary damages or non-monetary relief." Third, some policies, such as the National Union form, say that if the insured "becomes aware of any circumstances which may reasonably be expected to give rise to a Claim," that the date the insured becomes of aware of circumstances is the date the claim is known.
If your client is certain that they have no claims against them, and that they are aware of no circumstances that could give rise to claims, maybe they don't need to buy Extended Reporting Period insurance. If the premium to purchase the Extended Reporting Period is very costly, then maybe its purchase is a waste of money.
Conclusion: The purchase of management liability insurance is a best risk management practice. The purchase of Extended Reporting Period insurance is a optional business decision that requires thoughtful review. It will only cover wrongful acts that occurred before the change in control. Addtionally, it does not change the coverage in the terminated policy which may have undesirable limiting conditions and exclusions. For example, it is likely the investor will be unable to sue the officers and other directors of the sold company. Nor does a D&O policy cover the investment company against claims of wrongful acts and errors and omissions asserted by its private and institutional investors.
Analysis, Strategy and Advice = Solution
These tips for insurance professionals and risk managers are not intended to be used as a substitute for thoughtful review and analysis by a qualified professional. There are abundant resources available for practitioners. For example, Advisen,Ltd. has catalogued many management liability insurance policies and, through their RIMS BenchmarkingTM service, to which we subscribe, one can do side-by-side comparisions.
Please visit our Services menu to learn about our M&A Due Diligence Services. An M&A Checklist is available in our Free Tools menu.