Directors and Officers Liability Insurance Explained - business.com (2024)

When someone serves on a business’s board of directors or is a company officer, they represent that organization. If their actions are perceived to have an adverse effect on the company, they’re vulnerable to lawsuits for those alleged wrongful acts. Directors and officers (D&O) insurance covers fiduciary claims against those who serve as directors or officers of a company, protecting their personal assets.

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What is D&O insurance?

Directors and officers liability insurance, often shortened to D&O insurance, is atype of business insurancethat pays the costs of lawsuits or claims arising from allegations that a director or officer breached their fiduciary responsibility while serving the company.

Without a D&O insurance policy, directors and officers could be held personally liable for losses. The insurance policy can either pay legal fees directly or pay for the company’s defense of its directors and officers.

D&O insurance coverage is available for directors and officers of private companies. Nonprofit organization directors and officers also often take out D&O insurance to protect themselves against such claims.

D&O insurance gives those who serve on the board of directors the confidence to devote their time and energy to the business or organization, without the fear of being held personally liable for damages. If they’re accused of misuse of funds or other fiduciary violations, the D&O policy kicks in to cover their defense costs.

FYI

Organizations should also consider fiduciary liability insurance if they offer employee benefits plans. Fiduciary liability insurance protects directors, officers and plan administrators if honest, innocent and negligent mistakes lead to financial losses for the plan.

Why do you need D&O insurance?

All businesses, regardless of their size, are at risk for D&O claims. Obtaining D&O insurance is crucial for the following reasons:

  • D&O insurance protects personal assets. Without a D&O policy, directors and officers could be sued personally for decisions they made while running a company. A D&O policy pays for the costs associated with any potential lawsuits. It also protects your personal assets if the company declares bankruptcy and you’re subject to creditor claims.
  • D&O insurance protects you from the costs of spying and theft. Industrial espionage, corporate spying and theft are ongoing threats that drive cyberattacks and other corporate disturbances. These cases can incur massive legal costs, particularly when customer poaching or intellectual property theft occurs. D&O insurance protects you from these costs.
  • D&O insurance protects against corporate governance claims. Directors and officers have a fiduciary duty to make decisions that benefit the business’s shareholders. Disgruntled shareholders, especially activist investors, may seek legal action against board members if they believe specific decisions are not in their best interests. D&O insurance can cover these legal costs.
  • D&O insurance protects against employee grievances. While many employees’ grievances are handled via employment practices liability insurance claims, claims against a business’s directors and officers often aren’t. In such cases, D&O insurance protects directors’ and officers’ personal assets from being seized due to such lawsuits.
  • D&O insurance protects against compliance issues. To operate legally, companies must navigate many state and federal laws. These include regulations regarding reporting errors related to profit and taxation, the management of company funds, and workplace health and safety. Sometimes, regulators or law enforcement officials may try to hold company directors and officers accountable for systemic failures within a business. D&O insurance protects them in these situations.
  • D&O insurance can help you recruit board members. Without a D&O policy, it may be challenging to convince qualified individuals to become executives and board members at your company. They face much less risk with a D&O policy in place.
  • D&O insurance may be required by investors. Many venture capital firms require D&O coverage before they invest to protect them from insurance claims.

Did You Know?

D&O insurance differs from professional liability insurance. Professional liability insurance covers financial losses a business incurs when it's sued. In contrast, D&O insurance protects the personal assets of directors and officers.

Who needs D&O insurance?

These types of companies and organizations may benefit the most from a D&O policy:

  • Nonprofits: Many nonprofit organizations have volunteer directors on their boards; these individuals would be taking on liability for no real benefit if the organization didn’t have a D&O policy. Obtaining D&O insurance shows your desire to protect the people helping to build the organization.
  • Businesses with stakeholders: Many for-profit companies, including publicly traded ones, take out D&O policies to appease stakeholders and lessen their risk.
  • Organizations raising capital: Startups or companies that fundraise often fall under heavier scrutiny for the actions of their boards. Without D&O insurance in place, raising capital could be more difficult.
  • Smaller businesses with active boards: When family members run a small business, stakeholders tend to scrutinize board members’ actions less. Still, if a small business has an active board making critical business decisions about operations or financial strategies that could raise concerns among other stakeholders, it should consider a D&O policy.

Did You Know?

C-suite roles have evolved from traditional CEOs and chief operating officers to include chief technical officers and chief experience officers. These newer roles reflect the greater role of technology in business and a focus on end users.

What does D&O insurance cover?

While a D&O policy is designed to protect directors and officers from personal financial loss in a claim, policies have different aspects that cover various situations. Here’s an overview of the three primary D&O insurance coverage types:

Side A

This protects directors and officers in cases where the company cannot indemnify the participants, such as in bankruptcy proceedings.

Side B

This protects the company when it decides to indemnify the participants. For example, if the board is sued and the company defends the directors, the D&O policy will reimburse the company for any defense costs.

Side C

Sometimes called “corporate entity coverage,” this protects the company and its corporate assets from lawsuits over financial mismanagement. This coverage comes into play if stockholders sue the business instead of the board of directors directly.

A company and its board of directors are often named in a lawsuit. By naming all parties, including the company, those filing the lawsuit have the best chance of getting restitution from one or more of those named in the suit.

Duty to indemnify vs. duty to defend

The D&O policy will approach legal defense in one of two ways: It will reimburse defense costs or pay them directly. There’s a bit more to this concept:

  • Duty to indemnify: When a policy is designed with a duty to indemnify, the insured can choose their own counsel and know they’re getting the best representation possible. However, in these cases, the D&O policy will indemnify those costs based on what is deemed reasonable. Here’s where some frustration can occur: An insured’s idea of “reasonable” can be very different from the insurance company’s. In some cases, the insurance company may not pay all costs.
  • Duty to defend: When a policy is designed with the duty to defend, the insurance carrier directly pays the costs of legal counsel. In this case, the insured doesn’t choose their counsel. While this mitigates extra costs that might go unpaid and often expedites the settlement process, an insured may feel they’re not getting the absolute best defense.

What doesn’t D&O insurance cover?

As with any insurance policy, there are limits to what a D&O insurance policy covers. A D&O policy does not cover the following:

  • Internal conflicts: A D&O policy will not protect directors and officers who sue each other. If there is an internal conflict, this falls outside the scope of the policy.
  • Fraud: While a D&O policy may cover financial mismanagement, it will draw the line at fraudulent acts. If a final judgment against a director or officer finds them guilty of fraud, the insurance company will not pay the claim. In that case, the defendant would have to pay all legal costs.

What does the D&O policy pay?

The D&O insurance policy will pay for legal fees and any settlements or judgments obtained. It’s important to understand that the policy’s limits are an aggregate total, meaning the policy limit includes both legal fees and awards. Depending on how costly the litigation is, the D&O policy could quickly reduce claim limits.

For example, if the D&O policy had an aggregate limit of $1 million and there were $300,000 in legal fees, there would be only $700,000 left to pay settlements.

General liability insurance is another essential business insurance policy. This insurance protects your business if a third party is injured on your premises.

How much does D&O insurance cost?

Many factors affect the price of a D&O insurance policy, including the insurance carrier’s risk assessment. When determining the cost of a policy, the insurance carrier considers these factors:

  • Legal and claims history
  • Company assets
  • Company debts
  • Revenue
  • Industry

Obviously, the bigger your organization, the more risk you have and the more your policy will cost. Insurance carriers prefer financially stable companies with a low incidence of lawsuits and claims. Premiums are the lowest for these businesses.

As a rule of thumb, you’ll pay approximately $5,000 per year in premiums for every $1 million in coverage. Small businesses pay, on average, around $140 a month.

The more coverage you need, the costlier the policy gets. If you already have important business insurance policies, such asemployment practices liability insuranceorprofessional liability insurance, check with your insurance provider about adding a D&O policy.

Mark Fairlie contributed to this article.

Directors and Officers Liability Insurance Explained - business.com (2024)

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