Following our recent proposal for some possible solutions to the D&O dilemma, we have engaged with clients, insurers and the insurance broking community to test the waters. What follows is a summary of the feedback received, issues discussed and some ways the insurance market could respond to the dilemma and our proposed solutions.
Is there a D&O insurance dilemma or not? It depends on your definition of a dilemma…
Our initial assumption was that there has been a market failure. That assumption was challenged by some insurers on the basis that the D&O cover that the market is accustomed to purchasing each year is still available in the market, albeit at a much higher price and on less generous terms. Is it a market failure if the premiums for D&O cover become inordinately expensive? Or does market failure only occur once the product is entirely unavailable? In our view, in practical terms the failure occurs for policyholders when purchasing the insurance product becomes fundamentally unjustifiable, because of a combination of major price increase and significant coverage restriction.
Anyway, whether or not there is technical market failure is really not the point. However you classify the current state of affairs, there is a problem for policyholders. The general view among policyholders and brokers with whom we have spoken is that this has gone way beyond a normal D&O market cycle fluctuation.
Under such circumstances, a question arises whether Boards can justifiably commit their companies to pay for a D&O Policy which protects only them personally. At what point does the premium paid by the company, when weighed against the utility of the cover, mean that the transaction is no longer reasonable in the circumstances of the company concerned, within the meaning of the related party benefit exemption in sub-section 212(1)(c) of the Corporations Act? If it's not, then member approval is required to pay the premium and by the nature of the situation, it would be a difficult expense for management to sell to the shareholders. Nor could the directors themselves attempt to influence the vote, other than by making clear that they would consider their positions if the insurance cover was refused. We suspect that most Boards are already alive to this potential conflict and conundrum and it is this, in part, which is driving the curiosity in and willingness to explore alternatives to the traditional D&O insurance placement.
The insurance market gives its views on the current state of the D&O market in Australia
Some general observations were:
- There is a general willingness from policyholders to take a substantial retention or bring in a captive to infill cover. Since, however, the insurers' primary motivation is to rebuild the premium pool, they are not necessarily giving proper pricing consideration to that significant increase in retentions.
- Policyholders in some industries simply cannot get capacity at all for D&O insurance and so will necessarily have to look at alternatives to managing their risk.
- It is not likely that there will be any short- or mid-term relief for the D&O market through legislative change in Australia. The cause of action for breach of continuous disclosure obligations in Australia will remain the anomaly among the common law jurisdictions, with no requirement for proof of intention, recklessness or negligence
- Remember that it took a complete market collapse for the CLERP 9 reforms to be implemented. The sentiment is that nothing will change unless there is an immediate and existential threat.
In the absence of law reform, alternatives are necessarily being explored by policyholders.
A number of observations and insights received from the insurance broking community on the alternatives to private-sector D&O insurance are set out below.
Option #1: Dump "Side C" (Securities Entity) Coverage
Rumour is that Australia buys higher limits of side C than anywhere else in the world. There is a general sentiment that the capacity for Side C has reduced in Australia and so there is a real mismatch with demand and supply for Side C cover.
Side C is one aspect of the problems that are being experienced across the Australian D&O market. It is not, however, the only driver of the hard D&O market. The questions that must be asked of Australian companies are:
- Should the company continue to purchase securities entity cover?
- If it does, should that insurance be part of the D&O insurance program?
Those policyholders who have historically purchased Side C and continue to maintain that cover are understandably reluctant to dispense with it. In our view, regardless of whether or not a company prudently ought to buy insurance against its own exposure to Securities-related liability, Side C is inconsistent with the intended purpose of D&O cover and ought never have been tacked on to the product. But, a bit like trying to leave a long-term spouse whom you know to be fundamentally toxic, it is nonetheless difficult to abandon something that is embedded in your life.
Some policyholders who have dumped Side C are not getting the expected premium reduction. In other words, a Side A, B and C D&O program premium looks scarily similar to a Side A and B program. So why would you dump side C if you don't get the cost saving? And so the cycle continues.
We understand that many West Australian policyholders have not historically purchased Side C cover at all. Interestingly, there has not been the flurry of securities actions against many in the West either. Worth a thought. Those who do get rid of Side C are left with their Side A and B cover, which despite not attracting the same loss experience as the securities class actions under Side C, still face an increase in premium. Anecdotally this is thought to stem from, among other things, greater insolvency exposure and Australia's seemingly boundless appetite for regulatory investigations and inquiries.
One option raised that may be worth a moment for pause is a defence-costs only D&O program. How would the class action lawyers and litigation funders respond if they learned that a defendant's D&O program provided Side A and B cover solely in respect of the directors' and officers' defence costs? There would be no pot of gold at the end of that rainbow!
Those who choose to retain Side C cover (assuming they can), can expect an increase in the retention, with some insurers insisting on minimum, uninsured retentions in excess of $10 million. Some who maintain it have chosen to separate it from their D&O program and some are placing it through their captive insurers. While some underwriters have been offering standalone Securities Liability coverage for a while now, the take-up has been limited due to the continued prevalence of Side C in D&O programs. Given that the risk covered is essentially the same, there is no reason to expect this class of insurance to be priced any more favourably for the policyholder than is Side C.
The general consensus seems to be that if Side C is abandoned across the market, without a compensating purchase of Securities Liability cover for the companies, the class action focus will shift back to directors and officers in order to trigger a Side A or B claim. In an insolvency scenario with the company uninsured, claimants and litigation funders will look for ways to sheet home liability for continuous disclosure breaches or other corporate misconduct to the directors, in order to access the D&O policy limits. Therefore and as we predicted, a Side C dump appears to lead to an increase in both the Side B deductibles and insolvency exclusions, without any significant reduction in overall premiums.
Option #2: Ditch Side C & Side B as well
Despite the above factors conducing to a situation of limited price relief, there is certainly appetite for maintaining Side A only D&O programs with larger limits of cover.
As well as the historical claims experience and resultant need to replenish the premium pool, price pressure in this area primarily stems from concerns around insolvencies. There are some temporary protections in place during the COVID-19 period. A new section 588GAAA has been inserted in to the Corporations Act 2001 granting temporary relief for directors from potential personal liability for insolvent trading, absent dishonesty or fraud. This relief applies to debts incurred by a company "in the ordinary course of business" until 31 December 2020.
There is an expectation that once these measures are lifted there may be an onslaught of voluntary administrations, many of which will proceed to insolvency. This in turn will provoke attempts by investors to find grounds for claims against directors, along with any other relevantly insured protagonists, to try to recover debts or lost investments. With those factors in mind, as with Option #1, D&O underwriters are understandably circumspect, and no major reduction in premiums or more generous terms can be expected for standalone Side A cover either.
Option #3: A captive D&O insurer
The main advantages of using a captive are, as with the traditional insurance classes in which they have long featured, fostering internal risk management discipline, efficient management of retentions and direct access to reinsurance markets. In the case of Australian D&O, however, there is an additional complicating factor to consider: the Corporations Act's restrictions on indemnification of corporate officers by related or interposed entities.
While a captive insurer may lawfully underwrite Side B and Side C cover, the general view seems to be that without a substantial reinsurance component in the program it amounts to little more than right pocket paying left pocket. Reinsurance capacity is cheaper than direct insurance, if only by the frictional costs and the primary carrier's profit margin, but the reinsurance market too has been burned by the diabolical Side C claims experience and no dial-shifting savings can be anticipated. Alternatively – and particularly where reinsurers continue to insist upon large retentions, which we hear is becoming the norm in Australia – captive insurers may look to the capital markets to lay off a portion of the risk (see Option #5 below).
Anyway, the captive approach does nothing to address the problem of Side A cover that remains inordinately expensive and/or subject to onerous limitations. While the segregated account or protected cell form of captive is being actively explored by a number of clients and their brokers, for all the reasons we previously outlined, substantial (and costly) work needs to be done to provide a level of certainty and security when issuing Side A cover through a segregated cell; the core issues being separation of ownership and control, potential claw-back in an insolvency, enforcement by intended beneficiaries and the degree of funding / capitalisation required at the outset.
Option #4: A mutual
It was suggested that establishing an industry captive or mutual fund for D&O risks may be most appealing solution for SME policyholders in Australia. Even so, the response we got to the suggestion was underwhelming, maybe because the establishment and maintenance of an underwriting mutual fund in whatever form requires long-term commitment and a substantial up-front investment. It must be sustainable and competitive over time. The appetite for one may improve, however, should the D&O market continue to harden and a sufficient number of client organisations discover a common interest in keeping insurers honest.
One idea that arose in our conversations was a defence-costs only mutual. Another was the concept of personal D&O Liability insurance, purchased by directors and officers themselves from their own resources and responding only to the Side A category of risks (see Option #6 below). We think that these options warrant further consideration, especially by those SMEs and Not for Profit organisations which, although hardly exposed to the sorts of major corporate governance failures and class action liabilities which have poisoned the D&O claims experience well, nevertheless are facing the same consequences. The optimists out there questioned whether it was worth setting up a mutual if the risk factors may, in due course, fall away. Law reform in Australia may lead to a negligence requirement for liability for breach of continuous disclosure laws and the activity of litigation funders may recede in Australia if the recommendations made by the ALRC's Inquiry into Class Action Proceedings and Third-Party Litigation Funders Final Report are implemented.
That Inquiry recommended, among other things, that the Australian Government commission a review of the legal and economic impact of the operation, enforcement, and effects of continuous disclosure obligations and related provisions concerning misleading and deceptive conduct, contained in the Corporations Act 2001 (Cth) and the Australian Securities and Investments Commission Act 2001 (Cth). Unfortunately, one suspects that a further review of corporate law is not high on the Federal Government's agenda, given the current global pandemic and the focus that is demanding.
We hold the view that the mutual option is a viable one and should be explored further because:
- any significant legislative reform is unlikely in the short- to medium-term, if at all;
- there are no other identifiable factors which might feasibly cause a shift in the current state of the commercial insurance market;
- a functioning, well capitalised mutual offering a range of D&O products would help to raise competition, lift governance standards and provide a broader range of options for managing the personal liability risks of directors; and
- as with stockpiles of essential goods and facilities such as desalination plants, it’s hard to build them if you put it off until you desperately need them.
Option #5: Alternative Risk Transfer
Alternative Risk Transfer is a good option for those policyholders who:
- cannot find any capacity for their D&O program;
- have significantly higher retentions imposed upon them.
Those exploring this option and the brokers assisting them say that cost savings are not necessarily the driving consideration. It is more about choice and available recourse – exploring other alternatives to either accepting whatever terms increasingly obdurate insurers are willing to offer, or "running bare", to employ the US Professional Indemnity market's evocative phrase.
As we argued in our earlier paper, there appears to be no fundamental barrier to the use of ART instruments, specifically in the form of swap contracts, to provide a form of financial protection to directors and officers. It could serve a similar purpose to Side A insurance cover, and without any of the allocation disputes, reservations and equivocation that too often characterises the insurance industry's claim management of that product.
All that is required is the willingness to invest the time and professional resources required to analyse the issues in depth and develop a suitably robust but flexible set of contractual instruments, which will serve the purpose without infringing any relevant laws or regulations. Those organisations which are prepared to make that investment will find they have more viable choices available, not just to manage the D&O Liability risk but as other insurance markets harden also.
Option #6: Personal D&O protection
Politely declining all of Side A and B and C insurance, on the not unreasonable ground that in the directors' carefully considered opinion the costs outweigh the benefits to the organisation, is always an option. Some commentators may protest that it is a breach of the Board's duty of care and diligence not to cause the company to buy insurance against its own liabilities at any price. The duty, however, applies to the purchase of insurance no differently from the acquisition of any other asset, and it comes down in the end to the proper application of sound business judgment. The fact that the directors would be giving up their own company-supplied protection as well, and could only turn to the Deed of Indemnity and Access with the company for indemnity, would make it hard to impugn such a decision.
In the case of liabilities falling within the scope of section 199A of the Corporations Act, directors would be reliant upon their personal assets for legal defence and the payment of any compensatory damages. Fines and penalty orders are probably uninsurable in any case, as we have previously pointed out. Unpalatable as this may seem, if insurance makes you (and your company) a magnet for litigation, as does seem to be the case, then you must take that fact into consideration.
If you take insurance away, though, will the pool of suitably qualified persons willing to take on directorships inevitably shrink, as previously predicted? Moreover, how can even the most conscientious corporate officer be expected to weigh business risks in an objective, dispassionate manner when faced with the constant threat of personal liability, without the protection of insurance? With the continued proliferation of personal liability legislation, the inherent conflict of interest which it creates for governance professionals can only worsen and in the absence of effective mitigation, by insurance or by some other viable, risk – funding mechanism, eventually it will compromise their ability to discharge their responsibilities to their organisations.
The argument that without insurance, there is enhanced deterrence on corporate misconduct of the threat of prosecution or personal civil liability, is misconceived – D&O insurance never protects against wilful misconduct in any event. Its true value is to assuage the fear of the consequences of making the wrong call, or an honest mistake, and then having to spend hundreds of thousands of dollars on lawyers to prove that that was all it was and you did not, in fact, breach any law or duty. If that is taken away, the effect on corporations and the Australian economy, at every level, can only be chilling.
Suitably skilled and in-demand directors might, however, buy Side A insurance themselves and factor the cost of it in to the directors fees, which they negotiate as the price of their services – a sort of "have cover, will travel" route to the boardroom. Anecdotal evidence suggests that while some experienced Australian directors with several board positions have been able to procure such insurance offshore, it is not widely available in Australia. That may be from the difficulty of pricing it accurately, where the insured has multiple governance responsibilities across disparate industries.
One way to address this deficiency would be to set up a mutual underwriting pool for Side A type cover only – a sort of Protection & Indemnity Club for directors (as discussed in Option #4 above) offering personal, portable D&O insurance for public company directors, especially Non-Executive Directors. Conceptually it would be no different from the discretionary mutual indemnity funds which have traditionally provided malpractice cover to the medical profession, but would require an AFSL and prudential regulation by APRA.
Such a carrier would still need to price its cover by reference to industry or field of business, rather than individual experience and expertise, but it would only need to underwrite to break even, not make a profit. On that basis it ought to be able to offer Side A limits sufficient to cover an individual director's legal defence costs in any reasonably foreseeable scenario, at an individually affordable price.
That could be the way of the future.