How Much Side A Insurance Should You Buy to Protect Your Directors and Officers?

Last week, I highlighted a D&O insurance policy that provides relief in situations where a corporation can’t indemnify its directors or officers: the standalone Side A policy.

Once a corporation has decided that standalone Side A is a good idea, the next question is usually: How much in limits does it makes sense to purchase?

This is a complex question, and the answer will be specific to a particular company’s risk environment, balance sheet and risk management philosophy.

Let’s discuss some items to consider when deciding how much standalone Side A to buy.

Four Considerations When Buying Standalone Side A

1. The “A” in a Combination ABC Policy May Be Fairly Adequate.
   First, a reminder: When you buy a combination ABC policy as part of your D&O insurance program, it includes Side A. In last week’s post, I discussed why having a standalone Side A in addition to the combination policy provides broader coverage for directors and officers. Odd as this may sound, when considering the question of how much Side A coverage to purchase, many companies and their Ds and Os forget that the Side A portion of an ABC policy can respond in Side A-scenarios. A better approach may be to remember that the Side A portion of an ABC policy is part of the overall Side A limit of insurance that individuals have to protect them. In my experience, recalling this fact generally leads to a throttling back of the total standalone Side A that a company might otherwise purchase.
2. How Much Balance Sheet Protection Do You Need?
   When relying on the Side A portion of an ABC policy, however, it’s important to consider how much balance sheet protection the corporation wants. If individual Ds and Os use some of the ABC policy limit on a Side A matter, there is that much less available for the balance sheet protection provided by Sides B and C of the policy. In considering the question of balance sheet protection, first consider how much cash your company has and how much of that is surplus beyond working capital and other “normal” business needs. Next, consider how likely it is that a company will face bankruptcy, especially if it is faced with unexpected expenses like difficult litigation. Litigation can be surprisingly costly, and you have to pay your lawyers as events unfold. This makes cash flow a key consideration. Companies with less free cash may be more interested in purchasing more standalone Side A. Once companies hit about the $1 billion in free cash mark, we tend to see them dropping Side B and Side C from their D&O insurance program altogether. Side A limits, however, tend to remain robust out of concern for the D&O exposures where insurance cannot respond. More on this when we discuss derivative suits later in this article.

3. Understanding Insurance Layers, Limits and Standalone Side A Insurance
   Large insurance programs are built in layers with different insurance carriers. It’s a bad day if one of the carriers goes bankrupt while you have a claim. It’s a much worse day if a carrier goes bankrupt while you have claim that is not indemnifiable by the corporation. Of course, the best-case scenario is not to partner with an insurer who may become insolvent. Good brokers are careful to recommend stable, highly solvent carriers to their clients. If a carrier goes bankrupt while you have a non-indemnifiable claim, however, the limits you purchase for your standalone Side A can protect you. Ideally, you’ll purchase a limit of standalone Side A insurance that is at least as large as the largest underlying layer of insurance that you have on the D&O insurance program. This is important because a well-designed standalone Side A policy will drop down and step into the shoes of a carrier that becomes insolvent if that insolvency happens while you, the insured, have a Side A exposure. For example, if you’re a company that buys insurance in layers of $5 million, then the minimum Side A insurance purchase in order to take full advantage of the drop-down feature is $5 million. If your largest layer of insurance is $10 million, then you’ll want to match the standalone Side A to the $10 million layer.In each case, try to make sure that if you have to replace an insolvent insurer, you have enough in that drop-down limit to avoid any gaps in coverage.From time to time, we see the standalone Side A policy with a carrier that is also part of the underlying ABC insurance program; this is not helpful if that’s the carrier that goes bankrupt, but many corporations use this type of structure in order to gain better pricing in the overall program. This is a perfectly fine strategy so long as the Ds and Os understand the tradeoffs involved.

   (Quick side note: If that insurer becomes insolvent while you have an indemnifiable claim, the standalone Side A policy will not drop down to respond. This is obviously disappointing for a company from a balance sheet protection perspective, but at least the company is able to indemnify the Ds or Os who are named in the claim.)

4. Coverage for Derivative Lawsuits
   Side A insurance responds to non-indemnifiable claims. Outside of bankruptcy, the primary non-indemnifiable exposure faced by a director or officer in the United States is the settlement of a breach of fiduciary duty suit brought derivatively. The vast majority of these suits are quite small, so you’re often looking at less than $5 million in settlement value. In other words, $5 million in Side A insurance—be it within a larger ABC program or on a standalone basis—is a good amount of Side A insurance to purchase in most cases. However, there have been some derivative suits that have settled for much bigger numbers—hundreds of millions of dollars. For example, take Activision Blizzard (2014) for $275 million, News Corp. (2013) for $139 million and Freeport-McMoRan (2015) for $137.5 million. These examples are relevant, but it’s also important to remember that these are not representative of the majority of claims. In my experience, these are outliers that usually involve M&A or self-dealings. Buying an enormous standalone Side A limit is one way to address this risk. Another reasonable tactic to take is to implement strong corporate governance protocols to lower the risk of these bad events taking place.

Standalone Side A Is a Best Practice

For the vast majority of mid-market public companies, purchasing $5 or $10 million in standalone Side A insurance has become a best practice.

Standalone Side A has also become more popular over time; it’s increasingly unusual to see a public company decline to purchase any standalone Side A insurance. Larger, more sophisticated private companies have been purchasing this type of insurance for a long time.

However, before you layer standalone Side A insurance on top of your D&O program, it’s worth working with your outside counsel to understand the likely scenarios that would have to arise for that additional insurance to respond.

This sort of exercise will help you to ensure that you’re getting the best value for your insurance premium dollars.