If you were to ask what the expectations of a buyer of D&O (directors and officers) policy were, I suspect most would say that all costs which reasonably related to the insured persons should be covered. Yet that’s not the case. Why is that so and what can be done about it?
The allocation clause
An allocation clause will typically say that when the underlying claim includes (a) both covered and uncovered matters, or (b) both covered and uncovered parties, the insurer and the policyholder will use their best endeavors to agree on an allocation between loss covered under the policy and loss which is not covered, and that in the absence of agreement, the issue will have to be resolved by arbitration. On the face of it this sounds quite reasonable, but it’s when the clause is applied to defense and investigation costs that unwelcome expectation gaps occur.
Why the allocation clause matters
In the real world it’s often the case either that directors are named in proceedings together with the company (or with others), or that they find themselves sued in a variety of capacities (perhaps also as shareholders or as directors of other entities). In any of these situations the allocation clause may be engaged.
If you have purchased Side C cover, you will have in effect bought the application of the allocation clause to securities claims (i.e. claims brought by the company’s own shareholders). Under Side C cover, insurers will have promised to pay all the unallocated loss, including defense costs of both the directors and officers and of the company sued in the same claim. But one thing which is often missed is that Side C cover only gives you protection against claims, not investigations involving the company’s shares. The costs involved in a Securities and Exchange Commission or Financial Conduct Authority investigation are notoriously high and because they aren’t covered under Side C the allocation clause will also apply to them. In other words, the insurer will only pick up the “covered costs.”
What principles apply in determining the costs covered by insurers?
It’s helpful to think about the answer to this question as a Venn diagram divided as follows:
It’s really only at the intersection of the circles that problems arise. The question is, what principles apply in determining how much of the mixed costs are covered in any given case? That was the issue the House of Lords had to grapple with in the case of New Zealand Forest Products V New Zealand Insurance Company, in which US$8 million was spent defending both a director and a number of companies within the insured organization. The parties agreed that the costs related purely to the entities were not covered, and the costs related purely to the director were fully covered. Importantly, there was no allocation clause in this policy.
In the absence of an allocation clause, the House of Lords strove to ascertain the intention behind the cover. It said:
“Once it is accepted that the costs are not confined to those which relate solely and exclusively to the officer it is hard to find anything in the language which prevents the cover extending to all the costs which also relate to another defendant” (emphasis added).
In other words the Court concluded that all the mixed costs were covered, provided they related to the insured defendant. So in the absence of an allocation clause (and without other specific language to the contrary) the Court’s view was that all the mixed costs were covered. It went on to say that:
“The insurers are not left without any protection in all of this because by clause 6.1 they are not to be liable with respect to settlements or defence costs to which they have not consented.”
It’s worth noting that protection in the form of required consent is almost invariably available to insurers in D&O policies and it’s even sometimes made a condition precedent to insurers’ liability that such consent be obtained.
The application of the allocation clause to defense and investigation costs
Seen in the light of the New Zealand Forest Products case, it would not be an exaggeration to say that the insurers’ insistence that the allocation clause be extended to defense costs is born of the specific concern that mixed costs would otherwise be automatically covered. That concern may be well founded, but from the buyers’ point of view it can lead to very unwelcome outcomes. Taking for example the New Zealand Forest Product facts, a typical allocation clause covering costs would probably have meant that a large part of the US$8 million costs would not have been covered. That is not the result which the insured would have expected and yet it’s what happens to significant elements of D&O claims made today.
A possible solution
Interestingly, in the U.S. where similar allocation principles apply, some policies provide that insurers will pay up to 100% of the defense costs in a mixed claim. There’s no reason why such clauses could not be added into U.K. D&O policies nor is there any reason why allocation clauses could be expressed not to apply to defense and investigation costs. Indeed we have found that even in the more challenging market conditions we’re seeing now, some insurers are willing to accommodate this change. It’s simply a question of cost and choice.
Through your brokers you might wish to ask whether insurers are willing to offer what’s no more than a quite simple tweak to the allocation clause. After all, insurers still have the backstop protection of the requirement for their consent in relation to the costs being incurred in the first place. If insurers are willing to make this change, you will then need to decide whether you’re willing to pay any associated premium. As they say, you can’t get what you don’t ask for, but at least now you can make an informed choice.