Francis Kean, Executive Director, FINEX
Willis Towers Watson
It can be an unpleasant surprise to discover that not all costs reasonably related to an insured person’s legal representation are covered under most D&O policies. Francis Kean, Executive Director in Willis Towers Watson’s FINEX Group, explains why this is the case, and outlines what can be done about it.
The allocation clause:
An allocation clause will typically say that when an underlying claim includes both covered and uncovered matters, or includes both covered and uncovered parties, the insurer and the policyholder will use their best endeavours to agree on an allocation between loss covered under the policy and loss which is not covered. It will also usually stipulate 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 is particularly when the clause is applied to defence and investigation costs that unwelcome expectation gaps can arise.
The Hidden problem
It is often the case that company directors are named in proceedings together with the company (or with others) or in circumstances where they find themselves sued in a variety of capacities, for example, as shareholders or as directors of other entities. In all of these situations the allocation clause may be engaged.
If, as a purchaser of D&O insurance, you have opted for so called Side C or entity cover, you will have essentially bought out the application of the allocation clause to securities claims – that is, claims brought by the company’s own shareholders. Under Side C cover, the insurers promise to pay all of the unallocated loss, including defence costs of both the directors and officers and of the company sued in the same securities claim. However, what is often missed when it comes to Side C cover is that it only provides this protection against civil claims, and not in respect of the regulatory investigations which often precede them. The costs involved in an SEC or FCA investigation are notoriously high and, because they are not covered under Side C, the allocation clause will also apply to them thereby significantly restricting the scope of cover.
What principles apply in determining the costs covered by Insurers?
When it comes to assessing which principles apply to the determination of costs covered by insurers, there are three categories to keep in mind: uncovered costs, covered costs, and mixed costs (which includes both covered and uncovered costs). This can produce a complex situation, and issues commonly arise especially in the mixed costs category where both covered and uncovered costs collide.
In the case of New Zealand Forest Products V New Zealand Insurance Company http://www.bailii.org/uk/cases/UKPC/1997/37.html , some US$ 8 million had been spent in defending both a director and a number of companies within the insured organisation. The parties agreed that the costs which related purely to the entities were not covered and that the costs which related purely to the director were fully covered. What of the costs which related to both? Importantly, there was no allocation clause in this policy.
With the allocation clause absent, 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”
In other words the Court concluded that all the mixed costs were covered, provided that they also related to the insured defendant. So in the absence of an allocation clause (and without other specific language to the contrary) the Court decided that all the mixed costs were covered.
It is worth pointing out that the House of Lords also concluded that a layer of protection nevertheless existed for insurers in that D&O policies routinely included a clause (as did this one) relating to ‘required consent’, meaning insurers were not necessarily liable in respect of defence costs or settlements to which they have not explicitly consented.
The application of the allocation clause to defence and investigation costs
It might not be much of an exaggeration to say that the insurers’ insistence that the allocation clause be extended to all defence and investigation costs is born of the specific concern that mixed costs would otherwise be automatically covered. That concern may be well founded from their perspective but, from the buyers’ point of view, it can lead to unwelcome outcomes. Taking again, the New Zealand Forest Product facts, a typical allocation clause covering costs would very probably have meant that a large part of the US$8 million costs in play would not have been covered at all even if they reasonably related to the individual director’s defence. That is arguably not the outcome which the Insured would either have expected or welcomed and yet it can be what happens to significant elements of D&O claims.
Solving the puzzle
Interestingly, if we look across the Atlantic to the US where similar allocation principles apply, certain types of policy typically provide that insurers will pay up to 100% ( or perhaps a lower percentage) of the defence costs and investigation costs in a mixed claim. There is no reason why such pre-determined allocation clauses could not be added into UK D&O policies; nor indeed is there any reason why allocation clauses could be expressly dis-applied to defence and investigation costs. It is simply a question of negotiation, cost and choice. With signs of the D&O market hardening in the UK after a sustained period of soft conditions, it may be that insurers’ appetite for this type of revision is restricted. Even if that is so, it is better be aware of the issue up front rather than waiting until the insurers’ reservation of rights letter arrives following a claim.