When Should A Private Company Consider Purchasing D&O Insurance?

D&O Insurance

I get this question a lot, from prospects, clients, and centers of influence.  I understand that for a lot of private company owners, D&O may seem like a “nice coverage to have”, but since it’s not mandated by anyone or required by law the purchasing decision gets deferred, sometimes indefinitely!   I get it, insurance isn’t a fun purchase; it doesn’t add to the bottom line, and it’s purely an expense.  In this article I hope to uncover why and when a private company should make the D&O purchase decision.

I will use the term D&O and Management Liability interchangeably here and will explain that in a moment.

We don’t need to get into the weeds on policy definitions or coverage terms just yet to answer the question of when is it a good time to purchase coverage?  Instead, let’s focus on the number one reason why private company owners do purchase D&O coverage:

Business owners decide to purchase D&O insurance when they understand that it actually protects their personal net worth.

Here’s why D&O/Management Liability Insurance is actually Personal Net Worth Insurance:

Most lawsuits a business may face will name the corporate entity as the defendant.  Think the typical auto accident, slip and fall or other bodily injury or property damage suit.

But lawsuits which allege a wrongful act in managing the company’s affairs; including employment related suits, will often name individual business owners, officers, directors or managers as the defendants, and not the entity.

When a lawsuit names anyone acting within their capacity as an officer, director or manager as a defendant, their personal assets are at risk That’s why I call management liability protection – personal net worth insurance.

To protect the personal assets of a company’s owners, officers, directors and managers we will deploy a Management Liability policy –  which is a portfolio policy comprising three parts:

These three coverage parts are what’s commonly found in a management policy but can be expanded to include crime, cyber, professional, and several other coverage parts.  When a firm grows over $50M in revenues there may be reasons to break apart the management policy and write separate policies to better address certain exposures, but for the moment let’s address D&O in this broader management liability coverage form.

In public companies there’s never any argument that management liability is necessary, the concern/threat over securities litigation compels directors and officers to mandate protection before they ever consider serving on/in a public company.  But for private companies that don’t face the threat of securities litigation, owners often waiver on making this purchase, and the reasons they waiver is startling.

A recent survey of larger privately held companies by Chubb noted:

  • That 22% of decision makers thought these types of exposures are covered by their general liability or umbrella liability policies.  That of course is false.
  • About one third of firms didn’t purchase coverage because they believed that as a privately held firm, or family run business they had no exposure to management claims.  That also is false.
  • Another third of firms didn’t purchase coverage because they had never experienced a claim in the past or didn’t think it could happen to them.  That’s downright scary!
  • And what may be most interesting is that more than a quarter of respondents to this survey had reported a D&O loss in the prior 3 years!  The average D&O Claim is about $387,000 according to The Chubb Survey.

These misconceptions threaten the net worth of all those that serve in a position of leadership within a business, regardless if they have an ownership stake or not.

Now you may be saying – what about corporate indemnification?  Doesn’t the company have an obligation to indemnify any claim which directors, officers and managers may incur in their capacity as company leaders?

The answer is yes, most corporate charters and by-laws do have indemnification procedures, but where does the money come from to defend the directors and officers when a claim is made?  Or pay the ultimate settlement amounts?  Can the entity afford to pay out of pocket to cover these claims?  Would they need to borrow the money?  Do they even have the ability to leverage the type of cash needed for defense?  In most cases a firm will not have that type of un-deployed capital on hand, nor the credit to leverage it immediately when needed.  Further reinforcing the need for management liability protection.

So, to answer the question of when should a private company consider purchasing D&O or Management Liability coverage?  I think the answer is as soon as they can afford it.

There are other reasons that motivate the decision to purchase D&O:

  • When independent directors or advisers are brought onto the firm’s board. It is often impossible to recruit board talent without D&O protection.  Few advisers or directors will even consider board service if D&O coverage is not in place.
  • When investor money is brought into a firm, whether friends and family, venture, or private equity, outside capital investors present a unique challenge and risk to the management team.
  • Well before there is thought of going public.
  • When there is growth through M&A.
  • When the employee headcount starts to grow.

Have questions about D&O/Management Liability not addressed here?  Have an issue, question or concern that’s nagging at you?  Why not give me a call, or drop me an email so we can start a conversation.

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