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How smart buyers shop for Side A-only DIC coverage

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Side A-only difference-in-conditions directors and officers liability coverage can offer broad protection to valued executives and directors--but that protection's guaranteed only if the program is carefully crafted, say experts.

The coverage--which has been around for a couple of decades--responds only to non-indemnified losses by directors and officers, including shareholder derivative suits or in situations in which a company has declared bankruptcy.

Side A-only DIC policies generally offer broader coverage terms and much narrower exclusions than traditional D&O policies. Purchasing the coverage is way to attract qualified people who might otherwise shy away from corporate service for fear of having to pay losses out of their own pockets related to their jobs as corporate directors.

But experts warn that risk managers need to avoid pitfalls--including some that can render the Side A-only coverage virtually worthless--as they put together their programs.

Although Side A coverage was introduced in 1985 by Bermuda-based Corporate Officers & Directors Assurances Ltd., interest in it has picked up considerably just in the past three or four years for a variety of reasons, say observers.

"Lawyers consulting with board members" has helped drive the interest in the coverage, said Lou Ann Layton, managing director and national D&O practice leader for Marsh Inc. in New York. Board members hire law firms or outside consulting firms to find out how to make the D&O program best serve their needs, she said.

And board members obviously don't want to have to dig into their own pockets when the company can't or won't indemnify them, she said.

One of those occasions is bankruptcy, said Dan A. Bailey, a member of Bailey Cavalieri L.L.C. in Columbus, Ohio.

Under a standard D&O policy, the courts have generally held that the policy and proceeds are an asset of the bankruptcy estate if the company files bankruptcy, said Mr. Bailey. "Thus, the policy and its proceeds are frozen the moment the company filed bankruptcy and the directors and officers cannot access the policy for their own loss," he said, adding "that's the one point in time when they absolutely need to access the policy."

"A confluence of factors" has increased interest in the coverage in recent years, said Carol A.N. Zacharias, senior vp and counsel to ACE USA's Professional Risk Surety and Political Risk divisions in New York.

One is the rise of entity coverage that allows the entity itself to become an insured party under the D&O policy, which could allow the entity to exhaust the policy's limits, she said.

Another factor is claims severity, with the average securities class action case in 2005 being settled at $71.1 million, up from an average $27.8 million in 2004, she said, noting that the 2005 figure does not include WorldCom Inc. or Enron Corp. settlements.

There's also been a jump in non-indemnifiable claims, notably stock option-related suits in which state law precludes indemnification of directors and officers, she said.

Situations also arise when "black hats and white hats" compete for policy limits, said Ms. Zacharias. When so-called "black hat" directors and officers are sued, the black hats may be sued more frequently, she said. That leads their counterparts to worry that "they're going to need that coverage fast, and they're going to need a lot of limits" out of fear the "black hats" will erode available limits.

One thing that does not present a problem is capacity, said Marsh's Ms. Layton.

"I never had a client come to us citing limits that we couldn't put together," she said.

Risk managers need to be aware of the nuances of the coverage as they structure programs, according to experts.

Each carrier tailors its policy a different way, said Mr. Bailey. Some Side A polices afford much broader coverage than others, he said.

"If you're a buyer, you want to make sure you know what you're buying. Make sure you get the broadest coverage possible," he said.

An excess Side A-only DIC ought to incorporate a variety of features, said Mr. Bailey. These include it being nonrescindable in whole or part for any reason as well as a very narrow insured vs. insured exclusion. Such policies should not contain Employee Retirement Income Security Act or pollution exclusions, he said.

The broad DIC provision coverage should drop down if underlying insurers refuse to pay, cannot pay or are legally prohibited from paying, he said.

As risk managers attempt to put together layered programs, "you want to make sure you do it in a smart way and not trip up yourself," said Mr. Bailey. For example, the lowest level of the excess DIC Side A-only should be "treated conceptually as the primary policy for purposes of all of the other excess DIC Side A layers," he said. "That means that those other excess DIC policies should designate the base DIC policy--and not the true primary policy--as the 'followed policy,"' he said.

"Only the underlying Side A policy should be listed as 'underlying insurance' in the Side A policies excess of the base Side A policy," Mr. Bailey explained. "By doing so, the higher-level Side A policies will drop down on top of the base Side A policy whenever the base Side A policy drops down pursuant to its DIC provisions, regardless whether the policies underlying the base Side A policies are exhausted."

Mr. Bailey also said risk managers should pay careful attention to quota share Side A programs, which can result in unintended coverage limitations. That's because each insurer in the quota share program usually is liable only for its quota share percentage of the total loss covered on the quota share layer.

"The liability of any one insurer in the quota share program is not increased if another insurer in the quota share does not pay a loss for any reason," he said. "If an insurer in the quota share program does not pay a covered loss, a gap in coverage exists," a situation Mr. Bailey called "unacceptable."

"In my mind, it doesn't make good structural sense to purchase the DIC policy from the same insurers that participate in your underlying program. One of the risks you're trying to protect against is the underlying insurers being insolvent or unwilling to cover particular loss," he said.

Solvency is a key consideration, said an underwriter.

"We believe it's very important to first strongly consider the financial strength and claim paying reputation of the Side A insurer," said Jim Proferes, vp and deputy underwriting manager for D&O liability products in Warren, N.J.-based Chubb Specialty Insurance in Philadelphia.

"It is critical to assure that they are capable of performing when called upon," Mr. Proferes said.

Buyers need to consider what situations they might face that would make Side A DIC coverage critical, he added. "They should certainly focus upon the construction of the DIC feature as well as work with their agent or broker to consider scenarios which would trigger such a provision."

"You want to make sure you're getting the protection," said Marsh's Ms. Layton. "There are various Side A policies out there so you need to make sure you're getting one that has all of the components that make it special. You need to make sure you're negotiating all the right triggers."

"The first thing you want to look at is what the trigger is for the DIC. When does it drop down? You want to make sure it's dropping down to the primary," she said. "And then you've got to make sure everybody supporting that DIC has the same terms and conditions so there are no holes in it."

Finally, Ms. Layton said, risk managers need to make sure they're negotiating a fair price. "Pricing that product for what it does, how it does it and when it does it is very important."

Risk managers need to make sure they've adequately budgeted for the purchase, said ACE's Ms. Zacharias. She also noted that there's "a certain amount of delicacy in terms of the purchase" because the entity buys the coverage yet won't directly benefit from it.

Nevertheless, "it's a credibility buy," she said. "It's a solid, intelligent thing to buy."