Directors’ & Officers’ Liability

1. Zurich UK Commercial Directors’ & Officers’ Liability Training presentation Jim Gaskin, Financial Lines Manager Zurich UK Commercial August 2005

2. Topics to be looked at • Current market • Background and history • The cover • How liability arises • Statutory duties / the law • Sources of claims • Underwriting / financial analysis • Conclusion

3. D&O - current market place • 2005 market situation: • Last 24 months moved from soft to hard to soft market. • Rates increased – small private companies 20-30%. • Larger organisations – 200-300%. • 2005 rates now flat with some pressure to discount. • AIG and Chubb early dominance diluted by newer entrants RSA, ACE, Markel, St Paul, Zurich and others. • 2004 saw severe US losses plus some significant UK losses which drove price increases, capacity shrinkage and cover withdrawal but 2005 has seen some return to a softer environment. • Loss experience increasing but capacity also increasing, targeting SMEs via online facilities.

4. D&O - the UK market • Size of the UK marketplace: • 2004: £385 million (20% growth over 2003) • 2009: £749 million

5. Market changes • Premium rate increases now flattening. • Variation in wordings by sector such as tailored cover for charities. • Withdrawal of additional covers (Insured vs Insured by some). • New capacity has entered the market place in the last 18 months targeting SME business. • A cautious approach to risk selection still exists. • SME is the new battleground. • Online quote tools allowing brokers to quote and bind online, thereby simplifying the process.

6. D&O - recent SME survey findings • Zurich 2004 SME survey - findings: • Only 50% of companies are aware of D&O cover. • 20-30% expected growth for 2005. • Drivers are: • claims inflation • increased risk exposure • an increase in take up of D&O first time buyers • publicity generated by Higgs* report in 2004.(* see next slide)

7. Higgs report 2004 • Report that looked at the role and duties of non-executive directors. • Feeling that in the past they did not show enough independent thought and failed to provide sufficient challenge to the executive directors. • The report put forward a number of recommendations including the minimum number of non-executives on a board and the availability of D&O insurance to protect their liabilities and so encourage a larger pool to draw from.

8. History and background to D&O cover • Initially purchased by USA companies. • UK companies first bought in early 70s driven by their USA exposure. • Demand has grown from FT 100 companies down to PLCs, then to private companies, now non-profit entities. • Exposure increasingly driven by: • legislation • increasingly litigious society • greater number of shareholders who are much more aware of their rights to challenge directors, and more willing to use the courts.

9. The cover • Extensions: • Outside positions – covers directors and officers when sitting on the board of Associated Companies. • Pollution - defence costs and shareholder actions for any loss e.g. loss in value of shares. • Company cover for shareholder costs – order of court to cover shareholders costs in pursuing a claim against an insured person in the company. • Employment claims – covers past, current and prospective employees (deals with discrimination in the interview process)

10. How the cover operates • Claims made policy i.e. claims made in the policy period regardless of occurrence date. • Aggregate limits - costs inclusive (as opposed to costs in addition). • Advancement of defence costs by the Insurer so the directors are not out of pocket.

11. The cover - who is covered? • Directors of the company including non-executive directors and shadow directors. • Officers of the company including Company Secretary, Chief Accountant, Personnel Manager. • Managerial and supervisory positions. • Employees when joined as co-defendant. • Persons appointed by the company as liquidator administrator.

12. The cover - what is covered? • Civil awards, judgements and legal defence costs arising out of wrongful acts committed, or alleged to have been committed. • Allegations of a criminal nature are covered but only for legal defence costs incurred - if proven then any fines or penalties imposed are not covered.

13. The cover - what is not covered • Proven fraud and illegal profit. • Pension trustee exposure. • Insured versus insured. Cover will vary in response to directors suing fellow directors. • Professional indemnity. A director who also acts as an engineer is not covered for their advice as an engineer under a D&O policy. • Prior circumstances and litigation e.g. situations aware of in advance purchasing the policy.

14. How does liability arise? • Duty of skill and care: • Common law duty. • Test of reasonableness which is subjective. • City Equitable (1925) • “a director need not exhibit in the performance of his duties a greater degree of skill than can reasonably be expected from a person of his knowledge and experience. A director of a life insurance company does not guarantee that he has the skill of an actuary or a physician”

15. How does liability arise? • Fiduciary duties: • Common law duty and embedded in corporate governance. • Directors are in a position of trust, act honestly, in good faith and act in the best interests of the company with their first duty towards shareholders. • Conflicts of interest must be managed in the best interests of the company – e.g. non-executives who serve on two companies trading together. • Enron in the USA was good example of a breakdown in these duties.

16. Statutory duties • Continually evolving • Companies Act 1985 & 1989 – Patricia Hewitt, misleading auditors 2 years, unlimited fines. • Insolvency Act 1986 – fraudulent/wrongful trading. • Health & Safety at Work Act 1974 – unsafe working practices. • Environmental Protection Act 1990 & 1995 - pollution. • Employment legislation e.g. ageism. • European legislation – who knows? What’s next?

17. Who are the duties owed to? • Firstly to the shareholders – example Claims Direct faced a £200m claim from its shareholders. • The Company itself and minority shareholders. Future legislation may enable minority shareholders to hold directors accountable. • Creditors - allegations of wrongful trading can be made in the event of insolvency. • Employees including employment issues – unfair dismissal/discrimination etc. • Other companies - disposals and acquisitions. • Regulatory authorities e.g. health and safety issues

18. Consequences of directors failing in their duties • Criminal prosecution - fines and/or prison. • Civil proceedings leading to fines. • Civil proceedings leading to an award for damages or other remedy e.g. injunction. • Official enquiry, investigations etc - costly. • Disqualification of directors.

19. U.S.A. Company law • Securities legislation: • Securities Act 1933 • Securities Exchange Act 1934 • Racketeer Influenced & Corrupt Organisations Act 1970. • Recently the Sarbanes-Oxley Act - executive certification of financial statements plus other governance rules and increased penalties. This may have an impact on UK directors.

20. Company indemnification • The Companies Act states that the company cannot indemnify its directors unless the director is found to be innocent of the allegations - but it also allows the company to purchase insurance to offset that risk. • Therefore directors are on their own in terms of: • funding their defence • payment of civil awards • damages and settlements (all covered) • payment of fines • penalties • jail sentence (not covered). • This was the position up to April 2005.

21. Update on indemnification • Companies (Audit, Investigations and Community Enterprise) Act 2004 - effective 1st April 2005. • Allows the Company to now indemnify directors only, (not other insured’s as covered in a D&O policy) when there is permitted indemnity. • In other words it allows Companies to indemnify directors in respect of actions brought by 3rd parties for legal costs and the financial cost of any adverse judgement. • Except for: • criminal penalties • penalties imposed by regulatory bodies • legal costs of unsuccessful defence of criminal proceedings • legal costs in any civil proceedings brought by the Company or any Associated company when judgement is against the director.

22. Update on indemnification • So, in conclusion: • Directors are only protected by the Company in certain situations. • The Company is only able to indemnify and is not required to. • Only directors are protected not officers or other insured persons. • Directors and officers are still at risk for which both the Company and its D&O’s would seek to transfer that risk to a D&O policy.

23. Where do claims come from? • Shareholders - when they feel the company has been mis-managed to the detriment of their share value. • Share issues and listing on stock exchanges. • Creditors e.g. wrongful trading. • Employees e.g. discrimination, wrongful dismissal. • Libel and slander.

24. Where do claims come from • Regulatory and Government bodies e.g. Corporate manslaughter. • Competitors e.g. unfair competition as dealt with under the Enterprise Act. • Customers e.g. Holidays abroad and customers left stranded. • Mergers, acquisitions and disposals e.g. hostile takeovers.

25. What do underwriters look at to assess the risk • Report and accounts - key documents: • chairman’s statement – insight into future strategy • directors report –statutory requirement • auditors report – ‘true and fair view’ • profit / loss account – what has been happening • balance sheet – snapshot of assets and liabilities • notes to the accounts / contingent liabilities e.g. in dispute with the Inland Revenue. Provisions in the accounts for bad debts.

26. Underwriting factors • Financial performance and strength – the better it is the less likely a claim. • Share price performance if applicable – is it out of line with the industry sector. • Overseas exposures especially USA and Australia – amount of assets is the key measure. • Industry sector. • Length of establishment – longer in existence the less risk. • Acquisitive – Nature of business, aggressive acquisition strategy. • Future strategy – credibility of strategy.

27. Underwriting factors • Experience of Board of Directors e.g. some directors attract greater profile. • Recent changes at senior management or board level – churn rate of directors. • Changes in auditors – too cosy, challenging, poor relations/why? • Representation at proceedings – how often does this happen? • Previous claims / circumstances – number of previous claims, history. • Employment issues / layoffs / closures, e.g. failing strategy?

28. Rating • Traditionally assets have driven the rate - US assets carry a far higher rate. • U/W factors then load or discount premium but financials are the most important factor. • Other sources of info would include press coverage, credit rating services etc. • Turnover is an alternative but only suitable for small companies with low risk.

29. Conclusion • Directors’ & Officers’ Liability is an ever changing product responding to an ever more threatening legal landscape and driven by an expanding market place. • Cover needs to be examined carefully. • Please log in to the sales section of www.zurich.co.uk/commercial for more information on D&O cover including case studies. • Please contact your local Speciality Lines Underwriter with any questions.