Author: Walker Newell
Understanding the mechanics of a Directors and Officers (D&O) insurance policy can make a difference when directors and officers are assessing the coverage available to them or are simply seeking to understand what will happen when a claim hits.
This article explains how self-insured retentions (SIRs) work in D&O policies and contrasts that with deductibles.
We'll then look at the options available to directors and officers when a company is unable to fund the self-insured retention.
What is a self-insured retention (SIR) and how does it work?
A SIR as it relates to D&O insurance is often compared to a deductible, but it works a little differently. The following example illustrates this difference more clearly.
Imagine you had a $10 million D&O insurance policy with a $1 million SIR.
Now let's say an event happens that's indemnifiable, meaning there's a loss that the company is legally permitted to pay on behalf of a director or officer.
The insurance carrier won't pay anything until the insured company has paid that SIR of $1 million (in our fictional example), because the $1 million is the portion of the exposure the company is self-insuring.
However, once the company has spent $1 million on costs covered by the policy, such as defense attorney fees, the SIR has been eroded. At that point, the D&O policy will start to respond up to the full $10 million limit.
In other words, based on this example, if you had an $11 million loss, you would pay the first $1 million.
After that, the carrier would pay the rest of the policy limit — that is, the remaining $10 million.
How do deductibles work instead?
Now let's look at what would happen if the policy had a deductible instead of an SIR.
Let's say you had a $10 million policy with a $1 million deductible, and you experienced a loss of $11 million.
The carrier should hand you a check for $9 million, which is the amount left after the $11 million loss, the $10 million policy limit and the $1 million deductible.
Notice that in this example, the carrier is paying $9 million, leaving you to pay the remaining $2 million of your $11 million loss.
To be clear, this is just a hypothetical example because in D&O insurance, there are no deductibles, only SIRs.
What if the company refuses — or is unable — to pay the SIR?
A question that often comes up is, If a claim is indemnifiable but the insurance company doesn't pay the SIR, must the director or officer pay it?
If alternative arrangements haven't been made, the answer is yes. No one wants that, so let's discuss a way to avoid this outcome.
Indemnification agreements
An obvious way to protect individuals from having to pay the SIR themselves is to put a solid personal indemnification agreement in place. (And it is a good idea to do this in any case.)
Special policy terms
Another solution is to negotiate a term into the D&O insurance contract that specifies that the insurance carrier will essentially waive the SIR on behalf of an individual if the insured company fails to pay it.
This isn't, however, a get-out-of-jail-free card for the insured company — that would set up an absurd incentive structure. So, policies with this feature generally also include the right of the insurance carrier to recoup the SIR from the insured company.
Side A difference in condition policy
Another way to ensure that no individual will have to pay out of pocket for an SIR is a Side A Difference in Conditions (DIC) insurance policy.
A standalone Side A DIC policy is often added on top of a traditional D&O insurance policy. One typical feature of the "DIC" portion of this kind of policy is that it can drop down to pay a SIR if the insured company fails to do so.
This policy is all about being able to attract those high-quality directors and officers. The combination of a classic policy and a Side A DIC policy is very powerful for the following reasons:
Fewer exclusions. The Side A DIC policy typically has fewer exclusions than a classic D&O insurance policy.
Works if the company becomes insolvent. The Side A DIC can respond even if a company is facing bankruptcy.
There's concern that if a company with only traditional D&O insurance goes bankrupt, a bankruptcy trustee might attempt to seize the proceeds from that policy for the bankruptcy estate — leaving the directors and officers high and dry and without any coverage.
When a company has a standalone Side A DIC policy, however, it's much harder for the trustee to seize the policy proceeds, since the corporation isn't a direct beneficiary of that Side A policy.
Responds on a first-dollar basis. As discussed above, the drop-down feature provides powerful, first-dollar protection if a company refuses to advance legal fees to one of its directors or officers. This is a big deal, given that some SIRs are $10 million or more.
It's easy to see why so many directors and officers want the additional coverage that comes with a Side A DIC policy, and why so many companies purchase it.
Final takeaways
To wrap up, a self-insured retention under a D&O insurance policy isn't the same as a deductible.
With an SIR, the company must first pay its portion of the loss before the D&O policy responds at all, whereas a deductible would be subtracted from what the carrier pays.
That distinction is subtle but can have a significant impact when a D&O claim arises.
Importantly, understanding who pays the SIR and what additional coverage is available helps directors and officers better assess their true exposure.
