For most, D&O insurance is as exciting a topic as tooth enamel. In fact, prevailing views about the two (insurance and enamel) are likely quite similar: Each is important to have in the appropriate amount, but details are deferred to the “experts.” In this framework, the expert is king. When it comes to enamel, the dentist reigns supreme. For D&O coverage, however, mutual fund directors beware: The obvious expert may not be the expert you seek, and the coverage you have may not be the coverage you want.

D&O insurance is, understandably and rightfully, one of a director’s top considerations when deciding whether to join and remain on a fund board. While there are other forms of “insurance” that are also important (like the dedication and diligence of fellow board members; a proactive, professional and responsible management group; a robust compliance tone at the top with a chief compliance officer to match; and strong outside counsel), insurance coverage is that powerful last line of defense. It is the piece that promotes sound sleep. It deserves no less attention than is bestowed on the performance of the board, management, the CCO and counsel. Yet, the D&O policy rarely gets the same level of independent director review. Oversight tends to be delegated to insurance brokers, management, or both, on the assumption that they are the experts. They may well be, but don’t assume it to be so. The operative principle of “trust, but verify” ought to prove its worth at each insurance renewal.

There is no question that insurance brokers are steeped in the lingo, the “policy forms” and industry trends. But their expertise can lack one important element: Objectivity. Insurance brokers receive commissions from carriers for placing their policies. Thus, in the best of worlds, they operate with the specter of a conflict, and in the worst of worlds, they might succumb to it. This is not to impugn their professionalism nor suggest that simply the existence of a possible conflict renders their recommendations moot. They are entitled to the benefit of the doubt. There is no reason, though, why that presumption should not be accompanied by a cautious degree of skepticism

Who’s Your Insurance Expert?

Consider this: There is only one insurance carrier of which I know that pays no brokerage commissions for being “placed.” That carrier is a captive carrier in our industry and is regarded by many as the “gold standard.” Yet, in more than 20 years of practicing law, I have never been involved in an instance in which a broker recommended that carrier to one of my clients. Not once. This is too absolute and resounding a result to consider it a coincidence. I think of it as a warning. Brokers can be useful, but next time a broker suggests putting your existing coverage out to bid, or identifies different carriers for your “tower,” or looks to diversify your coverage by adding more carriers, evaluate those proposals with an understanding of the conflicts with which your broker may be saddled.

Management groups do not suffer from the conflicts that afflict brokers. They can, however, have different priorities than the fund board. For example, if a management group is covered by a separate corporate or similar policy, it may not take great interest in the terms of coverage outlined in the D&O policy, thinking that those are best left to the board and the insurance broker. Or, perhaps management is mostly focused on the cost of the policy because it advises funds whose expenses are capped and, in effect, it will be paying for the insurance. While cost is an important data point for all that a fund board purchases on behalf of its funds—including investment advisory services—it is not typically the sole driver of the board’s decision. Just as with any services that the board procures for itself and the funds, the nature and quality of those services (i.e., the coverage offered by a policy) and the service provider’s responsiveness to the board (i.e., the carrier’s history with and willingness to make good on claims when they arise) are arguably the most important elements associated with choosing a D&O carrier. Quality, rather than price, is what most directly yields peace of mind. Thus, while management’s interests and those of the board may be perfectly aligned on the topic of D&O coverage, it is worth investing a bit of time during the meeting or two prior to the next insurance renewal to confirm that fact. If the interests are different, that will have been time well spent.

Who is supposed to help a board through insurance matters if the D&O policy is placed through a broker and/or management’s interests are not perfectly aligned with the board’s interests? Outside counsel. Note that I did not suggest it be counsel to the independent directors. It would indict the objectivity of this article if readers considered it a self-serving piece. Any outside counsel will do. It could be fund counsel or it could be counsel retained simply to review the policy and advise on its terms. An attorney is as well placed as anyone and, in fact, is probably the best person to review the D&O policy. Remember that the policy is a contract. It is a long legal document filled with defined terms, cross-references, caveats and subtleties. This is why it is held in as high esteem as tooth enamel. If dentists are to enamel what attorneys are to contracts, who should your insurance expert be?

Understanding Coverage

Discerning the right person to help the board review its D&O arrangements is an important first step and one that will enable it to delegate that review with confidence. Yet, there are several important aspects of D&O coverage that a board should understand even when it has able assistance. Here are examples of a few:

• Who is your carrier? This seems like an obvious enough question, but it is deceivingly complicated. Every board presentation on insurance likely will reveal the carrier’s or proposed carrier’s rating. While that is useful, it does not begin to tell the story. It is important to know how the carrier responds when claims are made. In other words, will they be there when you need them, and how long will it take them to “arrive.” There are brand-name carriers that have long lists of requirements (many of which are unnecessarily onerous) that must be met before they pay a dime. There are other carriers that have come into and out of our industry over the years depending on the economics of their exposure to other industries. These carriers don’t always resolve matters favorably or easily for their insureds because the asset management industry is only one of numerous business lines in their portfolio, and therefore, their reputation in our industry is of little motivation to them. There are carriers who will take years to roll out “enhancements” to their policy and are well behind industry trends. This means a considerable delay in getting aspects of D&O coverage that others may have much sooner. Some carriers reinsure their own risk with reputable third-party insurers and they do so at very low levels. This means that when they are asked to pay a claim, they may be more user-friendly because they have diversified their own risk and are insured themselves. Did the insurance carrier ranking you last received reveal all this?

• What does the carrier consider a “claim”? Insurance only covers claims. That’s logical enough. Every policy will include a definition of claim. Most policies do not include in that definition inquiries from regulators. They do generally include coverage for “formal investigations.” That means that coverage would be effective only upon receipt of a formal document from a regulator that reveals the investigation. Those of us who have been in this industry for a bit know well that a regulator can knock on the door and review and examine for months and even years before a document evidencing the regulator’s actions ever appears. Yet the amount of time, effort and expense associated with responding in that eventuality can be staggering. Why should anyone pay for a policy that does not cover that?

• Does the policy include coverage for cybersecurity and data breach incidents? The thought leadership of a carrier is important. Emerging hot topics, particularly those on which the regulators and plaintiffs’ bar have focused, ought to be addressed by the D&O policy. As to cybersecurity, the investment adviser might have chosen to self-insure its risk (that is, it may have decided not to procure dedicated coverage for these types of claims) or it may have purchased specialty insurance. Even when the adviser has its own policy, it may or may not cover the funds and their board, and the level of coverage can differ significantly. Knowing that the D&O policy addresses this in some measure is critical, yet there are very few carriers that will offer this coverage to a fund board. Does yours?

• Are directors covered when they are “non-party witnesses”? If the adviser is sued (in an excessive fee case, for example) or if the adviser is the subject of a regulatory review and directors are deposed but are not the subjects of the suit or the review, they are considered “non-party witnesses.” They are scrutinized and involved but are not named in the action. For a director, this scenario can entail time and expense. Some policies provide coverage to non-party witnesses and some do not. If you were deposed in an excessive fee case that does not name you as a defendant, wouldn’t you want to be protected by your D&O policy?

The list of topics for a board to explore is longer than the items highlighted above. But, it’s not that much longer. Understanding the most important aspects of D&O coverage does not have to be a daunting or sleep-inducing exercise. The appropriate breadth and level of focus can make the review both interesting and worthwhile.

Continuity of Coverage

This article would be incomplete without a mention of “continuity of coverage,” a term that is rarely used when it should be and is most invoked when it’s least relevant. Continuity of coverage is a concept borne from the fact that D&O policies respond when a claim is made, not when the facts that led to the claim occurred. For example, many lawsuits will allege wrongdoing that occurred a year or more before the suit is brought. Under a D&O policy, the carrier on the hook is the one in place when the suit is filed. This why D&O policies are called “claims-made policies.” When a new carrier takes over D&O coverage, its form will exclude pending or prior litigation (and “related” claims). Understandably, a new carrier does not want to take on the liability that the prior carrier has an obligation to cover. The new carrier’s obligation to cover claims will only exist with respect to claims that are new (not related) to any prior claims. Even when a new claim arises under the tenure of the new D&O carrier, if the claim was known or could have been known to exist, the new carrier could exclude it from coverage under the theory that the prior carrier should have been notified and should have assumed the liability. Changing insurance carriers breaks the continuity of the reporting chain. There is now risk, both practical and legal. Both can be overcome or no one would ever change D&O carriers. But, it is important to make a change in an informed and logical manner.

When a board contemplates changing its D&O carrier, it should consider whether any claims are at the time being covered by the current carrier, whether additional “related” claims could be expected from the existing claims, and whether the current carrier has been notified of claims that could arise. If the answer to any of these is “yes,” it is probably prudent to postpone the change. The possibility for finger pointing between two carriers is quite real in this scenario. Further, even if the old carrier has agreed to cover the claim, how motivated a paymaster will the old carrier be when it’s no longer collecting an annual premium from the funds? If, on the other hand, the fund group has no pending or anticipated claims, moving to a different carrier with better terms would be enticing. The better the terms of the new coverage, the more tolerable the risks accompanying the lost continuity of coverage.

If the title of this article caused your eyes to skip most of the text and land on this paragraph for some practical takeaways, here they are:

• D&O insurance policies are contracts; ask an attorney to read through yours.
• Know your carrier; ratings don’t tell the story, nor does price.
• Not all policies are created equal; own your policy, and know its most important terms.
• Don’t let “continuity of coverage” work against you; don’t switch carriers when there are live claims, but don’t forego considering the change when things are calm and your terms of coverage would improve.
• Be proactive in procuring your peace of mind.

Paulita Pike is a partner in Ropes & Gray's Chicago office; the views expressed here are her own and not those of her law firm.