January 20th, 2010

Directors and Officers Liability Insurance Under New German Rules – The Right Way to Tackle the Problem?

Posted at 12:00 PM ET

wolfram-schultz-small2Wolfram Schultz, Senior Vice President

The Act on the Appropriateness of Management Board Compensation (VorstAG) came into force in Germany on 5 August 2009. The Act will impact new D&O insurance contracts and existing contracts after 30 June 2010. The Act is causing uncertainty through the introduction of a compulsory deductible for directors and officers.

Description of the law and aim:
Given the background of the financial crisis and the criticism of traditional payment systems for top managers, the German legislative body tried to introduce a tool that would guide directors and officers’ remuneration and introduce a compensation structure that promotes long-term company development. One part of these efforts was the introduction of a compulsory deductible in the D&O cover provided by the companies for board members and members of the supervisory board. The addition in law can be found in the new § 93 Abs. 2 S. 3 AktG (German Companies Act) that states: “If the company buys insurance against risks the board member will be faced with in connection with his occupational activity for the company, a deductible of min. 10% of the claim, max. 1.5 times of the fixed annual salary of the manager must be implemented.”

Potential problems with the law:
There is a perception that the text of the law lacks maturity due to its swift enactment. Some even question the constitutionality of the new regulation. Questions have arisen around whether the new § 93 Abs. 2 S. 3 AktG would be applicable for D&O policies only or for other liability products as well. The likelihood, however, is that it will be valid only for D&O insurance since § 93 AktG addresses the insured versus insured claims, which do not exist for other types of liability covers like Public Liability, Professional Liability or Legal Expense covers.

Solutions of insurers:
The new legal environment urges insurers to develop products for their clients, dealing with new challenges and needs. However, by developing new insurance products to cover the compulsory deductible, potentially eliminating the impact of the new law on board members, insurers could be in danger of being criticized for acting against the will of the government and the legislative body. Some in the market believe that since the legislative body has not introduced a ban on the purchase of additional insurance to cover the compulsory deductible, such a situation does not seem likely. Here we describe two solutions that insurers are offering:

a) Separate Cover
The first type of product is a complete stand alone cover, which is offered completely separate from the company’s existing D&O cover. With this solution insurers are offering a cover that might be broader than the limitation introduced by the law. This could mean that, in addition to board members, supervisory board members are covered. The majority opinion is that supervisory board members are not covered by the § 93 AktG, but due to the German Corporate Governance Code (Version of 18 June 2009), members of the supervisory board will follow the legal treatment of board members and therefore, may also seek cover in the future.

The solution offering separate cover implies insurers will offer separate capacities alongside the existing company policy. At the same time it means that the cost for that extra capacity needs to be paid personally by the directors and officers. It also points to the need to find new capacities in the reinsurance market. As D&O reinsurance capacity has decreased recently, the price for additional capacity will be costly and capacity will be limited.

A second issue involves the kind of coverage that will be available. The different, proposed original structures (100% share, lead with <100% share, following insurer, no involvement with primary/company policy) will create different environments and results for the insurer. The last named structure (no involvement with primary/company policy), is a structure that insurers should consider carefully before adopting. Products exist that do not exclude this type of structure, but problems could arise in the event of a claim. With this structure, the insurer of the company policy will more or less dictate to the insurer of the deductible the amount of claims paid because the final amount to be carried by the board member(s) will only be known when the claim has been first indemnified by the company policy.

One of the main concerns for the reinsurance market related to this method of resolution is the difficulty in setting proper accumulation controls for companies that have a large number of board members and/or supervisory board members. As the deductible can vary from board member to board member, it is likely that the capacity requested will be at the top end rather than at the bottom end of a possible participation. In the worst case scenario it would mean that in case of a claim the complete company D&O limit plus all limits of the existing directors and officers have to be paid separately.

b) Integrated Product
A second existing solution is a product that does not offer separate capacity alongside the company’s policy. In this case insurers offer unchanged cover for the entity. However, a right of subrogation against a separate deductible policy to be named will be integrated into the existing company policy. The deductible policy will provide cover for any amounts related to the compulsory deductible that might be payable in the future. The advantage in respect of claims handling is that it will be done completely out of one hand until a final settlement or court ruling has been reached. This product is seen more as a vehicle to reach theoretical compliance and to organize the handling of the deductible rather than as a real insurance solution. Therefore, the price will likely reflect a claims handling and administration fee rather than a price for capacity. From the reinsurance side this product does not impact the existing covers as it does not require more capacity than currently provided.

One point needs to be highlighted in connection with the integrated solution. The use of the integrated model will limit insurers. The insurers will be able to offer cover for the compulsory deductible to existing clients only because the process of subrogation and the movement of claims without additional capacity can only work properly if the company’s policy is entirely handled by the same insurer.

What to expect in 2010:
There are currently two main insurance solutions being offered in response to the Act on the Appropriateness of Management Board Compensation (VorstAG). However, the separate cover solution will likely be offered by insurers that have the resources to carry the additional work load caused by the underwriting, processing and handling of the new contracts and their several variations. Support from the reinsurance market for this approach is critical, and this additional capacity still needs to be available and paid for.

The integrated solution could be an interesting approach for smaller companies that do not have access to additional reinsurance capacity or that do not want to increase the D&O capacity they are offering to their clients. However, by using this solution their possibilities to market the product may be very limited.

Whichever path is chosen, the remaining question is whether the legislative body will accept one or both of the two approaches as being compliant with the intent of the law. It is unlikely that the courts will act in favor of insurers if they are of the opinion that the insurance market is offering solutions to avoid compliance with the VorstAG. Given that most D&O cases are settled out of court, it may take time for this question to be extensively discussed.

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Statements concerning accounting, legal, regulatory or tax matters should be understood to be general observations based solely on the author’s experience in the reinsurance industry, and may not be relied upon as accounting, legal, regulatory or tax advice which he is not authorized to provide. All such matters should be reviewed with your own qualified advisors in these areas


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