Understanding D&O risks, exposures and insurance options

By | September 25, 2006

What do a parent advisory board, parish council, the United Way and local athletic club have in common? They are all nonprofit organizations. Most people serving on the board of such organizations are volunteers who provide their time and efforts to foster or further a need, ideal or belief. While there are both federal and state Volunteer Protection Acts, it’s worth noting that organizations and their boards should not rely on those. The acts provide some immunity, but they do not forbid legal action against the organization or volunteers.

Nonprofit organizations often times are incorporated to serve a purpose. For example, if the organization is incorporated for religious purposes, its members share the same religious or moral beliefs. Organizations incorporated for public benefit include charities, hospitals or educational institutions. Groups incorporated to benefit its members include health clubs or country clubs, among others. Regardless of the reason for forming, most have a mission statement, in addition to the purpose outlined on the organization’s bylaws and/or articles of incorporation.

Director duties
The Board of Directors is ultimately responsible for the organization’s dealings, and its directors and officers may be held personally liable for their actions or inactions. That is perhaps the greatest or scariest exposure for board members in the for-profit and nonprofit worlds.

Individuals serving on nonprofit boards owe three basic “duties” to the organization, namely:

  • Duty of care;
  • Duty of obedience; and
  • Duty of loyalty.

The duties are similar to those in for-profit enterprises.

The duty of care means that the individuals serving on the board must exercise reasonable care when making decisions. In other words, they must exercise diligence and prudent judgment, such as a prudent individual would exercise under similar circumstances.

The duty of obedience requires those serving on the board to not only familiarize themselves with the organization and/or corporation’s rules, bylaws, articles of incorporation or charter, but to thoroughly understand, follow and enforce procedures and conduct guidelines; they must thoroughly understand their responsibilities. This duty extends to public policy.

Last but not least, is the duty of loyalty, which has at its core putting the organization first — not the personal interests of individual directors or officers. The duty includes discretion and confidentiality about matters discussed by the board.

In general, claims against nonprofits arise from breach of the above duties and can come from third parties such as vendors or fundraisers, for example. Recipients of benefits also may bring an action for negligence and wrongdoing. Insiders such as the directors themselves, the organization or employees also can go after the organization alleging poor employment practices, sexual misconduct, etc. So the nonprofit decides to obtain insurance to protect its interests in the event of a claim (defense costs) and/or loss (indemnity).

The nonprofit insurance submission starts with a thoroughly completed not-for-profit (NFP) directors and officers’ application, which should bear the chairman, president or executive director of the board’s signature and be currently dated at the point of binding. The attachments to complete the submission vary among carriers, but can include: copy of the mission statement; C,C&Rs (covenants, conditions and restrictions) if the applicant is a homeowners association (HOA) or condominium association; bylaws and articles of incorporation; copy of last filed tax form 990 (return of organization exempt from income tax); projected gross revenue for the next 12 months; 12-month income statement for the most recent fiscal year end that includes assets, liabilities, revenues and expenses; and a Web site address, if the nonprofit has one.

The underwriter will carefully review the attachments to determine the financial soundness of the applicant and the acceptability of the indemnification language. Because the vast majority of policies include employment practices liability coverage — usually as a shared limit — some carriers ask for the organization’s employee handbook, specifically looking for harassment, sexual and/or otherwise, and other policies.

While on the “coverage sharing” subject, it is worth noting that the insurance professional must explain to the applicant that the policy limit is shared (if that is the case) and the possibility of policy limit erosion by a claim on either side of the policy. Limits should be purchased carefully, understanding that they will be available to pay for claims against individual insureds and the entity, and that a severe claim against either one could possibly exhaust all policy limits. Reinstatement of limits is not really an option.

The main difference between for-profit and nonprofit D&O forms is that the latter has no exposure to securities claims. The form typically starts of with three insuring agreements:

  1. Individual Coverage: personal liability for individual insureds;
  2. Organization Indemnity Coverage: indemnifiable losses; and
  3. Organization Entity Coverage: Claims against the organization.

That is why D&O quotes show more than one deductible/retention. Individual coverage is typically at $0 deductible/ retention. The definition of wrongful act, claim, insured, individual insured, subsidiary, employee, employment practice claim, damages and wrongful employment practice, among others, are key and must be reviewed.

As mentioned, volunteers must be included under the definition of insured or employee, as most nonprofits use volunteers to carry out their affairs. Most forms have the spousal extension and/or domestic partner language built into the form; if it’s not, ask the underwriter to endorse it on. The exclusions section of the policy needs to be reviewed for those exceptions applicable to employment practices claims, for example, those involving “emotional distress or mental anguish” or “defamation, libel or slander.”

In regard to limits and deductibles/retentions, the limits apply per claim and in the aggregate. The deducti-ble/retention applies per claim or wrongful act. Most policies are “duty to defend,” and some carriers offer defense costs outside the limit for an additional percentage of the premium.

The “consent to settle” provisions are usually in favor of the insured. In other words, the carrier generally cannot settle a claim without the insured’s consent.

Claim reporting provisions are always important to review, because those policies are all written on a claims made or claims made and reporting form. Some policies are “incident and/or circumstance” sensitive, and allow the insured to report a circumstance that may lead to a claim. Those clauses are called “discovery” or “awareness” clauses. If the policy does not have such a clause, ask the underwriter if it can be endorsed.

Next is the extended reporting period (a.k.a. tail). That is the period of time the insured can buy to report claims or circumstances (if allowed by the policy) arising from wrongful acts or wrongful employment practices that took place after the policy’s effective date and retroactive date, if any, and before the policy expiration. Most policies offer an automatic free-reporting period, usually between 30 and 60 days. At its conclusion, the extended reporting period (ERP) is available for an additional premium and usually for a length of one to five years.

A bi-lateral reporting period, which is available whether the carrier or the insured cancels or non-renews coverage, is always preferred, although not always available. Again, ask if it is offered by endorsement and document the file accordingly. For budget purposes, it makes sense to try and get the premium the carrier will charge for the extended reporting period up-front.

There are three “dates” to keep in mind. The first one is the “retroactive date,” which should by all means be preserved. The second one — the prior and pending litigation date — needs to be avoided as much as possible. The third — the continuity date — seems to always cause some controversy, because it is not defined under the form. Most people in the professional liability world will agree that it is the date the main form application was first completed. The continuity date is not common on nonprofit placements.

The general conditions are usually found at the end of the policy, and they deal with cancellation and non-renewal notices, changes in control of the named organization, severability, etc. It’s always a good idea for agents and brokers to get copies of all forms being quoted to discuss them with the insured.

Finally, insurance agents and brokers should remember to avoid conflicts themselves by not pursuing the placement of a nonprofit D&O policy for boards they serve on.

Rocio L. Orta is a professional liability specialist with Western Security Surplus Insurance Brokers in Pasadena, Calif. E-mail: rorta@wssib.com.

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