Directors and Officers Liability Insurance

Dr Adolfo Paolini and Deepak Nambisan

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1 INTRODUCTION TO LIABILITY INSURANCE

I. THE NATURE OF LIABILITY INSURANCE

1.01 Insurance arose for the purpose of restoring the victim of an uncertain and unpredictable event, as far as is possible, to his or her original position. Insurance is essential to risk allocation between commercial operations, and also operates to remove the fear of personal and financial ruin. Since its earliest days, insurance has gradually expanded to cover the increasing risks inherent in a modern society. The earliest insurances were first party, in particular marine and, in due course, life, with the insurance of buildings and goods coming later. The idea of insuring against third party liabilities came relatively late, but liability cover is now a crucial element in all forms of insurance activity.

II. WHAT IS A CONTRACT OF INDEMNITY INSURANCE?

1.02 One of the main features of third party liability insurance1 is the fact that it belongs to the general area of indemnity insurance. Indemnity insurance may be defined as a contract under which the insurer agrees to indemnify a person (“the insured”), upon the occurrence of an uncertain and/or unpredictable event causing a “loss” to the insured, for the consideration of payment or the promise to pay a stipulated amount of money (“the premium”) to the insurer. The fact that it is a contract of indemnity means that the insured may recover only where he has suffered a loss caused by the occurrence of a peril insured against under the policy. 1.03 In answering this question it assists to differentiate between indemnity insurance and non-indemnity insurance. Although the aim of any type of insurance is to hold the insured harmless and indemnified where possible,2 that aim is manifested in different shapes and forms. Indemnity insurance pays compensation up to the amount of actual assessable loss3 in order to restore the insured to a similar condition to that which he/she would have been in if the unwelcome event had never happened. Although parties will almost always fix the maximum recoverable sum,4 unless the policy is “valued”, that is, the parties have agreed in advance the sum to be paid in the event of a loss,5 the exact amount of the actual payment

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falls to be ascertained at the time of the loss. Accordingly, the amount which may be payable is unknown by the parties when they enter into an indemnity insurance contract. 1.04 Non-indemnity insurance6 works differently since the contractual terms establish ab initio the exact sum payable to the insured in case they face the contingency. Since a contract of indemnity is an agreement by which one of the parties undertakes the obligation to compensate, within the terms agreed, he/she who suffers a loss up to the limit of the amount of their actual deprivation, subject to the financial limits of the policy, where the insured profits from their insurance by receiving more that their actual loss, the principle of indemnity is violated.7 The point was established by the Court of Appeal in British Cash & Parcel Conveyors v. Lamson Store Service.8 1.05 Third party liability insurance is the provision of coverage against either actual or potential damage caused by the insured’s personal or professional activity to a third person who is generally not a party to the insurance contract and whose individual existence is not contemplated by the policy at the date of its formulation. The insured’s insurable interest is based upon his/her potential legal liability to a third party, so that liability can be the subject-matter of indemnity in much the same way as physical loss. 1.06 The significance of third party liability insurance, as a submission-species of indemnity insurance, is reflected in its wide statutory recognition. Indeed, liability insurance is compulsory in a number of fields of activity9: for example, third parties are given a right of action against the insurers in the event that the insured becomes insolvent10 and the Marine Insurance Act 1906 recognises that third party liabilities give rise to an insurable interest.11 1.07 Professional indemnity cover is now a significant sub-species of third party liability insurance. Professional liability may arise from the failure to comply with statutory provisions, contractual obligations or common law rules. In professional indemnity cases there will normally be a breach of duty if the insured fails to comply with professional rules or standards of conduct.12 Liability generally does not arise on the basis of a failure by the insured to succeed in performing a task voluntarily undertaken for a third party,13 although if the insured voluntarily assumes the responsibility of achieving a particular result then he may face liability for failure to do so.14

III. THE SCOPE OF LIABILITY POLICIES

(a) Liability at law: is there a loss?

1.08 There is an additional important aspect of indemnity insurance that relates to what is considered to be a “loss” for the purpose of indemnity.15 The insured’s losses may be the

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result of either (i) a personal detriment or (ii) the fact of becoming potentially liable to pay damages to a third party by reason of a failure to comply with certain obligations or legal standards.16 Actual personal detriment, first-party property loss or damage and personal injury each fall within the first category. Anyone may insure their own belongings, house, car, etc and the contingency is the risk of losing these assets and the cost of replacing them. Furthermore, concerns may relate to matters such as the financial consequences of personal injury, the cost of medical treatment or even loss of income. Insurance may alleviate the insured during the period of recovery and compensate them in case of temporary or permanent disability. 1.09 As to the second category, the common law gradually came to recognise that a potential liability to pay damages could amount to a material detriment capable of giving rise to an insurable interest. However, it was suggested at first that nothing but payment would be satisfactory as proof of loss.17 Nowadays the established rule18 applicable to indemnity presupposes that “pay to be paid” is no longer a condition precedent for the right to an indemnity since “the plaintiff need not to pay and perhaps ruin himself before seeking relief”.19 This is the point at which the decision of the Court of Appeal in Post Office v. Norwich Union Fire Insurance Society Ltd 20 assumes crucial importance. In that case it was held that the insured’s right to an indemnity under a liability policy arose as soon as his liability to a third party was ascertained by means of a judgment, an arbitration award or a binding settlement contract,21 and not upon the earlier occurrence of the event which gave rise to such a liability,22 or on the later date on which payment was made to the third party by the assured.23 The standard form of wording under indemnity policies refers to the provision of cover when the insured’s “liability at law” is established, and this wording reflects the position reached in the Post Office case. That said, additional contractual terms may still be incorporated into a policy of this nature so as to prevent the insured from admitting liability without the written consent of the insurer or without allowing the insurer to take over the conduct of the defence proceedings on behalf of the insured.24

(b) Claim as a subject of indemnity

1.10 Third party liability policies can be issued in either of two forms:

(1) “occurrence” or “events” based; or
(2) “claims made”.

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1.11 Under an occurrence policy the insurer is required to provide an indemnity to the insured against his liability to a third party as long as the wrongful act which has caused loss to the third party occurs during the currency of the policy. It is immaterial that the insured’s liability to the third party is determined at some time in the future since what matters is the date of the occurrence of the contingency, provided that the contingency occurs during the policy period.25 1.12 Claims made policies work differently. Here, the insurer is required to indemnify the insured against any claim made against the insured during the currency of the policy, even if the event giving rise to the claim occurred many years earlier. A claims made policy may also provide indemnity for a claim arising after the insurance contract has been entered into, provided that the claim is made against the assured within the policy period. It is usually a requirement of a claims made policy that the insured notifies the third party’s claim to the insurers within the currency of the policy so that if notification occurs after the policy has expired the insurers are not liable (regardless of whether the claim is made against the insured during the period of coverage).26 Once the claim is reported to insurers, the insured discharges his/her obligation to notify the insurer and it is not necessary for the policy to remain in force at the time the claim is settled or finalised.27 1.13 Because a claims made policy applies to events which have occurred prior to its inception, the insurer will generally require any events likely to give rise to a claim to be disclosed when the contract is entered into. It is often a condition precedent that the insurer will not be liable for events which have been notified under earlier policies.28 The main purpose of a policy of this nature has been addressed by the American courts. It was held in Chas T Main, Inc v. Fireman’s Fund Ins 29 that “the purpose of a claims made policy is to minimize the time between the insured event and the payment”. This provides a series of advantages for the parties to the insurance. 1.14 First, by the end of the policy period, assuming that the insured has reported all the claims made against it, the insurer can complete its bordereaux30 of claims.31 Based upon this information or claims history the insurance company can in theory assess and accurately estimate its risk exposure, thus enabling it, again in theory, to offer lower premiums.32 In addition, the assured is relieved of any need to establish the exact date of occurrence where the wrongful act in question33 is spread over a long period of time.34 1.15 Secondly, shortly after expiration of a claims made policy the insurer can close its books.35 For insurers this is one of the claims made policy’s most important features. Under occurrence cover, insurance companies are obliged to keep their accounts open over a number of years to meet and cover events that take place and are reported within the relevant insurance period. As explained above, claims made policies work differently. The insurer on

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risk is the one to whom a claim is duly notified, irrespective of the time at which the event giving rise to the claim took place.36 This feature allows insurers to retire earlier since between the time at which a third party claims against the insured and that at which the insurer is to indemnify, no more than a few years may pass. Conversely, for example, in the case of a claim on an occurrence basis regarding asbestosis, which could develop within 20 or more years, the employer’s insurance at risk is the one whose policy is effective at the time when the employee contracts the disease. This forces the carriers of occurrence basis insurance to keep their accounts open for what may well be an unascertainable number of years, potentially affecting the insurer’s reserves, the opportunity to investigate claims in a consistent manner and/or any proportionate relationship between compensation and the original premiums (particularly if inflation is to be borne in mind).37 1.16 The problem of asbestosis and in particular the controversial decision in Fairchild v. Glenhaven Funeral Services Ltd 38 provides a perfect example of the potential problems that may arise. The decision of the House of Lords established that where an employee has been exposed to asbestos dust, which later causes the development of disease, by two or more employers, each is fully and individually liable for the resulting loss and regardless of the fact that the employee is unable to prove which of the exposures was the cause of his/her condition. Consequently, an occurrence policy issued many years earlier may result in an insurer, at risk when the exposure takes place, having to indemnify the employee in full irrespective of the fact that the disease develops some 10 or 20 years later.39 1.17 Thirdly, if the sum insured rises in each successive policy year with the inflation of decisions,40 the sum insured at the time of a later claim will be as likely to protect against the judgment made later in time.41 Also, with a claims made policy the insured is in a position to request a change in policy limits and negotiate new terms to reflect changes in personal circumstances or in accordance with his/her social, economical or legal environment.42 1.18 Finally, the occurrence policy provides separate limits of liability for each year of cover. For example, a five-year running policy written on an occurrence basis offers five limits of indemnity; in other words, the assured may use the cover on a yearly basis up to the total limit of indemnity. The limits to a claims made policy correspond to the number of years of cover, with the important difference that the assured has access to only one limit at any given point.43 So, a claims made policy also renewed for five years, although providing limits of indemnity for the same five years, allows the assured to exhaust only one limit—that of the year in which the claim was made and reported. 1.19 Against all this, policies issued on a claims made basis have the disadvantage of being very complex documents, difficult to both interpret and trigger. Cover under a policy of this type is triggered by the date the insured first becomes aware of and notifies the insurer of the claim or potential claim. Thereafter the insurer must defend, settle and indemnify the claim.44 As explained below, the question of notification imposes a heavy burden upon the

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insured, the execution of which represents a sine qua non condition for the activation of cover. 1.20 It is worth mentioning briefly that in certain (in particular) continental European countries there is or has been a dispute as to the legality of claims made policies on the grounds that they have an anti-consumer bias.45 Two main arguments have been advanced in support of the argument that claims made policies are against public policy. First, it is said, there is the harshness46 of depriving the insured of coverage for reasons outside his/her control. Since it is in the hands of the victim of any wrongful act to claim and thus notify the insured of a claim in process, if the victim takes the view that a claim ought to be delayed and, in fact, commenced at some time after the wrongdoer’s policy period lapses, this may prevent the assured from notifying the insurer in sufficient time in order to trigger coverage. This imbalance has led to the second major concern that there is an unlawful advantage geared only towards the profits of the insurer.47 Nevertheless, any doubts about the lawfulness of such policies have now been resolved and, in harmony with market practice, a series of statutes have been enacted in the countries in question in order to clarify the issue and lift the barriers preventing claims made policies functioning as designed.48 Consequently, it is safe to say that the continental European market represents no obstacle to the implementation and enforcement of policies trigger on claims made basis.

(c) Insurable risk: professional negligence 49

1.21 The subject-matter of liability insurance is not confined to the standard terms offered or strictly adhered to by insurers. One of the most important features of such policies is that they are often tailor-made, individually discussed between underwriters and the insured’s broker and adapted to the insured’s special needs. 1.22 It is commonplace that insurers observe three basic elements of risk50:

(a) the use of goods supplied by the professional;
(b) the provision of defective services; and
(c) defence costs.

1.23 First, liability insurance may afford cover for the use of goods supplied by the professional.51 Motor accidents, the use of machinery or the supply of defective goods are the most important examples under this heading.

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1.24 Secondly, and most importantly, the policy will extend to liability for the provision of defective services. The concept of the provision of services is extremely complex due to the variety of forms such services may take. The main legal principles in respect of the provision of services are found in the seminal decisions of Donoghue v. Stevenson 52 and Hedley Byrne & Co Ltd v. Heller & Partners Ltd. 53 In the first case it was emphasised that, for the purpose of indemnity, the victim is not required to be either a customer or a party to a contract with the potential wrongdoer. The break with the notion of privity of contract having been achieved, the decision in Hedley Byrne extended the concept of liability for the provision of services. In this context, professional negligence may be defined as “a failure to meet the standards of care to be expected from the average competent and experienced practitioner as to render the professional person committing the act, error or omission liable in law to a client or some other third party who occasions reasonably foreseeable loss by reason of reliance of that act, error or omission.”54 In order to succeed in a claim for professional negligence the victim must therefore satisfy three requirements:

(a) it must be proved that a duty was owed by the professional to the victim, such a duty normally arising as a result of an assumption of responsibility by the professional;
(b) it must be proved that there has been a breach of such a duty; and
(c) the victim must demonstrate that there has been damage inflicted upon him.

1.25 The result is that a person who suffers a loss as a result of relying upon negligent advice provided by a professional may successfully sue.55 Consequently, a professional indemnity policy provides cover in respect of liability for professional negligence claims arising out of breach, or even allegations of breach, of the duty of care in contract or in tort,56 provided the insured was acting in the ordinary course of their business or profession. 1.26 On the meaning of “liability”, in terms of what may or may not be covered under a liability insurance policy, the Court of Appeal has recently confirmed the controversial decision of the High Court in Tesco Stores Ltd v. Constable, 57 taking a narrow view of a contractual liability extension to a policy of public liability insurance and confining it to covering claims only to the extent they were co-extensive with a duty of care in tort. Tuckey, LJ commented that the type of insurance policy in question was “a strong pointer to the meaning of the words used” in a case such as this. The loss in respect of which Tesco claimed indemnity was in respect of pure economic loss. The fact that the policy in question was one for public liability insurance was therefore important since such policies do not generally cover pure economic loss. Accordingly, wording extending the ambit of the policy in question to cover third party claims in contract for such loss would be expected to say so clearly. By way of contrast, in Bedfordshire Police v. David Constable, 58 the Court of Appeal took a more purposive and commercial approach to the question of what “liability” is

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covered by an insurance policy. The court held that words in a public liability policy should be construed in order to give effect to the commercial purpose of the policy. In that case a Lloyd’s syndicate tried, unsuccessfully, to argue that the words “compensation” and “damages” should be distinguished such that the former was not covered by the policy. The court relied heavily on the fact that the syndicate has offered insurance knowing that the claims now sought to be distinguished as “compensation” were part of the usual liabilities of the assured police authority. 1.27 Thirdly, a professional indemnity policy will extend to coverage for defence costs. Liability for defence costs, a vitally important topic, is analysed in more detail in chapter 8, below, but it is useful, albeit briefly, to touch upon the salient features here. This element of cover is generally framed as a separate undertaking, operating independently of the primary cover for legal liability.59 Accordingly, there may be (and often is) an obligation to indemnify for defence costs even though there is a dispute as to whether the claim actually falls within the scope of the policy, a matter that may be resolved only in judicial proceedings examining the nature of the insured’s liability (if any). All that is generally required is the possibility that the claim falls within the scope of the policy.60 In some cases (rare in the case of D&O insurance), the contract may require that, for defence costs to be payable, the insured’s liability to a third party in respect of an insured risk has actually been established. Consequently, where the third party fails to prove liability on the part of the insured, under this form of wording the latter may have no right to recover defence costs under the policy and must instead look to the claimant to recover his costs in accordance with the ordinary principle that costs follow the event.61 1.28 Note that cover for defence costs may well be available even if the proceedings against the insured are not claiming damages (the usual remedy in cases of breach of contract, breach of a duty of care in tort or breach of fiduciary duty), but instead seek an injunction, declaration or rescission.62 The indemnity in respect of costs may also extend to the costs of defending proceedings brought by a professional disciplinary tribunal, but only where the sanction against the insured is unlikely to be financial in nature.63 1.29 One of the most important consequences of the principle that liability for defence costs is an obligation independent of the insurer’s primary obligation to indemnify is the danger of waiver. Where insurers become aware of a defence to a claim for indemnity (based, for example, on a breach of the duty of utmost good faith, a breach of condition or a breach of warranty) but nevertheless decide to undertake the insured’s defence, there is a risk that they may be deemed to have waived their rights to rely upon the relevant defence.64

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(d) Additional contractual terms

1.30 The nature of indemnity insurance demands that there be additional contractual terms in place so as to prevent either a spontaneous acceptance of liability on the part of the insured or a default by the insured in exercising their professional obligations. Either of these situations may prejudice the insurer by imposing a liability to indemnify the insured in circumstances where the insured’s liability could in fact have easily been avoided. 1.31 As to the first of these possibilities, it is commonplace for insurers to include a clause excluding liability under the policy where the insured has accepted liability without the written consent of the insurers. Although it is sometimes specifically stated that such consent must not be unreasonably withheld,65 in the absence of such wording, the current weight of authority favours the view that the court cannot second guess the decision of the insurer in this regard unless it is shown to have been based upon considerations entirely extraneous to the claim.66 This provision is often coupled with an express right reserved to the insurers to conduct the defence proceedings on behalf of the insured and to agree any settlement arising out of any claim against the insured. 1.32 There may well be a dispute between the insurers and the insured as to whether it is appropriate to defend proceedings: the insurers may wish to defend if they believe that the insured has a good chance of success, but even if the prospects are not at all good, the insured may nevertheless wish to defend in order to clear their name. To that effect, professional indemnity policies traditionally include a clause providing that insurers shall pay an indemnity without contesting any claim by a third party unless a Queen’s Counsel (mutually agreed on by the parties) advises that the proceedings should be contested. These contractual terms are known as “QC clauses”67 and their purpose is purely to settle any dispute between the insured and the insurer as to whether a claim ought to be contested or not. The nature and legality of a QC clause were considered by Devlin, J in West price & Co v. Ching.68 The issue in that case was whether the QC clause operated where there was a dispute between the parties as to whether the third party’s claim fell within the scope of the insured risks. The judge classified the QC clause as a form of contingency insurance rather than indemnity insurance and held that a dispute as to coverage had to be resolved by the court before the QC clause could operate. 1.33 The second contractual provision relates to the obligation of the insured to take reasonable care to prevent liability from arising in the first place. The problem here is that the trigger for liability insurance is generally a failure on the part of the insured to comply with the required level of care and skill in their dealings with a third party.69 Since this type of insurance provides cover for liability arising out of professional negligence, it is readily apparent that a term of this nature could operate to defeat the very cover provided by the policy. Accordingly, the courts have determined that such wordings of this nature fall to be construed as meaning that the insured is not covered where the conduct is either deliberately aimed at causing a third party loss, or occurs with reckless disregard as to whether loss is

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caused to a third party. In other words, mere negligence on the part of the assured will not defeat a claim under a professional indemnity policy.70 This contractual position more or less reflects the common law in this regard. 1.34 Finally, it should also be noted that professional indemnity policies, being contracts of indemnity, confer upon insurers the benefits of the principle of subrogation. Thus, by indemnifying the insured, the insurer retains the right to proceed against any third party who has contributed to the insured’s liability or any third party whose conduct has wrongfully caused the insured to incur insured defence costs.