The ACE Report is a periodic publication distributed to policyholders and other interested parties as a service by ACE. Its purpose is to address insurance concerns worldwide, as well as present timely information on current developments in liability issues surrounding directors and officers. The Editor of The ACE Report is Dan A. Bailey, a lawyer at Arter & Hadden in Columbus, Ohio, USA and a respected voice in the complex area of directors and officers liability.

Although prepared by professionals, this publication should not be utilized as a substitute for legal counseling in specific situations. Readers should not act upon the information contained herein without professional guidance.

D&O INSURANCE ALLOCATION
For various reasons, D&O insurance allocation issues are becoming a greater focus of insurer-insured discussions in both the underwriting and claims context. This Report explains this important issue and alternative coverage enhancements now available in the market to minimize those issues.

WHAT IS "ALLOCATION"?
The term "allocation" refers to the process of determining the amount of defense costs, settlements or judgments which is properly attributable or "allocated" to covered claims against insured directors and officers ("D&O"), on the one hand, and uninsured claims against D&Os and uninsured defendants, on the other. In essence, allocation simply refers to the process of determining the amount of insured loss when that loss is commingled with uninsured loss. The allocation process is one of the most troubling aspects of D&O insurance claims handling. It can result in a contentious claims handling environment if the insureds and insurer are not adequately forewarned of the allocation issues or reasonable in their allocation expectations.

The following example demonstrates how, depending upon the facts and allegations in a particular case, the allocation issued can potentially reduce the total recovery from a D&O insurer in a typical lawsuit which names as defendants both D&Os and the corporation:

WHEN IS ALLOCATION REQUIRED?
Allocation of loss is typically required in two situations.

Covered vs. Uncovered Parties. Some D&O lawsuits name as defendants not only directors and officers, but also their corporation or other parties. If the defendant D&Os retain the same defense counsel as their corporation or other uninsured defendant or incur jointly with an uninsured defendant a settlement or judgment, the D&O insurance policy covers only the portion of the defense costs, settlement or judgment attributed to the claims against the insured directors and officers.

Covered vs. Uncovered Allegations. A claim against insured D&Os may include both allegations which are insured under the policy and allegations which are not insured. For example, a claim may allege liability by a D&O in his/her capacity both as a director or officer and as a shareholder of the corporation. The D&O policy covers loss attributable to the alleged D&O liability, but not to the alleged shareholder liability. Similarly, a claim against D&Os may allege both liability covered by the D&O policy and liability not covered by virtue of one or more policy exclusions.

CAN A CORPORATION COMMIT WRONGDOING SEPARATE FROM ITS D&Os?
A corporation obviously may act only through its directors, officers, employees and agents. This raises the question whether the liability exposure of a corporation should be solely attributable to the conduct of the individuals who created that liability exposure. Two bases exist for allocating loss directly to a defendant corporation even though the corporation is a defendant by virtue of acts committed by its directors, officers, employees or agents.

First, a corporation is a separate legal entity which may act by itself and directly incur debts and liabilities independent from its directors and officers. For example, corporations may enter into contracts and incur obligations for which its D&Os are not legally responsible. In the eyes of the law, a corporation is a separate "person" which can independently act and incur liability. Corporations make disclosures and disseminate information, hire and fire employees, issue and foreclose on loans, etc. Liability exposure arising from these corporate acts should be allocated at least in part to the corporation even if the insured D&Os participated in those corporate activities.

Second, some corporate liability exposure may arise from the conduct of employees or agents of the corporation who are not D&Os and thus not insureds under the D&O policy. The corporation, not its directors and officers, may be vicariously liable for the wrongdoing of those uninsured person. In addition, D&Os who are not defendants may allegedly approve, acquiesce, participate or fail to properly respond to wrongdoing by defendant D&Os, thus also creating vicarious corporate liability.

WHAT HAVE COURTS SAID ABOUT ALLOCATION?
Relatively few courts have addressed allocation issues in the D&O insurance context, although the number of court decisions on this topic is steadily increasing. Courts have consistently relied that allocation is necessary if D&Os incur solely or jointly with others both insured and uninsured loss. Courts have not provided meaningful guidance, though, as to how allocation should be determined. The primary methods which have been recognized to varying degrees are summarized as follows:

Pro rata. Under a pro rata method of allocation, the loss to be allocated is simply divided equally among each of the defendants. For example, of the total loss is $5 million, which is jointly incurred by five defendants (four of whom are D&Os and one is the corporation), $4 million is allocated to the D&Os and $1 million is allocated to the corporation. Some courts have recognized that in applying this pro rata method, defendants similarly situated should be grouped together and treated as one. Thus, under the above example, the D&O defendants would be treated as one group if their conduct and basis for liability exposure was substantially similar. In that event, the loss would be split evenly between two groups, with $2.5 million being allocated to the D&Os.

The pro rata allocation approach frequently leads to inequitable results since it ignores the fact that various defendants do not normally have equal liability exposure and do not normally benefit equally from the defense and settlement of a lawsuit. Although the "grouping" approach tends to mitigate this inequity to some extent, it still results in rather artificial allocations which are not consistent with the unique facts and circumstances of each case. Accordingly, this methodology is not endorsed by many courts.

Relative Exposure/Benefit. This allocation method seeks to determine the relative liability exposure from the subject claim and the relative benefits incurred by the defendants in defending and settling the claim. Among other things, this method takes into consideration the allegations in the claim, the factual and legal support for the claims and the defenses of the defendants, the collectibility from each defendant, the benefits realized by the defendants in settling the case, the intent of the parties behind the settlement, and similar factors. This method results in a more equitable allocation of loss, but is extremely fact specific and somewhat subjective in its application.

"Larger Settlement Rule". A few courts have limited allocation to the corporation only to the extend that wrongful acts of uninsured parties increase the amount of the settlement. Thus, under this method, a portion of the settlement amount is not covered only to the extent that portion would not have been incurred absent wrongdoing by the uninsured parties.

Reasonably Related Defense Costs. Several courts have adopted a somewhat different method for allocating defense costs, recognizing coverage for all defense costs which are "reasonably related" to the defense of covered claims against insured D&Os. These cases frequently state that defense costs are "reasonably related" to the defense of covered claims if those costs would have been incurred if only covered claims against insured D&Os were alleged in the lawsuit. If defense costs relate to benefiting both covered and uncovered claims, these cases would hold that 100% of the defense costs should be paid by the insurers. This method appears to permit the corporate defendant to obtain a "free" defense by "riding the coattails" of the D&Os and the D&O insurance policy.

HOW HAVE D&O POLICIES ADDRESSED ALLOCATION?
Prior to the late 1980s, D&O policies did not expressly reference allocation, instead relying upon the insuring agreements and exclusions to define what loss would and would not be paid by the insurer. Beginning in the late 1980s, D&O policy forms began to recognize expressly the need for allocation of loss, particularly when both D&Os and the corporation are defendants. The National Union Fire Insurance Co. policy provision is typical:

Beginning in 1993, a few D&O insurers introduced two different policy endorsements to partially resolve allocation issues in advance. One approach, first offered by Chubb in early 1993, identifies in the policy a predetermined allocation percentage which applies to certain types of allocation, regardless of the facts of each claim. As originally introduced in 1993, this approach was limited to the allocation of defense costs. In early 1994, Chubb began offering a revised endorsement which pre-determines the allocation of all indemnified loss (i.e. defense costs, settlements or judgments) in securities claims where allocation is otherwise required. The endorsement contemplates a different allocation for defense costs than for settlements and judgments. The additional premium charged for this endorsement varies depending on the selected allocation percentage and can be quite substantial.

The second approach, first introduced by National Union Fire Insurance Co. in late 1993, extends D&O coverage (subject to a co-insurance clause) to claims against the corporation for either "open-market" or all securities claims in which both D&Os and the corporation are initially named as defendants, thereby eliminating the need for allocating loss between the corporation and the defendant D&Os. The additional premium charged for this endorsement varies depending on the selected co-insurance percentage and can be quite substantial.

WHAT CAN INSUREDS DO TO REDUCE ALLOCATION PROBLEMS?

• Understand the issues before the claim is made.
• Discuss with senior management and directors the allocation issue before the claim is made so that unreasonable expectations are not created.
• Consider the benefits and costs of purchasing an allocation endorsement.
• Discuss allocation practices with the insurer both before and soon after the claim is made.
• As allocation discussions become difficult, don't rush to litigation; keep talking.
• Involve principals in the claims allocation discussions in addition to, or in lieu of, legal counsel.

CONCLUSIONS
Allocation issues will continue to represent the single most difficult aspect of a D&O insurance claim, in many situations. However, use of an appropriate and cost-effective endorsement, combined with prudent and preventative allocation practices, can minimize this sometimes contentious aspect of the insurer-insured relationship.