Underwriting & Broking Insolvency Risks for D&O

Recently, a lot of brokers I’ve spoken to have complained about Insurer’s current approach to negative profit (i.e., loss making) companies. Namely, slapping an Insolvency exclusion on and calling it a day. So, in today’s article let’s look at the risks associated with insolvency, the application and use of insolvency exclusions, other considerations for underwriters, and finally some helpful tips for brokers in what information to provide to underwriters when negotiating the removal of an insolvency exclusion.

What is insolvency?

The Oxford dictionary simply describes Insolvency as “the state of not having enough money to pay what you owe”, and, although succinct and a bit simplistic, you certainly can understand exactly what we mean when we say a company is insolvent or facing insolvency.

Of course, most will immediately note that insolvency is not directly linked to simply making a loss. The two would appear intrinsically interlinked but this is not the case, as it is true both that:

1. Companies can make a loss (for several years) without being insolvent; and

2. Companies that are ‘profit-making’ can also become insolvent without ever posting a trading loss.

It is scenario 1 above that seems to really get brokers worked up when an insolvency exclusion is applied, and for understandable reasons. Let’s take a quick moment to flesh out an example more fully of when a loss-making company can avoid insolvency.

By far and away the most common example is a company which is backed by a much more financially stable parent or has significant P/E funding. This is very commonly seen is highly competitive industries. Take for example Disney and the Disney+ streaming service. They are not separate legal entities, but the analogy should work all the same.

Disney+ is a global streaming service featuring most of Disney’s, Fox’s and many others greatest hits and newest shows. It was created to compete with the likes of Netflix. It has over a 130m subscribers globally according to reports and yet, it doesn’t make Disney any money. In fact, it lost $2.8 billion in 2020, and some analysts expect it to continue draining money until at least 2024.

However, it’s extremely unlikely that (if it were possible) Disney+ would be insolvent, and that is for one major reason – it is backed by the financial behemoth that is the Walt Disney Company. With a net worth of nearly $100 billion, Disney can pump near unlimited cash into Disney+ until it makes money. It’s not about to cease trading because it lost money, it will simply get a new injection of cash until it no longer needs that.

Of course, there will always come a time when an experiment is deemed failed, but this just goes to show that loss does not equal insolvency.

Let’s now look at scenario 2 and provide some explanation around this.

Imagine if you will a company which made £30,000 last year. However, this is on an annual basis. Now, imagine this. They have a huge contract which is due to pay them £100,000 in Q4 2022, but – they have a loan outstanding for £70,000 which is due to Q1 2022. They don’t have £70,000 sitting around, it’s all dependent on this massive Q4 contract. They fail to pay the loan, and, for whatever reason the creditors seek insolvency proceedings to recoup their cash rather than extend the repayment period.

This introduces another very important concept – cashflow.

A company with poor cashflow is just as likely to fall afoul of creditors as a company which did not make any profit last year.

What risks does insolvency pose to D&O insurers

Some brokers, when presenting a harder to place risk, will simply ask an underwriter to put an insolvency exclusion on the policy if they decline to quote due to risks financials, or other times they will argue at length on pricing under the assumption that “the insolvency exclusion protects you (the insurer) from claims”. Unfortunately, both scenarios are based on a misconception that insolvency exclusions are the holy grail of protection to insurers when, in fact, they are not. This is due to what I will term ‘direct’ and ‘indirect’ insolvency exposures.

1. Direct Insolvency Exposures

These are the exposures that, theoretically, a properly worded insolvency exclusion should pick up and ‘protect’ the insurer against. Note this list is not exhaustive but contains just a few examples.

(i) Insolvency Act 1986 (the Act)

The Act contains various provisions under which directors (or former directors), or even the appointed administrator or liquidator, can be compelled to provide financial recourse to the company or even face prison time.

For example, section 212 provides the following:

(1) This section applies if in the course of the winding up of a company it appears that a person who

(a) is or has been an officer of the company,

(b) has acted as liquidator or administrative receiver of the company, or

(c) not being a person falling within paragraph (a) or (b), is or has been concerned, or has taken part, in the promotion, formation or management of the company, has misapplied or retained, or become accountable for, any money or other property of the company, or been guilty of any misfeasance or breach of any fiduciary or other duty in relation to the company.

(2) […]

(3) The court may, on the application of the official receiver or the liquidator, or of any creditor or contributory, examine into the conduct of the person falling within subsection (1) and compel him—

(a) to repay, restore or account for the money or property or any part of it, with interest at such rate as the court thinks just, or

(b) to contribute such sum to the company’s assets by way of compensation in respect of the misfeasance or breach of fiduciary or other duty as the court thinks just.

Furthermore, Section 214 of the Act allows for a liquidator or administrator to apply to the courts to force a director (or former director) to make a financial contribution if they “knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation or entering insolvent administration”.

Section 214 also makes former directors personally liable for any failing to take every step which ought to have been taken, with the aim of minimising the potential loss to the company's creditors.

(ii) Pension Funds

A company’s pension fund is often one of the largest creditors, so there may also be claims from the Pensions Regulator and/or the pension trustees if the conduct of the directors negatively affected the fund. Regulators have extensive investigation powers in matters of this nature.

2. Indirect Insolvency Exposures

These are the exposures an underwriter must continue to consider even if an insolvency exclusion is added to a policy. A lot of the indirect exposure from insolvencies occurs due to two main reasons:

• The narrow language of an insolvency exclusion; and

• The more general issue of the poor financial state of a business

Consider this, if a business is doing all it can to simply stay afloat, or to meet debts as they fall due – do we really think that they are being 100% pro-active in managing their risk elsewhere? If cash is in short supply, are they going to pay to have their machinery checked and serviced as regularly as they should? If not, that’s a potential claim for a HSE investigation, or even a defence action against corporate and/or gross negligence manslaughter on a D&O policy.

Perhaps some layoffs need to occur as staff expenses are too high – however, they can’t afford or refuse to use proper legal counsel and they conduct the redundancy process incorrectly – that’s a potential EPL claim (and with multiple claimants at that!).

Perhaps they decide one creditor is more important that another, or they renege on the terms of another contract which they can no longer afford to buy the supplies for to fulfil – that’s a potential contract claim under CLL coverage.

You can quickly see from the few examples above the knock-on effect a looming insolvency might have on the way a business is run, and none of these exposures would be picked up by your standard insolvency exclusion wording, or at least we’d have to have a long, drawn-out case to consider if they would.

Insolvency & COVID-19 – Is the worst yet to come?

The UK government introduced a number of measures aimed at protecting businesses and jobs from the impact of repeated COVID lockdowns. The largest of course being the Furlough and Business Loan schemes. However, a few less headline worthy changes were made that have very recently come to an end, and insurers are now (rightly) concerned about the tail on these schemes.

A few months ago I did a post (which you can read here) about the governments temporary memorandum which suspended statutory demand provisions and winding up petitions being submitted to the courts for COVID related debts. Although greatly reduced in October 2021, some caveats remained in place until just last month in March 2022. Therefore, businesses are now without the protection this memorandum offered, and those who have still failed to turn things around are no longer protected from the looming threat of insolvency.

Although there has not yet been the floodgate some predicted, we are still at very early doors with this situation, and insurers continue to be somewhat cautions in the wake of the memorandum’s removal.

Insolvency exclusions (and some other common limiters in policies)

1. Insolvency Exclusion

Different insurers have different insolvency language, but they generally all share similar traits. You might see something like:

• The Insurer will not pay for any claim or loss arising from, related to or in connection with any insolvency, including any liability under the Insolvency Act 1986; or

• The Insurer shall not have any liability for any loss directly or indirectly related to, arising from or in any way connected to any insolvency, administration, receivership or winding up of the company.

2. Insolvency Hearing/Investigation Sub-Limits

Several leading insurers standard D&O wordings include an extension for insolvency hearing (or investigation) costs. However, these are often sub-limited to a fraction of the total limit purchased, commonly £100,000 but some providers such as AIG have been noted offering limits of £50,000 for claims under this heading. These sub-limits apply as standard, and there has yet to be much flexibility seen to getting insurers to up these.

3. Other exclusions which may apply

The vast majority of D&O policies contain exclusions related to “fraudulent or deliberate acts” of directors. When appointed, liquidators and administrators may seek to recoup costs from former directors, but even without an express insolvency exclusion an argument could be raised as to the conduct of the former director and whether such conduct would be caught by the fraudulent or deliberate acts exclusion. For example, if a director continued trading even after it became clear the company was insolvent, that could well be a deliberate act for the scope of the exclusion.

Another source of potential limitation is if the policy contains an “insured against insured” exclusions which usually provide that insurers are not liable to pay any losses relating to a claim commenced by one insured against the company or other insured person. Depending on the language and structure, this exclusion may deny coverage for any claim by a liquidator or administrator commenced on behalf of an insolvent company against its former director, since both parties are insureds under the D&O policy.

Helpful information when negotiating removal of insolvency exclusions

Here’s a few examples of things underwriters look for when a broker asks to remove an insolvency exclusion. If you have a client facing an unacceptable exclusion, and you’re seeking to get this removed, it is always helpful to have this information to present to the underwriter.

1. Cash Runway and Cash Burn

Cash runway is a very simple calculation that, in theory, shows how long the business can operate on its current cash reserves without needing to raise additional funds. The formula for calculating cash runway is as follows:

Total Cash / Cash Burn* = Cash Runway

So, if you have a business with £100,000 cash in hand, and they have a cash burn of £10,000 a month, then the cash runway for that business is 10 months. As an underwriter, this falls inside my standard policy period (assuming 12 months), and so without reassurances on new injections of capital, I’m unlikely to consider removing the insolvency exclusion.

However, if they have a cash runway of greater than 12 months, or a contractually guaranteed injection of cash at some point in the future within their current cash runway, this will give me more comfort about removing the exclusion, as any insolvency is unlikely to occur in my immediate policy period and we can review it again at renewal.

*To calculate the cash burn, use the following:

(Starting Balance – End Balance) / No. of Months

So, if you have £150,000 on 1st Jan 2022, and on 31st March 2022 (end of Q1 and a 3-month period), you have £90,000, the calculation will look like this:

(150,000 – 90,000) / 3 = £20,000

Your cash burn is therefore £20,000 a month on average.

2. New or Extensive Funding Sources

Even if the cash runway or cashflow show negative results, you may be able to convince an insurer to offer cover without an insolvency exclusion if you can show guarantees of external funding being available to cover the liabilities as they fall due for the policy period.

This could be in the form of contractual commitments by parent companies, directors, or third-party investors to loan the business money or purchase equity, or perhaps unutilised bank loan or draft facilities (although they must be careful to not simply pile on more debt for a later time which they cannot afford).

Some underwriters will only accept guaranteed monies, whereas others may be open to the business simply showing they are in substantive talks with providers or investors, or have engaged assistance to launch a funding round, for example.

3. Debt Restructuring / Types of Debt

Debt restructuring can show a good awareness of the problem and a pro-active effort to find a solution. Generally, if banks or other creditors are willing to accept these sorts of arrangements it means they are at least somewhat confident that they will get their money at some point, which is also reassuring to us underwriters.

Some debt forms are also not as scary as others, convertible loan notes for example mean that if the company cannot pay its debts, they convert into equity in the business and so they are far less likely to result in creditor action (at least in the short term) and are a good way of raising capital as long as used responsibly (so they aren’t giving away control of the business in the process).

4. Historic strong performance

Very rarely, it is sad to say, are underwriters given up to date financials on companies, especially in the SME space. There is a clear push to write risks on less information and even simply via a proposal or statement of fact, which is all well and good for straight forward risks, but not when you are looking at companies like we have been discussing today.

When mapping performance over time underwriters should be presented with at least 3 years financial history, and ideally five or more. If you, as the broker, can shown that their current loss is due to a ‘blip’ (e.g., COVID closures, loss of a large contract which is being replaced etc.) and that historically the business has a sound financial framework and a robust customer base, then this will also go some way to assuring that an insolvency exclusion may not be needed on the policy.

Conclusion

This post has provided a short outline of a just a few key exposures presented in regards to insolvency for D&O insurers. We have considered how insolvency arises and also situations where insolvency may appear imminent but is actually a very remote event. This post has also provided a few key pointers for brokers and underwriters to consider when negotiating insolvency coverage.

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This insight piece is intended and published for information purposes only. It does not represent legal advice of any form, and although every reasonable effort has been taken to ensure the information is correct at the time of publication, the author does not accept liability for reliance on any errors or omissions contained within.