Even for established companies with proven track records, the current directors and officers (D&O) insurance market is challenging. For early-stage companies, present underwriting practices for D&O insurance resemble (rather like the opening line of Dickens' "A Tale of Two Cities") "the best of times and the worst of times."

In one sense, it's the "worst of times" for these small venture-backed companies because underwriters are looking to reduce their exposure to "risky" firms. Early-stage companies often have minimal cash reserves. Many are engaged in research and development that burns through cash without any hope of generating revenues in the near term.

As recently as six months ago, carriers seemed willing to overlook these risks, and obtaining D&O insurance for entrepreneurial companies was as easy as submitting cursory information and waiting a few days or hours for a quote. Not anymore. For the first time in years, earlystage companies are being underwritten with a sharper pencil. More documentation is being sought, and the length of time from submission to approval can now be weeks rather than days.

Underwriters now want to see more supporting financial information such as year-end and interim financial statements, cash on hand, funding sources — even, in one recent case, the company's most current bank statements.

The increased review has translated into some pricing impact. Several years ago, underwriters would not have been able to price for increased exposures, like higher employee counts and increased assets, but we are now seeing rate increases in cases where the employee count has increased significantly or where there have been claims against a company. Even if firms are lucky enough to receive a flat renewal, terms may be more restrictive. For example, there may be bankruptcy exclusions, higher deductibles, specific event exclusions, or exclusions for non-active investors or owners.

But there's also the "best of times" aspect of the situation.

The good news is that, while underwriters may be putting companies seeking D&O coverage under a microscope of scrutiny, these same carriers are probably grappling with overcapacity in today's weak economy.
Most of them genuinely need the business, which means that D&O coverage is available to even the riskiest of entrepreneurial companies — but only if they're willing to take the time required to gather and submit detailed information to carriers.

Scrutiny Plus Carriers' Overcapacity

Given these conflicting trends — tighter scrutiny plus carrier overcapacity — we're advising our clients to budget for the worst — but work for the best.

Smart CEOs and risk managers are learning that investing time to educate D&O underwriters about their company, its financial position and its future prospects will help minimize exclusions and rate increases at renewal.

By far the most important consideration for underwriters is a company's cash position. One company we know had only a three- to-four month cash reserve, versus the 12- to-18-month reserve underwriters like to see. Carriers know that a company with such a weak cash position can be quite vulnerable to bankruptcy. And bankruptcies always mean claims and litigation — things underwriters understandably seek to avoid.

In addition to its weak cash position, the aforementioned company also didn't allow adequate time for its application to be processed in this new world of increased scrutiny. We scrambled to compile all the basic information, and then we added explanatory paragraphs related to the company's cash reserves, its anticipated sources of new capital and other relevant financial information. In the end, the company obtained a renewal and the rate wasn't too bad, but the terms were more restrictive than previously.

Another consideration is that early- stage companies can't afford to be without insurance protecting their directors and officers in the event of lawsuits or other claims against the company.

In the current climate, our best advice to clients is that they start this process early as well (at least 60 to 90 days in advance). Also, be prepared for the process to include some interaction between the insured parties and carriers, either in person or at least by phone.

Be Creative

The current climate means that more creativity may be required, both in initial approaches to carriers and in how financial information is packaged to make it easy for potential underwriters to gain a "feel" for a company.

Some tips for navigating the current climate:

• Don't judge D&O insurance on price alone. Adequate and favorable coverage is the most important objective.
• Begin the renewal process at least three months in advance of the renewal. This will allow time to prepare the detailed financial information that underwriters now require.
• Foster a personal relationship with the underwriter. Make an effort to speak personally with underwriters to educate them about the company and its prospects. Choose the most passionate company spokespersons to participate in the call.
• Take the time to prepare a professional, complete submission that answers every possible question an underwriter may have about the company.
• Compare D&O insurance policies from a number of underwriters to ensure the company receives the most complete coverage. If building greater than $5 million in limits, include several carriers in the D&O insurance program. This provides flexibility and adds up to more coverage overall.

How will this modern-day Tale of Two Cities end? We believe that — at least through the end of 2009 — the abundance of carrier capacity will continue to offset the negatives that underwriters associate with D&O coverage for venture-backed companies. The process of creating, negotiating and acquiring D&O liability programs will remain time-consuming, confusing and frustrating. Teamwork between an experienced risk manager and a reputable broker or advisor ensures the best shot at a winning strategy.

Schwander is executive vice president and Owens is senior vice president of Lockton Denver's Financial Services practice. Both are national experts on D&O insurance, IPOs, bankruptcies, funding mechanisms, multiyear structures, mergers and acquisitions, and evergreen clauses. E-mail: mike.schwander@lockton.com; rachael.owens@lockton.com