Delaware law to broaden captive landscape for D&O buyers

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On February 7, 2022, Delaware Governor John Carney signed into law a groundbreaking bill that opens up new directors and officers (D&O) liability insurance options for companies. Senate Bill 203, which passed the legislature unanimously on January 27, 2022, clarifies how companies can use captives for Side A D&O coverage.

When exploring the impact of this law on their D&O insurance programs, companies should consider the following:

The scope of D&O coverage allowed through a captive may not exactly mirror the scope of coverage afforded in the commercial D&O insurance market. Companies should assess the cost/benefit tradeoffs.
Careful crafting of the captive vehicle and funding will be required to provide bankruptcy remote protection, equivalent to an insurance policy.
It is important to work with legal counsel and a risk advisory team that has both D&O and captive expertise.
Having captives as an option should help further enhance the competitive forces in an improving D&O insurance market.

Background detail about captives and D&O insurance, an overview of the new Delaware law, and the law’s implications can be found below.

Why use a captive for D&O exposures?

A captive can be used as an alternative to purchasing a commercial insurance product for any particular peril. There are different ways to structure a captive. Most commonly, a company may create a wholly owned subsidiary entity that acts as a captive. That subsidiary is capitalised to protect against potential claims. Another mechanism to accomplish the same goal is to utilise a “cell” within a pre-existing captive owned by an unaffiliated third party.

Captives can be used to insure a wide range of risks that would otherwise be covered by commercial insurance. Coverages like workers’ compensation, which is characterised by a high degree of claims frequency, are often a practical choice for captive use due to the extensive claims history and loss predictability. This claims history allows for robust and accurate actuarial modelling when determining how much capital to include in the captive to fund potential claims. Through proper planning, a captive may provide a more efficient use of capital to cover a particular risk area.

While the perils insured by D&O insurance — such as securities class action litigation — do not typically happen very frequently, companies can face sizeable defence cost and settlements when they do. This is often a reason why D&O insurance has not been included in a captive structure as frequently as other coverages.

Another significant reason revolved around uncertainty as to whether or not a captive could protect the directors and officers against a non-indemnifiable claim when the company is prohibited or financially unable to indemnify them.

A frequent example is a settlement payment in a shareholder derivative action. To date, Delaware law has permitted companies to indemnify defence expenses on behalf of an individual director facing a derivative claim, but not any resulting settlement. The public policy rationale is that the damages represent harm to the company itself and by indemnifying the individual for that amount, the company ultimately is not recovering any compensation. This raised the question: Is a company’s wholly owned captive allowed to include coverage for what would be non-indemnifiable, Side A loss?

New Delaware law facilitates captive use

The recently approved amendment to Section 145(g) of Delaware’s general corporation law specifies that companies can provide D&O coverage to their board members and executives through a captive. Notably, it expressly indicates that companies can include Side A coverage in captives where a loss may otherwise be non-indemnifiable by the company.

The amendment synopsis stipulates that D&O exposures can be included in a captive insurance company controlled by a corporation and can provide coverage “like third party insurance” for liabilities “whether or not the corporation would have the power to indemnify them under Section 145.” And, the amendment allows captives to cover amounts to satisfy judgments and settlements of claims brought by or in the right of the corporation, even though the corporation would not have the power to indemnify the covered persons against such amounts.

Beyond this clarification, the amendment synopsis notes that non-exculpated liability stemming from duty of oversight or “Caremark” claims can also be covered by a captive insurance policy.

The amendment also clarifies that the captive insurance company can be licensed in Delaware or another jurisdiction. The captive can be procured pursuant to a “fronting” arrangement with a third-party commercial insurer or another reinsurance arrangement.

The amendment further identifies some coverage restrictions when using a captive for D&O exposures, including one that mirrors the fraud or conduct exclusion commonly found in D&O insurance policies. This exclusion would apply to “deliberate criminal or deliberate fraudulent acts or any knowing violations of law.” Importantly, the exclusion is subject to a final non-appealable adjudication in the underlying proceeding. The amendment also has non-imputation language, making clear that the text was calibrated to conform with favourable insurance language available in the commercial market. The amendment, however, leaves open the possibility that companies could include exclusionary provisions beyond those identified in the text.

The amendment also addresses claims administration, allowing for the use of a third-party or a pre-established procedure to ensure that any persons claiming entitlement to the proceeds of a captive are not the same persons making the decision about whether to pay claims. This requirement would be of particular importance to commercial insurance carriers writing layers excess of the captive limit.

Implications and takeaways

Companies considering a captive for their D&O exposures in light of the recently signed Delaware law should be mindful of a number of open questions and issues.

Bankruptcy: While the new amendment provides some clarity, it leaves open the question of whether bankruptcy proceedings might encumber the available capital in a captive. Companies often procure Side A only coverage as separate layers in their D&O programs to protect individual insureds if the company is bankrupt and cannot afford to pay claims. A dedicated Side A policy may be less likely to be prohibited from paying claims by a bankruptcy court, depending on how a company’s captive is structured. Companies sometimes utilise a bankruptcy-remote “cell” structure to avoid this issue. It is not clear, however, whether a captive that is wholly owned by a company would be restricted from paying during a bankruptcy proceeding and, if so, in what circumstances. This could possibly interfere with Side A payments when they are needed most, leaving individuals personally exposed.

Capital and funding requirement: A company may decide to fund the entire limit of D&O coverage in upfront capital for various reasons, including to ensure sufficient cash is available to pay claims in the event of a bankruptcy or financial distress. There are different forms that this can take, whether it be to contribute cash to capitalise the entire desired D&O limits or using a letter of credit.

Reinsurance: Captives sometimes purchase reinsurance to transfer the risk of losses. However, the amount of available reinsurance capacity in the marketplace for D&O captive risks is questionable. Companies might find it difficult to procure sufficient reinsurance for a captive to be worthwhile.

Cost/benefit analysis: Companies will need to consider whether setting up a captive for all or part of their D&O insurance needs will be financially and administratively beneficial compared with the cost and coverage of a traditional Side A insurance program. The barriers to entry for a captive — notably the ongoing financial and administrative burdens — must be carefully weighed against the premium savings. Companies with access to traditional Side A insurance at attractive terms and conditions and confident about their renewals in an increasingly competitive market may be less likely to consider this approach. For some companies, particularly those whose risk profile limits the D&O insurance capacity available in the market, a captive could be a desirable solution. Certain industries and exposures, such as opioids, cannabis, and cryptocurrency, among others, also have faced limited options in the commercial D&O insurance market. Therefore, it is important for companies to engage in a robust feasibility analysis with their insurance broker and captive consultant before arriving at a decision.

Claims handling and administration: Companies must establish a process for claims adjustment. As the amendment notes, this obligation is often fulfilled by a third-party claims administrator. If not, the Delaware statute provides specific procedures, which will be particularly relevant if a company intends to seek coverage from commercial insurance that would sit above captive insurance. An excess commercial insurance carrier will want assurance that coverage determination is within the scope of the policy and any claims payment process is free from influence by the company itself.

Coverage and program structure: The amendment outlines some mandatory exclusionary provisions, but does not provide a complete picture of how D&O insurance through a captive should be written. Some of the coverage afforded by traditional Side A programs may be broader than the statute permits under Delaware law, particularly regarding coverage for independent directors. Companies will need to consider, with the help of insurance professionals and counsel, what policy form language will apply to their captive D&O programs. If a company intends to use a “fronting” arrangement with a commercial insurer, then that insurer’s form can be used, with any desired adjustments. The specifics of the form wording will be even more important where a company intends to have a commercial insurance carrier sit excess of some, or all, of the captive layers in the D&O program. That insurer will need to be comfortable that it is not following coverage from an excess position that is outside of the underwriting guidelines and scope of coverage that it would provide in a commercial market.

Shareholder notice: The law requires that a company provide notice to stockholders if it intends to pay a shareholder derivative settlement out of the captive. There is not a requirement for the stockholders to approve such a payment. However, companies should keep the possible reaction of stockholders in mind.

Preferences of the board of directors: Given the untested nature of captives and D&O protection, individuals may not want to risk any uncertainty when it comes to protecting their personal assets.

Market impact: The D&O insurance market has eased in terms of pricing pressure in recent months and seen reenergised competition from legacy carriers and new entrants. Having captives as an alternative (and possible threat) to the commercial market may lead to more favourable D&O insurance pricing.

Which option might make financial and business sense?

The approved Delaware law is a significant step forward as it allows more companies to consider a wholly owned captive or a “cell” as a partial or complete solution for covering Side A D&O claims. Companies with very high insurance premiums or that are struggling to obtain sufficient capacity in the commercial market may be particularly interested.

The process of setting up a captive for D&O exposures is no small undertaking and involves a number of considerations. Setting up a “cell” is much simpler and faster and provides a more arms-length approach to fund non-indemnified loss compared to a wholly owned captive. The fact that a “cell” is part of a standalone entity whose ownership, management, and control are largely independent of the company seeking to insure its directors and officers could reduce potential concerns about influence by company management and about disgruntled shareholders.

A company’s determination as to how best to manage its D&O exposures also will be impacted by the heightened competition and sharp deceleration of insurance premium increases in the commercial D&O insurance market.

A qualified insurance professional and captive consultant can help guide you through a D&O risk transfer assessment process and help you ascertain whether a D&O captive solution might be a good fit for your organisation.

Article

Delaware law to broaden captive landscape for D&O buyers

Why use a captive for D&O exposures?

New Delaware law facilitates captive use

Implications and takeaways

Which option might make financial and business sense?

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Ellen Charnley

Ruth Kochenderfer

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Delaware law to broaden captive landscape for D&O buyers

Why use a captive for D&O exposures?

New Delaware law facilitates captive use

Implications and takeaways

Which option might make financial and business sense?

You’ve gone public, now what?

Our people

Ellen Charnley

Ruth Kochenderfer

Related insights

Financial and professional lines claims continue to rise across Europe

Understanding professional indemnity insurance for accountants in Cyprus

Professional indemnity market update — part three: A focus on construction and property

Navigating the insurance market for professional services: A conversation with Steven Loveday