The past few years have seen eye-watering rates for companies seeking D&O liability insurance. Barney Dixon looks at the solutions that emerged to solve this issue and whether or not captives are a suitable alternative to traditional Side A coverage as rates return to normal
Last year, Delaware governor John Carney signed into law a bill that facilitates the use of captive insurance for Side A directors’ and officers’ (D&O) liability insurance. The bill amended the Delaware General Corporation Law (DGCL) to allow corporations to purchase D&O insurance through captive insurance companies to cover both indemnifiable and non-indemnifiable loss.
Initial expectations were that the legislation would have a “positive impact by providing flexibility and an alternative to traditional D&O insurance, either due to pricing considerations or limited insurance capacity,” according to J. Andrew Moss, partner at law firm Reed Smith.
Steep turns in D&O
Historically, companies would purchase traditional Side A D&O insurance to cover non-indemnifiable exposures. But, while D&O rates have been low for much of the 2000s, the past four years have seen a significant spike in prices.
Lorraine Stack, international consulting leader and head of operations at Marsh Captive Solutions, Ireland, says that up until 2019, Marsh had “less than 40 captives writing some element of D&O, almost exclusively Sides B and C.”
“At the time we were managing about 1500 captives, so this was a very small proportion.”
She explains: “The reason is that between 2002 (the last D&O hard market) and 2018/19, D&O rates were low, and there was plenty of capacity available. So there was really no reason to self-insure or take a lot of D&O risk on the balance sheet. But that really changed between 2019 and 2022.”
“In 2019, there was a steep turn in the D&O market. Prices spiked; buyers were seeing eye-watering renewal quotes and capacity was scarce.”
Stack says that an increase in US litigation, US securities claims, higher settlements and class action lawsuits drove these rises, pushed further by insolvencies resulting from COVID-19.
“As with any time when there’s a challenge in the commercial marketplace, there was a sudden interest in captives. During 2020 and 2021, the D&O premium written by the captives that we managed increased by 50 per cent.”
This increase in interest led to captive owners using their captives to fill in gaps and create additional capacity for their risk in the commercial insurance market, Stack notes, but this was primarily for Sides B and C.
She explains: “Side A is not indemnifiable by the group, so Side A, at the time, was not deemed necessarily suitable for a captive.”
“That’s because of the conflict that might arise around asking a captive, which is a subsidiary of the group, to pay a claim for an act by a director that the company is either not permitted to indemnify or actually chooses not to indemnify, and is maybe in dispute with.”
“What emerged during that time was an interest in the potential to use a protected cell company (PCC) for Side A D&O.”
Marsh operates a number of cell facilities, which Stack says are more often viewed at arm’s length and are more independent than a single parent captive.
She notes that interest in Side A D&O PCC captives increased during this time, and Marsh now has around 13 Side A D&O PCCs, mainly in Guernsey and Bermuda.
These cells are typically used by companies who are unable to get Side A and need it — namely crypto companies, cannabis companies and financially-strained companies who are about to go into Chapter 11 bankruptcy.
Arthur Koritzinsky, managing director at Marsh, says that companies will “generally be able to get permission from bankruptcy regulators to fully fund a cell.”
“The funds would be segregated and would theoretically be bankruptcy-proof in the event of claims resulting, after a certain point in time.” Stack adds that this is still an “emerging solution.”
The Delaware solution
Those in dire straits did not have to wait long for another solution to present itself, however. Senate Bill 203, was introduced in December 2021, and passed unanimously two months later. Delaware, known for its business-friendly corporate laws, would now be able to provide a solution for those struggling to acquire Side A D&O coverage.
Stack says that the Delaware solution was a “response from the Delaware regulator to the scarcity of D&O insurance.”
Koritzinsky says that following this legislation, Marsh decided to form a new cell facility in Delaware. He notes that the bill passing “took many by surprise, including the Delaware captive regulators,” but that key to Marsh’s decision “was the fact that the corporate laws would be the same for the captive as the insured corporation if both are incorporated in Delaware.” This would remove any risk of a conflict of law.
“That’s important,” he adds, “it’s one more thing that the directors can take comfort in.”
Koritzinsky says that in other states, a captive would be problematic where there are specific rules prohibiting the use of corporate funds; “we assumed if Delaware chose to specifically allow it, then Delaware is the place to do this.”
It took nearly six months for Marsh’s first cell to be approved as there were “no regulations or rules that were issued by the Delaware insurance regulator,” according to Koritzinsky, and Marsh is now working on a second client cell.
However, Koritzinsky says this solution “is not for the masses” and it will only be appropriate when there is a “significant rate online.” The average company will not pursue this type of policy.
“The company has to fully fund the policy limit. It was very important to make sure the claims adjustment process was independent so there are contracts with third-party administrators and legal counsel executed with the cell.
The cell is in a Marsh facility, we’ve got Marsh directors and officers, but the company that decides to form the cell only has a representative.”
And, specifically on the PCC structure, Stack notes that it hasn’t been tested in a court of law. So it is available as a “potential solution,” but certainly not for the majority of companies.
Stack adds the market opened up in the latter part of 2022 and demand has decreased a little. It’s easier to get commercial insurance, and rates aren’t as difficult as they were – new insurers have entered the market and capacity has become available.
Jalen Brown, associate at Reed Smith echoes this notion, and adds that “if pricing and availability of traditional D&O insurance is more attractive, one would assume that the use of captives as an alternative may decrease.”
However, Stack says that, despite this, there is still interest in the Delaware solution.
Considerations
With this in mind, what should companies consider when looking to use a captive or PCC in place of a traditional insurer for D&O coverage?
According to Carolyn Rosenberg, partner at Reed Smith, there are a few concerns for companies looking to use a captive for this purpose. For example, in a bankruptcy or insolvency situation, “the captive needs to be sufficiently capitalised and in compliance with applicable law to be able to protect the directors and officers if the company can not indemnify them, which may be inherently difficult.”
“In addition, those who control the captive may face competing considerations as to where to put capital in this circumstance,” she adds.
“It is also possible that payments by a captive may be challenged by creditors in an insolvency situation. Traditional Side A D&O coverage is typically negotiated with sufficient terms and conditions to allow it to remain a source of financial protection for the directors and officers.”
Stack says that for Sides B and C, many considerations are similar to factors that would be looked at with any other line of insurance. This includes consideration as to whether the captive is appropriately licensed to write the risk and if it fits with the risk appetite of the board.
However, for Side A, Stack explains that the biggest consideration is whether the risk can be fully funded. She recommends the appointment of an independent claims handler to further enhance the ‘arm’s length’ nature of the structure.
While the Delaware solution may not be for every company, and certain considerations may make traditional Side A insurance a more attractive option, Delaware’s captive D&O law provides an alternative for those that require it.
Rosenberg concludes that companies “may not want to take on the administrative and capital contribution responsibilities of a captive. It may also be that increased capacity and more attractive pricing have elevated traditional Side A coverage options above a captive.”
“That being said, retaining the flexibility is a positive development for those situations where it may make the most sense in terms of a company’s overall insurance goals and programmes.”
