Delaware legislation prompts captive Side A D&O debate

The global D&O market has been challenging for the past three years with corporates increasingly looking to their captive to insure Side B and C. Side A, however, which protects the assets of individual directors where the losses are non-indemnifiable by the company, either because they do not have the funds to indemnify them or they are not legally permitted to do so, has proved particularly problematic.

General consensus has been that a captive, as a wholly-owned subsidiary of the group, cannot provide this coverage, but Delaware’s Corporate Code amendment appears to open up that possibility.

The Bill’s original synopsis states: “Like third-party insurance, the captive insurance may provide coverage for liabilities incurred by directors, officers, employees and others whether or not the corporation would have the power to indemnify them under Section 145. Thus, captive insurance could be used to provide coverage for, among other things, amounts paid 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.”

The legislation, which was actively lobbied for by a handful of large Delaware-registered companies, has prompted a new debate as to whether insuring Side A through a captive is advisable. Over the past three years, some companies have used third-party owned cell captives to insure Side A, but the single-parent captive route is relatively untested.

A Marsh article authored by Ellen Charnley, President of Marsh Captive Solutions, and Matthew McLellan, D&O Product Leader for Marsh in the United States, highlighted a number of considerations for corporates when considering the use of their captive for D&O. One of those considerations was the status of the captive in the event the group enters bankruptcy proceedings.

“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,” the article explains.

“Companies sometimes utilize 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.”

Marsh questions whether sufficient reinsurance capacity will be available to captives if they want to transfer the risk of significant losses, while a robust and independent claims handling and administration process will also have to be put in place.

“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,” Charnley and McLellan write.

“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.”

While Delaware’s new law opens the door for corporates registered in the state to use their captive, whatever its domicile, to insure Side A, it remains to be seen what the reaction of captive regulators will be. Captive Quarterly understand in the US the major regulators are open to discussing the possibility, but will take each request on a case-by-case basis, assessing the health and suitability of the corporate and its captive.

UK state-of-play

The Delaware Corporate Code does not change anything for companies headquartered in the UK or elsewhere, but it has brought into focus which may, or may not, be possible under other corporate laws.

“With D&O insurance becoming less available and affordable, some companies are considering if a captive may be the answer for the provision of insurance,” Sarah McNally, Partner at Herbert Smith Freehills, told Captive Quarterly.

“There is nothing express in the company law of England and Wales about the use of captives to provide Side A D&O cover. However, certain provisions of the Companies Act 2006 (the Companies Act) need to be considered, together with various practical issues. In addition, for global entities there will be wider issues to consider as the law of Australia, for example, is even stricter in prohibiting certain forms of company indemnification than the law of England and Wales.”

McNally highlights that a director cannot be indemnified by the company against a penalty in respect of non-compliance with any requirement of a regulatory nature, or against any liability incurred in defending civil proceedings brought by the company in which judgment is given against the director.

“For some of these risks, risk management through insurance is permitted, when a corporate indemnity is not,” she explains. “A question which is therefore often asked is whether insurance from a captive is itself a corporate indemnity by another name so as to trigger this prohibition.

“While on the face of it a properly managed captive is providing insurance, the answer as to whether there is an infringement will likely depend on how the captive is organised, funded and operated. It is only if on the facts there is no such prohibition that questions of practical consideration arise.

Under practicial considerations, McNally highlights the risk of insolvency of the group since one of the key advantages of purchasing commercial insurance is to cover directors and officers in the event of an insolvency.

“The very type of investigation or claim which could give rise to individual costs or liabilities on the part of the director may be exactly the type of event which depletes the funds available to a company captive to provide insurance,” she adds.

“In contrast, the fortunes of an independent insurer should be independent of the company's fortunes.For this reason, captives may be seen by directors as constituting a less robust risk mitigant.”

There is also the question of independence and conflicts of interest. “From a practical perspective, companies will need to ensure claims are handled independently and objectively both for the benefit of directors, who may not wish for potentially sensitive information disclosed as part of a claim to become common knowledge among company employees, and shareholders,” McNally says.

“How claims are managed and funded may also impact whether there is a risk of breach of the Companies Act, as above.”

McNally adds that she has also seen the use of protected cell companies, the capital markets, trusts, parametric insurance and captive reinsurance of a front used to address the challenging D&O environment of the past three years.

She concludes: “Managing D&O risk continues to be a matter of concern and debate; as always looking at all options with the right advice is key.”