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Hugh's Views Issue 4: August 28, 2002
Hugh's Views on D&O insurance in Captives

Among the lines of insurance whose rates have been doubling and tripling is Directors and Officers insurance (this article does not encompass E&O, or Errors and Ommissions insurance, which is sometimes sold with D&O as a package). Yet, with the current hue and cry for external and non-executive directors, D&O insurance is important. Providing insurance protection for directors who feel more and more exposed to litigation is a requirement that cannot be entirely eliminated by standard corporate indemnification agreements.

There are four principal gaps in the kind of indemnification offered:

1. Public policy limitations that prohibit entities from reimbursing directors for actions taken in bad faith.
   
   
2. Situations in which the board becomes antagonistic towards a prior director seeking protection or indemnification. It is not hard to imagine such situations, especially where there a previously concealed conflict of interest arose.
   
   
3. Insolvency of the corporation itself, or inability to pay because of other financial actions by receivers or rehabilitators. This can be temporary for the corporation, but can be a big immediate problem for directors with current defence costs and even judgements.
   
   
4. Derivative actions where damages assessed to individual directors are payable to the corporation itself rather than to third parties.

All but the first of these is typically covered by D&O insurance, in spite of all the exclusions and limitations found in policy wordings. "Side A" coverage is for the individual directors; "side B" coverage is corporate reimbursement coverage. So why not use the captive to cover layers, percentages, or even exclusions?

First of all, if a captive is used, the arrangement must be considered "insurance" to avoid problems with public policy limitations. The familiar definition of insurance that applies includes risk shifting and risk distribution, concepts that are well-documented in the tax cases in your captive information file. Unrelated business helps bolster the definition of "insurance.", too. This doubt as to whether or not a captive provides insurance is not trivial, as the many tax cases lost by captive owners will confirm.

Some states (AZ, CA, IL, LA, MD, NE, NJ, NM, OH) permit the use of captives for writing D&O insurance. Delaware doesn't, though, nor do Illinois or New York; these are states in which a lot of corporations are incorporated. But even here, the definition of insurance is important, since if the transaction is not deemed to be insurance, then the policyholder may be blocked from any indemnity under the non-existent insurance.

Of course, a captive could be consolidated into a bankruptcy proceeding under the provisions of "equitable consolidation" which can be applied if the captive is found to be too closely controlled by the parent, or a mere instrumentality (most of them are, as we all know).

Financial and operational independence of the captive from the parent may reduce this risk, and separate corporate identities may help defend against creditors trying to pierce the corporate veil through to the captive - notably an offshore captive. There have been some noteworthy examples of the success of this effort for independence, notably in the continuing operation of Texaco's captive insurer Heddington during Texaco's temporary chapter 11 status in the 1980s.

Statistics show that the most frequent kinds of D&O actions are those from shareholders. It is difficult for me to imagine how these shareholders would react upon discovering that their derivative claim was being paid from a captive, thereby further reducing shareholder value (which is the basis for most of these actions).

Promoters of captives naturally suggest to single-owner and group-owned captives coverage of D&O by the direct or reinsurance captive. I always considered D&O in captives to be a bad idea, and still do, except in the case for "developing capacity" (see below).

Using a captive for the "side B" coverage may still make sense, as it does for other kinds of corporate liability, but anything short of full funding for "side A", the personal coverage, seems a weak kind of protection to m. And there are less cumbersome fully funded mechanisms than offshore captives that can be used.

The biggest problem with covering side B coverage in a captive is the handling of claims or the threat of claims. Defense costs and bonds have to be paid as incurred; captives traditionally reimburse and don't get involved in claims.

And will the highly-sought-after directors really appreciate guarantees from a company subsidiary, no matter how well designed and funded, compared to a guarantee from a third-party insurer? I doubt it.

According to Mark Larsen, compiler of Tilinghast's annual "Directors and Officers Survey," fewer than five respondents reported involving their captive insurance companies in their D&O programs. That news dates from 2000-2001, though, before the current crunch. He expects to see a higher number in his 2002 survey, but still not many.

There is a contemporary reason why captives might and sometimes should be included in a D&O program. That is to develop capacity that may be available from sources reluctant to take on the risk. These sources are sometimes overlooked by traditional placement brokers, but shouldn't be. The proposition is this: "If the client captive will take 10% (for instance) of this high excess D&O layer, will that convince you of their risk management seriousness so that you will commit your 10% (or extra $100 million, why not?)?" This argument worked for difficult-to-place product liability placements in the past. Any captive owner considering how to use a captive in the D&O area ought to challenge their direct or reinsurance broker with developing capacity by means of sparing use of the captive's participation. Captive managers who are looking for protection when serving on captive boards could take some initiative in the same way.

Hugh's view: Wouldn't this leave the directors exposed, as I previously discussed? Yes, but to a much smaller degree. And, with some luck, the layer involved would be a low-likelihood layer. Some disclosure would be called, for of course. At least I would want it if I were invited to be a director of a partly captive-insured D&O risk. And in some cases, after looking at the financial strength of the captive, its separate jurisdiction and management, it might just provide me some added comfort, as a director, to the presence of the big-name insurer on the primary policy.

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Hugh Rosenbaum, one of captive.com's friends and valued contributors, is a freelance consultant. Hugh can be reached by telephone at +4420 8883 6729 or by e-mail at hughro2@yahoo.com. Learn how you can spend a day with Hugh!

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