Captive insurance companies as a potential alternative

One potential alternative to purchasing insurance on the private market is forming a captive insurance company. A captive is a wholly owned subsidiary formed by a parent company that operates as an insurance company and insures only the parent and its subsidiaries. Captives generally are funded by the parent company and may be tailored to cover risks that may be challenging to insure in the private market, including providing more favorable terms and conditions. Captives must issue a policy to the parent company that must be a bona fide transfer of the risk in order to comply with regulatory and tax requirements. Captives have drawbacks, such as the initial financial investment to start the captive that could put the corporation’s own capital at risk, as well as the challenges companies face when exiting or winding down a captive. Further, under the current version of section 145(g), it is unclear whether a Delaware corporation may use a captive to insure against liability of directors or officers – in particular, liabilities that the company cannot indemnify.

Delaware seeks to clarify the law to permit captive insurance companies to issue D&O insurance

The Delaware General Assembly recently passed a bill that would amend section 145(g) of the DGCL to allow a captive to perform the role of a traditional D&O insurer and provide coverage for directors or officers regardless of whether or not a corporation would have the power to indemnify.²

The amendment to section 145(g) sets forth some limitations for D&O insurance through a captive that are consistent with the private market for “full side” D&O coverage. For instance, the proposed amendment states that a captive may not provide D&O coverage to a director or officer if it is determined in a final judgment that the individual received a financial benefit from self-dealing or engaged in deliberate criminal or fraudulent actions. This restriction on captive coverage generally reflects the scope of “conduct” exclusions in traditional D&O insurance policies available in the private market, which often require that there be a final, non-appealable adjudication that an insured party committed the excluded conduct. According to the proposed amendment to section 145(g), these limitations are the minimum requirements for D&O coverage under a captive; the corporation has broad discretion on any other exclusion.

What’s next?

The proposed amendment to section 145(g) appears to settle Delaware public policy with respect to using captives for D&O insurance, and provides a potential alternative for companies facing headwinds in the private D&O insurance market. But captives may not be a perfect, feasible, or the only solution to placing sufficient D&O insurance in a hard insurance market. Captives present their own challenges, including the initial financial investment, administrative costs, difficulties in exiting or winding down a captive, and unique regulatory and tax requirements.

Thus, there are a number of important questions that companies should consider before determining whether a captive may be a viable alternative to traditional D&O insurance:

1. What happens if the parent company becomes insolvent? Can creditors attach funds within the captive? The proceeds of private D&O insurance generally do not become part of the bankruptcy estate. Does this add to the risks faced by directors and officers?
2. Are there any other limitations on the scope of D&O insurance provided by a captive? Although captives often are used to insure risks that are difficult to insure in the private market, captives are not often used to insure D&O risks. Further, many Side A-only policies provide broader coverage than appears to be allowed under the amended section 145(g), such that more attractive terms and conditions may remain available in the private insurance market.
3. Section 145(g) will require that coverage determinations be made by an “independent claims administrator.” Are there any public policy restrictions on or litigation risk for individuals wearing “two hats” as corporate officers and officers of the captive insurer?
4. Does the cost of forming and administering a captive outweigh the cost of obtaining D&O insurance in the private market? Although the D&O insurance market is currently tough, conditions may change as litigation trends and the COVID-19 pandemic (and other market forces) change or subside. Further, the amount of capital likely required to be set aside to form a captive may make this a feasible option only for large companies.

Companies should engage experienced counsel to analyze these questions in the context of the company’s insurance needs, and to ensure that any decision to provide D&O insurance conforms with all corporate governance, risk transfer, regulatory, and tax requirements.

1. Section 145(g) of the Delaware General Corporation Law (DGCL) states:
   A corporation shall have power to purchase and maintain insurance on behalf of any person who is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise against any liability asserted against such person and incurred by such person in any such capacity, or arising out of such person’s status as such, whether or not the corporation would have the power to indemnify such person against such liability under this section.
   
   Title 8 Del. Code section 145(g).
   
   
2. The proposed amended version reads:
   
   A corporation shall have power to purchase and maintain insurance on behalf of any person who is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise against any liability asserted against such person and incurred by such person in any such capacity, or arising out of such person’s status as such, whether or not the corporation would have the power to indemnify such person against such liability under this section. For purposes of this subsection, insurance shall include any insurance provided directly or indirectly (including pursuant to any fronting or reinsurance arrangement) by or through a captive insurance company organized and licensed in compliance with the laws of any jurisdiction, including any captive insurance company licensed under Chapter 69 of Title 18 of the Delaware Code, provided that the terms of any such captive insurance shall:
   1. Exclude from coverage thereunder, and provide that the insurer shall not make any payment for loss in connection with any claim made against any person arising out of, based upon or attributable to any (i) personal profit or other financial advantage to which such person was not legally entitled or (ii) deliberate criminal or deliberate fraudulent act of such person, or a knowing violation of law by such person, if (in the case of the foregoing clause (i) or (ii)) established by a final, non-appealable adjudication in the underlying proceeding in respect of such claim (which shall not include an action or proceeding initiated by the insurer or the insured to determine coverage under the policy), unless and only to the extent such person is entitled to be indemnified therefor under this section.
   2. Require that any determination to make a payment under such insurance in respect of a claim against a current director or officer (as defined in paragraph (c)(1) of this section) of the corporation shall be made by an independent claims administrator or in accordance with the provisions of paragraphs (d)(1) through (4) of this section.
   3. Require that, prior to any payment under such insurance in connection with any dismissal or compromise of any action, suit or proceeding brought by or in the right of a corporation as to which notice is required to be given to stockholders, such corporation shall include in such notice that a payment is proposed to be made under such insurance in connection with such dismissal or compromise.

For purposes of paragraph (1) of this subsection, the conduct of an insured person shall not be imputed to any other insured person. A corporation that establishes or maintains a captive insurance company that provides insurance pursuant to this section shall not, solely by virtue thereof, be subject to the provisions of Title 18 of the Delaware Code.