Specialty Podcast: The Intersection of D&O Insurance and Captive Insurers

Intro (00:00):
You're listening to the Alliant Specialty Podcast, a show dedicated to insurance and risk management professional solutions. Here’s your host Brian Dunphy.

Brian Dunphy (00:14):
Hello everyone and welcome back to the Alliant Specialty Podcast Series. I am Brian Dunphy, the Managing Director for Alliant Management Professional Solutions group. I'm pleased to be joined today by Steve Shappell, our Executive Vice President of Claims and Legal, and our Managing Director of our Captive group here at Alliant, Seth Madnick. Good afternoon gentlemen.

Today, we're going to be talking about something which is a rare occurrence for us in the world of directors and officers' liability, the intersection of D&O insurance and captive insurers. Delaware has recently passed a law that's received a lot of publicity as it pertains to the utilization of captives for Delaware-organized corporations. And so, Steve, if you can spend a few minutes and talk to us about the history of captives and D&O, some of the conversations that have happened in the past, I think it'd be helpful for everyone to provide a little bit of background context.

Steve Shappell (01:09):
Thanks, Brian. So, the discussion about captives has really been in and out of D&O for decades and it's an interesting discussion, right? Because one of the challenges that exist for D&O, in particular, is the ability of an entity to indemnify its directors and officers and particularly directors and particularly in derivative litigation, a suit brought on behalf of a corporation. And so, we've been battling this issue for, as I said, decades and Delaware is an interesting jurisdiction, and it's a jurisdiction where the vast majority of corporations choose to incorporate for many other reasons. But the challenge in Delaware has been that your corporation is not permitted to indemnify a derivative settlement in Delaware, right? They can advance expenses and they can pay the legal expenses in advance. But a settlement is not indemnifiable. It's not authorized by the statute. Now, that's in contrast to many other jurisdictions where we've had this captive discussion, there are a bunch of jurisdictions out there.

And if anybody wants to know whether particular jurisdiction, is different from Delaware, feel free to reach out to me, but there are a lot of jurisdictions that allow indemnification. And so, we've been having this captive discussion because the law will allow an entity in ticket, right? Nevada to indemnify its directors for a derivative settlement. Therefore, a captive is a more viable tool. And we've been talking about and exploring that in, jurisdictions like Nevada, Indiana, Minnesota, Maryland. So, the challenge here is while this is an interesting development and I'll say, a positive development in Delaware, it doesn't solve a whole lot of the problem, right? A corporation, still cannot indemnify its directors for derivative settlement, but they can form a captive, fund a captive and pay it. One of the challenges with that is you then are left looking to a captive for Delaware, for derivative settlement, and there are a lot of restrictions.

So, one of the things the Delaware legislation does is add some guardrails in there to make sure that there's no ability to indemnify somebody that in the legislator's view, shouldn't be indemnified, which creates a lot of challenges. And, in my opinion, right, I think I'd rather have some bespoke D&O insurance wording to deal with, rather than this language. That's in a statute, which is captive can't pay for a claim based upon rising out of, or attributable to certain conduct, right? Where we can narrow that language. And we do narrow that language in a D&O policy. And, in addition to that, right, you have numerous layers of insurance and with differences in condition where insurers are really sitting on top of and dropping down where an insurer fails to perform. So, that's one of the challenges I see with the use of the captive.

The other really significant issue I want to highlight is this is one of many gaps in indemnification. And while the statute does not allow indemnification, it does allow you to form a captive to pay what the corporation would otherwise not be allowed, to indemnify. And that's good on a derivative, but the issue that we need to consider is there are other gaps in indemnification that we need to pay attention to. And the glaring one here is under the securities exchange act of 33, a section 11 claim. When you file for an IPO, the SEC requires you in the filing to state that you acknowledge that the corporation cannot and will not indemnify you for a violation of the 33 Act. And so, there are gaps in the indemnification, outside of this derivative gap that this amendment seeks to address. And so, the fact that you have a captive, SEC is going to have a lot of issues. And this is, this is the topic that I've explored for decades. Will the SEC allows you to form a captive to indemnify your director for violating section 11 of the 33 act when under the law you're not allowed to indemnify? Can you do indirectly what you can't do directly? And that is a huge gap that this doesn't address, right? And, nor could it address because it's a state issue, not a federal issue.

Brian Dunphy (05:35):
Right. And so, Steve that's great. And thank you if we zoom out for a second from D&O specifically Seth, historically speaking in your work with captives, and your work with captives is exhaustive. And it'd be great to hear about some of your experiences there. What have companies historically utilized captives for insofar as what they shift to a captive as opposed to place in a commercially available market?

Seth Madnick (06:02):
So, captives generally, when you think about, single captives with single parent captives are really structured as private or niche insurance companies, they're designed for a specific purpose and will typically see the casualty lines going into a captive. Lines that the clients either think to have a strong underwriting profit, or there are areas where there are gaps in coverage, or the marketplace simply is not filling that, or the current conditions, for example, a lot of excess liability markets where the rates are just shooting up at certain industry segments and the clients have the balance sheet to support that. So, they'll take on a layer of the risk themselves. So, when clients typically form a captive, there's a core group of coverages they're looking at, and then they look to expand or bolt on other lines of coverage. And so, the professional liability lines are getting a lot of discussions right now, along with cyber insurance, what can be added to the core captive, because when you have a captive, you certain critical, mass or size to run a small insurance company and to fund the operating expenses. So, with that, you have to say, what is real when you look at it, what is not my exposure, but what is my premium or cash flow dollars flowing into the captive to cover the overhead and the risk charges and support the collateral to my risk sharing insurance companies with that. So, those are some of the factors, that we look at.

Brian Dunphy (07:22):
Yeah, I think a lot of people hear the word captive and they, they think it's some sort of panacea that can solve very quickly an issue that they may be having in the placement or procurement of insurance generally. And so, if you can talk a little bit about that setup process, the costs related to that, the funding of the captive. I think that that would be helpful for folks to understand.

Seth Madnick (07:46):
Sure. Well, good questions. Because one of the areas you look at is what are the economics, what are the dollars involved here? And to form a captive, you're forming a small insurance company, and you can have a captive in over 30 states in the United States plus typical law for domicile came in Bermuda, but the states compete on capital and surplus requirements, and premium tax. They all charge a tax or a fee to have your captive base there. And they all have minimum capital and surplus requirements. So, most states to form a captive, you need a minimum capitalization of $250,000 as a base, as part of what we call a premium to capital or premium to surplus ratio. In addition to that. So, it can range from your initial capitalization as much as low as three to one, which is for every $3 in premium, you have to have a dollar, a capital with a floor of 250,000 to as high as four to one or five to one, depending on the lines of coverage in the financial strength of the parent. So, if you're running 4 million a premium into your captive, you need a million dollars of capitalization typically, or higher a million 250, a million 3. In addition, you're going to have to have your organization startup. You're going to have to perform, what we call a feasibility study actuarial review, where you have to show the regulator what the projected losses are in both an expected and an adverse scenario and show that the captive is adequately funded for the risk exposure for that. So, all those factors, it's a process that typically takes, by the time you're gathering the data and running the application process it really a four to six-month process. If you're going to own the captive as a client or rent a captive, or you're renting someone else's facility, it's a two to three-month process, depending on how fast you can go on the data collection, actuarial review, and processing.

So, that's just getting to the license approval process with the domicile and then once you're up and running, there are the expenses of actually running the captive, every jurisdiction, these create white collar jobs. So, every jurisdiction wants you to have, a captive manager that's approved in that state. You have to have actuaries that are approved. Your captives are managed by their balance sheet or financial statement. So, you need an annual actuarial review and audited financial statement, captive are C-Corps for tax purposes. So, you have to file a federal tax return, plus all the joys of running captive insurance claims, administration, reinsurance, expense, brokerage and all those other factors. So, you're really running a small insurance company, and all the expenses that go with that.

Brian Dunphy (10:11):
Right? And, I think that those are certainly not necessarily hurdles for every company, but certainly hurdles for many that would be looking to put D&O through a captive insurance vehicle. And as we sit here today, while the last three years of this market cycle has in fact been hard even, for the buyers and us in the brokerage community, for some segments of the market, it certainly has been even can cost prohibitive, but it doesn't mean that the insurance is not commercially available as it had been in certain previous market cycles. And so, when we think about it, what are, again, some of the other factors Seth, that go into it? There's also the manuscripts of the form that has to be taken care of and even, and I think one of the things, that some people confuse about captives is the adjudication of a claim. It's not an automatic payment, right?

Seth Madnick (11:01):
Right. Just like any insurance company policy, you're either, you have to have a policy form that you're underwriting and that form is part of the application process. You really have, just like any other line of coverage, you have to have, a scope of coverage that is agreed upon and is approved by the regulator where you're filing. So, you can have more expansive coverage than perhaps what other markets may offer, but it still has to be truly insurance and has to have that. So, the claim process itself is just like very similar to a standard insurance process. You will have either a third-party claim administrator or a partnership with an insurance company, someone else processing the claim, but you still have all the issues of indemnity. Is the claim valid? Is it covered? What are the defense costs, the economics of that claim, that doesn't go away?

I mean, the captive itself has really become a funding mechanism or a way to finance the risk for that. But there will be claims and you have to have a methodology to pay those. So, going back to the size, if you were a premium, just the economics when you look at a single parent captive, just kind of a rule of thumb, you need to look at a premium going into the captive north of a million dollars a year to really make the economics work of running a captive. So where is your D&O premium in relation to that? Is it standalone? Can it do that, or are you bolting it onto an existing captive with other lines of coverage to reach that critical mass? And the more size you have in the captive, the better you have in risk sharing, but it also reduces your operating expenses as a percentage of the premium base. So, you can afford, to run the captive, but there's also beyond just the economics. You need a commitment by management or ownership of the company to be actively participating in the captive and the finance side and the claims issues because it's their money. So, it's not a passive model. It really requires a commitment of ownership, if you would, to work with us on helping manage their captives and their claims issue.

Steve Shappell (12:59):
And Seth, is there a risk? One of the things we worry a lot about in D&O insurance is the dilution of limits. If the scenarios like you described where its cost prohibited. So, you're going to kind of roll this cover into a captive that has other lines of cover, and there would be a risk thereof diluting the limits available in that captive for a D&O claim, right?

Seth Madnick (13:20):
Well, what you run into is that if there, and that goes to the balance sheet or financial strength of a parent, it's a very good point. What if you have a claim on one line of coverage, I have an adverse scenario, and that really diminishes your capitalization or your surplus, if you would, available for other lines of coverage. So, when we do the feasibility studies, we look at the adverse scenario and there has to be a commitment by management, very right on your point, Steve is that without that management commitment, to put new capital in the captive, you're going to be short of money to pay your clients. So that becomes if you're writing directly with the cap if it's a direct risk. And one of the changes that Delaware brought, we were talking about is that the captive can now write this coverage directly. But if you're placing that coverage and partnership with a risk-sharing and standard market insurance companies, those companies will want to see collateral or some type of credit letter credit or trust funds to make sure that there's enough money and try to credit margin to pay those claims should the captive run short.

Brian Dunphy (14:20):
Steve, as we think about specifically the perspective, of directors and officers, the individuals themselves, especially as we think about D&O insurance, as a tool used to attract competent and qualified, outside directors to act as independent members of the board. From my perspective, I could see the prospect of saying that our D&O insurance is in part handled through a captive as an impediment to attracting that talent simply because of the things that Seth talked about, which is the funding required. Whereas we have certain minimum security requirements for commercial insurers, meaning how much capacity or, how much capital they have in reserve to pay claims. That certainly is called into question. If you're blending D&O into a captive, along with more volatile casualty lines.

Steve Shappell (15:12):
That is certainly a reality, Brian, right? You know, directors who sit on these boards are pretty attuned to the issue of D&O insurance and limits, right? They, often are high-net-worth people, sit on multiple boards. They really depend on the performance of this D&O insurance program and the tower. And to your point, right, the financial ratings of each of the carriers on that tower. And so, it's critically important, right? When I talk to a board, it's one of the times I say, look, this is one of the times you've got to think very selfishly, right? How are we going to structure it? How are you going to make sure that your personal assets are protected here because of this gap in indemnification and the cause of other gaps in the indemnification, selfishly, what is the best way to make sure you're protected? Right? And, so this will be a challenge, Brian. It's a great observation. Directors are going to have a lot of questions.

Seth Madnick (16:09):
And along the line, very few captives are rated it by AM Best. And most captives, especially newer ones do not have enough financial history to go through an AM Best rating. Now that's not to say you can't go through that process. And it is a process, but most captives are not rated by AM Best. So, you'll have a non-rated carrier writing this policy directly. And would the customer buy it? What does that mean to the buying decision?

Brian Dunphy (16:36):
Right. And as we think about the capitalization of a commercial insurer, generally the security requirement is that insurers maintain a minimum of $250 million in reserve to pay claims. And, certainly based on Seth, your comments, it certainly doesn't sound like most captives that would be set up would even scratch the surface of that.

Seth Madnick (16:56):
No, which is why many captives who need that A-rated paper will go enter into fronting arrangements with carriers, and then it becomes a credit relationship between the fronting company and the captive and, and that whole issue. And yeah it is a challenge if you're going write it directly for this line of business.

Brian Dunphy (17:15):
So, listen, gentlemen, I appreciate the time we spent. This conversation could obviously go on for hours. And I know it will evolve over time because there are certainly some things here that we've discussed that need to be sorted out and, probably taken up the chain in the Delaware legislature for, reconsideration. But I think we'll pause there in a now and we'll revisit as developments warrants. So, thank you very much. And everyone listening, thank you for stopping by and checking back in for future podcasts and checking in with your professionals to find out about the more rewarding way to manage risk.