With special purpose acquisition companies increasingly being used in initial public offerings and the commercial insurance market continuing to harden, captive insurance could be a solution for offering directors and officers protection against increased shareholder scrutiny and resulting derivative lawsuits.
The use of SPACs—special purpose acquisition companies or “blank check companies”—is showing no sign of slowing down. SPACs now make up nearly 70% of initial public offering (IPO) activity and continue to attract deep-pocketed sponsors, including high-profile athletes and public figures, drawn to market opportunities with potential for investment big returns and liquidity.
SPACs target businesses across multiple sectors and engage in accelerated acquisitions that often expose directors and officers to shareholder scrutiny. To attract and retain qualified directors and officers (both pre-and post-acquisition), SPACs must offer comprehensive directors and officers liability coverage (D&O insurance) to protect against that increased exposure and resulting derivative lawsuits. But this insurance hurdle is becoming tougher to clear as the commercial insurance market, particularly for Side A D&O coverage—which protects claims against directors and officers not indemnified by the public company—continues to harden. Captive insurance could be the solution to fill the insurance gap, including any timing gap.
A SPAC is a nonoperating company created by a sponsor solely to raise funds in the public securities markets to acquire a private operating company (the “to be determined” target) in the short term. SPACs present unique insurance needs due to their fast-tracked life cycle and willingness to dabble in hot, emerging sectors marked by high risk/reward and by volatile private company valuations, frequently with no earnings history.
SPACs involve a three-stage life cycle: (1) IPO; (2) Business Combination; and (3) New Public Company, with insurance needs at every step of the way.
D&O insurance protects a company and its corporate directors and officers in the event of a suit for actual or alleged wrongful acts in managing the company. D&O insurance typically comprises three insuring agreements, called Side A, Side B, and Side C.
D&O insurance in the commercial market for newly public companies (like SPACs) with no track record can be prohibitively expensive or completely unavailable. This coverage can be even harder to secure for SPACs because of the short life cycle of the insuring relationship: SPACs often seek short-term policies (18 months to two years) with no intent to renew.
With the surge in SPAC IPOs combined with a general “hardening” of commercial insurance markets and the current hesitance of many commercial insurers to write D&O coverage, SPAC sponsors may be left with a gap in the D&O market that makes it hard for SPACs to get off the ground. Indeed, high-quality directors will not accept appointment to a SPAC without adequate D&O insurance protection to back-stop and supplement the company’s indemnification obligations.
Captive insurance is a solution to fill coverage gaps or a means to control insurance terms and conditions. A captive insurer is a wholly owned subsidiary that is licensed to insure the risks of its affiliated companies through the issuance of insurance policies in exchange for the payment of a premium. A specialized actuary retained by the captive typically sets the premium, which is composed of a loss reserve and a risk margin. Captive insurance can be utilized flexibly at any “level” of the insurance tower, or at varying levels dependent on the risk insured.
Captive insurance offers cost-saving benefits, in addition to filling a market void:
Unique challenges exist to protect directors and officers from Side A claims where commercial insurance is unavailable, particularly for SPACs, which are often formed as Delaware corporations. Delaware law prohibits a company from indemnifying its directors and officers directly for derivative settlements and judgments but permits the company to purchase insurance to pay for such non-indemnifiable claims. A captive arrangement may offer an attractive solution provided the arrangement is properly structured such that it qualifies as “insurance” (applying the four-part test set forth above).
Delaware law is highly protective of corporations, including SPACs, and Delaware courts are experienced in handling complex corporate transactions and their insurance ramifications. Because of the importance of Delaware law and its unique indemnification law that favors a captive solution for protecting directors and officers, we encourage considering a captive option whenever feasible to do so.
There are several captive funding options that should be carefully considered when exploring a potential D&O coverage captive solution:
Regardless of which captive funding option is selected, using a proper actuarial study, implementing claims procedures, and following insurance accounting practices are critical to demonstrate that the captive should be treated as an insurance company.
We have experience assisting clients in setting up and managing captive structures and counseling companies on how best to use a captive insurer to supplement their existing insurance programs. We work closely with all major captive manager firms, captive actuaries, and accounting firms to set up captive programs in a tax-efficient manner, and counsel on the best uses of captive insurers.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Jeffrey S. Raskin
 Amrith Ramkumar, Red-Hot Stock Market Pushes More Companies to Go Public, Wall St. J. (Feb. 25, 2021).
 Policy forms can, however, vary considerably in how they define a “non-indemnified” or “non-indemnifiable” event.
 Del. Code Ann. tit. 8, § 145(b); Del. Code Ann. tit. 8, § 145(g).