Delaware Fully Embraces Captive Insurance as an Option to Protect Directors and Officers

Delaware amended its Corporation Law (Section 145(g)) to expressly permit the use of captive insurance to protect directors and officers, including from claims for which indemnification is prohibited, joining many other key business jurisdictions.

Prior to amending Section 145(g) of the Delaware General Corporation Law (the Amendments), Section 145 permitted companies to purchase insurance to cover non-indemnifiable claims against directors and officers, but the law was silent as to whether “insurance” included captive insurance. While the Amendments include certain restrictions when captive insurance is used that require careful analysis, in the whole, they confirm that Delaware companies have great flexibility in finding solutions to protect directors and officers. 

D&O INSURANCE CHALLENGE

Comprehensive director and officer (D&O) insurance is critical to attract and retain qualified directors and officers. D&O insurance offers different coverage parts (referred to as “sides”) to protect or reimburse claims made directly against a company (Side C), claims made against a director or officer that are indemnified by the company (Side B), and claims made against a director or officer that are not indemnified by the company (Side A).

In Delaware, as in many states, a company is prohibited from indemnifying its directors and officers from judgments for certain claims, most notably stockholder derivative lawsuits. High-quality directors and officers may not accept appointment (and accompanying exposure) without adequate D&O insurance protection to back-stop and supplement the indemnification obligations provided by the corporation. This is especially true now with skyrocketing settlement values in certain derivative lawsuits. Securing that coverage in today’s commercial market is increasingly difficult where D&O coverage—and particularly Side A coverage for non-indemnifiable claims—may be unavailable or prohibitively expensive.

Role OF CAPTIVE INSURANCE in Protecting Directors and Officers

Captive insurance has been used as a strategic risk management tool for many decades. It is insurance issued by a subsidiary company that is organized and licensed as a captive insurer in a particular state or overseas jurisdiction (referred to as the captive domicile) to sell insurance to affiliated companies. Captives may also be set up as a “group captive” that is owned jointly by unrelated companies, typically that are in the same line of business, to insure those companies.

While captives can issue almost any type of policy that third party insurers sell, they are generally used to insure (1) the deductible or self-insured retention layer, sometimes referred to as the “working layer;” (2) employee benefits or similar risks; (3) risks that third-party insurers are unwilling to cover, such as legacy asbestos or environmental liability; and (4) risks for which insufficient capacity exists in the commercial market, such as D&O coverage.

Captive insurance provides the company and its directors and officers with sufficient limits when the commercial insurance market is tight. It can be utilized flexibly at any “level” of the insurance tower, or at varying levels dependent upon the risk insured. There are some clear benefits of using a captive to supplement a broad insurance program. To name a few:

• Investment of Risk Premium: Risk premium is retained by the captive and is invested for the benefit of its parent and affiliated businesses. Investment returns on premiums (profit) are retained by the company.
• Tailored Coverage: Insurance coverage counsel can prepare a manuscript policy tailored to the specific needs of the businesses affiliated with the captive. Captive policies can be written without exclusions that commercial insurers require when a risk becomes too prevalent.
• Tax Savings: Generally, loss reserves of an IRS-qualifying captive insurance company may be immediately deductible (on a discounted basis) for tax purposes under Internal Revenue Code Section 832, thus accelerating the tax deduction within the company’s consolidated group and monetizing the associated deferred tax asset.
• Access to Reinsurance: A captive provides its insured with access to the broader reinsurance market where opportunities may exist to shift a portion of the captive’s risk to reinsurers in a cost-effective manner.
• Potential Risk Transfer Mechanism: A captive can serve as a risk transfer vehicle to shift risk over time.

Some downsides of using a captive are capitalization requirements and administrative expenses. A company without a strong balance sheet and ability to obtain letters of credit will need to capitalize its captive with cash. In the context of D&O coverage, most noticeably Side A, captive insurance may present challenges if the captive’s parent company files for bankruptcy, potentially threatening the assets of the captive to fund claims. For that reason, directors and officers likely prefer D&O coverage from highly rated commercial insurers, to the extent available. However, captive D&O coverage can “layer in” and complement the commercial coverage the company is able to obtain.  

One captive issue—compliance with Section 145(g) of Delaware law, which was previously silent about captive coverage—has now been clarified by the Amendments. The Amendments expressly authorize D&O coverage issued by a captive where the coverage meets the substantive and procedural requirements of the amended Section 145(g). The Amendments are expected to be signed into law in the short term and will pave the way for increased, more readily available protection for Delaware corporation directors and officers.

Navigating Delaware Law and Amendments to Section 145(g)

Delaware has a well-established public policy of encouraging capable, qualified officers and directors to serve corporations, and advances that policy by permitting corporations to indemnify their officers and directors for liabilities they might face by reason of the fact that they served as officers or directors. However, at the same time, Delaware does not authorize corporations to indemnify their officers and directors directly for derivative suit settlements and judgments (i.e., claims brought by stockholders on behalf of the corporation alleging directors or officers breached fiduciary duties) per Section 145(b). In derivative suits, any judgment or settlement is paid to the corporation. Indemnification by the corporation for a settlement or judgment in a derivative suit against an officer or director goes against public policy because the corporation effectively pays money damages to itself and does not benefit from the successful derivative action.

At the intersection of these competing concepts, Section 145(g) allows a corporation to purchase insurance for its directors and officers “whether or not the corporation would have the power to indemnify such person against such liability.” D&O insurance, and specifically Side A coverage, provides this coverage for claims against directors and officers for wrongful acts undertaken in the management of the corporation that are not indemnified by the corporation.

The Amendments to Section 145(g) broadens this protection by clarifying that permissible “insurance” encompasses direct or indirect (fronting or reinsurance) captive coverage so long as certain substantive and procedural requirements are satisfied.

• Substantive: Required exclusions. Captive coverage must exclude loss “arising out of, based upon, or attributable to” any (1) personal profit or financial advantage to which the covered person was not entitled (e.g., undue financial benefit from self-dealing transaction); or (2) “deliberate criminal or deliberate fraudulent act” or “knowing violation of law.” These required exclusions only apply where such loss is established by a “final, non-appealable adjudication in the underlying proceeding in respect of the claim.” See Amended Section 145(g)(1).
• Procedural: Claims handling and notice requirements. The Amendments impose two procedural requirements relating to payments under the captive policy for non-indemnifiable claims: (1) the payment determination must be made by an independent claims administrator or in accordance with 145(d)(1)-(4) approved procedures; see Amended Section 145(g)(2); and (2) where stockholder notice is required in advance of payment in connection with “dismissal or compromise” of suit brought by or in the right of the corporation, the notice must state that the payment is proposed to be made by the captive. See Amended Section 145(g)(3).

Practical Considerations: Is Captive D&O A Solution for Your Company?

The Amendments chart a clear path to enhance D&O programs with captive insurance. While analyzing D&O coverage needs and exploring whether captive coverage as a solution, bear in mind these practical considerations:

• Substantive exclusions mirror equivalent exclusions expected in commercial D&O market: The substantive exclusions (i.e., no coverage for loss arising from deliberate acts such as crime, deliberate fraud, or knowing violation of the law) are common to D&O coverage in the commercial market. As a result, captive D&O coverage as limited by the Amendments is no more restrictive than the coverage typically available for purchase in the market.
• Settlements of claims alleging proscribed conduct could be covered: The substantive exclusions apply only where proscribed conduct is established by a “final, non-appealable adjudication in the underlying proceeding.” The substantive exclusions do not foreclose coverage for settlements of claims alleging prohibited conduct.
• Claims handling requirements are consistent with recommended captive best practices: The implementation of claims procedures, including use of an independent claims administrator as required in some circumstances by the Amendments, is already a recommended best practice to demonstrate that the captive is acting as an insurance company and distinguish it from a circular indemnification relationship. Accordingly, this requirement is not viewed as a detriment to using captive insurance. This is particularly true for IRS-qualifying captives where the corporation must establish that the captive follows common notions of insurance.
• Required notice to stockholders of captive involvement in funding settlement: The Amendments require notice to stockholders if any captive insurance will be used to fund a settlement of claims against directors and officers, even if the captive is only reinsuring part of a policy issued by a commercial third-party insurer. It is unclear how stockholders will react to captive involvement and whether this fact may influence court approval of settlements. Close coordination between counsel involved in settling derivative lawsuits and captive insurance counsel will be important. Structuring the captive’s participation in the D&O program to minimize circularity challenges (i.e., the corporation effectively paying itself the entire settlement amount) should mitigate stockholder challenges to court approval of the settlement.
• An existing captive can be utilized, regardless of its domicile: There is no requirement that the captive coverage be issued by a Delaware-licensed captive. The Amendments allow for coverage issued directly or indirectly by “a captive insurance company organized and licensed in compliance with the laws of any jurisdiction.” This provides the flexibility to leverage an existing non-Delaware domiciled captive, and to establish the captive in a domicile that may help avoid a self-procurement tax on premiums.
• Additional requirements apply for IRS qualifying captive: The Amendments do not require the captive insurer—for 145(g) purposes—to qualify as an IRS captive. If seeking tax saving benefits for a captive, the IRS test for insurance must be satisfied. Courts look to four criteria in deciding whether an arrangement constitutes “insurance” for federal income tax purposes: (1) the arrangement involves insurable risks, (2) the arrangement shifts the risk of loss to the insurer, (3) the insurer distributes the risk among its policy holders, and (4) the arrangement is insurance in the common accepted sense.

HOW WE CAN HELP

We have experience assisting clients in setting up and managing captive structures to meet D&O coverage needs. We routinely counsel companies on how best to use a captive insurer to supplement their existing insurance programs. We work closely with 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.

Contacts

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:

Washington, DC
Daniel E. Chefitz
Lauren Silvestri Burke

Boston
Ariane Baczynski

Hartford
Michael D. Blanchard