3 May 2023ArticleAnalysis

D&O difficulties—how captives can help plug a gap

In 2022, the state of Delaware approved using captives for directors & officers (D&O) insurance, which encouraged Meta, the parent company of Facebook and Instagram, to put Side A coverage in its pre-existing traditional captive.

Meta has said that it is the first Delaware-incorporated company to do so, and it also purchased a Laser DIC (difference in conditions) insurance policy for coverage gaps.

According to Lauri Floresca, senior vice president, management liability and cyber liability at Woodruff Sawyer, which works with Meta on its D&O insurance program, Meta already had a captive in place in Hawaii when the two companies started this project, but they created a separate cell to house D&O, which is part of what they think are their best practices in this area.

According to Floresca, Meta, in particular, had a challenging start as a public company in the D&O market and had several major claims in its first couple of years as a public company—so D&O insurers were not enthusiastic about continuing to write it. As a result, its D&O premiums were very high, even though it was buying very limited coverage—it was buying only Side ‘A’ covers, the bare minimum that public companies generally buy if they want to self-insure.

The reason the company needed that Side ‘A’ piece was because of the D&O developments in Delaware, but also in many states, where you can’t indemnify for all things, such as a derivative lawsuit. So, when Delaware made its legal change, which was prompted by a group of companies that were advocating to the Delaware State Bar Association on this point, there was a fast decision for Meta to go ahead.

“They’ve been preparing for it—one of the reasons they were the first in the state is that they had been thinking about this and we started working on it in advance,” Floresca told Captive International.

“The decision was made pretty quickly that they wanted to go ahead and transfer part of their programme initially into the captive, but they wanted to be able to say to their board that doing so was equivalent to what they had before.”

However, Woodruff Sawyer concluded after studying the Delaware legal change that it would not be possible to get 100 percent of the way there, partly because there were some specific requirements in Delaware around the wording in the captive policy that did not match up exactly with the commercial markets.

In addition, there was also the possibility that the captive, while the possibility of bankruptcy was remote, could still have its own financial troubles and a director would still ultimately be the personal backer if the captive failed, because the company would not be permitted to indemnify.

“That’s why we worked with Meta, helping them put the captive in place and to create the companion product that we call Laser DIC to fill in those two gaps and give their directors the complete solution that matches up with what they had before,” Floresca explained.

She said that the captive is very specific to Delaware, where the legislature inserted into the law the form of a fraud exclusion they wanted the captive policy to have, and because they were so specific in the language that they prescribed that the captive policy (and all policies) include fraud to some extent after final adjudication and exhaustion of all appeals.

The specific version picked and voted to the Delaware law is not quite as broad in terms of favouring directors as you can get in commercial markets—there were a couple of differences in that language that were filled in with the Laser product, she said.

Floresca underlined that this is not something that the companies expect to happen regularly because these cases almost never get to that point of adjudication, but Woodruff Sawyer and Meta wanted to be able to say to the board that this was an equivalent solution.

A difficult market

D&O is not an obvious product to go into a captive, Floresca added, saying that it can be a very volatile line of coverage, with infrequent but very severe claims, and it can be hard for a single company captive to adequately predict premium. The backstop for that is the limit is 100 percent collateralised and fully funded in the captive, and Floresca thinks that was a requirement from its Hawaii captive for Meta.

“I think it would also be a requirement of the board if they were to investigate the strategy and would want to see that there is 100 percent of the limit funded in the captive, but also given that unpredictability of risk it makes sense for a company that’s fully funded to alleviate it,” she explained to Captive International, adding that that obviously gets very expensive, especially over time if companies are noticing claims to the captive, which big public companies probably will need to.

Over time, reserving can become challenging and the accumulation of capital on those aggregated limits will be a particular challenge. As a result, Floresca doesn’t think that D&O was an obvious product initially for captives or that the market will see a tonne of companies rush to this solution.

Instead, she thinks that the Meta-style captive is more for companies which have already stopped buying traditional D&O and are trying to self-insure as much as they can, which have a really strong balance sheet and are able to divert some of those assets into a captive to be able to support this.

She believes it’s an important option for companies to hedge against future changes of the D&O market, as part of what drove Meta and the other companies that joined in the petitioning in Delaware is the knowledge that the D&O market is becoming very difficult.

According to Floresca, between 2019 and 2021 premiums were rising substantially, especially for the type of coverage that big public companies buy, because there’s been a growth in these big derivative settlements, with some insurers raising rates for Side ‘A’ as many as five to eight times.

“So there were rising costs of insurance and the declining capacity, with insurers who were pulling out of this space,” she concluded. “If you’re a public company that buys a large D&O limit and you want to be able to stay there and maintain that large D&O limit if the market disappears and there isn’t that much capacity available year to year, this is an option that companies can use to flex their D&O programme and put that last $100 million into a captive for a couple of years. When capacity reappears they could then come back into the commercial market.”