Structuring D&O risks into captives
Even before COVID-19, the directors’ and officers’ (D&O) insurance market was hardening, driven mainly by ever-increasing litigiousness. Some carriers have withdrawn capacity, making D&O coverage more expensive and sometimes unavailable. The pandemic, bringing more insolvencies and scrutiny of the actions of corporate boards and managers, is likely to add to the lawsuits and increase strain on the D&O market. This trend has no end in sight.
“The long-tail nature of D&O claims should add comfort to the decision of using a captive to provide coverage.”
It is understandable that risk managers are considering self-insurance options. Traditionally, the placement of D&O risk in a captive was limited, largely because of the issues that could arise from Side A, one of the three aspects of D&O insurance.
• Side A: Insures liabilities incurred by an individual in their capacity as a director or officer in situations where the company is prohibited from indemnifying or chooses not to.
• Side B: Provides reimbursement to the company for the indemnification it provides directors and officers for claims brought against them alleging covered wrongful acts.
• Side C: Primarily covers securities claims brought against public companies, or in the case of private entities, it provides broader coverage to insure the company for its own liability.
Placement of Sides B and C into a single-parent standalone captive is a broadly accepted option and is in use. The complications arise in Side A coverage, because of potential conflicts. For example, if a company is unwilling or unable to indemnify a director, would a captive owned by the same company pay the claim?
Three considerations for risk managers looking to put Side A risk into a captive are:
• Ring-fencing of funds: Ensuring that a captive’s assets are not vulnerable to attack by creditors in the case of the parent’s insolvency.
• Circularity of funding: If a company is prohibited from indemnifying a director, there is risk that this may extend to the captive, preventing payment of a claim.
• Independent claims handling: A director may feel uncomfortable with the coverage without a claims-handling process that is objective and independent from the captive.
Creating distance between the risk and the parent is key to mitigating these concerns. One way to achieve this is to use a fronting company, which writes the policy, handles the claims and cedes the risk to the captive through a reinsurance arrangement.
Another option is the use of a segregated accounts company, owned by an entity other than the parent, which can issue the coverage.
The long-tail nature of D&O claims should add comfort to the decision of using a captive to provide coverage. KPMG’s D&O policy benchmarking, based on our loss development pattern data, shows the lag between the time a claim is incurred and when it is paid.
Only 40 percent of the total claim amount has been paid by year five, and 88 percent by year 10. If a loss occurred on day one of operations, the captive would have to reserve adequately to cover it. However, it would have significant time to collect more funds through premiums and additional capital to pay the claim.
Captives are already being increasingly used for D&O coverage. In 2016, professional liability cover (including D&O) accounted for only 7 percent of long-tail gross written premiums placed into Bermuda-domiciled captives, rising to 19 percent by 2018, according to Bermuda Monetary Authority data. We expect the upward trend to continue.
However, given the untested nature of captive D&O coverage and the lack of a legal precedent, the big question risk managers should ask themselves is: will the claim be honoured?
Jonathan Barnes is senior manager at KPMG in Bermuda. He can be contacted at: email@example.com
Alex O’Shea is senior advisory at KPMG in Bermuda. He can be contacted at: firstname.lastname@example.org