Using Captives to Transform Executive Risk Coverage

This article originally was published on Captive.com and is reprinted here with permission.

As companies seek ways to trim insurance spending, they often take a close look at costly policies that never seem to pay out. For example, company leaders watch the dollars flowing into executive risk policies such as directors and officers (D&O), employment practices, errors and omissions, professional liability, crime, and fiduciary liability coverage—yet many have yet to see an instance in which those policies pay benefits. “Do we really need this?” becomes a logical question.

Executive risk coverage is more than just a necessary evil in this era of nuclear verdicts. The likelihood that a well-managed company will need to tap into its coverage in the foreseeable future may be unlikely, but if it does happen, the loss is likely to be substantial. Additionally, decisions and actions made by executives often create long-tail risks that may not find their way into litigation for years or decades. Finally, a company that is unwilling to provide such protection may have difficulty filling director and officer vacancies with high-caliber candidates.

Discussions about using captives for executive risk coverage frequently stem from a common frustration. Given the potential for massive verdicts, risk managers recognize the need to implement higher limits, but discover purchasing that coverage through traditional sources is cost-prohibitive.

While each type of insurance provides unique coverages, the process for establishing a captive insurance company and the benefits of doing so are similar. For the purposes of this article, we’ll use D&O coverage as an example.

Designed to cover financial losses resulting from legal judgments and settlements involving issues including negligence, noncompliance with regulations and reporting requirements, breach of duties, and claims made by other parties, D&O insurance addresses three different categories that are referred to as sides.

What’s known as Side A protects the individual directors and officers from personal financial losses for which the company chooses not to indemnify them (or cannot do so, as in the case of insolvency or bankruptcy). Side B provides reimbursement to companies for situations in which they have had to indemnify directors or officers because of actions they have taken (or with negligence, failed to take). Today’s rapid pace of change and decision-making uncertainty underscore the value of this coverage. Side C protects the company’s assets from legal claims when the company itself is named in a legal action along with its directors and officers. Within public companies, it’s a situation that may occur in class action lawsuits filed by activist shareholders.

NOTE: Care should be taken when considering a captive option for Side A coverage, given the potential for, among other issues, the circulatory nature of funding, insolvency and independence of claim handling.

Creating a captive insurer for D&O policies can provide a variety of advantages. It allows the company to gain access to the reinsurance market and price coverage based on its unique historical exposure. Captives replace much of the volatility associated with the traditional insurance market with stable pricing and allow coverages that traditional insurers may exclude. Companies may also benefit from being able to deduct premiums paid to a captive as a business expense.

Executive risk coverages are well-suited for captives for another reason: because the likelihood of claims is slim, a well-structured and prudently managed captive should generate a substantial surplus within a fairly short time. While part of that surplus may be returned to the company in the form of dividends, another common use is to fund loss control efforts in other coverage areas that can reduce the company’s overall insurance spend.

The inherent versatility of captives allows companies to structure a variety of approaches. One of the most common views is the captive as protection for losses that surpass the traditional coverage the company has purchased. Suppose the company has been purchasing $5 million of D&O coverage, but recent actions against other companies in their industry lead them to believe they’d be better off with $10 million. They then establish a captive to sit above their existing policy, with the option of tapping into the reinsurance market to further mitigate the risk.

Alternately, a captive may be used to provide what’s often referred to as first-dollar coverage. As an example, the company asks its existing insurer to consider deductible options, potentially assuming responsibility for the first $1 million in losses. This structure makes purchasing the required $5 million limit of liability more affordable. The traditional carrier now covers anything between $1 and $5 million. Structurally, the primary $1 million becomes the responsibility of the company, typically through the use of a deductible reimbursement policy issued by their captive.

Because the structure of a captive can be complex and varies across domiciles, it’s critical that any organization considering using strategies like these rely on the expertise of experienced captive consultants. Having the right consultant dramatically improves the likelihood the captive will achieve all of the company’s objectives.

The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.