Using Your Captive In Your D&O Insurance Program IBC’s 9th Annual Executive Forum On Captives Boston October 22-24, 2003 By Michael A. Rossi Insurance Law Group Main Office (Los Angeles) Representative Office 655 North Central Avenue Tower 42, Level 6 17th Floor 25 Old Broad Street Glendale, California 91203 London EC2N 1HN Ph: +1-818-649-7654 Ph: +44-(0)20-7877-0078 www.inslawgroup.com

Goals For Today’s Presentation To give a policyholder-oriented coverage lawyer’s view of current thinking on using a captive in a D&O insurance program Probable Uses For the Primary Layer For an Excess Layer As a Direct Insurer or as a Reinsurer Issues to Consider Legality/Enforceability Issues Hedging Legality/Unenforceability Risk

Why Are Some Companies Exploring The Use Of Their Captive For D&O Insurance? Might view D&O insurance as too costly In “bad renewals,” rates on line are coming in at 30% and more (one insurer confirmed charging $45 million for a primary layer in recent months) Might view D&O insurance as too illusory Might not have severability as to exclusions or the application for insurance (very bad if “application” is deemed to include all documents filed with the SEC, etc.) Might have one or more problematic exclusions Might not be able to get D&O insurance at all! There is at least one reported case of this happening (occurred in Germany); publicly traded company could not get renewal quotes (as a result, all directors resigned and company closed its doors)

Why Are Some Companies Exploring The Use Of Their Captive? (cont’d) “When the market hardens, your captive becomes another competitor in your insurance renewal process. It gives you direct access to reinsurers and puts pressure on your traditional insurers. Without it, you’re fighting with one hand tied behind your back.” Risk Manager Fortune 500 Company

D&O Insurance Terminology Side A Cover (aka D&O Liability Coverage) Insures claims made against directors and officers that are not indemnified by the corporation Side B Cover (aka Corporate Indemnification Coverage) Insures a corporation’s indemnity obligations to its directors and officers for claims made against them Side C Cover (aka Entity Coverage) Insures a corporation’s liability for “securities claims” made against the corporation (the definition of “securities claims” varies from one insurer’s form to the next)

Captive “Plays” In A D&O Program Providing a Primary Layer As direct insurer (retain all the risk, or reinsure out the Side A risk) As reinsurer (assume all the risk or just Side B/C risk) First excess layer is true “risk transfer” layer, but “follows form” to the coverage wordings dictated by the primary layer

Captive “Plays” In D&O (cont’d) Filling “Gap” in Excess Layers As direct insurer (potentially can reinsure out the risk) As reinsurer (likely have to assume assume all of the risk) Allows you to tap into higher-layer excess carriers that will write the program only at certain attachment points

Captive “Plays” In D&O (cont’d) Providing All or Part of a “Side-A Only” D&O Insurance Program Some companies are buying only Side-A D&O insurance (they have stopped buying Side B/C) The captive can play a role in such a program by insuring all or part of the program Why use the captive for only part of the program? Some companies want to build their captive participation up over time Excess policies provided by third-party insurers can drop-down if a legality/unenforceability issue arises

Captive “Plays” In D&O (cont’d) Providing All or Part of an Excess/DIC Side A Layer Same “play” as for Side-A only program, but this is for an Excess/DIC Side A layer Excess/DIC Side A insurance sits on top of a layer of D&O insurance that provides Side A and B/C coverage It provides excess Side A insurance if underlying limits are exhausted It also can “drop down” over underlying insurance that does not pay out for any number of reasons, and provide first-dollar Side A cover

Legality/Enforceability Issues There are certain prohibitions against a corporation’s ability to indemnify its directors and officers for claims made against them If coverage provided by a captive insurance arrangement (whether as direct insurer or reinsurer of a front) is deemed, as a matter of law, to be an act of corporate indemnification, the ability of the captive insurance arrangement to pay out could be subject to the same prohibitions

Legality/Enforceability Issues (cont’d) If the corporation enters into bankruptcy, and the captive’s assets are rolled up into the bankruptcy, or the bankruptcy trustee otherwise takes action against the captive, the captive might not be able to pay out on claims Other legality/enforceability issues?

Corporate Indemnification Issues For some states, indemnification of a settlement payment or award/judgment in a derivative action is not allowed Excerpt of Delaware Corporations Code § 145(b) (b) A corporation shall have power to indemnify any person who was or is a party . . . [to] any action or suit by or in the right of the corporation . . . against expenses (including attorneys’ fees) actually and reasonably incurred by the person in connection with the defense or settlement of such action . . . Some states permit indemnification of settlement payments and/or judgments in derivative actions Federal securities laws might prohibit indemnifi-cation of claims otherwise permitted by a state’s corporations code

Corporate Indemnification (cont’d) A corporation can buy “insurance” that covers claims against directors and officers that the corporation cannot itself indemnify Excerpt of Delaware Corporations Code § 145(g) (g) A corporation shall have power to purchase and maintain insurance on behalf of [directors and officers] . . . against any liability asserted against such person and incurred by such person in any such capacity, or arising out of such person’s status as such, whether or not the corporation would have the power to indemnify such person against such liability under this section. Some states’ corporations codes expressly provide that this “insurance” can be purchased from the corporation’s captive insurer

Some Corporations Codes Expressly Discuss Use Of A Captive For D&O Insurance With respect to the use of a captive insurer, the statutes appear to fall into one of the following categories: No restrictions on % ownership, and no requirements of % of 3rd-party risk insured, and can cover claims/liabilities the corporation cannot itself indemnify (Arizona, Colorado, Louisiana, Nevada, New Jersey, Ohio) No restrictions on % ownership, and no requirements of % of 3rd-party risk insured, but can cover claims the corporation cannot itself indemnify only if the corporation gets shareholder approval (Texas) Restrictions on % ownership or how used, so that not really helpful (California, Maryland)

Hedging Legality/Enforceability Risk Use Only a Captive that Has Sufficient Third-Party Risk so That it Constitutes “Insurance” If the captive has sufficient third-party risk so that you can deduct the premiums, it arguably qualifies as “insurance” as used in Delaware Corporations Code §145(g) and similar codes from other states that do not expressly discuss buying D&O insurance from a captive D&O Insurance “Wrap” Concept is the same as punitive damages wrap Policy sits behind captive insurance policy and provides coverage on same basis as captive’s policy if captive is unable to perform Other Hedges?

Concluding Thoughts To do proper “due diligence” on the use of your captive in your D&O insurance program, a multidisciplinary team should be assembled Consider making a presentation to the Board of Directors after doing a brief feasibility study – they might “shoot down” any alternative that has “questions” and save you a lot of time Share information with your colleagues to understand who is doing what, why they are doing it, and how they are doing it

Questions?