Guide to alternative structures: An important tool in a hardening D&O market
Companies purchasing directors & officers (D&O) liability insurance are facing mounting challenges. Dramatic cost increases, limited capacity, increasingly aggressive litigation, risks related to COVID-19, and heightened scrutiny on board diversity are all contributing to a hardening market that’s likely to last for at least the next 12–18 months. While this creates challenges, companies still have compelling options—if they think creatively and look outside traditional approaches to D&O.
Nontraditional alternative structures can help mitigate the impact of a hardening market and better position companies to take control of the market. Traditional structures, which companies are likely already familiar with, have three types of cover: Sides A, B, and C. Alternatives can be tailored to an individual company’s needs, risks, and capital, and offer different levers for managing risk and retention. Those companies open to nontraditional approaches may also find that this level of innovation can help tackle complexity across different dimensions and bring a different perspective to problem solving—which has benefits that extend beyond risk.
Companies can use this guide to nontraditional alternative structures and start having more strategic D&O conversations now.
A captive – wholly owned or a cell – can be utilized to address insurance needs, serve as a strategic risk management tool, increase influence over costs and premiums, and allow a parent company insured to have more control of the coverage. Companies that go this route can utilize the captive for layers with challenged capacity or prohibitive pricing, including entity coverage (Sides B and C) within the D&O insurance contract. Additionally, parent companies with a captive have a more effective negotiating tool when it comes to premiums and terms and conditions on other policies; and they can also use the captive to in-fill a corporate retention. This allows a company to potentially take a higher retention beyond their risk tolerance to drive a more competitive primary premium which should translate into savings up the tower.
Companies seeking to create a captive should consider the following:
- Their ability to commit the necessary capital to insurance risk shifting
- The risk of adverse results in the event of claim severity
- The process for planning and filing with regulators and getting the necessary regulatory approval
- A captive is a long-term strategy and best suited to companies with significant balance sheets and ability to commit meaningful capital to the captive structure
- Other coverage to be placed in the captive beyond Sides B & C D&O insurance
- Their Side A coverage—a captive is typically not a recommended solution for Side A (non-indemnifiable loss, personal protection for directors and officers), for which they need to go to the traditional market
- A cell captive can offer more flexibility to capital commitment, risk distribution and inclusion of Side A
Risk retention group insurance
Risk retention group insurance essentially functions as a captive insurance company established for the benefit of a group of participating companies. Companies facing similar risk exposures can proactively manage their total cost and address the coverage needs of fellow members by pooling their resources. In one example, a group of companies challenged with restrictive language and high costs associated with prescription drugs banded together for risk retention group insurance.
Considerations for this solution include:
- A significant capital commitment
- The strategic selection of fellow participants—this is critical due to the risk of systemic losses depending on the class of business and financial solvency of the participants, especially in an evolving litigation environment
- Significant lead time in advance of renewal
- The possible preference of individual directors and officers for a conventional risk transfer solution, including a Side A D&O policy to address non-indemnifiable claims
Trust fund/indemnification trust
In this approach, the company would establish an irrevocable trust in connection with a bank or third-party trustee, thereby establishing a funding source managed outside of the company. The trust agreement would establish the terms of the D&O insurance contract, including how these funds are designated, with individual directors and officers as beneficiaries. Like fronting/finite risk arrangements, the risk is not transferred to an insurer.
- Companies considering this arrangement should know the following: There can be legal challenges due to the optics of an indemnification trust, particularly questions of whether the arrangement is actually insurance.
- This approach is unlikely to address non-indemnifiable loss (Side A, personal protection for directors and officers) because of the circular nature of the company retaining the risk and the concern that the trust proceeds may be accessed in an insolvency situation.
- This requires an independent third party for the management and handling of claims.
A willingness to innovate and look beyond traditional approaches can have myriad benefits for companies. In addition to managing a hardening D&O market, creative thinking can elevate risk management—and help support overall business strategy. These nontraditional structures can be a foundation for more strategic conversations, and by starting early, companies have the flexibility to bring an array of solutions to the table.