With special purpose acquisition companies increasingly being used in initial public offerings and the commercial insurance market continuing to harden, captive insurance could be a solution for offering directors and officers protection against increased shareholder scrutiny and resulting derivative lawsuits.
The use of SPACs—special purpose acquisition companies or “blank check companies”—is showing no sign of slowing down. SPACs now make up nearly 70% of initial public offering (IPO) activity and continue to attract deep-pocketed sponsors, including high-profile athletes and public figures, drawn to market opportunities with potential for investment big returns and liquidity.[1]
SPACs target businesses across multiple sectors and engage in accelerated acquisitions that often expose directors and officers to shareholder scrutiny. To attract and retain qualified directors and officers (both pre-and post-acquisition), SPACs must offer comprehensive directors and officers liability coverage (D&O insurance) to protect against that increased exposure and resulting derivative lawsuits. But this insurance hurdle is becoming tougher to clear as the commercial insurance market, particularly for Side A D&O coverage—which protects claims against directors and officers not indemnified by the public company—continues to harden. Captive insurance could be the solution to fill the insurance gap, including any timing gap.
SPAC LIFE CYCLE AND INSURANCE NEEDS
A SPAC is a nonoperating company created by a sponsor solely to raise funds in the public securities markets to acquire a private operating company (the “to be determined” target) in the short term. SPACs present unique insurance needs due to their fast-tracked life cycle and willingness to dabble in hot, emerging sectors marked by high risk/reward and by volatile private company valuations, frequently with no earnings history.
SPACs involve a three-stage life cycle: (1) IPO; (2) Business Combination; and (3) New Public Company, with insurance needs at every step of the way.
- Stage 1: IPO. Soon after the creation of a SPAC, its sponsor selects directors and files a Form S-1 registration statement with the US Securities and Exchange Commission (SEC) to bring the SPAC public. Once approved by the SEC, SPAC shares begin public trading on an exchange. Once common stock of the SPAC is publicly traded, the SPAC’s directors are exposed to lawsuits from public investors. D&O insurance protects against that risk.
- Stage 2: Business Combination. Post-IPO, SPAC executives search for a target company. Once the target is identified, the parties consummate the transaction whereby the SPAC combines with the target to form one publicly traded company (the combined company). The business combination, referred to as the “de-SPAC,” must occur within a specified window of time, usually 18–24 months after the IPO. The business combination is a change-in-control event that triggers a runoff provision in the SPAC D&O policy to protect claims alleging wrongful acts that took place prior to the transaction date up until the policy expiration; an extended reporting period is needed to provide protection beyond the policy expiration to report claims that may have arisen during this stage.
- Stage 3: New Public Company. Once the combined company is fully operating, it carries with it all the risk of a public company, including the risk of public shareholder derivative lawsuits. The combined company will need a new D&O policy to cover operations post-closing, as well as coverage for property and casualty lines, and necessary specialty coverages, such as employment practices, cyber, fidelity, and fiduciary policies.
D&O INSURANCE
D&O insurance protects a company and its corporate directors and officers in the event of a suit for actual or alleged wrongful acts in managing the company. D&O insurance typically comprises three insuring agreements, called Side A, Side B, and Side C.
- Side A covers claims against directors and officers for wrongful acts undertaken in the management of the corporation that are not indemnified by the corporation.[2]
- Side B covers claims against directors and officers for wrongful acts undertaken in the management of the corporation that are indemnified by the corporation.
- Side C covers claims for wrongful acts that are asserted against the corporation. This coverage is limited to “securities claims” in policies issued to publicly traded companies.
D&O insurance in the commercial market for newly public companies (like SPACs) with no track record can be prohibitively expensive or completely unavailable. This coverage can be even harder to secure for SPACs because of the short life cycle of the insuring relationship: SPACs often seek short-term policies (18 months to two years) with no intent to renew.
With the surge in SPAC IPOs combined with a general “hardening” of commercial insurance markets and the current hesitance of many commercial insurers to write D&O coverage, SPAC sponsors may be left with a gap in the D&O market that makes it hard for SPACs to get off the ground. Indeed, high-quality directors will not accept appointment to a SPAC without adequate D&O insurance protection to back-stop and supplement the company’s indemnification obligations.
THE CAPTIVE SOLUTION
Captive insurance is a solution to fill coverage gaps or a means to control insurance terms and conditions. A captive insurer is a wholly owned subsidiary that is licensed to insure the risks of its affiliated companies through the issuance of insurance policies in exchange for the payment of a premium. A specialized actuary retained by the captive typically sets the premium, which is composed of a loss reserve and a risk margin. Captive insurance can be utilized flexibly at any “level” of the insurance tower, or at varying levels dependent on the risk insured.
Captive insurance offers cost-saving benefits, in addition to filling a market void:
- Investment of Risk Premium: In the captive setting, the risk premium is retained by the captive and is invested for the benefit of its parent and affiliated businesses. By contrast, in a typical commercial insurance setting, the third-party insurer keeps the risk margin, which is the expected profit from the risk being insured.
- Tailored Coverage: Insurance coverage counsel can prepare a manuscript policy tailored to the specific needs of the businesses affiliated with the captive. By contrast, a third-party commercial insurer typically uses a standard form policy typically utilized by the issuing insurer with exclusions added to limit the scope of coverage.
- Access to Reinsurance: A captive provides its insured with access to the broader reinsurance market where opportunities may exist to shift a portion of the captive’s risk to reinsurers in a cost-effective manner.
- Tax Savings: Generally, loss reserves of a captive insurance company can be immediately deductible (on a discounted basis) for tax purposes under Internal Revenue Code Section 832, thus accelerating the tax deduction within the company’s consolidated group and monetizing the associated deferred tax asset. Courts look to four criteria in deciding whether an arrangement constitutes “insurance” for federal income tax purposes: (1) the arrangement involves insurable risks; (2) the arrangement shifts the risk of loss to the insurer; (3) the insurer distributes the risk among its policy holders; and (4) the arrangement is insurance in the common accepted sense.
- Potential Risk Transfer Mechanism: A captive can serve as a risk transfer vehicle to shift risk over time. This is particularly beneficial for SPACs as they rapidly progress through the three-stage life cycle. One captive could be used to serve the evolving insurance needs of the SPAC, or, if desired, risk could be shifted throughout the life of the SPAC and beyond via loss portfolio transfer (LPT); regardless, investment income earned in the captive is captured and maintained through each stage.
IMPORTANT DELAWARE LAW CONSIDERATIONS
Unique challenges exist to protect directors and officers from Side A claims where commercial insurance is unavailable, particularly for SPACs, which are often formed as Delaware corporations. Delaware law prohibits a company from indemnifying its directors and officers directly for derivative settlements and judgments but permits the company to purchase insurance to pay for such non-indemnifiable claims.[3] A captive arrangement may offer an attractive solution provided the arrangement is properly structured such that it qualifies as “insurance” (applying the four-part test set forth above).
Delaware law is highly protective of corporations, including SPACs, and Delaware courts are experienced in handling complex corporate transactions and their insurance ramifications. Because of the importance of Delaware law and its unique indemnification law that favors a captive solution for protecting directors and officers, we encourage considering a captive option whenever feasible to do so.
CAPTIVE OPTIONS
There are several captive funding options that should be carefully considered when exploring a potential D&O coverage captive solution:
- Pure Captive: Captive is owned and operated for the benefit of a single parent company. An unrelated, third-party captive manager can be appointed to manage the administrative side of the captive. Formation and operating costs are high compared to other captive funding options.
- Cell Captive/“Rent-a-Captive”: Captive is owned, managed, and controlled by an unrelated entity for a fee. Cell captives provide for a fast startup and a quick dissolution (with no liquidation costs), attractive features for the accelerated SPAC life cycle.
- Group Captive: Captive is owned proportionally by a group of entities with similar risks. The scope of risk insured is limited to what the group will agree to insure. Group members must work cooperatively in the life of the captive.
Regardless of which captive funding option is selected, using a proper actuarial study, implementing claims procedures, and following insurance accounting practices are critical to demonstrate that the captive should be treated as an insurance company.
[1] Amrith Ramkumar, Red-Hot Stock Market Pushes More Companies to Go Public, Wall St. J. (Feb. 25, 2021).
[2] Policy forms can, however, vary considerably in how they define a “non-indemnified” or “non-indemnifiable” event.
[3] Del. Code Ann. tit. 8, § 145(b); Del. Code Ann. tit. 8, § 145(g).
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