Self-Insuring D&O Liability: Commercial Insurance versus Indemnification Trust

The primary reason why D&O liability is not widely self-insured is the lack of claims frequency and the tendency for claims experience to confound attempts to forecast frequency and severity. Another reason why D&O is not routinely self-insured is the notion of "optics." In the absence of a detailed understanding of the self-insurance plan, company directors and officers often assume that the firm is assuming additional risk, as compared to purchasing insurance. However, for the right company, self-insurance can not only provide protection comparable to that which is available in the commercial insurance markets, it can do so less expensively and more efficiently.

A typical D&O liability insurance program might cost $200,000 in annual premium, purchasing $10 million of coverage, subject to a $250,000 per-claim self-insured retention. Unlike self-insurance, commercial insurance must be purchased annually, regardless of claims activity. At the end of each policy year, the $10 million insurance limit must be purchased once more, even though no claims were paid.

The best candidates for self-insurance are companies with strong balance sheets and adequate cash reserves. For firms with little or no historical claims activity, the economics of self-insuring D&O can be quite favorable. The company would no longer spend irretrievable insurance premiums each year. The company would have the option of funding each year or funding based on perceived needs.

D&O liability insurance provides more than just claims payments. D&O insurers are experts in defending D&O claims. A portion of the company's annual premium is allocated to these expert legal services. This is not a problem for the self-insured company, as it would be able to retain the same outside legal expertise, as would the insurance company. This article provides an overview comparison of the salient features of D&O insurance procured in the commercial markets and the use of an indemnification trust.

Purchase D&O Insurance from Conventional Insurers

Purchasing insurance is the most popular method of managing D&O risk. Claims costs excess of a self-insured retention (as defined in the insurance policy) are transferred to an insurance company in exchange for an annual premium. The coverage form is "claims made," meaning that reported losses are paid assuming that they occurred after the retroactive date.

Insurance allows business to thrive without the risk of unmanageable loss. It is, however, subject to the changing conditions of the insurance market and the decisions of individual insurers. Market pressures force premiums and available capacity up and down based on insurer profitability and supply and demand for coverage. Insurers may choose to exit lines of business that are deemed to be unprofitable. Policy exclusions may apply to prevent, or reduce the amount of, claims payments. So, while commercial insurance companies remove certain risks from their clients’ balance sheets, the insurance transaction is subject to some volatility and uncertainty.

Self-Insure D&O Risk through an Indemnification Trust

Indemnification trusts are a relatively common method of retaining the D&O liability exposure for large companies with significant capital and cash reserves. A trust is not insurance in that it does not transfer risk to a third party—it is a self-insurance vehicle designed to establish a pool of funds; legally segregated from the company's general account; managed by a third party; and designated to finance pretrial settlements, court-ordered judgments, and legal expenses associated with D&O liability.

Trust Program Structure—an Example

Company A funds an indemnification trust with $10 million. This fund is designed to cover each director and officer subject to company indemnification, nonindemnifiable losses, and coverage for the company as the entity.

Excess of the trust, Company A may decide to purchase D&O liability insurance. The pricing of the excess insurance should reflect the fact that the trust is fully funded, thus eliminating any counterparty risk charge built into the premium. The premium should also reflect the fact that the cover applies excess of $10 million, a significant self-insured cushion.

Indemnification trusts are formal financial structures. They are not unlike any other trust arrangement wherein funds are legally segregated and designated to be used for a specific purpose—a detailed description of which is codified in the trust agreement. The D&O trust is typically funded at a level deemed to be adequate to cover legal costs and potential court-ordered judgments, based on the company’s exposure to loss, capped at a reasonable level.

Since the trust is fully funded (eliminating credit risk) and segregated in a formal trust administered by a third party, it provides the security expected by the company’s board of directors and senior officers in the absence of commercial insurance.

Highlight Comparison of Salient Features

Company A—Estimated 5-Year Financial Picture (Highly Simplified)

Assumptions

• No losses and no tax effect
• $10,000,000 loss funding in the trust mirrors insured limit of liability
• Annual commercial D&O premium $250,000
• Trust funded only once, in the first year, assuming losses permit
• Trust expenses based on the $10,000,000 funding and include bank and trustee fees

Conclusion

This treatment highlights the important differences between commercial insurance and self-insured trusts. A trust, in my humble opinion, is the clear winner, for companies that can afford them.

However, there is one issue in this comparison that has not yet been mentioned and must be considered. As noted above, D&O insurance is written on a claims-made form. If Company A leaves its insurer for a trust and then, after a period of years, decides to reenter the commercial insurance market, it will find that the new policy's inception date will also be its retroactive date. This makes sense, of course, because the new insurer is not going to cover prior acts—they are self-insured in the trust.