Delaware Corporations May Use Captives to Insure Non-Indemnifiable Loss

The Delaware legislature recently passed an amendment to the statute governing Delaware corporations’ ability to indemnify directors and officers. That statute—8 Del. Law 145—provides that Delaware corporations “may” purchase “insurance” to insure liability of their directors, officers, employees, and agents “whether or not the corporation would have the power to indemnify such person against such liability.” The recent amendment clarifies that “insurance” includes captive insurance. It states: “For purposes of this subsection, insurance shall include any insurance provided directly or indirectly (including pursuant to any fronting or reinsurance arrangement) by or through a captive insurance company organized and licensed in compliance with the laws of any jurisdiction . . . .”

The amendment also sets forth three additional requirements that a Delaware corporation must follow if it elects to use captive insurance in this manner.

• First, the captive insurance policy must exclude coverage for loss arising out of “financial advantage to which [a covered individual] was not legally entitled” or “deliberate criminal or fraudulent act of [the covered individual],” but only if there is a final, non-appealable adjudication finding that conduct and the Delaware statutes otherwise allow for indemnification. This is consistent with exclusions in most D&O insurance policies.

• Second, the decision to pay under the captive insurance must “be made by an independent claims administrator,” by a majority of directors that are not subject to the claim at issue (or a committee of those directors designated by a majority of those directors), by independent legal counsel, or by stockholders. This helps avoid potential conflicts of interest that could arise if a captive insurance company was deciding whether its captive D&O policy insures particular directors and officers, particularly given that leadership of captive insurance companies often overlaps with the leadership of the captive’s parent company.

• Third, the amendment also mandates that if notice is required to stockholders about the dismissal or settlement of any claim, then that notice must include notice that the payment will be made under the captive insurance. This promotes transparency in how the captive insurance company is providing coverage.

The amendment also states that any corporation using captive insurance in this regard will not cause the corporation to be subject to the insurance provisions in the Delaware code. And it clarifies that the captive insurance can include fronting or reinsurance arrangements and that the captive insurer can be domiciled in Delaware or any other state.

It remains to be seen whether this amendment to the existing statutory framework is truly meaningful, or even necessary, given that captives arguably fell within the meaning of “insurance” already permitted in Section 145. While the language of Section 145 applies to captives organized in any state (not necessarily in Delaware), one need look no further than Delaware’s existing Captive Insurance Program as evidence that Delaware has recognized the formation and use of captives, including for D&O insurance, dating back to at least 2005 when the Delaware General Assembly modernized the state’s captive laws.

Moreover, Delaware captives, like all captives, will face the same capital requirements, licensing and regulatory hurdles, and similar challenges that remain unchanged following the amendment. Companies must balance these drawbacks against the potential upside in using captives as an alternative risk vehicle, which can include tax benefits, insulation from traditional insurance market volatility, and other cost savings.

In any event, the amendment provides helpful clarification about what kind of insurance Delaware corporations are allowed to use, and time will tell whether this leads to any substantial increase in Delaware corporations’ use of captive insurance for D&O liabilities. Regardless, the amendment is another example of Delaware clarifying its broad protections afforded to directors and officers at Delaware corporations, which is one of many reasons companies incorporate in Delaware and why Delaware is viewed as a leader in sophisticated and current corporate laws to enforce those protections.