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Insurance captives are a great solution to the right problem. A captive is a licensed insurance company that provides insurance for designated risks to its corporate parent company (essentially, creating your own insurance company) or third parties.
But are captives the solution to the problem of escalating prices for D&O insurance for SPAC IPOs, as some are suggesting?
The short answer is no, for all the reasons that I’ve outlined with my colleague, Evan Hessel, in: Should We Form a Captive for D&O Insurance? …and a few more, which I’ll discuss next.
When a Captive Makes Sense
As a general matter, captives make the most sense for high-frequency, low-severity, predictable claims that pay out over many years. Workers’ compensation claims are a good example; director and officer claims, on the other hand, are not. That is because D&O insurance claims are, by nature, low-frequency, high-severity events.
Remember, too, that the captive has to be funded. If a SPAC is challenged in having enough risk capital to purchase D&O insurance at the current rates, that SPAC will certainly not be able to fund a captive properly.
The upfront investment in captive formation and capitalization will likely be more than the cost of two years of D&O insurance. There is also the additional cost of regulatory compliance and possibly being required to add more capital to the captive over time.
In addition, the tax benefits that captives offer—a major reason to form an insurance captive—likely don’t apply here. Captives are particularly ill-suited for SPACs given the fact that SPACs don’t have operating profits against which they could deduct expenses (such as captive premiums) for a tax benefit.
Additionally, consider timing. Most SPACs are formed and go public in a very short period of time, at which point D&O insurance must be in place. There is unlikely to be enough time to form a captive.
Finally, not all aspects of D&O risk are suitable to be covered by a captive. Specifically, Side A risk would almost certainly need to be financed by commercial insurance, even if a captive is in place to cover the Side B and C D&O risk.
Remember that Side A responds in the case of claims in which a company is legally prohibited from indemnifying a director or officer, such as in the case of a derivative action settlement or corporate bankruptcy. If the captive is a wholly owned subsidiary of the parent company, as is the case for large corporate captives, it would likely suffer from the same inability to indemnify the directors and officers as the captive’s parent. So even if a SPAC forms a captive to underwrite the SPAC’s Side B and C risk, the SPAC would likely still need to purchase Side A-only coverage.
4 Ways SPACs Can Save Money
There are, of course, ways SPACs can save money on their D&O insurance that don’t involve forming a captive. In an article I wrote on how SPACs can save money on their D&O insurance premium, I outline four ways:
- Being comfortable with having almost no D&O insurance limit at the time of the IPO if the insurer can guarantee coverage for future claims after a de-SPAC transaction has closed.
- Placing a one-year policy instead of the standard two-year policy that most SPACs purchase to avoid paying for two years of coverage at the time of the SPAC IPO.
- Putting more premium in the tail policy and less in the initial SPAC IPO policy.
- Writing smaller layers with each insurer and taking a higher self-insured retention, or purchasing a Side A-only policy.
For more, see our Guide to D&O Insurance for SPAC IPOs.
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