Recently in New York, a company was compelled to pay back revenues obtained in what was deemed an inappropriate manner. While I have not yet seen it, I must guess that we will soon see exclusions for disgorgement in D&O and errors and omissions policies due to judgments on inappropriate activities, especially since some reports on this situation have stated that the companys earnings would not be affected, as its E&O carrier would pay back the revenues.

(Editors Note: NUs reports on the collectibility of disgorgement payments to regulators have quoted experts saying that recovery is questionable in one case. See May 19, page 37. In another situation, a court has ruled that such payments were not covered under an E&O policy. See July 28, page 8.)

As decisions and settlements are reached in which the financial recoveries are dependent on the commercial insurance marketwhere no provisions for loss have been taken in advancecautious underwriters will be as creative in their exclusions and limitations as the bar will be in litigations. The actuarial science for determining D&O losses will be under great pressure to address these new causes of loss.

While it might be good risk management to accumulate funds in a captive for claims due to disgorgement, the actual funding of the potential loss and the gain of regulatory approval must be taken into account. It is tempting to think of a captive as a panacea, but a captive can, in fact, create problems.

Even in situations where a firm has a superior record, history and ability to eventually pay the bill, evidence must be provided in order to assure all concerned that the bill will be paid when it comes due. Regulators require that evidence be in the form of a letter of credit.

As time moves forward, the aggregate number of letters of credit required by regulators will increase. Though the aggregate numbers can be reduced through diligent and persistent management, the letters of credit will not go away any time soon.

The trend in commercial insurance today illustrates that many traditional carriers are choosing to protect themselves and their stakeholders from loss by avoiding risk altogether. This is understandable, though unfortunate.

When the largest commercial purchaser of reinsurance announces it will henceforth require 100 percent security from most of its reinsurers, and when most risk sharing partners want more expenses outside the limits of the policy with security against the ultimate payouts, we will have a situation in which uncertainty of future loss will challenge risk certainty.

If a captive manager can make a case to the regulator that the potential for loss is real, that actuarial estimates are reliable and the commercial market untenable, then it may be a good decision for the captive under discussion to write policies.

A careful review must address whether or not an existing captive, established for other purposes, can or should be used for D&O. Potential impact on existing claims as well as the accompanying reserves and security should be questioned. While placing D&O in a captive may address a short-term need, the requirement to post ever increasing letters of credit may negate the solution.

The analysis may well suggest that the establishment of a separate captive, just for the D&O exposure, is the best course of action. This would allow different levels of security to be agreed to, when the loss profile of the D&O differs markedly from workers compensation, automobile liability or whatever is covered by the first captive. Having an alternate structure provides opportunities for innovation and creativitythe heart and soul of captives.

Operating multiple captives brings new challenges in the form of increased frictional costs and management resources. The D&O captive will require different skills from the workers comp self finance. There also will likely be different service providers in terms of claim adjustment, litigation and settlement.

The nature of D&O claims is such that each claim must be given a considerable amount of time by senior executives and/or highly compensated outside professionals.

Certainly the use of a single source for management and coordination of services should produce some efficiency, but there are inherent costs that must be addressed. The parent company must choose whether to pay a management firm for performing services or pay internal costs.

In terms of enterprise risk management, D&O in a captive will produce multiple triggers for loss which will call in to question the efficiency of using the firms capital in this manner. Conceivably the parents balance sheet could be called upon to perform new and additional support roles not in line with the overall financial objectives of the company.

Current portfolio theory suggests that the use of a captive for D&O would be efficient, but the commercial market has not yet been willing to reflect this in the pricing for layers of excess coverage.

A thorough analysis of the parents exposure to loss from a D&O claim may show that some level of primary coverage is well served by a captive, but at some level the board of directors or executive management will want to see risk transferred to another balance sheet. Costs in terms of premium and security, however, may not be favorable for the captive.

Another approach might be working with the commercial market to carve out coverage that is particularly difficult to price, such as unplanned disgorgement, and place those “offending covers” into the captive. This would require a cooperative commercial underwriter and creative wordsmithing to find a balance that suits all partiesbut it is well worth the effort.

After all analysis is complete, there remains the matter of control of risk dollars, which I believe is the central reason to form a captive. Even if no clear conclusion can be drawn from the numbers, the attraction of controlling ones destiny is compelling and should be given considerable weight in the decision matrix.

While the question of whether or not a captive should be considered for D&O is not an easy one to answer, the investigation has merit. The “right” answer will, as always, be in the details.

Michael R. Mead, CPCU, is president of Crusader Captive Services, LLC, in Chicago, the newly formed umbrella for several domicile-specific management companies, all a part of Crusader International Group. He serves as a director and past chair of the Captive Insurance Companies Association and director of the Arizona Captive Insurance Association.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, November 26, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.