"Captivating

Florida State University Law Review Volume 51 Issue 2 Article 5 2024 "Captivating" D&O Insurance: Rectifying Moral Hazard through Captive Insurance Note Morgan "Lea" Nobles Follow this and additional works at: https://ir.law.fsu.edu/lr Part of the Law Commons Recommended Citation Morgan "Lea" Nobles, "Captivating" D&O Insurance: Rectifying Moral Hazard through Captive Insurance Note, 51 Fla. St. U. L. Rev. 515 () . https://ir.law.fsu.edu/lr/vol51/iss2/5 This Article is brought to you for free and open access by Scholarship Repository. It has been accepted for inclusion in Florida State University Law Review by an authorized editor of Scholarship Repository. For more information, please contact . "CAPTIVATING" D&O INSURANCE: RECTIFYING MORAL HAZARD THROUGH CAPTIVE INSURANCE MORGAN "LEA" NOBLES I. II. III. IV. V. VI. INTRODUCTION ............................................................................ CORPORATE PROTECTIONS FOR DIRECTORS AND OFFICERS FROM LITIGATION-RELATED LIABILITY....................................... 515 A . Indemnification..................................................................... B. Advancement ......................................................................... C. Directorand Officer Insurance............................................. 519 519 520 518 POLICY REASONS FOR ALLOWING THE PROVISIONS.................... 521 A. Attraction and Retention of D&Os ....................................... B. R isk-Taking Incentives ......................................................... 522 522 THE RISKS ARISING OUT OF AFFORDED PROTECTIONS............... 523 A. Moral Hazard........................................................................ B . Market for Lem ons ................................................................ 523 524 POTENTIAL SOLUTIONS AND THEIR PITFALLS............................. 525 A. Higher Deductibles on D&O Insurance Plans..................... B. Exclusions for CertainBehavior .......................................... 525 526 STATUTORY APPROACHES ............................................................ A . The D elaware A ct .................................................................. B. Contrast to the Uniform Act ................................................. "CAPTIVATING" THE D&O INSURANCE MARKET ......................... 527 531 531 A . Captive Insurance................................................................. 531 B. Producingvs. ProcuringInsurance ..................................... 533 528 C. Addressing Hesitancy Towards Using Captive Insurance................................................................. 535 D. How Captive Insurance Rectifies the "MorallyHazardous Market for Lemons"............................ 537 CONCLUSION ............................................................................... 539 INTRODUCTION Most states define statutorily and in great detail the obligation of a business, whether it be a corporation, LLC, or partnership, to indemnify its directors, officers, or other members for costs incurred during corporate activities, including expenses to defend themselves in litigation.1 Though the risk of liability is remote, the potential damages and litigation expenses can be substantial; thus, directors and officers cannot ignore their exposure to liability arising out of their position in 1. STEPHEN M. BAINBRIDGE, BUSINESS ASSOCIATIONS: CASES AND MATERIALS ON AGENcY, PARTNERSHIPS, LLCs, AND CORPORATIONS 468 (LEG, Inc. 11th ed. 2021). FLORIDA STATE UNIVERSITY LAW REVIEW 516 [Vol. 51:515 a company. 2 This Note explores the measures protecting directors and officers from liability, the downfalls of those measures, and a potential solution to the hazards arising out of those protections. Indemnification, advancement, and director and officer ("D&O") insurance are each seen as necessary to some extent for companies to attract talented officers and directors. 3 Without those protections, directors' and officers' personal assets become "fair game" in the event of a suit in which they are personally named a defendant because of their position.4 In fact, many directors and officers will not accept positions at a company that does not provide D&O insurance.' D&O insurance provides indemnification and advancement for expenses incurred by a company's officers and directors when the company otherwise cannot or will not provide such indemnification or advancement. The policy also reimburses the company when it does indemnify or advance fees to its directors and officers.7 Thus, the policy is seen as a necessity for the company and for its directors and officers. The provision of insurance is not without issue, however. Though largely seen as beneficial to any company, D&O insurance 8 creates a moral hazard problem and a market for lemons. The provision of D&O insurance lessens the accountability that directors and officers face for their actions, making them less incentivized to avoid risk and do good work. This situation is described as a moral hazard, in which the insured is more inclined to take unreasonable risks, given that the potential costs associated with that risk will not be incurred 9 by the risk taker, but rather by the insurance provider. D&O insurance also creates a market for lemons, in which "bad" directors are 10 likely to seek companies with high policy coverage. Thus, although the company provides insurance to attract "good" directors and officers, a company providing high levels of coverage under its D&O policy may actually find itself with "bad" directors and officers who are less risk averse because they feel protected from personal liability. State legislatures and the insurance market have both attempted to address the "morally hazardous market for lemons" created by D&O 2. Id. 3. See infra Part I. 4. Directors & Officers Insurance, EMBROKER, https://www.embroker.com/coverage/ directors-officers-insurance/ [https://perma.cc/YR7S-6BXQ] (last visited Feb. 10, 2024). 5. See infra Part II. 6. See infra Part I. 7. See infra Part I. 8. See infra Part III. 9. CFI Team, Moral Hazard, CORP. FIN. INST., https://corporatefinanceinstitute.com/ resources/economics/moral-hazard/ [https://perma.cc/J42Q-2Y54] (last visited Feb. 10, 2024). 10. George A. Akerlof, The Market for "Lemons": Quality Uncertainty and the Market Mechanism, 84 Q. J. ECON. 488, 492 (1970). 2024] CAPTIVATING D&O INSURANCE 517 insurance, though each falls short of providing adequate protection." Statutes disallow indemnification and advancement for certain behaviors, including bad faith actions by the director or officer. 2 However, despite statutes limiting when a company may provide indemnification or advancement, the statutes also anticipate the use of insurance to provide such indemnification and advancement on behalf of the company. 3 Thus, although some effort is made by state legislatures to limit the consequences of (...truncated)