Restructuring and Insurance Optimization

When a business is in distress and forced to sell assets or consider filing for bankruptcy protection, the company’s property and casualty insurance policies likely aren’t a top priority. They should be.

Insurance Optimization and Restructuring

Insurance optimization has four key uses in the restructuring process:

• Protecting key stakeholders (management liability pre- and post-restructuring).
• Identifying and recovering sources of trapped cash (collateral recovery in Chapter 11 and 7, and consensual restructuring scenarios).
• Facilitating sales of businesses or assets from distressed sellers (including Section 363 sales).
• Cost optimization of risk management and insurance programs (pre- and post-restructuring).

When can it apply?

For any company going through a restructuring or bankruptcy process, or involved in distressed asset sales or purchases. This includes:

• Chapter 11 and 7 filings
• Consensual (out of court) restructurings
• Debt-for-equity deals and swaps
• Asset sales purchases, whether from a bankruptcy (for example, a Section 363 sale) or pre-petition asset sales (including Article 9 transfers)

What are the general process steps?

1. Get ahead of potential insurance coverage or collateral issues by making your directors and officers (D&O) insurance and professional lines “bankruptcy proof” and negotiating reduced collateral requirements for casualty programs at renewal. Strongly consider stand-alone “Side A” excess “difference in conditions” coverage if not yet in place.
2. In the weeks before restructuring discussions commence, discuss key D&O policy provisions with D&O insurers to clarify coverage for all insured stakeholders (directors and officers, entity, outside directors, interim management and CRO).
3. Either before or after the restructuring, restore “trapped” cash or letter of credit collateralized casualty programs to the balance sheet, by understanding whether historic and current programs are over- or inefficiently collateralized.
4. Building representations and warranties, successor liability or fraudulent conveyance insurance into the asset sale process can optimize sale value and facilitation, and protect asset buyers.
5. Post-restructuring, put more efficient risk management programs in place (including captive structures and appropriate scaled and priced TPA arrangements). Protect new management and business operations with optimized go-forward D&O and professional liability policies.

Directors and Officers Liability Insurance Optimization

D&O liability insurance can be an essential source of protection for company directors and officers, including their personal assets, and other stakeholders, but only if properly structured policies are in place. There is enormous variability in the language of D&O liability insurance policies, and knowing how and when to negotiate these terms with insurers can be critical to a good outcome in a bankruptcy or restructuring process.

As a starting point, it’s important to understand that D&O insurance policies actually protects directors and officers and the company with three distinct types of coverage:

1. Side A coverage protects directors and officers when the company a) may not indemnify its directors or officers by law or because of public policy reasons (non-indemnifiable losses) or b) cannot indemnify its directors or officers due to financial considerations (insolvency). Many companies take out what’s known as excess “difference in conditions,” Side A coverage in addition to the company’s general D&O program. Such excess difference in conditions coverage sits on top of the ABC D&O insurance policy or program (tower of insurance), but “drops” down to provide primary coverage (generally without a deductible or retention) for the individual directors and officers in the event that the ABC policy does not respond due to an exclusion or other policy condition (thus “difference in conditions” coverage), exhaustion of ABC limits, or in the event of bankruptcy, where the ABC policy is considered an asset of the debtor’s estate, and procuring reimbursement for directors and officers is denied or delayed at the least.
2. Side B coverage provides reimbursement to the company for amounts paid to directors and officers as loss indemnification.
3. Side C coverage, known as “entity” coverage, protects the company itself when it is named as a defendant alongside its directors and officers, and is typically limited to securities claims for public companies (but responds to a broader set of claims against private companies).

What are the most material restructuring-related D&O insurance traps to avoid?

Change of control. There are several issues that can arise from the changes in control or legal status of the filing company:

1. filing and entering a Chapter 11 bankruptcy proceeding
2. undergoing a consensual restructuring (with a change of more than 50% of the equity ownership) or
3. upon emergence from Chapter 11 bankruptcy.

Under some D&O policies, the act of filing under Chapter 11 constitutes a “change in control” which automatically converts the policy into “runoff,” meaning that it only provides coverage for acts that occurred prior to the filing date. Other D&O policies may provide that the appointment of a trustee, receiver, liquidator, conservator or any comparable authority shall constitute a change in control and similarly trigger the policy’s runoff provision. Another possible trouble spot under some D&O policies is when at filing the company becomes the “debtor in possession,” which may be a technically distinct legal entity, and one that’s not considered an “insured” under the policy.

In a consensual restructuring where there is at least a 50% change of ownership (such as in a debt-for-equity swap), the change in control provision will be triggered under nearly all policies, putting the policy into runoff.

Upon emergence of a reorganized company from Chapter 11, a policy’s change of control provision would likely be triggered (if it had not been at filing), assuming a substantial change in ownership/equity participation as part of the reorganization.

Once there is a change in control under one of the above scenarios, the D&O policy (unless amended) would only cover wrongful acts by the directors and officers that occurred prior to the event triggering the policy’s change in control provision (the policy would be in runoff). This means that a new policy or policies would be necessary to provide protection for 1) the interim or post-restructuring management team, 2) newly appointed directors, 3) the CRO/liquidator/trustee and 4) post-emergence directors and officers, as well as 5) the insured entity post-petition and post-restructuring or emergence.

Interim and newly appointed directors, officers, CROs or trustees will most likely want fresh, dedicated limits that only apply to postpetition acts, for themselves and the restructured entity, but such coverage comes at a cost: putting the old policy into runoff typically costs multiples of the original premium (in addition to that original premium), and the D&O market is currently at a multi-year pricing high for risks, reflecting claims inflation and perceived COVID-19 exposure. Keeping existing coverage in place through the bankruptcy or restructuring, which may be achieved by amending policy language at renewal, or with a strong broker and good insurer relationship in the weeks just prior to filing, may be a more affordable option.

Insured vs. Insured Problem

The inverse problem created by a debtor-in-possession not being considered an insured under the D&O policy is when the insurer considers a bankruptcy trustee or creditors’ committee to have the capacity of an insured when that trustee or committee brings claims against directors or officers on behalf of the debtor company. Insurers may reject such claims as barred under the “insured vs. insured” exclusion, and deprive the directors and officers of coverage. While this exclusion was intended to avoid the multiple insured parties under a D&O policy collusively bringing claims against each other to effect a loss payment, the exclusion in its broadest form can have far-reaching, unintended consequences. The “insured vs. insured” exclusion should be narrowly tailored to avoid its application to a bankruptcy trustee or creditors’ committee as an insured party.

Order of Payments

Another common provision in D&O insurance policies is one that designates the order or priority of payments to different stakeholders, so that Side A coverage has first priority, Side B second, Side C last. Not every D&O policy will have an order of payments provision, but for those that contain such provision, it’s important to make the language as clear and unambiguous as possible — for example, the order of payments provision should apply to payments for any claim (insolvency or non-insolvency related). A court may decline to uphold an order of payment provision that is only triggered by a bankruptcy filing/applicable in a bankruptcy context, considering it an unenforceable “ipso facto” clause.

(Non-) Cancellation, (Non-) Rescindability, and Severability.

D&O policies should be noncancellable by the insurer (except for nonpayment of the premium). If the policy has a state noncancellation amendatory endorsement, there should also be a “most favored nations” clause clarifying that any conflict in the cancellation terms between the amendatory endorsement and the policy itself shall be construed to apply the provision most favorable to the insured.

D&O policies should be as close to non-rescindable as possible. Rescission of a D&O policy, which voids coverage ab initio, is generally only possible if there were material misrepresentation in the policy’s application, and the insurer can show it relied upon the misrepresented information in its underwriting decision. The insurer will also have the burden of establishing these elements in order to rescind coverage — which is a high and difficult bar to reach. Given the high bar for demonstrating rescission, many insurers decided to make non-rescindable Side A coverage available as a commercial position, and it should always be sought as an option.

D&O policies should also provide for “severability” of insureds, and non-imputation of knowledge. “Severability” means that material misrepresentations in the policy application that were known by one director or officer, should not be imputed to other directors or officers, or the company, and that any attempt to void or rescind coverage for a director or officer with such knowledge of a misrepresentation should be severed from (and not imputed to) directors and officers that were unaware, such that coverage cannot be voided or rescinded as to them.

Collateral Recapture and Optimization of Casualty Program Cost

Over the years, many insureds have elected to purchase large deductible casualty insurance programs in order to optimize their workers’ compensation, general liability and automobile liability costs.

Depending on the insured’s desire, ability and appetite to retain meaningful sums of risk, large deductible policies usually employ per claim deductibles ranging from $100,000 to $1,000,000 (and oftentimes more). These programs offer the insured control and cost savings typically associated with self-insurance, but importantly, in the event that the insured defaults on making claim payments, the insured utilizes the balance sheet of insurance companies as the ultimate guarantor of claim payments.

As a result, the insurance company requires that the policyholder post some form of collateral, most commonly in the form of an evergreen letter of credit. This:

• Protects the insurance company against credit losses
• Provides the insurance company with a secured liability
• Enables the insurance company to meet statutory requirements imposed by the state(s)
• Improves insurance company surplus requirements
• Maintains insurance company financial rating

Collateral amounts and adjustments, as well as which forms of collateral are acceptable, are governed by the collateral agreement. This document, which is outside of the insurance policy, addresses (among other things) how collateral is calculated, when additional collateral is due (or returned) and dispute remedies.

In addition to charging a fixed fee for the letter of credit, the issuing bank typically secures its default exposure against the insured’s revolving line of credit. As a result, letters of credit often take up a company’s borrowing power and leverage by depleting revolver headroom.

Insureds need to understand how deductible levels relate to collateral requirements and how collateral requirements grow more burdensome (due to pyramiding) with each passing year. Briefly, the higher the deductible, the more credit risk is assumed by the insurance company — which in turn results in a corresponding increase in collateral. As for changing insurance companies multiple times over a few years: the insured is left with stacks of collateral spread across multiple insurers, none of whom are eager to give up their secured position.

In terms of an insurance company demanding additional collateral, it is likely that the insured will have little choice but to post the additional collateral “within 30 days.” When attempting to claw back collateral, the insured is again at a disadvantage as the terms of collateral agreement call for collateral to be reviewed once a year (generally around the insured’s renewal period). Insurers loathe reviewing collateral requirements off-cycle, and getting an insurer to do so can be challenging.

In times of financial distress, it is key that insurance be properly addressed.

By focusing on the right financial levers, delivering deep analytical analysis and engaging senior and executive-level insurance company personnel, meaningful amounts of trapped cash can be returned to the company (and provide liquidity for other uses). There are multiple scenarios in which trapped cash can be freed up:

• Insureds having had large deductible programs with multiple insurance companies over a period of several years are ripe for being oversecured.
• Independent and objective claims and actuarial analyses identify over-securitized bands and frame negotiating positions with current and legacy counterparties to release excess collateral held by insurers.
• Over-reserved claims can have a significant impact on the amount of collateral demanded by the insurance company and can be used by the insurance company to justify the amount of collateral demanded.
• Claim audits (conducted in concert with independent actuarial reviews) reduce and/or offset calls for additional collateral.
• The higher the loss development factors, the higher the “loss pick” and the more collateral the insurance company will require. Understanding the insurance company’s developed loss pick and loss development factors is critical to establishing a level playing field. Assuming that the insured’s loss data is statistically credible, the insured should compare its loss pick and loss development factors against those generated by the insurance company. The results may be surprising.
• In terms of claims administration for bundled programs, it pays to be watchful of insurers overpaying claims within the deductible. Doing so will negatively impact the insured’s loss history and result in more collateral required.
• Program cross-collateralization can be used to improve capital efficiency.
• Establish contact with insurance company decision makers, including the chief credit officer, to drive rational responses on the release of collateral.
• Research legacy counterparties to determine if they are in receivership – e.g. Reliance, Kemper or Legion Insurance Company – and if so,
• determine if monies are due the insured.
• Review legacy polices for aggregate stop loss provisions and if reached, confirm that claims in excess of the stop loss are being returned to the insured on a timely basis.
• It can be difficult for past clients to obtain the same level of credit worthiness as they did when they were a current client. Oftentimes, this presents an opportunity to employ proven alternative risk strategies to reduce or eliminate future collateral obligations through a deductible buy-down or loss portfolio transfer.

Distressed Deal Risk Optimization

Distressed asset sellers can help maximize value, and buyers protect against future legal liability, while shifting allocation of liability away from the parties and to third-party insurers.

Buyer Representations and Warranties Insurance (R&W).

R&W was used on approximately 3,000 M&A deals in North America in 2019, surpassing the use of indemnity escrows as the main form of recourse for losses arising from breaches of purchase agreement representations, warranties or pre-closing tax indemnities. On healthy deals, R&W is a more efficient, less contentious way to manage deal indemnification, but not the only way. Financially healthy sellers can also provide indemnity

On distressed deals, purchases out of a bankruptcy process (Section 363 sales) or Article 9 transfers, R&W has the benefit of creating a pool of indemnity, via an insurance policy, that a debtor or distressed seller would not be able to provide either at all, or with sufficient credit quality to protect buyers. Provided there is a knowledgeable person to give representations, a disclosure process behind them and sufficient buyer due diligence, the R&W insurance market has appetite to write these transactions. A particular form of R&W product, “synthetic” R&W, may be available on certain deals where there is no knowledge party with the ability to give representations, rather the buyer and insurer create a set of representations that exist only in the policy document and not the purchase agreement. While this approach has been frequently used to create synthetic pre-closing tax indemnities, it can be expanded to provide insurance for a limited set of fundamental and general representations.

Fraudulent Conveyance Insurance

Fraudulent conveyance coverage protects asset buyers against claims by aggrieved creditors of a distressed asset seller alleging that the asset buyer bought the assets for less than “reasonably equivalent value.” The most common scenario is where the asset seller files for bankruptcy protection within two years after the asset sale closed, and the asset seller (now debtor) has unsecured or undersecured creditors seeking to be made whole by unwinding (avoiding) the alleged undervalued sale and returning the assets to the estate (or seeking other remedies for the creditor). The fraudulent conveyance provisions are in Section 548(a)(1)(B) of the bankruptcy code, known as “constructive” fraudulent conveyances, and noting that “actual” fraudulent conveyances under Section 548(a)(1) (A) would be uninsurable as against public policy.

Fraudulent conveyance insurers have greater appetite when the asset sale was conducted as some form of auction process, and it is also helpful if valuation and solvency opinions were obtained in connection with sale.

Other fact patterns can be insured, including business spin outs or dividend recapitalization deals where the business subsequently fails, and creditors allege the valuation at the time of the transaction was overvalued or misrepresented. Fraudulent conveyance insurance is also available for actions under the Uniform Fraudulent Transfer Act (adopted by 45 states), whose provisions mirror those of Section 548.

Successor Liability Insurance

Successor liability coverage protects asset buyers against courts imposing liability on them, despite contractual limitations to the contrary. Successor liability is a legal doctrine that grew out of asbestos liability and other product liability cases, where asset buyers purchased valuable assets but left behind substantial liabilities, which undercapitalized or distressed sellers could not meet.

While asset purchase transactions contractually allow asset buyers and sellers to pick which assets and liabilities are transferred to buyers or are retained by sellers (unlike a share purchase agreement where all assets and liabilities transfer), courts were concerned 1) that such deals were effectively share deals only with large liabilities left behind (form over substance), and 2) about claimants having no effective recourse against undercapitalized sellers or shell companies. Thus courts crafted the doctrine of successor liability under state and federal common law, deeming asset buyers as “successors in interest” to liabilities of the asset seller, and creating an extracontractual remedy in making the buyer responsible to meet them. Courts call this doctrine different things – “de facto merger,” “continuing operations,” “product line continuity,” “alter ego,” etc. – but the results are effectively the same for imposition of liability.

Successor liability insurance can be used in a variety of scenarios, including restructuring scenarios, non-bankruptcy-distressed sales (including Article 9 sales), and Section 363 asset sales where there is concern that the court’s “free and clear” order may not extinguish all liabilities. Use of successor liability insurance can help facilitate an asset sale happening at all – when there are concerns over material retained liabilities – or can help improve valuation by removing the potential liability overhang on buyer.

Post-Restructuring Insurance Optimization

Insurance and risk management solutions can enhance the value of a businesses after a bankruptcy process or consensual restructuring.

• Eliminate pre-restructure collateral requirements by extinguishing legacy casualty programs and installing new, financially efficient program structures, including reduced or no letter of credit obligations.
• Consider short-term policies coupled with funded deductible or retrospectively rated programs.
• Evaluate the cost benefit of several different program structures ranging from guaranteed cost all the way to and including loss funded plans.
• Optimize all go-forward insurance program costs based on facts to account for reduced business revenues, employee count or market cap on a post-restructured basis.
• Where possible or permitted, evaluate the economic benefits of converting program structures and to self-insured retentions (opting out), i.e., non-subscription policies where permitted, self-insurance, etc.
• Select the most financially efficient program structure consistent with reemergence cash flow models, administrative impact and ability/desire to retain risk.
• Evaluate and stress test various retention levels to determine the optimal attachment point (deductible levels).
• Introduce carrier management, including establishing relationships with the insurance company’s executive team and chief credit officer.
• When communicating with insurers, be prepared to discuss any unique factors associated with positive change. For example, hiring an experienced risk manager, unions, change of TPAs, refreshed safety programs, etc. Loss experience should match the talk with the walk.
• Consider alternative forms of letters of credit, including a trust, cash, surety bond, or a credit buy-down.
• Review, streamline or eliminate TPAs, external risk management and other insurance service provider costs.
• Implement new risk management strategies with executive management support and commitment, including cost-efficient retention structures.

For more information on insurance optimizations, contact NFP today.