Insurance Considerations When Facing Bankruptcy

Andrew Pendergast


August 1, 2023

Gavel on a Bankruptcy Law book

While the regional banking crisis this spring and the immediate threat of a recession appear to be behind us, the aggressive actions taken by the Federal Reserve to combat inflation have created a very challenging environment for businesses to navigate. Higher borrowing and labor costs, coupled with banks implementing stricter credit requirements, continue to put pressure on established and start-up businesses. As a result, companies are left wondering how to prepare for worst-case scenarios. Fortunately, there are various risk transfer and insurance optimization strategies available for all businesses and their leaders to secure their corporate and personal assets in the case of a bankruptcy or distressed sale.

The following pre- and post-distress risk transfer solutions can be used to address the impact of corporate and personal liabilities in a bankruptcy scenario, and can help increase value for those considering a sale of corporate assets, either pre-petition or via the bankruptcy process. 

Protect key stakeholders with directors and officers insurance. The most common allegation against a company filing bankruptcy is that leadership mismanaged corporate assets and breached a fiduciary duty owed to the company. Directors and officers often overlook the fact that, in the event of insolvency, many jurisdictions will hold that their fiduciary duty extends beyond just the interest of shareholders and includes creditors as well. This raises the pool of potential claimants for a lawsuit, and increases the potential severity of a settlement—as well as the commensurate defense costs. Because company funds are unlikely to be available to meet claims and indemnify individuals, directors and officers liability insurance (D&O) can be a source of protection for both the company and—critically—the individual insured’s personal assets, but only if properly structured policies are in place.

As is the case with all insurance contracts, the devil is in the details, and base policy forms in today’s marketplace will need to be addressed and amended to make sure that coverage is afforded in these special situations. Key policy enhancements include:

  • Amending the D&O policy to affirmatively state an individual’s defense costs and settlements for which they are liable will be reimbursed before the company
  • Ensuring the policy is not captured by an automatic stay and remains available to pay individual insureds during the bankruptcy process
  • Incorporating affirmative language stating that bankruptcy does not relieve the insurer of its obligations
  • Amending the insured versus insured or entity versus insured exclusion to carve back coverage for claims brought by trustees, receivers and debtors-in-possession
  • Adding affirmative language that the policy is non-cancellable by any trustee or receiver

These amendments typically need to be requested and negotiated prior to the placement or renewal of your D&O program. However, in some circumstances, coverage enhancements can be made mid-term. Right now, organizations should be having proactive conversations with their broker to determine whether or not these provisions are included to head off issues in the future.

Restructure inefficient casualty programs to identify trapped cash. D&O liability is not the only insurance policy that should be examined in the event of a bankruptcy or distressed sale. Many insureds have historically elected to purchase large-deductible casualty insurance programs, including general liability, workers compensation and commercial auto. This results in the insurer requiring the company to post collateral, typically in the form of an evergreen letter of credit.

If an issue with solvency is on the horizon or bankruptcy has been filed, this “trapped cash” could help the company satisfy its current and ongoing obligations. By focusing on the right financial levers and restructuring overcollateralized or inefficiently collateralized programs, meaningful amounts of this trapped cash can be returned to the company and can provide liquidity for other uses. To achieve these objectives, insureds should consider the following:

  • Conduct an independent claims and actuarial analysis to identify over-securitized bands and frame negotiating positions with counterparties to release excess collateral held by insurers
  • Examine program cross-collateralization to improve capital efficiency
  • Establish contact with insurance company decision-makers to prompt reasonable responses on the release of collateral
  • Employ proven alternative risk strategies, such as captives, to reduce or eliminate future collateral obligations
  • Assess ways to reduce insurance program expenses post-restructuring, including TPA agreements, claims mitigation strategies, ROI-based safety and loss control directives, retention optimization, and alternative captive implementation

Use representations and warranties insurance to enhance deal value. Companies in distress may face the scenario of being sold, either in the form of an asset sale purchase from a bankruptcy or pre-petition asset sale. In such cases, a major issue that arises is whether sellers can provide potential buyers with a form of indemnity to backstop the representations and warranties made within any purchase agreement.

Representations and warranties insurance can be key in these situations. The coverage increases efficiency (and potentially value) by creating a pool of indemnity—assumed by insurers—that a debtor or distressed seller would not be able to provide either at all or with sufficient credit quality to protect buyers. Additionally, fraudulent conveyance and successor liability insurance policies can be utilized to protect distressed asset buyers against claims by aggrieved creditors and from court-imposed liability despite contractual limitations.

Do not overlook post-restructuring planning. To help ensure prior solvency issues do not reoccur post-restructuring, it is important to optimize all go-forward insurance program costs based on facts and deep technical analysis to account for reduced business revenues, employee count or market cap. Organizations should consider various carrier management strategies, including: establishing relationships with the insurance company’s executive team and chief credit officer; streamlining or eliminating TPA, external risk management and other insurance service provider costs; and implementing new risk management strategies to include more cost-efficient retention structures.

Andrew Pendergast is managing director and special purpose acquisition company (SPAC) and general partner liability (GPL) practice leader at NFP.