D&O for Canadian Cannabis Companies
Author: Kyle Muscat
In this article we will explain the basics of D&O insurance for Canadian cannabis companies. We will touch on how it’s priced, what it covers and how licensed producers can save money on their D&O program.
- How much does D&O insurance cost?
- Self-insurance with a Captive Program
- Why is D&O insurance so expensive?
- What does D&O insurance cover?
- D&O Claims Examples
- How to save money on your D&O program
What is D&O insurance?
Directors and Officers, or “D&O” is a type of liability insurance that provides coverage to the directors, officers and senior executives of a company in case they are sued for alleged wrongful acts committed in their capacity with the organization. In other words, this form of insurance provides personal financial protection against the costs of legal defense and potential settlements for instances in which when members of the company are personally named in a suit.
Why is it important?
As stated above, D&O insurance is used to protect the personal assets of directors and officers. Many readers will note that having this insurance is often a prerequisite to attracting experienced board members and executives. The same applies for soliciting investment. Large investors will often require a seat on the board and therefore demand that the company carry a comprehensive D&O policy. Regardless of the company size, corporate structure or investor base, nearly all organizations are vulnerable to D&O claims.
How much does D&O insurance cost?
Generally speaking, the cost of D&O insurance is derived by evaluating the perceived riskiness – or propensity for loss within a specific organization. The insurers will also consider the limit of insurance required, historical claims activity and broader claim trends within the industry. In an effort to get a handle on an organization’s risk profile – underwriters will consider a number of factors, including:
- Financial Health of the Company (Financial statements; revenue, working capital, debt…etc.)
- Corporate Structure (Public vs. Privately Owned)
- Market Capitalization (for public cannabis companies)
- Board Composition
- Management Profiles (Related experience, character profiles…etc.)
- Size & Scope of Operations
- Forward looking activities (Planned capital raises, M&A)
Given the wide variance in the above characteristics, no two organizations will be priced the same. This, coupled with evolving insurer appetites and broader macro economic factors will all contribute to the D&O pricing formula. In this regard, it is difficult to generalize costs. We have seen D&O policies for publicly traded licensed producers range anywhere from $10,000 to more than $200,000 per $1M of coverage limit.
Protecting Directors & Officers through a Captive Insurance program
Due to the historically limited availability of open market D&O solutions, some Canadian cannabis producers have opted to employ a self insurance strategy for their D&O risk.
Self insurance can often be achieved through the use of a captive structure whereby corporations retain their annual premiums to offset future claims. Rather than paying an insurer, the money would be kept “in-house” and the organization would be on the hook for any claims. This strategy is typically best suited for larger organizations who have the required expertise and depth within their dedicated risk management teams.
While self insurance can be a viable option to address D&O risk – the topic itself is quite complex and deserving of a blog post on its own. For those interested in learning more, please reach out to our dedicated Cannabis practice team.
Why is D&O insurance so expensive for Cannabis Companies?
Compared to most other industries, it is fair to say that cannabis companies are generally charged more for their D&O insurance. This is an unfortunate reality felt across the industry, drawing parallels to other necessary service providers such as banks and lenders. From an insurance perspective, there are a few reasons why this is the case:
1. Limited D&O Insurance Supply
One of the primary contributing factors for the inflated costs of D&O insurance relates back to the simple economical equation of supply and demand. As it stands today, there is a very limited appetite amongst domestic insurers to offer D&O coverage for organizations with cannabis operations.
The reasons for which are quite varied. We’d generally point to historical stigmas, U.S banking relationships and the lack of actuarial data and underwriting expertise as the primary factors. While we won’t debate the merits of such decisions, the reality stands that there is a limited number of insurance companies in the cannabis space. As a result, the lack of competitive pressure has allowed insurers to maintain market share without significant downwards pricing movement.
2. Recent Claims Activity & Lack of Historical Data
Since legalization, the industry has experienced a number of high-profile lawsuits. Regardless of whether there is merit to these claims, D&O insurance would typically be there to pick up the tab when it comes to legal defense and settlements. These cases often set a precedent which bias insurer pricing models and drive up the premium which they require. These recent losses are more heavily relied upon given the lack of established historical claims data.
3. Legal & Regulatory Risks
The legal and regulatory risks associated with the cannabis industry is another reason why D&O insurance remains expensive for Canadian cannabis companies. The wide range of regulations at the federal, provincial and municipal levels make it a highly complex and rapidly evolving sector. As a result, there is a higher likelihood of regulatory investigations, enforcement actions and lawsuits related to compliance issues. This increased potential for loss is not overlooked by insurers and contributes to the overall higher costs.
4. Economic Headwinds & Broader Sector Performance
It is no secret that Canadian cannabis stocks have experienced considerable volatility in the last half decade. What was once soaring highs and an abundance of capital inflow has now turned to record lows, forced divestures and a tightening of the cannabis markets.
Times of economic downturn often coincide with an increase in D&O related claims activity. As company’s struggle and insolvencies rise, insurers can expect to see lawsuits from disgruntled investors, unpaid suppliers or ex-employees seeking compensation. While most firms may be able to weather the storm, broader sector claims activity will be more heavily factored into D&O pricing decisions.
What does D&O insurance cover?
D&O insurance can generally be broken down into three main coverage types. These are referred to as Side A, Side B and Side C coverage. Each of which provide slightly different benefits – summarized below:
Side A Coverage:
This side of D&O insurance provides coverage for individual directors and officers when the company is unable or unwilling to indemnify them. This most commonly applies in instances when the company is either financially unable to cover the costs or prohibited by law from doing so. Side A would then step in to protect the individual from any legal defense and settlement costs related to the suit.
Side B Coverage:
Side B D&O insurance provides coverage for the company itself when it indemnifies its directors and officers. In other words, if a company decides to cover the costs of a legal claim against a director or officer, Side B coverage would step in to reimburse the company for those costs. This type of coverage is also known as “indemnifiable” coverage.
Side C Coverage:
Side C D&O provides coverage for the company in the event of a securities claim. Because this type of suit is often a class-action brought forth by the shareholders, it would not make sense for the company to use internal funds to defend the directors and officers. Therefore, Side C or “entity coverage” would be called upon to cover these costs.
Cannabis D&O Insurance Claim Examples
We often find that D&O insurance is best illustrated with a few, simple examples.
1. Mismanagement of Funds
A privately owned cannabis producer decides to shift their focus away from dried flower and expand into the infused beverage market. The firm’s executives decide that they would like to keep production in-house. They bring on a new team member with beverage manufacturing experience and end up spending close to $2M on the necessary equipment.
Twelve months later the company is forced to take on additional debt. They missed revenue targets and struggle to gain market share in the infused beverage category. The financial struggles continue and the company falls close to defaulting on their debt.
Sensing a potential insolvency, two private investors decide to sue the executive team for the mismanagement of funds which has led to their current state. The firm’s D&O policy would step in to cover these defense and potential settlement costs.
2. Class-Action Shareholder Lawsuit
A licensed cannabis producer experienced a 30% drop in their stock price following a public announcement that one of their major partners had terminated their contract with them. After further digging, it was discovered that the contract was lost due to a breakdown in the relationship between the two executive teams.
Shareholders of the cannabis producer then launched a class-action lawsuit against the executive team, alleging mismanagement and a breach of fiduciary duty. The resulting costs of legal defense and any potential settlement would then be covered under Side C of the company’s D&O policy.
Ready to get started?
Directors and officers liability insurance is an important tool that cannabis companies can utilize as part of their overall risk management strategy. It is imperative that companies partner with a knowledgeable insurance broker who understands the risks of cannabis production. This expertise must also extend to the nuances of the legalized cannabis insurance markets.
Whether you are large, publicly traded entity or just starting out – our dedicated cannabis practice team welcomes the opportunity to review your D&O program and discuss strategies on how we may be able to help.