Risk Retention Groups in a Nut Shell
Your Guide to Understanding RRGS
Compliments of John J. O’Brien JD, CLU, CPCU
History of the Liability Risk Retention Act of 1986
To some legal scholars back in the nineteen sixties, what Professor Dean Prosser was to the field of Torts, Professor Dix Noel was to the field of Products Liability. Dix Noel taught Products Liability at the University of Tennessee College of Law. It was an impressive experience for this writer as a young man to be trained by Professor Noel from the foremost treatise (Noel on Product Liability) in an emerging field of law.
Three times a week Professor Noel at the highest level of “case book” method escorted us from the doctrine of caveat emptor through negligence to the emerging doctrine of strict liability. As product manufacturer’s liability expanded, privity of contract fell by the wayside. Strict Liability according to Professor Noel “...extends not only to manufacturers but to all suppliers of chattels, such as retailers and wholesalers. Liability runs to all users or consumers, with no need to prove either privity of contract or negligence.” Strict Products Liability Compared with No-Fault Automobile Accident Reparations, Dix W. Noel, 38 Tenn.L. Review.
Punitive damages as a way to punish manufacturers of defective products was a new concept. We students speculated if a cigarette could be considered a defective product and we were encouraged to consider both sides of the controversy including the pleasure the consumer derived from smoking - citing the popular advertising slogan of the times: “Winston Tastes Good. Like A Cigarette Should.”
Years spent in the insurance and law fields have helped me understand how the breakdown of product liability tort law we learned in law school led to the insurance availability crisis of the mid nineteen seventies. Because their products were no longer sheltered by the protection of caveat emptor and because states were adopting uniform statutes imposing strict liability, product manufacturers were becoming anathema to the commercial insurance industry.
The insurance industry responded to the product liability risk crises by increasing rates, not renewing coverage, and avoiding policyholders that sold products the underwriters considered hazardous. These actions created a product liability insurance crises. During this same period the states of Vermont, Colorado, Virginia and Tennessee enacted captive insurance laws and suggested that industry employ alternative risk transfer strategies as a solution to the insurance crises. Manufacturers began forming captive insurance companies in theses domiciles as well as in the off shore captive insurance domiciles of Bermuda and the Caymans.
A beleaguered industry also brought its predicament to the attention of President Carter and Congress. In 1976, the United States Department of Commerce established a federal interagency task force on product liability to determine why insurance coverage for defective products had constricted.
Years earlier the McCarran Ferguson Act had established a dual insurance regulatory structure where the federal government would, on a case by case basis, allow the states to regulate insurance unless the federal government decided differently. Essentially, the states were granted the right to regulate at the pleasure of Congress
In 1976, the 96th Congress House Committee on Energy and Commerce conducted hearings on the “product liability crises.” I was not able to determine if Dix Noel testified but if he did, he would have provided a keen insight into the evolution of the liability of products. Ultimately three causes of the product liability crises were identified:
1. questionable insurance company rate making and reserving practices;
2. unsafe products; and
3. uncertainties in the tort litigation system.
Congress then enacted and President Reagan signed into law the Product Liability Risk Retention Act of 1981 (LRRA). Simultaneously, it seemed, insurers experienced an unexpected recovery linked to favorable investment returns. During periods of high investment returns, insurance that might otherwise be unavailable or unaffordable tends to be obtainable at a reasonable price. This phenomenon has caused several insurance experts to argue that the most influential criteria for whether there is a soft or hard market (the so-called cyclical nature of the insurance marketplace) are investment returns. Insurance reserving allows insurance companies to hold loss payments for long periods at high returns prior to loss payment. A high rate of investment return on reserves can convert what would be a bad book of business from a loss ratio perspective into a profitable book of business from an investment return perspective. This apparently is what transpired in the early eighties thus enabling the industry to be more receptive to receiving premiums to place product liability risk.
The product liability insurance cycle had shifted before the Product Liability Risk Retention Act of 1981 was used by groups seeking alternative vehicles to insure their risks. Meanwhile, however, the insurance availability pendulum was swinging towards other types of casualty insurance such as environmental and errors and omissions coverage. Congress reacted to this new need in 1986 by broadening the 1981 Act significantly to enable purchasing and risk retention groups to offer not only product liability coverage but also all types of liability insurance arising out of the operation of business, professional practices as well as out of the operation of state or local government.
The Liability Risk Retention Act of 1986 provides for the creation of risk retention groups as well as purchasing groups to enable industry, groups and state and local government to address the liability insurance crises. Although the concept of risk retention and purchasing groups was devised by the federal government, the federal government does not regulated risk retention and purchasing groups. Instead, regulation pursuant to the McCarron Ferguson Act is left with the states and particularly for risk retention groups, with the state where the risk retention group is domiciled and licensed. Clear mandates as to formation criteria and regulation are provided for in the federal act.
What are Risk Retention and Purchasing Groups?
A risk retention group is a liability insurance company that is owned by its members all of whom are members of the same industry and face similar exposures. Essentially, it is a group captive. The federal statute permits a group to domicile the risk retention company in one state and engage in the business of insurance in all states subject to certain restrictions. Under the McCarran Ferguson Act, regulation of insurance is handled by the individual states and specifically the insurance commissioners of those states. That is the case so long as the federal government does not elect to preempt that state oversight. Through the Liability Risk Retention Act of 1986, Congress did preempt state regulation and therefore the federal act takes precedence over state insurance laws and regulations generally. The provisions of the 1986 Act set forth a lengthy description of what makes up a risk retention group which I paraphrase here.
The Act defines a risk retention group as a group:
1. whose primary activity consists of assuming the liability risks of its members and spreading that risk amongst its members and is organized for that purpose;
2. that is organized and authorized to do business in and by one state (there is a provision to allow an existing chartered Bermuda or Cayman company to do business under certain conditions);
3. that does not exclude members solely to provide a competitive advantage to the group;
4. that has as its owners only insured members;
5. whose owners are engaged in similar business or related with respect to the liability to which they are exposed;
6. whose insurance activities are limited to liability insurance or reinsurance for assuming and spreading the risk of members; and
7. whose name includes the phrase “Risk Retention Group”.
The Act provides two options for structuring the ownership of a risk retention group. The first option limits ownership directly by the members of the risk retention group. The second option provides for ownership by a sole owner that is an organization which has as its members only persons who comprise the membership of the risk retention group and who are provided insurance by the risk retention group. Accordingly, an association can actually be the owner of the risk retention group. Insurance departments will look for an association that has been in existence for at least a year and do not look very kindly on associations that are formed solely for the purpose of owning the risk retention group. In fact overall, regulators will be on the lookout for entrepreneurial motivations behind the formation of risk retention groups and will also check to see if there is an availability or affordability problem in the commercial market. One application I attempted to lead through South Carolina in the early days of the captive program here was cut short by our regulator because it was viewed as an attempt by entrepreneurs to position themselves in an emerging market. We were dismissed with the appropriate application of Southern charm and compliments:
“I applaud the business savvy and foresight of your client. However, this is
simply too far outside the parameters of our captive program to go forward
with at this time. I’m sorry for taking so long to get a decision on this but I
wanted to give it every chance for consideration.”
Purchasing Groups
The Liability Risk Retention Act in addition to providing for the formation of risk retention groups also contains provisions that apply solely to the formation of purchasing groups. There are differences between risk retention groups and purchasing groups.
A purchasing group is comprised of insurance buyers who band together, frequently on a national basis, to purchase their liability insurance coverage from an insurance company or from a risk retention group. Congress by creating the purchasing group concept was endowing industry with the benefits of association and group purchasing power in the face of unkind treatment by the insurance industry. As the name implies, the purchasing group serves as an insurance purchasing vehicle for its members. A purchasing group may also form a risk retention group to buy down a large self insured retention for example. A key difference between a risk retention group and a purchasing group is that participants in a risk retention group are required to capitalize the risk retention group but the purchasing group does not have to be capitalized because the purchasing group does not itself take on risks. Purchasing groups purchase insurance from an insurer that issues the policies and takes the risk. As insurers, unlike purchasing groups, risk retention groups issue policies on their members and bear risk. Purchasing groups obviously are not regulated to the same degree as are risk retention groups. Purchasing groups purchase insurance from insurance companies that are already capitalized and subject to insurance company regulation. Another difference is that almost all risk retention groups purchase reinsurance while purchasing groups do not.
The broad exemptions from state regulation available to risk retention groups are not available to purchasing groups. Instead the Act exempts them only from specified state laws, rules and regulations and all other requirements not mentioned are not preempted. State laws that are preempted are primarily in the nature of fictitious group and countersignature requirements.
Purchasing groups have served an important purpose in permitting commercial insurance consumers to obtain better control over their liability insurance programs. They provide their members with tailor made coverage, broader coverage terms, dividends and reduced premiums through the employment of large group purchasing power. In both purchasing groups and risk retention groups, the members/owners have to be from the same homogenous industry. Purchasing Groups when employed by savvy insurance professionals provide an excellent risk transfer vehicle but the methods of how purchasing groups are so employed would be the subject of another “in a nutshell” paper. I have centered this paper on the formation, licensing and management of risk retention groups. They are subject to many more requirements and are much more complicated from an organizational and operational perspective than are purchasing groups.
Regulation of Risk Retention Groups
A risk retention group obtains its license from one state. It is said to be domiciled in that state. It is licensed through the action of the state insurance commissioner and its operations are governed by that state insurance commissioner. Those operations could extend into fifty states. Understandably, this is a much different situation than a standard insurance company or for that matter a traditional captive where each state has some control over the licensing and business operations of the entity when business is written in that state. Many states particularly those states that are not themselves active captive domiciles are uncomfortable with this regulatory situation.
The National Association of Insurance Commissioners (NAIC) is an advisory group of the states insurance commissioners. It is a voluntary association of heads of insurance departments from each state, the District of Columbia, and five U.S. territories. It does not have authority to make law or to enforce law. It does however draft and recommend model insurance acts for adoption by the states and these are usually adopted as law by the individual states.
The NAIC does not take a position as to the legality or utility of different state approaches to interpreting the Liability Risk Retention Act of 1986. It does however provide advice for its members on regulating risk retention groups and purchasing groups primarily through an NAIC publication know as the Risk Retention and Purchasing Group Handbook.
The position of the NAIC is that once the risk retention group has obtained its license, it may operate in all states without the necessity of a license in each state and is regulated almost exclusively by the domicile state’s insurance department. Non-domicile states require risk retention groups to comply with the following laws or requirements:
1. unfair claims settlements laws;
2. laws requiring the payment of premiums and taxes on a non-discriminatory basis;
3. laws requiring the participation in a residual market mechanism for liability
insurance;
4. laws requiring the risk retention group to designate the insurance commissioner as its agent for service of process;
5. laws against deceptive, false or fraudulent acts or practices; and
6. laws requiring the policies issued by the risk retention group to contain notices
that the company may not be subject to all state laws and that the guaranty fund
protection act does not apply.
In addition non-domiciliary commissioners are granted authority to monitor the financial solvency of risk retention groups and to examine them under certain conditions. They can:
1. require the risk retention group to submit to an examination in coordination with the
domiciliary commissioner to determine the risk retention group’s financial condition
if the domiciliary commissioner has not begun or has refused to initiate an
examination of the risk retention group;
2. require the risk retention group to comply with a legitimate court order issued in a voluntary dissolution proceeding; and
3. require the risk retention group to comply with an injunction issued by a court of competent jurisdiction alleging that the risk retention group is in hazardous financial condition.
Risk retention groups as a rule are domiciled in states that have captive statutes and they are characteristically formed as captives. The captive statute will set forth the capital and surplus requirement which is generally lower than would be required by non captive states where risk retention groups may also be formed. Also these captive states have sometimes allowed a risk retention group to build capital from its members over a certain period of time after a license has been issued or to capitalize with a letter of credit. As a result of these and other advantages, the majority of risk retention groups have domiciled in six states- Arizona, the District of Columbia, Hawaii, Nevada, South Carolina, and Vermont. A captive could be licensed in a state that allows them to be chartered as a captive insurer even though no business is written in that state and all the business is written in another state.
As of June 30, 2004, the breakdown of active domiciled risk retention groups was Vermont 63, South Carolina 36, Hawaii 17, District of Columbia 12, Nevada 8 and Arizona 6. These numbers are always increasing. The 19th annual survey of risk retention groups conducted by the Risk Retention Reporter revealed that 25 risk retention groups were formed in the first nine months of 2006 compared with 21 for the same period in 2005. Most of these were healthcare captives. Total premium written in risk retention groups has risen to $2.7 billion.
The Licensing Process for Risk Retention Groups
Because most risk retention groups are formed as captives, one of the first considerations in forming a captive is domicile selection. Captives may only be formed in states or jurisdictions where captive legislation has been enacted. Risk retention groups may only be formed in states of the United States or the District of Columbia. Although thirty three states now have some type of captive laws on the books, only a handful of those states have a dedicated alternative risk staff, an active captive formation history and an industry infrastructure in place to assist with the licensing and management of a risk retention group. Different domiciles are more receptive to risk retention groups than others and. Different domiciles also have higher degrees of receptiveness for some groups compared to others. Risk retention groups are formed by groups ranging from independent truckers to brain surgeons. The experience of captive domiciles may lead a captive domicile to shy away from particular groups for example “wheels” in a domicile that has experienced insolvencies with trucking risk retention groups. Most captive insurance consultants worthy of the name are aware of the receptivity of each captive domicile to particular types of risk retention groups and can assist in the domicile selection process as part of the services they offer.
In those domiciles that are actively forming captives, there has evolved a fairly uniform pre-application procedure which I call the “getting to know you, getting to know all about you stage.” Here for example is how the procedure works in South Carolina. The proposed captive manager, attorney or consultant will first contact the insurance department to alert them to a pending application and to arrange a face to face meeting with the alternative risk regulatory group and the principals of the proposed captive. Before the meeting takes place a brief written synopsis of the proposed captive is prepared and submitted to the insurance department. This written synopsis will include at least:
1. the name of the South Carolina captive manager (required);
2. South Carolina legal counsel (if selected);
3. a brief, but complete, business plan;
4. names of principals;
5. information on the parent company or names of group members for risk retention groups;
6. retention levels;
7. reinsurance proposed;
8. capitalization ; and
9. estimated annual premium.
After the material submitted is reviewed by the designated alternative risk regulator, the face to face meeting takes place. In South Carolina, it could have as many as five participants from the insurance department. The captive manager should always attend and as many of the principals as practical are encouraged to attend. In the case of risk retention groups since the owners are the insured and the insured the owners, the principals would be drawn from the proposed insureds. These meetings generally last about two hours and there is often a lively exchange of questions and answers leading up to an understanding on the part of the risk retention groups principals of the regulatory process and the regulatory environment and an understanding on the part of the regulators of the corporate structure and business plan of the proposed risk retention group. Uniformly, in all captive domiciles these introductory meetings turn out to be beneficial to groups wishing to form a risk retention group. Alternative risk regulators typically will be anxious to see the group succeed and have valuable information and suggestions that they will freely provide at this meeting. It is an important step in the risk retention group formation process and the first opportunity to meet the regulators who will be interacting with the risk retention group on a regular basis for many years after the group is licensed.
.
Shortly after this initial meeting or sometimes actually at the meeting itself, the insurance department will ask the captive manager or consultant to submit a petition for a Certificate of General Good. This generally indicates that the captive has found favor with the insurance department. The petition itself is prepared by the consultant or captive manager and contains boilerplate language describing why the formation of the risk retention group will answer a need and provide a benefit and contribute to the overall good. The Certificate of General Good will enable the attorney to incorporate the company or establish it as a limited liability insurance company. It is filed along with the articles of incorporation at the office of the Secretary of State. Without it, the Secretary of State will not allow the risk retention group to incorporate.
The Certificate of General Good is incorporated into the complete application which is submitted as soon thereafter as practical. Following the theory that it is judicious to strike while the iron is hot, it is always an advantage to have the application completed and ready to submit even before the “getting to know you, getting to know all about you stage “meeting. Most insurance department web sites including South Carolina’s contain the states entire official captive insurance company application form.
Generally, the business plan of the risk retention group will contain all of the information required to answer the specific questions asked on the application form. That the answers to all questions asked can be pulled from the business plan is a measurement of the thoroughness of the business plan. The business plan of the risk retention group will typically provide an overview of how the risk retention group will operate and be governed. It will describe the coverage it will write and the homogenous group that the insurance policies will be issued to and in what amounts and also what amounts will be reinsured and who will be the reinsurers. Ideally, the business plan will describe and provide a copy of the insurance policy and historic loss data, ongoing loss data, a rating plan including rates and a classification system. A thorough business plan will provide a description of the data processing system utilized for underwriting, policy issuance, claims and accounting. A copy of the insurance policy to be issued by the risk retention group will be included because the regulators will be looking for the language required by the federal act in the size type then required. It began as a 10-point type and has now gone to 12-point type. The notice says:
“NOTICE: This policy is issued by your risk retention group. Your risk retention group may not be subject to all of the insurance laws and regulations of your State. State insurance insolvency guaranty funds are not available for your risk retention group.”
The initial funding of the risk retention group will be described in detail. Often the initial funding for a risk retention group is provided in the form of a surplus note or letters of credit that are repaid with the approval of the insurance commissioner over the first several years of the risk retention groups operation. Usually each new insured will pay part of his premium towards the capital of the risk retention group. This investment and the offering to make the investment in a risk retention group are exempt from federal securities laws as well as state “Blue Sky” laws. Information on the members of the group will be viewed carefully. The domiciliary state has the power to determine if the risk retention group qualifies as a risk retention group under the federal act. There is no federal administrative body available to review the decision of the state regulator.
The business plan will contain biographical affidavits and resumes on key service providers of the risk retention group who could include all officers, accounting, underwriter and claims manager. Similar information will be provided on outside service providers like a CPA, attorney, actuary, coverage counsel and insurance broker.
A captive structure chart should be provided. Program objectives should be outlined remembering the purpose of the Liability Risk Retention Act is to create a vehicle for providing insurance where insurance is not available or affordable. The actuarial feasibility study will be attached. Attachments to the application would include:
1. the underwriting manual;
2. captive manager staff resumes;
3. captive structure chart;
4. historic underwriting results;
5. reinsurance treatise;
6. expected underwriting results;
7. pro forma financial statements and projections;
8. actuarial opinion regarding the determination of minimum premium and
participation levels required to commence operations and to prevent a
hazardous financial condition;
9. the states in which the risk retention group intends to operate; and
10. marketing materials.
The term “feasibility study” is a widely used term in the captive insurance industry. Sometimes it is used interchangeably with the term “business plan”. In the strictest and most correct sense, the feasibility study is that study prepared by a professional actuary that provides evidence of the expected costs and benefits of the captive, expected underwriting losses even under a worse case scenario as well as expected return on investment. It will demonstrate to the investors as well as the regulators (as well as can be expected by a document that is prepared as an attempt to predict the future with accuracy) that a risk retention group will be a financial success. While in a pure captive, the feasibility study may not be required, for a risk retention group it cannot be overlooked and the regulators will expect to see it and it is required under the NAIC Model Act.
Organizational Steps and Management after Formation and Licensing
The domiciliary state will issue a license to the risk retention group if the regulators are happy with the application material submitted by the group. Sometimes, this license is written subject to certain conditions. One constant condition is that no business can be written until the risk retention group is capitalized.
It is necessary that the risk retention group have an organizational meeting of the shareholders and board of directors. The requirements for these meetings vary as to where the meetings should be held and who should attend. There usually is a requirement that the risk retention group have at least one director who is a resident of the domicile. This role is typically played by the captive manager and the captive manager after stewarding the application for license through his state’s insurance department now becomes the bedrock for future compliance and regulatory reporting of the risk retention group.
Actions that are taken at the organization meetings of directors and board of directors include:
1. ratification of the actions of the incorporators;
2. designation of financial institution for holding capital and investments;
3. appointment of officers;
4. issuance of shares certificates;
5. acceptance of corporate governance policy;
6. acceptance of the form of stock certificate;
7. adoption of a conflict of interest policy with parties signing it and disclosing
Any potential conflicts of interest;
8. adoption of check writing policies;
9. appointment of auditor;
10. appointment of attorney;
11. adoption of investment policy;
12. appointment of captive manager;
13. acceptance of the form of insurance policy;
14. signing of any other service provider contracts;
15. opening bank and investment accounts;
16. reviewing and accepting reinsurance treatise;
17. accepting corporate seal; and
18. accepting form of subscription agreement.
This meeting customarily takes place in the offices of the captive manager in the domiciliary state. There usually is a requirement that the meeting take place in that state as well as for subsequent shareholders and board of directors meeting. It is strongly recommended that the organizational and operational functions of the risk retention group be carried out under the oversight and tutelage of a qualified captive manager. Granted it is not rocket science but a risk retention group is in reality an insurance company and insurance is only considered “simple” by those who are trained and nurtured in the field. To all others, it is rocket science.
Although the regulation of traditional captives by a state might be limited, regulation of risk retention groups tends to be a bit more stringent. The risk retention group will be subject to an organizational examination sometimes during the first ninety days of its existence. In addition the risk retention group is subject to the same requirements of the domiciliary state that apply to any captive including providing a copy of the annual statement certified by an independent public accountant and an annual actuarial opinion on the adequacy of loss reserves.
Risk retention groups are required to apply for an NAIC company number or code. The form is available at www.naic.org. A certified copy of the state license must be provided in order to obtain the company code. Subsequently, the risk retention group must also file annual and quarterly financial statements with the NAIC and are subject to accreditation standards. Risk retention groups must also file quarterly statements with the states where they are registered and with the domiciliary state. The National Association of Insurance Commissioners establishes the format for the annual and quarterly statements. For property and casualty companies, the annual statement has a yellow cover and is popularly know in the industry as the “Yellow Peril.”
The owners of successful risk retention groups embrace the oversight by the domiciliary state. Attitude as in most endeavors is important in the operation of a risk retention group. Attention to detail and establishment of corporate governance standards will go a long way to ensure the success of a risk retention group. The federal preemption of separate state regulation is a valuable commodity. It will enable a group after it receives a license to have almost instant access to market and be free from the red tape of individual state regulation. It is a privilege that is best employed in a reasonable fashion with careful attention to the filing requirements, fee requirements and tax requirements of each state. This corporate good behavior is a small price to pay for the rights granted by the Liability Risk Retention Act.
Registration Process and Annual Filings / the Non Domiciliary States
After a license is granted by the domiciliary state, the risk retention group must register in all states where it expects to do business. These filings are usually carried out by the risk retention group’s captive manager. The manager handles these filings on forms provided by the states. The forms are filed along with the required filing fees. The filing fees vary from state to state ranging from no fee to several hundred dollars and from just an initial fee to an initial fee and annual fees after that.
After a state filing, the risk retention group will receive a response from the particular state that acknowledges that a group has been registered and reminding the group to pay taxes on the business that is written in that state. If a state objects or raises roadblocks to the operation of the risk retention group in the state, then the risk retention group or its counsel or even the National Risk Retention Association (if requested and if appropriate) will respond to the situation and a decision can be made as to whether to proceed to write business in that state or not. Risk retention groups have been known to ignore individual filing state’s unreasonable mandates and simply write business relying upon the authority of the federal preemption of such state mandates
Overreaching of the non domiciliary states generally takes place in three areas:
1. improper assessment of fees;
2. impermissible requests for informational; and
3. making operation in a state contingent upon regulatory review and approval.
The existence of a significant number of court cases around the country since the enactment of the LRRA demonstrates that several states did not accept the federal preemption readily and saw it as a threat to their desire to have the last say when it comes to providing insurance consumer protection. However, the case law or decisions reached by the judges in those cases from around the country have generally upheld the preemptive nature of the Liability Risk Retention Act.
Only a few states today raise such roadblocks and it is suggested that this area is an evolving situation because some states question the effectiveness of particular domiciliary states regulation. As the NAIC addresses the problem and establish a uniform level of oversight by the various leading captive jurisdictions, this questioning or rather objection by a few states should dissipate. This area is briefly addressed below in the reference to the report of the Government Accountability Office.
The risk retention group in response to a state filing will by and large receive an acceptance of the filing by a letter from the state’s insurance department saying that the state has added the group to the list of groups registered in the state to do business. This letter will then alert the risk retention group to the annual filing requirements and notice requirements of that states insurance laws relating to risk retention groups and that states guaranty funds and point out that the risk retention group must file an annual premium tax return and then disclose the rate of the annual tax. The letter might also point out the states agent’s licensing requirements and that any person, firm, association or corporation who acts in any manner in soliciting, negotiating or procuring liability insurance must hold the appropriate license.
The annual filing requirements for foreign registered risk retention groups consists of the annual statement, statement of actuarial opinion of loss reserves, report of examination, management discussion and analysis, CPA audit report, designees for service of process, plan of operation or feasibility study if there have been changes or amendments from the original. Each risk retention group should address these individual requirements with their own captive manager and counsel.
The Report of the Government Accountability Office
At the request of the chairman of the Committee of Financial Services of the U.S. House of Representatives, the United States Government Accountability Office conducted a study of the regulation of risk retention groups. On August 15, 2005 the Government Accountability Office filed its report consisting of over 100 pages. That report and testimony leading up to it are available through the GAO’s Web site. (www.gao.gov) In short, the report concluded that risk retention groups have had a small but important effect on increasing the availability and affordability of commercial insurance for certain groups. Risk retention groups roughly have accounted for 2 billion or over 1% of all commercial liability insurance. There has been a deluge of risk retention groups formed in recent years and this trend will continue according to the report. Physicians and medical groups are forming risk retention groups at an increasing rate and seem to be forming these groups regardless of the soft or hard market for commercial insurance. Physicians in Pennsylvania in 2003 saw the availability of commercial insurance disappear with the withdrawal of St. Paul Insurance Company so advocates of formation of risk retention groups to physicians are finding receptive ears to the concept that a soft market might be a good time to form a risk retention group so that the physician’s med mal program will be freed from reliance on the unpredictable commercial market.
The overall conclusion of the Government Accountability Office was that common regulatory standards were needed amongst the states and greater protections are needed. According to the report, the LRRA’s partial preemption of state insurance laws has resulted in a regulatory scene characterized by widely divergent state standards. Some states charter risk retention groups as captive insurance companies and captives operate with fewer restrictions than do traditional insurers. The report stated that most risk retention groups are domiciled in six states and those states make no secret of their desire to attract captives to their states as part of an economic development strategy. Most new risk retention groups tend to make their way to a newly emerging state captive domicile. The report suggested that this desire to be a successful captive domicile may result in a captive domicile lessening its regulatory standards.
Additionally, because most risk retention groups are captives, they are not subject to the same uniform baseline standards for solvency regulation as traditional insurers are. State requirements in important areas such as financial reporting also vary. Regulators may have difficulty assessing the financial condition of risk retention groups operating in their state because not all risk retention groups use the same accounting principles.
Because the LRRA does not specify characteristics of ownership or control, or establish governance safeguards, risk retention groups can be operated in ways that do not consistently protect the best interest of their insureds. For example, the LRRA does not explicitly require that the insureds contribute capital to the risk retention group or recognize that outside firms typically manage risk retention groups. Some regulators believe that members without “skin in the game” will have less interest in the success and operation of their risk retention group and that risk retention groups would be chartered for purposes other than self-insurance, such as making profits for entrepreneurs who form and finance a risk retention group.
The distaste regulators display for the entrepreneur who promotes the formation of a risk retention group is somewhat disturbing. It presents a dilemma to promoters of much needed risk retention group. For example physician groups can truly benefit from forming and belonging to a risk retention group but corralling the physicians, because of their busy schedules and their dedication to their medical practices, has been described by one expert “as trying to herd cats on ice.” In most cases, it will take an entrepreneur such as a broker or consultant to the medical profession to orchestrate the formation and management of a physician’s risk retention group. This person cannot be an owner since he will not be an insured. Obviously, that entrepreneur wants to be compensated and also to protect his own position and investment.
The LRRA provides no governance protections to counteract potential conflicts of interests between insureds and management companies. The report suggests that sometimes management companies have promoted their own interest at the expense of the insureds. Risk retention groups the report suggests could benefit by corporate governance standards that would establish the insured’s authority over management. In fact this is an issue that risk retention groups have themselves struggled with so input and even reasonable regulatory guidelines would probably be viewed with favor by the industry.
The report suggests that non- captive domicile states feel that there has been a lessening of regulatory standards in the six states that license risk retention groups. A combination of single state regulation, growth in new domiciles, and wide variance in regulatory practices has increased the potential that risk retention groups would face greater solvency risks. As a result, the Government Accountability Office believes risk retention groups would benefit from uniform, baseline regulatory standards.
The manner in which other states view the regulatory posture of a domiciliary state is important because the insurance departments themselves are subject to examination by the NAIC periodically and must be accredited by the NAIC. If they fail in obtaining accreditation, they could lose their right to license risk retention groups altogether.
WHAT LIES AHEAD
Risk retention groups are a creation of Congress to solve an insurance availability and affordability crises. Since insurance is cyclical, it would appear that risk retention groups will continue to have a purpose. History has demonstrated the popularity of risk retention groups and risk retention groups have been successful in giving commercial insurance consumers control over their insurance costs. To the commercial insurance consumer, a risk retention group has many advantages including:
• Avoidance of multiple state filing and licensing requirements
• Member control over risks and litigation management
• Stable market established for coverage and rates
• Elimination of market residuals
• Exemption from countersignature laws for agents and brokers
• No expense for fronting fees
• Services unbundled
• Access to the reinsurance markets
As well as disadvantages:
• Risks are limited to liability insurance
• Not permitted to write outside business
• No guaranty fund availability for members
• Might not be able to comply with proof of financial responsibility laws
It appears that the regulation of insurance is taking a federal turn. The LRRA creates an attractive formula for a system of dual regulation. Congress passes the law, creates some rules and then passes off the ongoing regulation to the states. Congress is seriously considering expanding the LRRA to allow property insurance to be written in risk retention groups. It would make sense that it would not be expanded if the state system of regulation was in disrepair. The state system is not ready for the junk heap but it does need some repairs. Continuing efforts by the NAIC will ensure that uniform high standards of regulation of risk retention groups will be established to prevent insolvencies. It seems logical that Congress will keep the existing procedure for regulating risk retention groups after some needed adjustments are made. There will be development of more uniform and appropriate regulation of risk retention groups along with standardized accounting requirements. Thereafter, the numbers of well run and well regulated risk retention groups will continue to grow and continue to write a larger and larger percentage of the commercial insurance market.
Individual states will find a happy balance between economic development and sound insurance regulation interests. The efforts of The NAIC will result in providing a surer foundation to support the growth of premium volume brought about through new business in existing groups, the ever increasing formation of new groups and the expansion of product lines of risk retention groups which could then lead to the eventual elimination of the above named disadvantages of risk retention groups. Court cases will ultimately determine where the regulatory power resides. It is an emerging and interesting although complicated field of alternative risk finance and law. It is a subject that a forward thinking college professor or law school professor in the tradition of Professor Dix Noel could easily embrace.
April 6, 2007
Charleston, South Carolina
No comments:
Post a Comment