RRG Boards' Best Practices - Reprinted FRom the Risk Retention Reporter- I would recommend this pubication if you do any work with risk retention groups!

Will The NAIC Guide lines “Crowd Out” RRGs
Board of Directors Best Practices Along With The
Best Independent Directors?
By John J. O’Brien JD, CLU, CPCU
In response to the Enron failure, the Sarbanes-Oxley Act of 2002 (SOX) was
enacted and requires that public companies have independent directors and an
audit committee chaired by an independent director with a financial background.
Enron did have a majority of independent directors and an audit committee
chaired by an independent. The hearings leading up to SOX demonstrated that in
the Enron case, independent directors were expected to be, and were, deferential
and obsequious.
The captive/RRG industry is not accustomed to SOX type board require -
ments. RRGs and captives are usually required to have a resident director and
typically the captive management company supplies this individual. Opinions
differ whether this resident board member is independent.
Three of the captives/RRGs in which I serve as an independent director have
audit committees. I serve on all three audit committees and chair two. Creating
these committees were choices made by the boards and the operation of the
committees mirrors both SOX and best practices. The committees are seen as an
important part of the corporate financial oversight, and members are expected to
be diligent.
The RRG industry, as it matures, is embracing corporate governance best
practices, such as the best practices developed by the Captive Insurance
Companies Association. A series of quarterly articles in the Risk Retention
Reporter, beginning in January of 2008, written by RRG experts, describe best
practices in action within the industry and also trace the progress of the NAIC
proposed guide lines that seek to introduce Sox like laws to the RRG industry.
In any financial industry there are “good actors” and “bad actors.” New laws
do not “crowd out” the “bad actors.” Many learned experts have demon strated
that crooks will always find new ways to circumvent new rules.
This article explores the possi bility that the NAIC guide lines as law will
“crowd out” self imposed best boards of directors’ practices and the best
independent director candidates—“good actors.” The concepts of “crowding in”
and “crowding out” are explored in detail in an article “Corporate Gover nance
for Crooks? The Case for Corporate Virtue” by Margit Osterloh and Bruno S.
Frey that appears in Corporate Gover nance and Firm Organization, edited by Anna
Grandori (Oxford University Press, 2004). Studies cited in the article explore
corporate environ ments and how individuals are self-motivated to improve and
to contribute to the success of an organization. These “good actors” like to see
themselves as devel oping plans and initi ating action to fulfill those plans.
In the case of good independent directors, my experience has been that they
want to make a signif icant and creative contri bution towards good corporate
gover nance and are willing to take the lead in providing leadership towards that
goal. If they, and their team members, are allowed to operate in an environment
where they are not being told what they have to do, “crowding in” of
self-motivation for good corporate gover nance flour ishes. These “good actors” are
not motivated by extrinsic influences, such as compensation, because they
recognize that unreasonable compensation would “crowd out” their intrinsic
motivation. Unrea sonably high compensation fosters deferential and obsequious
independent directors. An involved independent director structures his fee so that
he never finds himself in the position where his fee comes between him and his
motivation to do what is right. Good actors come equipped with an intrinsic desire to do what is fit and proper. RRGs should always look for team members who bring creativity combined with an intrinsic desire to do what is fit and proper. “Good actors” are motivated by their desire to serve, to make a serious and creative contribution to an organization, and to experience a sense of appreciation that is more valuable to them than monetary compensation. The most important conditions for “crowding in” to occur are the need for autonomy (the experience of seeing oneself as a causal agent), competence (controlling outcomes and efficiency and experiencing positive feedback), and social relatedness.

My observation is that “crowding in” is the growing environment in our
industry and “good actors” are leading the way. Laws that require good corpora -
tions to do what they would want to do anyway and impose high transactional
costs for compliance and expensive monetary penalties for non-compliance will
seriously harm this “crowding in” best practices environment.

It has been said that finding a well qualified independent director for a RRG
is a challenge. I always question how extensive and how recent the searches
were. RRGs have moved away from entre pre neurial entities that tended not to
seek out independents toward true owner/insured groups that recruit
independent directors who know insurance. We find this with the growing
number of physician RRGs where doctor insured/owner board members value
the partic i pation of someone who under stands concepts like adverse selection,
finite reinsurance, and tail coverage. There are qualified insurance profes sionals
who welcome the oppor tunity to serve on these boards. The best captive
management companies and the best captive insurance attorneys are advising
RRGs to recruit independent directors who are not affil iated with any service
provider.

As now proposed, the NAIC guide lines in parts provide:
· A majority of the board must con sist of independent directors.
· Any service provider contract must be approved by a majority of the independent
directors.
· There must be an audit committee composed of independent directors. One duty of
the audit committee is to assist the board with legal and regulatory compliance. The
audit committee requirement can be waived by the regulator if impractical.
· The board is required to establish a written charter in its by laws that in part would include a set of governance standards.
· The governance standards adopted by the board are re quired to provide for direc -
tors’ responsibilities, orientation, and continuing education.
· The board must adopt business ethic standards that include requirements for pro -
tection of the risk retention group’s assets, compliance with the law, and report ing of any non compliance (whistle blowing).
· The domestic regulator may take action against any director who violates these
standards.
Paradoxically, the proposed NAIC rules would permit remuneration to an
independent director that any “good actor” independent director would avoid.
An independent director would not be considered to have a “material
relationship” if he received up to 5% of gross premium and 2% of surplus of the
RRG. This could be a substantial amount with some RRGs. Any “good actor”
independent director would question his own independence if he were to receive
compen sation outside of his director fees and expenses. No personal financial
consid er ation, whatsoever, should stand in the path of an independent director
who finds cause to make a noisy exit from a board.
All good RRG independent directors are aware of the duties, responsibilities,
and liabilities they have under the Model Business Corporation Act. They will
not fail to notice that these new NAIC guide lines create for them additional
responsibilities to a state’s insurance regulator.
With the new NAIC guide lines, the intrinsically motivated “good actor”
potential independent director will be aware that he is being asked to join the
team because the RRG must fill three government mandated slots, that he will be
responsible for developing governance and ethical standards—including whistle
blowing, that he will be required to undergo orientation and continuing
education, and that he is now subject to action by the state insurance commis -
sioner for any violation of these standards. He should under stand that he is
being offered the position because the RRG did not have a choice. He will most
likely conclude that this is not the type of environment that nurtures his best
performance. This will alert him that he is being asked to enter an environment
where the professional “joy” he seeks in being a member of a dedicated team is
not likely to be experienced.

If compensation should be based upon degree of responsibility, then
arguments will be made by those who seek the position of independent director,
motivated by remuneration, that the amount of compensation should be
substantial. The transactional costs for compliance and board operation by most
RRGs will increase. Increased compensation and rules that tend to make an
independent director a pawn of the domestic regulator are conditions that will
conflict with the intrinsic motivation of the “good actor” independent director.
With the possi bility that a vacuum will be created by “good actor”
independent directors declining invitations to join RRG boards, I suggest that
there is a likelihood that the vacuum will be filled by independent directors who
are more focused on compensation and personal exposure issues— “will you
indemnify me in the event of personal liability?”.
My final suggestion is that rather than enacting laws that evidence indicates
could “crowd out” growing best practices, our industry will be improved instead
by nurturing the “crowding in” of current best practices trends, including the
trend of RRGs to volun tarily seek out fit and proper “good actors” as
independent directors.